On July 19, 2021, the Israeli Government published for public comments a memorandum for the Law for Amendment of the Income Tax Ordinance (Partnership Taxation), 2021 (the "Memorandum"). The purpose of the Memorandum is to update the tax rules applicable to partnerships in Israel. The Memorandum is revolutionary and proposes significant changes in the taxation of partnerships and investment vehicles in Israel. The Memorandum, in its current form, is the most comprehensive and significant amendment made with respect to this matter, and has wide implications.
A. The Main Amendments Proposed in the Memorandum Regarding the Taxation of Partnerships and Investment Funds in General
The main proposed amendments in the Memorandum are set forth below –
1. Determination of the Taxable Income. The calculation of taxable income with respect to the partnership will be made at the level of the partnership. This means that while a partnership will be transparent for Israeli tax purposes, it is still regarded as a separate entity. Accordingly, provisions with respect to distributions from the partnership were also determined, as detailed below.
2. Registration and Reporting Obligations. The Memorandum expands the reporting and registration obligations imposed on partnerships and applies draconian reporting obligations on non-Israeli partnerships. for example, the Memorandum suggests that –
- All partnerships in Israel, whether registered or not (with certain exceptions), will be required to open a tax file with the assessment officer and submit tax returns, as of the commencement of the partnership's activities (or, with respect to existing partnership, as of the date the new legislation comes into effect).
- Foreign partnerships that generate Israeli source income or that at least 50% of its partners are Israeli residents will also be required to register and report as aforesaid. This requirement for foreign partnerships to register and to open a tax file in Israel has far-reaching implications for many investment structures and investment funds. For example, many foreign partnerships that were established by Israeli residents for the purpose of purchasing real estate abroad will now be required to open a tax file in Israel and report their income.
In all the aforesaid cases, the report will be submitted by one of the partners who will be appointed as a Reporting Partner. The tax assessment procedures of the partnership will be conducted at the partnership level. The Memorandum imposes on the Reporting Partner withholding tax obligations with respect to distributions to foreign resident partners.
3. Classification of the Partnership Income. The classification of partnership income as business income or passive income (e.g., interest, dividends or capital gains) will be determined at the level of the partnership, according to the nature of the partnership's activity. This classification will also apply to the partnership income attributed to the partners, regardless of the level of their involvement in the partnership activity. Traded partnerships will be taxed according to the two-stage model, similar to a corporation (i.e., corporate tax at partnership level and tax on distributions at the partners' level).
4. Taxation of the Partnership's Interest/Dividend/Capital Gain. The tax rates that will apply to interest, dividends and capital gains will be determined according to the partnership’s (and not the partner) holding percentage in the underlying investment. For example, interest income is subject to marginal tax rates if paid to an individual who holds at least 10% of the shares of the payor. Interest paid to a partnership by a company in which the partnership holds at least 10% of the share capital, will be subject to marginal tax rate at the partner level (up to 47% with an additional tax surcharge of 3%) instead of a reduced tax rate of 25%, even if such partner beneficially owns less than 10% of the share capital of the payor. Similarly, the tax rate for individual partners on dividend and capital gain in this scenario will be 30% instead of 25% (with an additional tax surcharge of 3%). This rule may have significant implications on many investment funds that have been incorporated as partnerships that invest in foreign subsidiaries. In many instances these partnerships extend loans to the subsidiaries that effectively erode the tax base of the subsidiary’s country of incorporation. The determination that interest on such loans will be subject to tax in Israel at a marginal tax rate, would require these investment structures to be re-examined.
5. Taxation of Interest on a Loan Granted By a Partner to the Partnership. Interest on a loan extended to the partnership by an individual partner would be subject to tax at marginal rates, even if the partner holds less than 10% of the rights in the partnership.
6. Taxation of Distributions from the Partnership. A distribution from the partnership to a partner that exceeds the cost basis of the partner in the partnership (adjusted for partnership profits attributed to such partner), would be subject to tax at a capital gains tax rate. This is also a revolutionary provision. This provision contradicts the law in some foreign countries, in which distribution in excess of the cost basis in the partnership result in a "negative basis" in the partnership and do not necessarily result in recognition of income. Accordingly, this provision may result in double taxation. We recommend to partners in partnerships that have financed distributions with loans (for example, in the case of a refinance at the partnership level in order to facilitate a distribution) to urgently ask advice on the matter.
7. Capital Gains Taxation upon Sale of Rights in a Partnership – the Memorandum suggests to codify the existing case law, a sale of partnership interests is subject to capital gains tax, similar to a sale of shares in a company. This means that the sale of the "external basis in the partnership", adjusted for undistributed profits that were attributed to the selling partner and for losses attributed to such partner, is subject to capital gains tax.
8. Utilizing Partnership's Losses. The ability of the partnership and partners to utilize losses was significantly limited. The main provisions relating to this matter are as follows –
- Limited partners would be allowed to offset the partnership losses attributed to them up to their cost basis in the partnership (in this regard the Memorandum includes provisions for determining the cost basis relevant to loss offsetting).
- Losses incurred by the partner prior to the acquisition of the partnership interest may not offset partnership income attributed to such partner.
9. Issuing New Partnership Interests. The Memorandum clearly states for the first time that, as a general rule, the issuance of a partnership interest to a partner will not constitute a tax event for the other partners. However, as an anti-tax-avoidance measure, the Memorandum provides that such issuance will constitute a tax event to the other partners is the partnership interest were issued to a tax-exempt entity (such as a non-profit organization or a provident fund organization) or to a foreign resident partner, if such tax-exempt entity or foreign resident was issued interests that exceed 10% of the partnership interests during a period of 12 months. In this matter, the Memorandum does not distinguish between foreign partnerships and Israeli partnerships. Thus, for example, an Israeli resident investor in a foreign partnership may find itself liable to tax where the foreign partnership has issued partnership interests to foreign residents.
10. Taxation of Success Fees (Carried Interest). If partnership interests are issued to a partner in exchange for a service provided by such partner to the partnership, such partner’s share in the taxable income of the partnership and in its capital gain shall be regarded as business income. This means that carried interest received by a partner from the partnership will be considered business income that is subject to marginal tax and not as capital gain.
11. Transfer of Property by a Partner to the Partnership. Such transfer shall be subject to capital gains tax, unless it is exempt from tax pursuant to the provisions relating to reorganizations. However, the Memorandum further provides that no exemption would be granted with respect to a transfer of property to the partnership, if the transferring partner received property or cash (excluding cash from distribution of partnership profits) from the partnership during the 7-year period that commences on the day of the transfer of the property.
12. Specific Anti-Planning Provision for Partnerships. The Memorandum includes a very broad anti-planning provision, which gives the Assessing Officer the authority to ignore actions carried on by a partner or partnership if these actions are intended to improperly reduce tax liability. For example, the Assessing Officer may ignore the allocation of partnership interests as determined in the partnership agreement
13. Investments of Partnership in Financial Assets. Rules to determine whether income generated by partnerships that invests in financial assets (such as hedge funds) constitute business income or capital gains shall be promulgated by the Minister of Finance. Under these rules, the Minister of Finance will be able to determine that partner income in respect of such investments will be subject to capital gains tax.
B. Amendments Relating to Investment Funds Operating in Israel
Following an audit by the State Comptroller, the Memorandum proposes the repeal of section 16A of the Income Tax Ordinance [New Version], 1961 (the "Ordinance"), by virtue of which tax rulings have been issued to investment funds to date, and provides an alternative arrangement under legislation. The said tax rulings are issued to funds that have operations in Israel, which may result in a permanent establishment in Israel for the foreign investors of the fund, and guarantee a tax exemption for foreign investors of the fund with respect to capital gains arising from the fund's investments in Israel (and with respect to venture capital investments, also exempting interest and dividends income from Israeli tax), and an exemption from a reporting obligation in Israel solely due to their investment in the fund.
The main aspects of the alternative arrangement proposed in the Memorandum include –
1. Apply the Tax Arrangement to a Venture Capital Fund Only. In contrast to existing practice, in which tax arrangements are granted to venture capital funds, private equity funds and funds of funds, the Memorandum provides relief only for venture capital funds. The Memorandum offers a temporary exemption for foreign investors in other private investment funds with respect to capital gains generated from the realization of an investment that was made as of the date of publication of the law until December 31, 2022. The Memorandum does not refer to all the aspects included in the tax arrangements granted to date by virtue of section 16A of the Ordinance (such as co-investment or measuring the institutional investors' holdings under section 9(2) of the Ordinance at the level of the portfolio investments ). Furthermore, the Memorandum does not authorize the Director of the Tax Authority to grant tax arrangements on the matters that are not covered in the Memorandum, and for which tax arrangements have been provided in the past. Additionally, the Memorandum does not determine transitional provisions regarding the status of the tax arrangements granted so far by virtue of section 16A of the Ordinance.
2. Changing the Existing Conditions for Tax Arrangement Application. The Memorandum proposes to limit the scope of the investment, directly or indirectly, of the general partner or a related party of the general partner in the fund to 4% of investors' commitments (while under the current arrangement, the general partner can invest over 4%, provided that the general partner pays higher tax on the excess part). This provision is in contrast with the demand of fund investors, who typically want the general partners to have as much skin in the game as possible. Another example is a change in the definition of the term "qualifying activity", which was defined in the Memorandum as a manufacturing activity under the definition of "industrial enterprise" in section 51 of the Law for the Encouragement of Capital Investments, 1959, including the establishment of national infrastructure.
3. Taxation of Carried Interest. Carried interest to a partner will be subject to tax at the rates applicable to business income (instead of the IVA arrangement that was customary until now, and set a tax rate ranging from capital gains tax to marginal tax, depending on the amount of money raised from foreign and exempt investors). The share of a foreign resident general partner in the carried interest of a venture capital fund would be subject to tax at a rate of 15%. No similar arrangement has been provided with respect to carried interest from an investment fund other than a venture capital fund.
The draft bill (which includes many other significant changes) is expected to enter into force on January 1, 2022, and will apply to every entity that is registered as a partnership. As stated, this Memorandum is still subject to changes by the Tax Authority and needs to undergo the legislative proceedings in the Knesset.