Hedging would commonly be regarded as prudent business practice. However, the Israel Tax Authority (ITA) has expressed a view that could jeopardize, or at least complicate some basic hedging tactics.

In a nutshell, the ITA’s stance is the following: No withholding tax for hedging assets – Yes withholding tax for hedging liabilities.

But let’s unpack this a bit.

As is all too common in Israel, the ITA uses its very broad withholding powers to take positions that are debatable under the law, and sometimes not founded in the law altogether. This phenomenon is particularly acute when a payment is being made to a non-Israeli person. There is some ambiguity as to whether “outbounding” payments with no taxable component really need the ITA’s blessing. But Israeli banks, which make thousands of payments and are wary of becoming embroiled in disputes with the ITA, generally insist on a withholding exemption certificate for almost any payment to a non-Israeli resident.

All this means is that if an Israeli company enters into a hedging transaction with a foreign bank, it will often need to seek the ITA’s approval that the payment due under the hedge is not subject to Israeli withholding tax.

So how does the ITA react to such requests?

In 2012, a ruling was published on the subject. The ruling does not give much detail and it certainly does not expose any of the analysis behind its conclusions. What it does say is that payments made to a non-Israeli for “hedging assets” will not be subject to withholding tax, but payments made to “hedge liabilities” will be subject to withholding tax.

It is not at all clear how one determines whether it is hedging a liability or an asset. A company will of course always have both assets and liabilities. If the company enters into a hedge transaction, it may not always be so simple to “color” the transaction as hedging a liability or an asset. In actuality, the entire exercise is often a false start, since the motivation to hedge an asset is really part of an effort to properly balance liabilities.

Even when the nature of the hedge is more straightforward, the implications of the ITA’s approach could be very problematic. For example, consider a company that enters into an interest rate swap with a foreign bank to hedge a loan it took out in Israel. The foreign bank would not be prepared to suffer withholding tax on payments it receives under the swap. That would force the local company to gross up the withholding tax component of the swap, in which case the effectiveness of the hedge may be called into question altogether.

The legal basis for the ITA’s approach is hardly self-evident. A number of strong legal arguments why no withholding tax applies are available, both domestic and treaty based. But it is not at all clear what the analysis generating the ITA’s approach is — at least not at a level sophisticated enough to engage with it in any meaningful way.

It remains to be seen, how the ITA will implement its position when facing a variety of financial instruments and hedging scenarios. But the upshot is that companies in Israel should consider the withholding tax implications of hedging transactions in Israel before entering into them with non-Israeli counterparties to ensure that they are not left with Israeli tax costs when a payment is due. Same goes for the non-Israeli banks acting as counterparties in an a hedging transaction with Israeli companies. These banks may want to introduce safeguards into their hedging transactions to ensure that they do not incur Israeli withholding tax.