Until now, Israel deemed foreign professional corporations to be controlled and managed from Israel even if they aren’t, making them resident and taxable in Israel.
On December 23, 2013 the Knesset made changes to the Israel’s tax regime for offshore companies by passing Amendment 198 to the Income Tax Ordinance, effective January 1, 2014. These changes affect controlled foreign corporations (CFCs) and foreign professional corporations (FPCs).
Controlled foreign corporations
In the case of CFCs, the changes are fairly minor. A CFC is basically a lowly taxed investment corporation. Israeli residents are taxed on deemed dividends received from a CFC if they hold 10 percent or more of the CFC. A foreign corporation (or any other body of persons) is considered to be a CFC if all of the following conditions exist: First, the CFC primarily derives passive income or profits that are taxed at a rate of 15% or less abroad. Previously the threshold was 20% tax.
Second, the CFC’s shares are not publicly traded, or less than 30% of its shares or other rights have been issued to the public or listed for trading. Previously it was enough if the 30% was offered to the public.
Third (unchanged), Israeli residents own either directly or indirectly more than 50% of the CFC, or an Israeli resident owns over 40% of the CFC and together with a relative owns more than 50% of the company, or an Israeli resident has veto rights with respect to material management decisions, including decisions regarding the distribution of dividends or liquidation.
Foreign professional corporations
In the case of FPCs, the changes in Amendment 198 are broader. An FPC is basically a high- or low-taxed foreign service corporation. As services are invisible, the Israel Tax Authority (ITA ) thinks the services don’t always exist.
Until now, Israel deemed FPCs to be controlled and managed from Israel even if they aren’t, making them resident and taxable in Israel.
However, it was generally accepted that Israel’s tax treaties don’t allow Israel to deem FPCs to be resident if they aren’t. So now the amendment makes Israeli residents liable to Israeli corporation tax on deemed dividends from FPCs if they are major shareholders with a 10% interest or more.
A corporation is considered to be an FPC if it meets all of the following conditions: it has five or fewer individual shareholders; it is owned 75% or more by Israeli residents; most of its 10%-or-more shareholders conduct a “special profession” for the FPC; most of its income or profits are derived from a special profession. The special professions include engineering, management, technical advice, financial advice, agency, law and medicine, among others.
Israeli tax is calculated at three stages: (1) deemed dividend from the FPC to a major shareholder; (2) actual dividend from an FPC to a major shareholder; (3) from a major shareholder if it is an Israeli company to its shareholders.
There are many things wrong with the new FPC rules.
First, low tax is NOT a criterion; Israel taxes FPCs in high-tax countries too.
Second, Israel’s tax treaties only allow Israel to tax the profits of foreign corporations that have a “permanent establishment” (fixed place of business) in Israel; most don’t.
Third, it seems that Israeli resident shareholders will pay corporation tax on FPC profits even if they are individuals and not corporations.
Fourth, the Israeli tax calculations are incredibly complex.
But apparently they may be advantageous to the taxpayer in certain cases.
Control and management in Israel
If any foreign corporation is controlled and managed from Israel, it may be deemed resident and taxable in Israel.
This principle is unaffected by Amendment 198.
By coincidence, an important verdict in this area was handed down by Judge Altuviah Magen in the Tel Aviv District Court on December 26. In the Yanko Weiss case, an Israeli company migrated to Belgium shortly before realizing a large capital gain. The taxpayer claimed to be exempt from Israeli tax under the Belgium-Israel tax treaty.
The ITA contended the company remained controlled and managed in Israel and was therefore taxable on the capital gain.
The court sided with the ITA because the whole situation was strange. In particular, the local Belgian directors each earned a mere 250 euros per month, which the court felt, on the face of it, was insufficient to support the claim that those directors really exercised control and management over the company’s business.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.