In Moskovitch v Assessing Officer of Haifa (August 4 2011), the taxpayer was a controlling shareholder of a public company. In 1999 the company ran into financial difficulties and in 2001 it underwent reorganisation proceedings. However, these failed and in 2003 it was put into liquidation. The company accounts showed that the taxpayer's outstanding debt had accumulated over many years as a result of withdrawals (or loans) from the company. The assessing officer grossed up these loans and assessed the tax due thereon as employment income. The assessing officer agreed to tax the outstanding amount, comprised of the principal and those agreed-upon loan provisions that related to linkage differentials and interest.
The appeal raised three questions:
- Did the loans constitute taxable income of the taxpayer?
- When did the loans become includable in income?
- What was the exact amount of the loans?
In answer to the first question, the court held that the loans had been informally written off - the circumstances surrounding the loans proved that the company would not attempt to collect the loans, no collection effort had been made by the liquidator (who explained that the taxpayer had no assets with which to repay the loans and consequently enforcement proceedings would be futile), and the taxpayer himself demonstrated no effort to repay the loans. The court therefore classified the loans as income from the company to the taxpayer.
When considering the second question, the court showed the taxpayer leniency. It agreed that the growth of the loans between 1996 and 1999, the taxpayer's inability to repay the loans in 1999 and the lack of any attempt by the company to enforce repayment of the loans all suggested that the write-off occurred in 1999. It rejected the contention that since the loans were employment income, they had accrued over previous years on which the statute of limitation had run out. Nevertheless, the court decided to regard the loans as having been written off in the year most beneficial to the taxpayer. If this year was after 1999, interest and linkage differentials would continue to accrue until then.
In deciding the third question - the amount of the loans - the court considered the company accounts and rejected the contentions that:
- the interest charged was excessive;
- no linkage differentials and interest should be added to the loans until their inclusion in income;
- a notional fee for a guarantee by the taxpayer of the company's loans should be offset against the loans; and
- payment made by the taxpayer's father and credited to him should reduce the amount of the loans.
It did, however, find that severance pay due to the taxpayer and certain amounts due on insurance policies to the taxpayer which the company seized were to be offset against the loans.
The court was aware that if the loans constituted income, no corresponding deduction would be available to the company, because the statute of limitations had apparently expired with respect to its assessments for the relevant years. It therefore decreed that the tax on the loans be levied as if they were a distributed dividend (taxed at 25%) in order to take into account the company tax levied at the corporate level.
The main lessons for the taxpayer from Moskovitch with respect to income from debt write-offs are that:
- loans received from a controlled company should be repaid gradually and continually in order to avoid classification as income; and
- the controlled company should take action to collect the loans in order to avoid adverse tax consequences.
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]).