Tax Alert No. 26 - 3.7.2017

International taxation - Change in Israel Tax Authority’s position - taxation of foreign income in the hands of a returning resident - shall be taxed on a cash basis

On December 2016, a non-consensual tax-ruling No. 2873/16 was published, dealing in taxation of income produced when the individual was a foreign resident and received when he became an Israeli resident again.

The individual was a resident of Israel until 2006 and worked as an employee in a series of senior positions in an Israeli company.
During this year, the individual and his family (including minor children) relocated to the USA and the individual began working in an American related company. From the time of relocation, the individual and his wife are considered US residents for tax purposes, and file their returns accordingly.
On January 2011 the individual was offered a senior position in an Israeli company. Hence, the individual left his job in the US and returned to Israel on his own (his wife and children remained in the US) in order to work for the Israeli company. The individual rented an apartment in Israel, in which he lived until September 2012, when he moved to an apartment he bought in May 2011.
Over 2011-2012, the individual received income from salary differences, redemption of vacation days, and additional accompanying income from the American company (“the Compensation”) with respect to his period of employment in the USA.
It was decided that the individual shall be considered a foreign resident from January 2007 until December 2010 and from the day of his return shall be considered an Israeli resident and be entitled to the benefits of a “regular returning resident”.
It was further decided that based on the Israeli tax laws, employees shall report their income on a cash basis i.e., on the date of actual receiving the income. Since the individual received compensation at the time he was an Israeli resident (according to the Tax Authority’s approach), it has been determined that this compensation is taxable as Salary income!
By this decision, the Tax Authority has overturned its decision No. 22/2006 from June 2006 which determined an identical issue of receipt of compensation from a former employer abroad by a person who had just become an Israeli resident.

In a decision from 2006 it was determined that if an applicant shall prove that the compensation was given with respect to his period of work abroad, before becoming and Israeli resident, the applicant will not be taxed in Israel for the compensation received.

In our opinion, as interpreted by the Tax Authority in similar cases in the past, and to the extent that this is a published position of the Tax Authority (followed by many taxpayers) it is appropriate that the change in position apply from the day it’s issued and onward and not retroactively.

International taxation - Agency, implied trust, and implied partnership

On December 2016 the Tel Aviv – Yafo District Court (tax appeal 25689-02-13) gave a ruling on the matter of Roni Lerner (“the Appellant”) with regard to classification of relations between a foreign company and its registered shareholders, whether as a trust or as formal relations between a company and its owners. Within this ruling lie interesting issues, which could be relevant as far as many common investment structures are concerned.
The details of the case are somewhat complex, and are detailed in brief as follows: Several shareholders incorporated through a company incorporated for this purpose (referred to as an SPC – Special Purpose Company) i.e., holding shares in the main company which had business activity and was subsequently issued to the public (“the Company”). The Appellant held shares in the SPC through another foreign company owned by him (we shall note briefly that it was agreed that the other foreign company served as a trustee for him).
A procedure was conducted between the shareholders and the Tax Authority for receipt of preliminary approval, determining that transfer [by the SPC] of Company shares to shareholders shall constitute sale; however, remuneration and taxation will be deferred until the actual sale of the said shares. The details of the agreement are not too clear from the ruling, since, if indeed this is sale then the tax event is determined on the SPC level, and the very distribution of the asset to the final shareholder may constitute a dividend in his hands. Thus, in the assessment issued by the income tax assessor to the Appellant, it was determined that the very transfer of company shares to his possession does indeed constitute a dividend (it appears that this assessment contradicts the principles of the preliminary approval but we will not discuss this issue).

The court was required to classify the relations between the shareholders and the SPC for the purpose of analyzing the tax events involved with the transfer of shares. In the final analysis, the court has determined that this is a trust in which Company shares are held for the shareholders, while the SPC and its formal manager serve as a trustee for it. This, despite the fact that the preliminary approval received from the Tax Authority with consent of the shareholders, including the Appellant, referred to the SPC as a company for all intents and purposes.

The ruling determines or repeats several principles on this matter, for example:

  • That the formal substance of relations shall not affect the classification for tax purposes, which follows the economic substance of the transaction or engagement, even if an agreement is made with the Tax Authority indicating a different substance of relations; and in the words of the court:
    “These shareholders may have considerations of their own for acting as they have acted, and they may have acted out of caution”;
  • That an arrangement according to which an SPC is established for the purpose of common, passive holding of shares, serving as a conduit only for the shareholders, constitutes an implied trust arrangement, in accordance with the parties’ intention of actually engaging in this type of agreement; it should be noted that the existence and meaning of “implied trust” involves tax advantages or risks.
  • That the very fact that the appellant reported his holdings in SPC shares (apparently as part of Form 150 – a form in which Israeli residents are required to report holdings in a foreign resident company) and not in Company shares, does not disprove the claim that the SPC constitutes a trust for holding Company shares;

The ruling also notes that trust agreements (fiduciary agreements) between the parties have been signed at different times. According to our understanding, this type of relationship usually shelters under an agency type rather than a trust type of arrangement, although at times only a thin line separates trust arrangements from agency arrangements. The taxation aspects of the two types of arrangements will not necessarily be different; however, the trust chapter of the Israeli Tax Ordinance does not apply at all to an agency type arrangement; hence, no special reporting obligations are required of the trustee, the settlor or the beneficiary, according to the matter.
In light of the aforementioned, in those cases in which a particular corporative structure is formed for the purpose of investment in a substantive company, the substance of the relations and agreements should be examined. It may very well be that it is a trust or agency type of arrangement, despite the formal guise given it. It should be noted that the distinction is important in light of the possibility of certain gaps between the two approaches, implications on the matter of crediting foreign taxes, and implications with regard to control and management when the agent is a foreign corporation.

International taxation - Issues in attributing income of a foreign company to Israel

On October 2016 taxation ruling 6631/16 was published, dealing with determining the existence of a permanent establishment for a foreign company and attributing income to Israel.
Facts and details: A foreign company that is not a resident of a treaty country (“the Company”) deals among other things in providing international money transfer services, for the purpose of which the Company has engaged with a non-related foreign clearing company, resident of a treaty country (“the Clearing Company”), as well as currency service providers serving as subcontractors around the world.
In conducting their regular business, the above provide money transfer services, in effect constituting “end points” the final customer reaches when interested in transferring money from one end point to another. The Company conducts an elaborate operation of activity in connection with the clearing services which includes conducting business vis-a-vis the clearing company, operating supporting IT systems and a customer service system, and making decisions pertaining to the end points and other various actions. All of the aforementioned actions are performed outside of Israel by the Company’s foreign employees.
Due to regulatory requirements connected with the clearing activity in Israel, the Company has established an Israeli subsidiary (“the Israeli Company”) whose job it is to oversee compliance with regulatory requirements and other actions the nature of which is, apparently, auxiliary to the Company’s core activity.
Fund transfers are performed from one end point (in Israel, for example) to another end point in the destination country, through a chain of factors: the end point, the Company (through its bank account in Israel), the clearing company, an agent of the clearing company in the destination country and the end point in the destination country. All of the above receive a part of the fee paid by the customer for the transfer. In effect, the Company’s only income is the part of the fee remaining in its hands.
The taxation ruling determines that part of the Company’s income should be seen as if generated in Israel, both due to its activity in Israel through the Israeli company and the existence of end points in Israel. However, it is not a treaty country; if this were the case it could be claimed that the end points acting over the course of their regular business constitute in effect an “independent agent” as its meaning in the tax treaties, and therefore no Permanent Establishment has been established in Israel. It would subsequently be claimed that the activity of the Israeli company is only auxiliary to that of the Company, and nor does this type of activity establish a Permanent Establishment for the Company. In our opinion, even when not in a treaty country, it would still be appropriate to attribute less weight, if at all, to the role of the end points and the Israeli company.
Later on, the taxation ruling determines that the profit attributed to Israel will be determined according to the ratio of expenses made in Israel and total Company expenses with respect to activity in Israel (including expenses of purchases made abroad).
In our opinion it should first be clarified (and this matter is not clear from the taxation ruling) whether these expenses made in Israel also include the fee charged by the end points in Israel. Our position on this matter is that these are not Company expenses at all, since from the accounting standpoint it appears that its income includes only the fee to which it is entitled and not the total fee paid by the end customer after deduction of the fees charged by the other factors in the chain as stated above. If the intention is to include these fees as expenses of the Company, then the rest of the fees charged by the other factors in the chain are considered mainly as expenses outside of Israel.

Company expenses apparently include operation costs due to the activity of the Company described above, and the costs of the Israeli company. In light of the aforementioned circumstances, it would definitely be appropriate to attribute less weight to Company expenses made by its employees outside of Israel as opposed to expenses of the Israeli company, since the nature of actions performed by the Company outside of Israel is substantive and of a higher contribution compared to the nature of actions performed by the Israeli company. Generally speaking, it may be that the income attributed to Israel, if at all, should be calculated only according to the “Cost Plus” method derived from the expenses of the Israeli company; again, due to the purely auxiliary nature of the activity performed by it (it may be that the stated method was determined simultaneously with determining the taxable income of the Israeli company).

In addition, the mechanism determined for attributing the profit to Israel does not take into account other Company assets that contribute to its profit generation, including intangible assets (reputation, know-how, designated software, etc.) nor does it take into account the element of risk to which the Company is exposed as opposed to the supposedly risk-free activity performed by the Israeli company, and perhaps the method of profit attribution determined as stated simultaneously assumes attribution of this intellectual property and risks to Israel.

International taxation - Taxation of debit balances, owner’s withdrawal and shareholder’s use of company assets

As part of the economic reorganization law for budget year 2017-2018 (“The Law”), a provision has been added to the Income Tax Ordinance for the purpose of preventing substantial shareholders (or their relatives) from withdrawing profits from the Company without taxation, beyond payment of corporate tax. All this while making private withdrawals under the guise of loans which in the final analysis are “rolled over” and are not repaid to the Company or, alternately, enjoying personal use of assets purchased with Company surpluses. On this matter:
COMPANY: Including a foreign company owned by Israeli shareholders, and an Israeli company owned by foreign shareholders.
WITHDRAWAL FROM COMPANY: Withdrawal of funds or putting an “asset” (apartment,works of art or jewelry, boats or aircraft, and other assets determined by the minister of finance with approval of the finance committee) up for the private use of substantial shareholders or their relatives.
WITHDRAWAL OF FUNDS: By substantial shareholders or their relatives, including cash, securities, loans or any guarantee or collateral the company has put up for it, provided that it is in excess of ILS 100,000.
BILLING DATE for withdrawal of funds will be at the end of the year following the withdrawal; for personal use of company assets, at the end of the first year of use and at the end of each following year until the date on which the asset is returned to company use.
On this date, substantial shareholders will be taxed for ‘withdrawal from company, according to the following hierarchy and order:

  1. If there is profit for distribution in the company, according to the Companies Law, and corresponding to each shareholder’s part in it, as a dividend.
  2. If there is no profit for distribution:
    • If employer-employee relations exist, then as salary.
    • If no employer-employee relations exists, then as income from business / occupation.
    On the matter of inter-company loans, it has been determined that a loan given by one company to another, which is not a “fiscally transparent entity”, for economic purpose shall not be considered a withdrawal.
    Furthermore, anti-planning provisions have been determined with regard to funds/assets returned to the company before the end of the year and re-withdrawn after a certain period of time.

In the amendment to the law, transitional provisions have been determined.

International taxation - Temporary order on distribution of dividends at beneficiary rate and treatment of the matter by the Israel Tax Authority

In December 2016, a law was passed as part of which far-reaching amendments were made on tax matters including amendment and institution of sections in the Income Tax Ordinance dealing with owners’ withdrawals from companies (including use of company assets for shareholders’ own personal benefit) and attribution of “wallet companies” income to the shareholder; furthermore, the director of the Tax Authority is given the option, under certain conditions, to impose a coerced distribution of undistributed company earnings, and more.
Along with the above amendments, a relief was given with regard to distributing a ‘beneficiary’s dividend’ as a temporary order, its principles are as follows:

  • A dividend that the company shall distribute to substantial shareholders over the period 01.01.2017-30.09.2017 will be taxed at a rate of only 25% and no surtax shall apply to it. If the dividend had been distributed in 2017 without the temporary order, a tax of 33% would have applied.
  • The reduced tax rate shall apply to distribution of a dividend deriving from profit accumulated until 31.12.2016.
  • As an anti-planning measure, and so that those substantial shareholders shall not distribute dividends at reduced rates and in the coming years reduce withdrawal of salaries, management fees, etc. from the company, thus reducing taxes paid to the state, it has been decided that for each year during 2017-2019, income received by substantial shareholders (salaries, management fees and other payments) from the company shall not be less than the average sum of such incomes, direct or indirect, during 2015-2016.
  • It will not be possible to offset capital losses as against a dividend distributed as part of this temporary order.

Notes and attention:

  • The temporary order shall apply to any company, including a foreign company.
  • In wake of the legislation on the matter of debit balances, “distribution” of the debit balances should be considered and, in appropriate circumstances, also distribution of apartments used by shareholders as a beneficiary dividend.
  • Revaluation profits do not constitute a source for distribution of a beneficiary’s dividend.
  • The source of profit may also be profit accumulated in companies held by the distributing company, provided that they are actually distributed to the company distributing the beneficiary benefit to the individual by 30.09.2017.
  • One may suffice with accounting entry of the dividend while withholding tax at source and transferring it to the Tax Authority (as opposed to requirement of actual cash distribution).
  • Violation of the average income conditions by one of the shareholder shall not compromise the right of the other shareholders to a beneficiary dividend.
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