On 25 December 2013, the Amendment of the Income Tax Ordinance Law (the “Law”) was published. As part of the Law, significant changes were made to some of the provisions of Section 75B of the Income Tax Ordinance (the “Ordinance”), dealing with the taxation of a controlled foreign corporation (the “CFC”).
The purpose of the provisions of Section 75B of the Ordinance is to prevent a situation in which an Israeli resident redirects their passive income (interest, dividends, royalties, rent and proceeds from the sale of capital assets) earned outside of Israel, to a legal entity that is not an Israeli entity (e.g. a foreign corporation), so that the taxation date of that Israeli resident is deferred to the date on which he actually receives the income. In general, the provisions of Section 75B of the Ordinance determine that the controlling shareholder (10% and above) in a CFC should be considered to have received as a dividend his relative share in such income (Imputed Dividend), and shall be taxed on the income.
The effective date of the new provisions, the key principles of which are detailed below, is 1 January 2014.
- Reduction of the tax rate applicable abroad
Section 75B(a)(1)(c) of the Ordinance determines that one of the conditions for applying the CFC rules to an Israeli resident who is a controlling shareholder in a foreign corporation, is that the tax rate abroad on the passive income of such a company does not exceed 20% (this rate was set in 2003, when the corporate tax rate in Israel was 36%, and corporate tax rates in other countries were also relatively high). In light of the decrease in the corporate tax rate in Israel over the years (in 2014 it was 26.5%), and in parallel to the decrease in corporate tax rates in other countries, the tax rate which constitutes a condition to the application of CFC rules was adjusted to 15%.
The implication of this amendment is that the CFC rules shall not apply to foreign entities where the tax rate imposed on passive income exceeds 15%.
- Revocation of Imputed Credit
The imputed credit was set in Section 75B(c) of the Ordinance, where taxing the controlling shareholder in a CFC, taxes which would have been paid in the foreign country if the dividend was actually distributed, would be recognised as a tax credit for the purposes of Israeli taxation. As part of the amendments made to the Law, Section 75B(c) of the Ordinance was revoked, and with it was revoked the imputed credit, and in its place Section 75(B)(d1) set a mechanism for recognising a credit for foreign tax actually paid (as explained below).
- Amendment of Tax Laws - Applicable to a CFC
Section 5(5)(c) of the Ordinance, applied to CFCs in the past, determined that the “applicable tax laws” with respect to such a company which is a resident of a reciprocating country (a treaty country) are the tax laws in that country and, in the case of a nonreciprocating country, the generally accepted accounting principles in Israel. As part of the Law, Section 5(5)(c) of the Ordinance was revoked and replaced by the following provisions:
- CFC that is a resident of a non-reciprocating country – Section 75B1 of the Ordinance determines that the tax laws of Israel shall be applied to a CFC that is a resident of a nonreciprocating country.
- CFC that is a resident of a reciprocating country – for a CFC that is a resident of a reciprocating country, the tax laws of that country shall be applied (as in the past), but calculation of the CFC’s income, taxable income and profits shall also include the items specified below
(1) A dividend or capital gain, even if exempt from tax or not constituting income pursuant to the tax laws of that country (excluding capital gain as part of a structural change that is by nature deferral of a tax event)
(2) Amounts deducted for tax purposes in that country, which are
not recognised as an expense or
deduction pursuant to the generally accepted accounting principles, as provided in Subsections (a) to (e) below:
- (a) imputed interest
- (b) imputed royalties
- (c) depreciation calculated on a new cost basis, without such cost being paid
- (d) depreciation in excess of the cost actually paid
- (e) additional expenses as determined by the Minister of Finance, with the approval of the Knesset’s Finance Committee
- Company whose shares are publicly traded
Section 75B(a)(1)(a) of the Ordinance determines that a corporation shall not constitute a CFC if:
- its shares are listed for trade on the stock exchange, and in case only part of the company’s shares were offered to the public, shares constituting at least 30% of the company’s shares were offered
- as part of the amendments to the Ordinance, it was determined that the fact that a company’s shares were only
- offered for sale to the public, but were not actually issued to the public or listed for trade, shall not prevent the company from meeting the definition of a CFC
- Indirect holdings in an Entity in a chain of companies
Section 75B(a)(1)(d)(2) of the Ordinance determines the manner of calculating the percentage of indirect holdings in an Entity in a chain of companies. The section dealt with holdings exceeding 50% and holdings below 50%, without addressing holdings at the rate of 50%. Therefore, this section was amended so that it now addresses holdings of 50% or less.
- Amendment of the definitions of “passive income” and “unpaid profits”
Profits from securities – The definition of “passive income” does not include income that, if produced in Israel, would have constituted, pursuant to Israeli tax laws, income from a business or occupation. It could have been argued, in certain cases, that the income of the foreign corporation abroad from the sale of shares is business income. As a result, CFC rules would not apply to such a foreign corporation. As part of the law, Section 75B(a)
(5)(a1) to the Ordinance was added, providing that profits from the sale of securities shall constitute passive income, even when classified as business income, unless the security was held by the foreign corporation for less than one year, and the tax assessor is convinced that it was used by it in a business or occupation.
Income from dividends – Section 75B(a)(12) of the Ordinance determines that the foreign corporation’s dividend income derived from income for which foreign tax was paid at a rate exceeding 15%, shall be excluded from the definition of passive income. The Law determines that income from such dividend shall be excluded, if and to the degree that the percentage of direct or indirect holdings in the dividend paying company is at least 5%, when referring to a company traded on a stock exchange outside Israel, or at least 10% in another company. This amendment was also simultaneously made to the definition of unpaid profits.
- Actual distribution of dividends from the CFC
As part of the amendments made to the Law, Section 75(B)(d) of the Ordinance determines that at the actual time of a dividend payment from the CFC to the controlling shareholder, the amount of the imputed dividend (which was taxed in the past) shall be deducted from the dividend paid. Then it will be adjusted by the rate of increase in the Israeli Consumer Price Index from the end of the tax year in which the imputed dividend is considered to have been received by the controlling shareholder in the CFC, until the date of actual payment (but no more than the actual dividend amount), as long as tax was paid on the imputed dividend.
- Sale of means of control in a CFC
Section 75B(e) of the Ordinance provided in the past that when a controlling shareholder sells their means of control in the CFC, they shall be given tax credit for the tax applicable to the sale, at the amount of the tax paid in the past for the imputed dividend on unpaid profits, which by the date of sale are yet to be distributed as an actual dividend. As part of the Law, the credit was revoked and the foregoing section determined that in selling means of control in a CFC, the amount of the imputed dividend considered as if received by the controlling shareholder shall be deducted from the proceeds. The amount of the imputed dividend shall be deducted from the proceeds under the condition that tax was paid on the holding of the sold means of control, and under the condition that by the date of sale this amount was not distributed as an actual dividend.
- Credit for foreign tax
As previously stated, the imputed credit was cancelled, and in its place Section 75B(d1) set a mechanism for
a credit for the foreign tax actually paid. Preconditions for a foreign tax credit: (1) The controlling shareholder was paid an actual dividend, derived from the profits for which tax was paid as an imputed dividend.
(2) Foreign tax was paid abroad for the distribution of the actual dividend, including by way of a source tax deduction (Foreign Tax Amount).
The foreign tax credit stages for tax imposed on the income of the controlling shareholder in a CFC:
- Foreign tax paid / source deducted abroad shall be first credited against the tax payable on the income of the controlling shareholder produced or accrued outside of Israel during the tax year.
- The net remaining foreign tax credit shall be deducted from the tax due on the income of the controlling shareholder produced or accrued in Israel during the tax year.
- In the case that a foreign tax balance remains, for which no credit was taken, the balance shall be returned to the controlling shareholder at the end of the tax year in which the foreign tax was actually paid.