We are setting out below an important update regarding proposed legislation in respect of the classification of income as a "Passive Income" by Controlling Shareholders of Controlled Foreign Corporations ("CFC").
 
1. Background
 
The Budget Bill for 2017 – 2018, which was recently approved by the Government, includes far-reaching proposed legislative changes in the field of international taxation, including expanding the definition of "Passive Income" with respect to the taxation of Controlling Shareholders at a CFC. As of the date of this update, the legislation has not yet been enacted.
 
2. Taxation of Controlling Shareholders at CFC Under Existing Law 
 
Under section 75B of the Income Tax Ordinance (new version) 5721-1961 (the "Ordinance"), Controlling Shareholders of a CFC, which have Undistributed Profits, are deemed as if they had received dividends based upon their proportional share of such profits. In this regard, it was determined that "Undistributed Profits" are profits which originated from Passive Income that was generated during the tax year. In addition, one of the conditions set out in the definition of a CFC is that the majority of the corporation's income is Passive Income.
 
The existing definition of the term "Passive Income" does not include income that would have been classified as business income in accordance with Israeli tax law.
 
3. The Proposed Legislation 
 
The proposed legislation introduces a new presumption according to which interest income, income from linkage differentials, royalties and rental income will be considered as Passive Income, even if such income would have been deemed as business income, under the following conditions:

Interest income and income from linkage differentials – The proposed legislation determines that such income will be regarded as Passive Income, even if it is business income, unless such income was received from an unrelated party, and it was proven to the satisfaction of the assessment officer, that it is a business income.

Royalties – it was determined that royalties will be regarded as Passive Income, unless all of the following cumulative conditions are fulfilled: (a) the royalties are received with respect to an asset that was developed directly by the company that receives the royalties; (b) the income was received from an unrelated party; and (c) it was proven to the satisfaction of the assessment officer that the income is business income.

Rental income – rental income will also be regarded as Passive Income, even if such income is business income, unless the income was received with respect to an asset that was leased or that was available for lease, for a cumulative period that is shorter than one year, and it was proven to the satisfaction of the assessment officer that the income is business income.

The significance of broadening the definition of "Passive Income" is that more companies will be regarded as CFCs, and that the component of "Undistributed Profits", in respect of which tax is paid, will inevitably increase.