In November 2020, a court ruling was handed down in the Hosen House Ltd. case (hereinafter: “The Hosen ruling“).

General background

The self-purchase of shares (share buyback) is an economic transaction within the framework of which a company purchases shares that it has issued using retained earnings that are available to it, which is a transaction that has been permitted in Israel according to the legislation of the Companies Law.

On the plain of tax laws, the question arises of whether a self-purchase has an identical tax result to the distribution of a dividend or should the sale of shares within the framework of a self-purchase be related to as if it were a taxable event in respect of which only capital gains tax should be imposed?

The Tax Authority’s position and the position adopted in case law up to the Hosen ruling

In the past, the Tax Authority has published an income tax circular (hereinafter: “The circular“), which mentions the two previous court rulings (the Dan Bronavski and Bar Nir Tamar rulings), which determines across the board and without any connection to a claim of artificiality that, in both of the rulings, a self-purchase triggers dividend income for the remaining shareholders and sometimes also for the outgoing shareholders. According to the approach that was delineated in the Bronavski case (which will be discussed in this newsletter), the transaction is to be classified as a transaction comprising two stages:

• In the first stage, the distribution of a (notional) dividend in an overall amount in accordance with the amount of the purchase for each of the shareholders prior to the purchase in accordance with their relative share, including the seller.

• In the second stage, the remaining shareholders purchase the selling shareholders’ shares from him in the gross amount of the notional dividend (which has been “distributed” to the remaining shareholders.

The Hosen court ruling

This ruling deals with a self-purchase that is not pro-rata and determines that in a self-purchase transaction, only the selling shareholder will be taxed on a capital gain. The result is that there is no taxable event for the remaining shareholders, and they should not be seen as having received a (notional) dividend from the company whereas for the selling (outgoing) shareholder there is no reclassification of a self-purchase transaction from a capital gain to a notional dividend.

The implications of the Hosen ruling

We will present the implications of the Hosen ruling (in which, as mentioned above, the situation of a notional dividend for the remaining shareholders is refuted) for the tax aspects that would apply in accordance with the “Bronavski approach”:

• A self-purchase by an Israeli company that is held by individuals who are foreign residents

No tax event will occur for the remaining shareholders involving a notional dividend and therefore they are not to be charged with tax at a rate of 25% or 30% (for a substantive shareholder) or a lower rate where the issue involves individuals who are residents of a treaty country.

For the selling shareholder, the full amount of the income will be classified as capital gain and not as a notional dividend, even though this might, in certain circumstances, increase the tax rate (according to a linear calculation, due to the fact that until 2003 the capital gain tax rate was taxed at the marginal tax rates up to 50%,) however in other circumstances, an exemption from tax may be granted to foreign residents pursuant to the Israeli Tax Ordinance or pursuant to a treaty.

• A self-purchase by an Israeli company that is held by foreign companies

No tax event involving a notional dividend will apply to the remaining shareholders and therefore they will not be charged with any tax. For the selling shareholder, the non-classification of the income as a notional dividend and leaving the full amount as capital gain may even afford a full exemption of the provisions of the Ordinance are met or pursuant to a treaty.

• A self-purchase by a foreign company that is held by Israeli residents

As mentioned above, no taxable event involving a notional dividend will apply to the remaining shareholders and they will not be charged with tax.

In relation to the selling shareholder:

• Where the seller is an individual: as mentioned above, the classification of the income as capital gain and not as a notional dividend, in certain circumstances, may increase the effective tax rate; however, in other circumstances, a full or partial exemption from tax (on a linear basis) may be granted, if the person in question is a new immigrant or a returning veteran resident, in the appropriate circumstances.

• Where the seller is a company: the classification of the income as capital gain and not as a notional dividend will negate the possibility of receiving an indirect (underlying) tax credit (in contrast to the dividend approach).

To summarize, the ruling reawakens the Tax Authority’s position in a self-purchase event. However, we would mention that this is a ruling by the District Court, it is reasonable to assume that the Tax Authority will appeal to the Supreme Court.

Until there is a final ruling, it is expected that this issue will be the subject of uncertainty and we would recommend that each case be examined in depth and in accordance with the circumstances.

Furthermore, we would mention that on all matters relating to a self-purchase by a foreign company, it is also necessary to examine the relevant company laws in that country that may affect the legal conclusion on the tax issue.