On February 3, 2015, the Israeli Supreme Court in Damary and Hirshzon et al v. Tax Assessor Rehovot and Kfar Saba handed down a ground-breaking decision. The Court considered the question of whether the appellants who returned the full amount of money they stole and were subsequently charged income tax on these monies may be entitled to a tax deduction in respect of the money returned against the stolen money even though the money was returned several years after it was stolen. The traditional rule and approach pursuant to the Israeli Income Tax Ordinance, 1961 ("the Ordinance") is that tax deductions and losses cannot be carried backwards and may only be deducted in the year they occur or carried forward as losses against future income. The Court in this decision adopted a different approach and thus set a remarkable precedent.
By way of background, the appellants had both stolen money in the past from each of their employers over a number of years. They had held on to the stolen money for a few years but had subsequently returned the full amount of the stolen funds within the framework of other civil and criminal proceedings arising out of the theft of these funds (both were convicted and sentenced to imprisonment and ordered to pay a fine).
Upon the appellants returning the full amount of the stolen funds, the tax assessor determined that, pursuant to the Ordinance, the appellants were required to pay income tax on these funds in respect of the tax years in which the funds were stolen and that they were not entitled to any tax deduction or set off of the tax loss in returning the stolen money in the subsequent years notwithstanding that they had returned the funds. As the appellants did not receive any income in the year they returned the stolen money and in the subsequent years such approach resulted in the appellants paying taxes on that money even though they had returned the stolen funds. Under the Ordinance, a taxpayer may make a claim for a tax deduction in respect of income earned during that fiscal year or subsequent years and not with respect to income received in previous years. Since the stolen funds were not returned during the years in which the theft was committed, but in a subsequent year, allowing such a deduction would result in permitting a retroactive set off of the tax loss, which according to the tax assessor would not satisfy the requirements of the Ordinance. The appellants then appealed.
At first instance, the District Court agreed with the tax assessor's decision and the appellants appealed again to the Supreme Court. On appeal, the Court unanimously agreed that the stolen money should be classified as income in accordance with the Ordinance as the appellants had held onto it for a substantial period of time and had used it as their own. In addition, unlike the case of a fine (which is not tax deductible), the return of the full amount of the funds was made within the framework of previous civil proceedings and not as a result of penal sanction. Therefore, stated the Court, there is nothing per se preventing it from being eligible for a tax deduction.
Since the money was returned several years after it was stolen, the Court was required to address the appellants' claim that it is not equitable that they should have to pay tax on money which was ultimately returned. In this regard, the Court was split (2:1). The majority held that in the interests of justice the appellants are entitled to receive a tax deduction on a portion, in this case half, of the returned funds. It explained that the principle of taxing a taxpayer based on his actual income as well as the need to provide an incentive to return the stolen funds supports the finding that the appellants should be allowed to deduct the loss from the returned stolen funds but that it should be limited to half of the stolen money in light of the circumstances. Deducting such an amount reflects the fact that the appellants held onto the money for a few years, on the one hand, yet returned them, on the other hand. The minority, however, held that such a finding contradicts the provisions of the Ordinance, which allow for deduction of a loss to be made only in the year in which the loss occurred or in a subsequent year, and not retroactively.
This decision is a controversial and precedential one as in the interests of justice the Court ruled that the losses may be carried backwards, notwithstanding the provisions of the Ordinance. Already at this stage the Israeli Tax Authority has taken steps to appeal the decision by way of a further hearing. In Israel, a decision to hold a further hearing is made, among other things, where the importance or novelty of a ruling made by the Supreme Court justifies such a further hearing. On assessment, on the one hand, allowing a retroactive deduction may be seen as an important step. It has the effect of charging the taxpayer based on his actual income. On the other hand, it does not seem to sit well with the wording of the Ordinance and appears to be quite a novel ruling in light of its unique circumstances. Stay tuned for any developments.