In computing a capital gain, the Income Tax Ordinance sets down strict rules, as follows:

  • The gain must be split into the inflationary amount and the real gain. The inflationary amount is computed by linking the cost of the asset to the consumer price index (or in some cases, the foreign currency used to purchase the asset) and deducting the nominal cost. The remainder of the gain is the real gain, which effectively is the true enrichment of the seller. The inflationary amount is tax free (although an inflationary amount arising before 1993 is taxed at 10%), while since 2003 the real gain has been subject to a tax of 20% or 25%, depending on the asset sold and the seller.
  • Where the purchase occurred before 2003, the tax is computed on a linear basis in order to tax the pre-2003 return gains at the then-prevailing rates (up to 50% of the real gain).
  • The consideration determinative of the gain is the market value of the sold assets, unless the assessing officer is satisfied that the contractual price was established in good faith and was not influenced by a special relationship of the parties, in which case such price shall govern the transaction.
  • Where shares are sold, a shareholder that owns 10% or more of the shares will pay a tax of 25%, and this rate will also apply to the distributable profits.

Distributable profits are retained profits which occurred as of 1996, as indicated in the company's financial statement, provided that they do not exceed the taxable income for those years minus the tax incurred with respect thereto, dividends distributed therefrom and unused net operating losses while adding exempt income.

In Selman v Tiberias Assessing Officer the Supreme Court considered two aspects of the capital gains computation in a case involving the sale of shares. The first dealt with the determination of the consideration. The court held that where the assessing officer refused to accept the contractual price, the officer must present evidence regarding the market price of the sold assets. Once such evidence has been adduced, the onus is on the taxpayer to establish that the consideration was established in good faith and was not influenced by the parties. No evaluation is necessary if the latter is proven. An adversarial relationship lends weight to the contention that the contractual price should prevail. In the case at hand, the price was set by an accountant appointed by the parties and, to a certain extent, was based on a prior transaction. Hence, the contractual price prevailed.

The court then dealt with the question of whether, in determining the distributable profits, a declared but unpaid dividend was to be deducted therefrom. It held that such a deduction was called for in accordance with accounting principles and in order to accomplish the purpose of the statutory rule. This purpose was to grant relief from tax on profits already taxed at the corporate level in order to avoid onerous taxation at shareholder level. In effect, the case referred to a sale which took place where the distributable profits were taxed at 10% – this stems from an earlier time when this rate equalised the tax treatment of a dividend or a sale with an amount equal to such a dividend retained as undistributed profits.

Today, the equalisation is almost preserved by the rates which apply to corporate earnings (24%) and dividends (20% or 25%). For example, assume a real gain of 200, comprising 100 distributable profits. If distributed, the 100 distributable profits would be subject to a 25% tax (assuming the shareholders held more than 10% of shares). The distributable profits suffered a corporate tax of 24% (31.5),(1) so the combined tax equals 56.5 (31.5 plus 25). which is 43%(2) of the total income (131.5 being the 100 grossed up by 24%). Upon sale of the shares, the gain is taxable at 25% for a tax of 50. In effect, the distributable profits have been subject to the same tax that they would have suffered had they been distributed as dividends (25% on the post-corporate tax income). They were subject to corporate tax of 31.5 plus 25% at shareholder level, for a total of 56.5, of which 25 were paid as a capital gain tax rather than a tax on dividends.

Thus, if declared before the sale, a dividend decreases the distributable profits and falls to be taxed by the seller as a regular dividend. This result was disadvantageous in Selman, where the distributable profit was subject to a low 10% tax. However, it may be advantageous where a purchaser has net operating losses which may offset the dividend (to which it is entitled), which in turn may decrease the purchase price payable out of post-tax earnings.

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]).


(1) The amount of 100 distributable profits is the after-tax amount. In order to reach the pre-tax amount, the 100 should be grossed up at 76%. The grossed-up amount is 131.5 and the difference between the 131.5 (grossed-up amount) and the 100 (net amount) is 31.5 ,which is the tax imposed on the 100 net distributable profits.

(2) 56.5 out of the grossed-up amount of 131.5 is 43%.