Service companies are a common feature of the Israeli fiscal landscape. They serve two main purposes. First, they allow their ultimate owners (ie, shareholders) to draw dividends in lieu of salaries. Dividends are not subject to the substantial national insurance contributions. Usually, the shareholder receives a salary from the company, computed in such a manner as to gain the maximum benefit from the personal credits and progressive rates of the tax system. Since the total company tax and dividend tax is a flat 43% (of which 24% is company tax and 25% is dividend tax on the profit after company tax), the salary takes advantage of progressive rates up to that threshold. The taxpayer even benefits from the flat tax as it is lower than the 45% maximum rate prescribed by the Income Tax Ordinance for ordinary income.

The second purpose of service companies is the accumulation of profits subject merely to the company tax, charged at 24%. Thus, the dividend tax may be deferred while the company invests its retained earnings in income-producing investments.

On October 27 2011 judgment was delivered in the Yamin case, in which a taxpayer set up a company and claimed that it was the recipient of certain 'management fees' paid by another company. The assessing officer argued that the sums paid were paid to the taxpayer and therefore assessed him for tax on them.

When assessing whose income it was, the court agreed with the taxpayer that he had a right to incorporate and to have his business conducted by a corporation, which enjoyed a legal personality of its own. However, the court found that the taxpayer, not his company, was the party entitled to the amounts paid by the other company. The company had nothing to do with the payer while the taxpayer was, for all purposes, its employee. The payments were therefore classed as employment income.

The court pointed out that the taxpayer served as the chairman of the board of directors and chief financial officer of the payer - these are personal services, which a company cannot perform. This holding has led some to believe that the demise of the service company is near. However, this is not so. A service company may provide services for a fee and be remunerated for such services. In Yamin the company never billed for services and never paid its shareholder (the taxpayer) for the services he rendered. It is therefore little wonder that the court refused to regard the company as having been even minimally involved in deriving the income.

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]).