Despite the legislator's intention, an undesirable phenomenon has emerged in practice,where significant profits are accumulated in companies without beingdistributed as dividends. This phenomenon occurs primarily in personal servicecompanies, including professional service companies and holding companies.These companies exploit the two-stage mechanism for indefinite tax deferral,accumulating profits and investing them in financial assets rather than in realbusiness activity. As a result, there is an estimated loss of revenue to thestate of about 5-6 billion NIS annually.
The Israeli tax system is based on the principle of two-stage taxation forcompanies. In this framework, corporate tax is imposed on company profits inthe first stage, and in the second stage, tax is levied on dividendsdistributed to shareholders. The purpose of this mechanism is to create taxequivalence between individual activity and activity through a company, whileproviding an incentive for companies to invest their profits for growth andbusiness development.
The Problem
Despite the legislator's intention, an undesirable phenomenon has emerged in practice,where significant profits are accumulated in companies without beingdistributed as dividends. This phenomenon occurs primarily in personal servicecompanies, including professional service companies and holding companies.These companies exploit the two-stage mechanism for indefinite tax deferral,accumulating profits and investing them in financial assets rather than in realbusiness activity. As a result, there is an estimated loss of revenue to thestate of about 5-6 billion NIS annually.
International Comparison
The report reviews the approaches adopted in various countries to address the issueof undistributed profits. In the United States, for example, there are two maintaxes: Accumulated Earnings Tax (AET) and Personal Holding Company (PHC) tax.Ireland imposes a special tax on passive income of companies controlled by asmall number of individuals. The Netherlands has a "minimum salary"requirement for substantial shareholders, and Cyprus requires a minimumdividend distribution. Japan imposes a tax on accumulated profits in familycompanies.
The Committee's Recommendation - Formulation of an Integrated Action Model
After examining various alternatives, the committee recommends an integrated actionmodel that includes three main components:
1.Amendment to Section 62a of the Income Tax Ordinance, focusing on professionalservice companies:
a. Expanding the scope of the section toinclude partners in partnerships. This amendment aims to close a loophole thatallowed partners in partnerships (mainly lawyers and accountants) to avoidpaying individual tax rates.
b. Changing the definition of servicesprovided to related companies. It is proposed to narrow the existing exemptiononly to cases where there is a 50% or more holding in the other company,instead of 10% as it is today.
c. Adding a new taxation mechanism forcompanies with a business turnover between 200,000 NIS and 30 million NIS, witha business profitability rate exceeding 25%. Under this framework, asubstantial and active shareholder in such a company will be taxed atindividual tax rates on their share of the company's business profits thatexceed 25% profitability, with a "folding ceiling" mechanism.
The "folding ceiling" mechanism isdesigned to create a balance between fair taxation and maintaining incentivesfor business activity. The mechanism operates so that as the company'sprofitability rate increases, the amount taxed at corporate tax ratesdecreases, and the amount taxed at individual tax rates increases. Thiscontinues until the "ceiling" is fully eroded at a 100% profitabilityrate.
For example, a company with a 25%profitability rate will be taxed at corporate tax rates on all its profits,while a company with a 50% profitability rate will be taxed at corporate taxrates on part of its profits and at individual tax rates on the excess. Acompany with a 100% profitability rate will be taxed at individual tax rates onall its profits. This mechanism ensures that companies with exceptionally highprofitability will not have an incentive to incorporate solely for taxreduction purposes.
This mechanism is designed to identify andtax more accurately professional service companies operating in an incorporatedmanner mainly due to tax outcomes, while allowing companies with mediumprofitability rates to pay corporate tax on part of their taxable income.
2.Enactment of a new section to deal with holding companies:
It is proposed to impose an"interest" tax of 2% annually on accumulated profits above a defined"safety cushion". The safety cushion will be the highest of threeoptions:
a. The average of expenses allowed for taxpurposes in the tax year and the two preceding years.
b. The cost of assets, minus financialassets and investment real estate.
c. 500,000 NIS.
The safety cushion is designed to protectcompanies with real business activity and encourage real investments, whiletaxing profits invested passively. The tax will not apply in a year whereaccumulated profits were eroded by 20% or more.
3.Amendment and simplification of Section 77 of the Income Tax Ordinance:
The amendment is intended to allow the TaxAuthority to conduct a specific process with companies that have high surplusbalances. It is proposed to remove the existing requirements in the section andrecommend new criteria that will serve the Director of the Tax Authority inexercising discretion, such as the extent of external financing in the company,the scope of business activity, and business risks.
The Director's discretion will be subject tolimitations, such as avoiding prohibited distribution under the Companies Law,avoiding harm to the company's creditors, and proportionality in relation tothe company's scope of activity.
Theintegrated model is designed to provide a comprehensive response to thephenomenon of undistributed profits, while adapting to different types ofpersonal service companies. The committee estimates that implementing the modelwill lead to additional revenue of about 5-6 billion NIS annually for thestate, with the majority of this amount (about 98%) coming from the top decileof income in the economy.
Itis important to note that the committee also considered the option of a"preferential dividend campaign" but recommended against this step.The committee believes that such a campaign could distort companies' investmentdecision considerations, create uncertainty in tax policy, and increaseinequality in the economy. Furthermore, such a campaign could reduce thestate's revenue from dividend taxation in the medium and long term.
Analysisof Advantages and Disadvantages of the Integrated Model
The proposed integrated model presents several significant advantages:
1.Comprehensive approach: The model provides a solution for the two main types ofpersonal service companies - professional service companies and holdingcompanies, adapting the solution to the nature of activity of each type ofcompany.
2.Balance between tax collection and investment encouragement: The model seeks tocreate a balance between the need to collect fair taxes and maintainingincentives for real investments in businesses.
3.Flexibility and proportionality: The use of a "safety cushion" andprofitability levels allows for flexibility and proportionality in applyingtaxation, taking into account the business needs of companies.
4.Improvement of tax equivalence: The model promotes the principle of taxequivalence between individual activity and activity through a company.
5.Significant collection potential: It is estimated that the model will lead toadditional revenue of about 5-6 billion NIS annually for the state.
Onthe other hand, several potential challenges and disadvantages can beidentified:
1.Complexity: The integrated model presents a relatively complex tax system,which may make implementation and enforcement difficult.
2.Compliance costs: Companies will need to invest resources in adapting to thenew tax requirements, which could lead to high compliance costs.
3.Concern about tax planning: Despite efforts to prevent it, new loopholes fortax planning may emerge.
4.Impact on business decisions: The model may influence business decision-making,especially regarding corporate structure and profit distribution policy.
5.Implementation challenges: The success of the model depends on the ability ofthe Tax Authority to implement and enforce the new provisions efficiently.
Comparedto the current legal situation in Israel, the proposed model represents a moresignificant and comprehensive change than previous attempts to address theissue of undistributed profits. While previous amendments, such as Amendment235 to the Income Tax Ordinance, focused on specific aspects of the problem,the current model offers a more holistic approach.
Inrelation to the global situation, the proposed model combines elements existingin various countries, adapting them to the Israeli reality. For example,imposing an "interest" tax on accumulated profits is similar inessence to mechanisms existing in the United States and Ireland, while thespecific reference to professional service companies is reminiscent of theDutch approach.
Conclusion
The integrated model proposed in the committee's report on examiningundistributed profits represents a comprehensive attempt to address thephenomenon of profit accumulation in personal service companies. The modeloffers tailored solutions for different types of companies, aiming to balancefair tax collection with maintaining incentives for real investments. Despitethe challenges involved in its implementation, the model offers significantpotential for increasing state revenue and improving tax equivalence in theIsraeli economy.
Successful implementation of the model will require special attention tolegislative details, clear guidelines for taxpayers and the Tax Authority, aswell as ongoing monitoring and evaluation to ensure that the model achieves itsobjectives without creating undesirable distortions in business activity in theeconomy.
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