The Delek Hungary court ruling has recently been published. The ruling (and the analysis it raises) is quite fascinating, but without going into the details of all issues raised, we feel it’s important to mention here that ultimately, the court preferred to take the perspective of the objective at the basis of the various legal provisions rather than adhering to the letter of the law. In particular the court focused on the principals behind the provisions of the Income Tax Ordinance on “profits available for distribution” (accumulated profits of a sold Israeli company at the time of its sale, on which there is a tax liability on the part of the seller as if they were distributed to him as dividends on the eve of the sale), on “underlying foreign tax credit” (a tax credit upon corporate tax that a foreign company paid, that an Israeli company holding that foreign company at the time of dividend distribution has a right to) and the combination of the two.
And so, basing it on the principles of “two stage taxation”, it established that given the circumstances of the case, the desired outcome would be for the dividend distribution before sale of a foreign subsidiary to be equivalent as far as taxes are concerned to the sale of a company including its not-yet-distributed surplus, both in order to create neutrality for business decision-making and in order to maintain a similar effective tax burden.
From the point of view of the appellant, there was no tax equivalency between the two alternatives in this particular case due to the fact that the dividend option would have placed an additional tax burden on him – the amount withheld abroad at source at the time of dividend distribution, but why ruin the party? As a result of the ruling, an Israeli company could have its cake and eat it too – it could receive an underlying tax credit and also avoid withholding tax upon dividend distribution.
Although you should not conclude from this ruling that taxation of a portion of the capital gains at the time of sale of a subsidiary is always equivalent to the tax on dividends it distributes, this idea – which is not unreasonable given the ruling – may have other international tax ramifications one way or the other. Here are several examples and some questions to think about:
1. A foreign company selling an Israeli subsidiary (on the assumption that it is not tax exempt at the time of sale), is in fact eligible to benefit from the provisions of the laws of “profits available for distribution”, such that the sum of accumulated profit may be viewed as if it had been distributed as dividends. The principle of equivalency applied in the ruling reinforces our conclusion by which the tax rate on a portion of the capital gains equal to the profits available for distribution, must be equal to withholding rate on dividends as per the relevant tax treaty, even if according to the Tax Ordinance it is considered capital gains!!!
2. In addition to the aforementioned, and on the flip side – could the Tax Authority claim that at the time of sale of an Israeli company’s stocks by a foreign company which is tax exempt (whether by virtue of Israel Tax Ordinance provisions or by virtue of a tax treaty) that the “profits available for distribution” component which is part of the capital gains must still be taxable (rather than granting an exemption in lieu of it) at the same withholding rate that applies to the dividends as per the provisions of the treaty? And this would be for the sake of carrying out tax equivalency…
Although it would be tempting (in the eyes of the observer) to do so, we would like to add that as a rule, provisions of the tax treaty (in our case – withholding taxes on dividends) are not intended to create a tax burden in a place where provisions of the internal law do not allow it.
3. Could we stretch our imagination so far as to claim that implementing tax provisions that apply to capital gains are relevant even in the case of dividends distributed in practice as part of a comprehensive sale deal? For example:
– A foreign company received dividends from an Israeli subsidiary a moment before selling it – can it claim that the sum of the dividends should be viewed as a part of the consideration for the sale? And can it apply to it the exemption that applied to the capital gains?
– A similar question comes up when a new immigrant or returning Israeli resident sells his holdings in a foreign company after the 10 year exemption period, and is forced to distribute the available surplus as dividend prior to sale (for example, if the purchaser does not wish to acquire cash). Could he claim that the dividend is an equivalent substitute to capital gains (the exemption on his portion on a linear basis) that would have been higher had the surplus not been distributed as dividends? This is especially so in the case where the distribution was forced upon him.
– In order to balance things out, could the Tax Authority claim that anyone who ceased being an Israeli resident and after a period of time received dividends from a foreign company that had been under his ownership prior to the cessation of residency before its sale or liquidation, must be taxed? After all, if that same individual had sold the company (with the accumulated surplus) he would have had a tax liability on that portion of capital gains in accordance with the provisions of the exit tax.
Many more such examples exist.
We can safely assume that some of the examples raised above deviate from the interpretive boundaries brought down in the ruling, and it is quite reasonable that the Tax Authority objects to some of them, since the ruling relates only to the combination of the provisions of profits available for distribution and the possibility of obtaining underlying tax credit at the actual time of dividend distribution, for the purpose of avoiding unreasonable effective taxes.
Thus, in the event of the alternative between dividend vs. capital gains (before or after the relevant tax event), make sure to carefully examine how the ruling would apply in the particular case.
Another interesting point in the ruling is the term “tax”, defined in the Tax Ordinance as “… either personal income tax or corporate income tax imposed under this Ordinance (hereafter known as “Israeli Tax”). According to this, logical language dictates that any time the Ordinance refers to the term “tax” it is referring to Israeli tax. Yet in the ruling the court preferred the intentional interpretation and not the literal one, as we described above, and this interpretation may require viewing taxes paid abroad also as “Israeli tax”. This paved the way for defining foreign corporate profits as profits available for distribution for purposes of carrying out provisions of the clause, and in the words of the ruling itself: “… to include in the term ‘tax’ any tax taken into account as part of the overall taxation method… Therefore, foreign taxes, too, although they are not ‘imposed’ by the Ordinance, but are ‘imported’ into the Israeli taxation method by means of granting an exemption at the time of dividend distribution, is considered ‘tax’ for this purpose, and should be seen as such”.
The judge mentions in the ruling that “the legislator is not to be held as one who has created a masterpiece in all that relates to formulation of tax provisions, and especially in international taxation”
We can sum this up as follows: First, we cannot establish categorically that every use of the term “tax” in the Ordinance includes foreign taxes. But neither should we conclude the opposite – that use of the term “tax” always excludes foreign taxes. And so, the question of whether foreign taxes must be taken into account as part of the definition of the term “tax” must be examined based on context and on the purpose of the clause under consideration. Many examples could be found on the ramifications that this ruling could have on the definition of the term “tax” in the Ordinance, and in relevant cases it would be advisable to consult with experts to determine whether foreign taxes can be viewed as “Israeli taxes”. Each case, of course, must be addressed individually.