Late on December 31, 2024, the Knesset passed the controversial “trapped profits” tax amendment. There were dramatic scenes as the prime minister had to leave his hospital bed to vote. But the drama doesn’t end there.
Overview
Commencing in 2025, the amendment makes the following main changes: (1) A 2% surtax on undistributed profits of many companies, including profits earned years ago, (2) up to 50% tax for shareholders on profits made by various professional companies.
The intention is to raise NIS 10 billion in tax revenues at a stroke. A side effect seems to be double taxation at the international level. Olim and returnees may be affected.Below is our first take.
Rationale
The Finance Ministry thinks it is wrong for companies to hoard profits. That way they collect “only” 23% company tax even if the company uses the after-tax profits to build up the business.
Surtax on undistributed profits
Starting in 2025, a 2% surtax will be applicable to excess undistributed profits of closely held companies (with five or fewer shareholders) at the end of the preceding year.
For example, if excess undistributed profits generated over 50 years totaled NIS 100 million at the end of 2024, the surtax in 2025 would be NIS 2m.
Alternatively, 6% of preceding year profits may be distributed as dividends, or 5% in 2025 under transitional rules apparently. If so, 33% tax of that 6% would again be 2% but on all profits not only excess profits.
A third alternative is to distribute more than 50% of the excess profits at the end of the previous year as dividends.
Excess profits are the excess of undistributed profits at the end of the preceding year minus the highest of the following three “cushions”: (1) NIS 750,000, or (2) expenses that year – or average expenses in the three years ending in that year, or (3) total cost of company worldwide assets minus shareholders capital or premium, loans from related parties and “special” assets.
A fourth cushion relates to unlinked no-interest loans made up to the end of 2024.
Special assets are essentially passive assets and include: securities, financial assets, intangible assets generating mainly royalties, real estate not for own use nor entitled to rental benefits, and bonds unless for certain regulatory reasons.
The surtax may not be imposed in years where losses exceed 10% of prior year profits.
Exempt profits include: preferred enterprise income, Israeli industrial enterprise income, income from construction projects lasting over a year, and financial institution income. Detailed rules apply in this regard.
Transitional rules are available for companies liquidated in 2025 – whereby distributions in kind of company assets to shareholders may result in only 0%-10% tax now.
But the tax saving is only deferred until an actual sale of such assets.
For example, an office property is distributed by a company in liquidation to its shareholders in 2025 and sold by them in 2030.
Most Israeli taxes may be deferred until 2030, but there is no corporate limited liability for the shareholders should there be a lawsuit regarding the building. Is the tax deferral worth the hassle?
Professional partnerships
In Israel, most professional firms (lawyers, accountants, etc.) are organized as partnerships, where the partners each hold their partnership interest via their own closely held company.
Until now, this structure resulted in 23% company tax on undistributed profits of those companies, instead of around 48.41% tax on distributed profits or up to 50% tax on employment or freelance income.
Israel already has rules that treat income from officer-, management- or employment-type activities provided via a company to be salary or freelance income of the shareholders.
This means such income is reallocated from the company to the shareholder and taxed at rates generally up to 50%.
Up to 2024, these rules did not apply to partners (or 10% of corporate shareholders). Starting in 2025, these rules apply to partners too.
The definition of employment-type activities has been tightened up to include cases where one customer accounts for 70% of income or taxable income over 22 months (previously 30 months).
Labor-intensive companies
In addition to the above, starting in 2025, labor-intensive activities of a closely held company may be treated as freelance income of its 30%-or-more shareholder(s).
This means such income is reallocated from the company to the shareholder and taxed at rates generally up to 50%.
Labor-intensive income is basically active income, rather than: non-business income from interest, dividends, rent, sales of asset sales or securities, or real estate in Israel and abroad.
There are exclusions from these rules for preferred and privileged enterprises (i.e. most hi-tech in Israel) as well as foreign professional companies and controlled foreign companies (all as defined).
Certain hurdles apparently apply to the labor-intensive income: (1) Below NIS 30m. that year (we wonder why), and (2) excess profits over 25% of revenues.
The rules are poorly drafted, but it appears that if the closely held company is entitled to at least 10% of the income of a partnership, 75% of its share of excess profits may taxed as freelance income, if accumulated profits of the company exceed NIS 750,000. We await clarification in this regard.
If the closely held company is entitled to less than 10% of the income of a partnership, 55% of its share of income may be taxed as freelance income.
Also, 55% of dividends paid (by whom?) to the closely held company are treated as freelance income if some or all of its income is earned income.
Expenses should be allocated specifically where possible, otherwise pro rata to types of income.
Payments to related companies may be deductible if improper tax reduction isn’t a motive. Other detailed rules also apply.
Immigrants
New residents and senior returning residents who lived abroad for 10 years) are exempt from Israeli tax on foreign source income and gains for 10 years. But does the amendment change that?
For example, Abe migrated to Israel in 2024 and spends 365 days in Israel in 2025. Abe owns and runs a profitable UK distribution company with 1,000 employees, all in Britain.
Is the UK company out of the Israeli tax net? Or could the new legislation make him taxable on all the UK company’s profits as if they are freelance profits he “earned” in Israel?
Can the Israel Tax Authority deem him to be a taxable permanent establishment (branch) of the UK company under the Israel-UK tax treaty? The new law is silent on this.
Let’s hope the Israel Tax Authority clarifies the issue urgently, it applies to virtually all olim with business interests in any country (except possibly the US?)
In the meantime, a transfer pricing study should be prepared showing the arm’s length profit derived by employees outside Israel.
At the international level
A Finance Ministry public webinar on January 1 revealed that the trapped profits amendment overlooks international issues. Only Israeli residents are subject to the new amendment and hi-tech is largely excluded.
But Israeli resident shareholders in foreign companies in Israel may not get a foreign tax credit in Israel for tax paid at the corporate level abroad. Result: double tax.
If the foreign company is American, this may apparently not be allowed under the US-Israel tax treaty’s source rules.
US citizens and green card holders residing in Israel may not get a foreign tax credit in the US for company income attributed to them for Israeli tax purposes. More double tax.
The 2% tax on past undistributed (reinvested) profits may also not always qualify for foreign tax credits. Actual dividends are needed.
This author put these issues to Finance Ministry officials at the January 1 webinar and got muffled answers.
Their only advice was to invoke discussions between the Israeli and foreign tax authorities concerned.
But this can take years, and it is doubtful that foreign tax officials will fix problems in unconventional Israeli legislation. Israel should fix them.
General comments
The above remarks are based on our current limited understanding of brand-new legislation. Regulations are expected from the Knesset. An explanatory tax circular is expected from the Israel Tax Authority.
That said, Israel is becoming a more taxing place to do business.
Israeli hi-tech may be protected from most of the tax measures but the proposed legal reform upsets some tech investors and credit rating agencies.
The amendment might trigger outbound migration abroad of Israelis and their businesses in the next few years.
By contrast, raising the VAT rate again (it just went up from 17% to 18%) might bring in tax revenues more easily.
Olim should take advice in each country concerned, and so should others with international business interests.
It remains to be seen how the amendment works in practice.
As always, consult experienced professional advisers in each country at an early stage in specific cases.
[email protected]The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.
