In recent years the Israeli currency - the new Israel shekel - has gained considerable strength against the US dollar. Israeli exporters have been seriously damaged by the flow of 'hot money' to Israeli capital markets in order to exploit the differences in prevailing interest rates.
In an effort to curb the flow of foreign funds into Israel with the purpose of purchasing short-term government bonds and notes, the government recently brought a bill before the Israeli Parliament (Proposed Amendment 186 to the Income Tax Ordinance). If enacted, the bill would abolish the present exemption granted to non-residents with respect to capital gains derived from securities traded on the Israeli Stock Exchange (ie, gains derived from the sale of short-term government bonds and notes). In this context, 'short term' is defined as a term of one year before redemption of the government security.
The proposed bill misses its mark.
Taxation of trading profits
First, profits derived by non-residents from trading in short-term government bonds and notes are generally trading profits. As such, they should be classified as ordinary income.
Most of the 'hot money' flowing into Israel has its source in developed and industrial countries. Israel is a signatory to more than 50 treaties for the prevention of double taxation. This treaty network includes all wealthy nations, with each treaty providing an exemption for trading profits that were not generated by a permanent establishment (eg, an office or dependent agent). The net result is that these trading profits are unrelated to the capital gains exemption granted to non-residents on capital gains derived from gains realised on the Israeli Stock Exchange. Thus, non-residents from treaty countries will continue to be tax exempt as long as their activities reach the degree of a trade and they refrain from establishing a permanent establishment in Israel.
Interestingly, the tax authorities have not attempted to use the ordinary income classification to tax non-treaty non-residents. Perhaps the latter did not appear on the tax radar screen.
Taxation of capital gains
The second problem arises with respect to capital gains derived by non-residents from the realisation of short-term government bonds and notes on the Israeli Stock Exchange. Once again in the case of funds flowing into Israel originating from developed and industrialised nations, the treaties for the prevention of double taxation will again exempt these gains from Israeli taxes, as under these treaties, capital gains are to be taxed exclusively by the country of residence. The lack of an Israeli exemption will not do away with the treaty exemption.
The end result is that removing the present exemption will extend the tax net to reach the trading profits and capital gains of non-residents who reside in countries with which Israel has not entered into a double taxation treaty. These are likely to include foreign tax havens employed by residents of wealthy countries to speculate in Israeli short-term government bonds and notes or to derive capital gains from their realisation.
The proposal would require treaty-exempt non-residents to apply for a tax withholding exemption. At present, such an exemption is not required as any capital gains are statutorily exempt. In short, bureaucrats will gain work, but the government will gain no income from the proposed bill, if indeed it becomes law.
For further information on this topic please contact Amnon Rafael or Shlomi Lazar at A Rafael & Co Law Offices by telephone (+972 3 696 6999), fax (+972 3 696 1444) or email ([email protected] or [email protected]).