“End of Season” Tax Discount

A popular advertising jingle in the US goes “I have an annuity but I need cash now” (put to operatic accompaniment).  In Israel the jingle may go something like “I have a tax exempt approved enterprise but I need cash now”. Then instead of some shady quick cash company, the Israel Tax Authority’s phone number would flash at the bottom of the screen.

Let me explain. If you are a shareholder in an Israeli company, which has generated profits, your dividends may be held hostage, or captured, by the company. This is not because the company necessarily wants to reinvest the money in R&D or future projects – that might be OK. Instead, the company is scared to distribute dividends because the company (not the shareholder!) may be subject to corporate tax for making that distribution. But let’s back up a bit. Why would a dividend cause the company an adverse tax liability and why would that be different now?

To understand this, we need to review a central piece of Israel industrial incentive tax holiday.

The Recapture Tax

As you probably know, Israel heavily incentivizes its industrial and high-tech industries (we love our high-tech).These incentive programs, enshrined under the Israeli Capital Investment Law, allow industrial and high-tech companies a corporate income tax exemption of two to 10 years! But there is a fine print (there always is). The earnings must be retained at the corporate level.

If the earnings are distributed, the corporate income tax that would have applied if the earnings had not been exempted will be reinstated.  This is the so-called recapture tax. Why? Well the idea is to encourage investors not just to start a high-tech company in Israel but to keep generating more companies and projects with the earnings (like I said we love our high-tech). That sounds pretty reasonable, so what went wrong? The answer, to put it succinctly, is that it just didn’t work. Instead of reinvesting the profits in the Israeli business sector as intended, companies put their cash balances in bank deposits, nonindustrial and nonproducing assets, and foreign investments.

So now, Israel sees no tax revenue and no reinvestment — what to do? That is the subject of some debate as we will see. But here is what was done:

The Temporary Tax Relief

The temporary tax relief takes the form of a fire sale on recapture tax applicable to previously exempt earnings.  The tax relief provides up to a 60% discount in the corporate tax otherwise applicable to earnings distributed.  I will say it again: 60% discount!

So for example, if a company that previously benefited from a tax exemption decides to distribute its earnings, and such distribution would have triggered a 25% recapture tax, under the temporary relief provision, the actual tax will now be only 10% (25%-60%*25%).  These are huge figures!

Public Scrutiny

The recapture tax discount has been heavily criticized for undermining the policy behind the Capital Investment Law (that is, to encourage investment in Israeli companies).  Critics maintain that by motivating companies to distribute dividends, the recapture tax relief dissuades companies from reinvesting their earnings in Israel. A somewhat minimal requirement to reinvest in Israel was introduced as a condition to qualify for this relief, in order to provide a partial response to that concern.

The recapture tax discount has also been criticized for favoring companies that didn’t distribute their profits, as compared with companies that made such distributions and companies that have already made an irrevocable election to transition to the new tax incentive program under amendment 68 to the Capital Investment Law, which now in retrospect looks less attractive compared to the old regime combined with the recapture tax discount.

Not to worry though, an opinion published by the Israeli deputy legal adviser to the government also supports the tax advantage to companies benefiting from the recaptured tax relief, noting that there is no civil right to preserve tax legislation.

Finally, the recapture tax relief has been criticized for granting additional tax breaks to big companies that have already benefited from a substantial tax exemption.  This stands in sharp contrast to the tax increases that are expected be imposed on the public in the near future. But one thing at a time, right?

Revenue Raiser

Israeli Ministry of Finance supported the recapture tax discount, claiming that the recapture tax on undistributed earnings resulted in very little government revenue (about $150 million between 2005 and 2012) and that without the recapture tax relief, additional tax increases would have been needed.