Business / Industry Sectors
Israel's Tax System in a Nutshell
11/05/2013
Israel's tax system is also investor-friendly and well suited to encourage cross-border business initiatives.In this brief article, we will touch on the main features of the Israeli tax system, highlighting those which would be of importance to the Indian entrepreneur or investor.

Beyond Israel's attraction as a dynamic, technology-based economy which boasts a highly-educated and motivated workforce, Israel's tax system is also investor-friendly and well suited to encourage cross-border business initiatives.

In this brief article, we will touch on the main features of the Israeli tax system, highlighting those which would be of importance to the Indian entrepreneur or investor.

 

Low Corporate Tax Rates

Israel's general corporate tax rate is 25%. The Investment Encouragement Law provides for reduced rates of company tax for businesses which engage in manufacturing activity - broadly defined so as to include for example software development ventures - and which meet certain export criteria. These "Preferred Enterprises" are currently entitled to pay 10% tax if located outside the center of the country, and 15% if located in the central region. Those rates will be further reduced to 6% and 12%, respectively, by 2015.

 

Research and Development Centers

Many multinational technology enterprises have established major R&D centers in Israel. The local R&D entity typically operates on a "cost plus" basis, with an operating margin of between 5% and 10% normally being acceptable. In many cases, an R&D center may also qualify as a "Preferred Enterprise" (see above) and pay significantly reduced rates of corporate tax. R&D services performed on a contract basis for foreign affiliates also usually qualify for "zero rating" Value Added Tax treatment. For companies performing R&D activities for their own account (not as contractors), investment in R&D may be deducted annually as a current expense for tax purposes (subject to certain conditions).

 

Profit Repatriation

The Israeli withholding tax on dividends distributed by an Israeli subsidiary company to an Indian parent company is limited to 10% under terms of the India-Israel double tax treaty. Moreover, the treaty contains a special provision which requires the Indian tax authorities to grant a tax credit of 15% on dividends received from an Israeli subsidiary, despite the fact that the Israeli withholding at source cannot exceed 10%. This benefit appears to be of particular interest in light of recent changes to the Indian tax system which limit the basic rate of Indian tax on an inbound dividend to 15%.

In this context it is important to note that Israeli tax law does not contain any restrictions on the amount of debt which may be used in the financing of the operations of a local company, in relation to the amount invested in shareholders' equity (i.e. there are no "thin capitalization" rules). This allows for leveraged investments and the repatriation of cash through the repayment of loan principal with no tax consequences.

 

Capital Gains Tax Exemption

Successful investments in Israel companies, especially in the high tech sector, are typically realized through "exit" transactions which involve the sale of shares in the local company (and in a minority of cases, the sale of the technology assets themselves). These exit transactions can give rise to significant capital gains. While the India-Israel tax treaty would allow Israel to tax gains derived by an Indian investor upon the sale of shares in an Israeli company, recent amendments to Israel's tax code provide a broad exemption to foreign investors on capital gains derived from the sale of Israeli companies (irrespective of the terms of the applicable tax treaty). The practical meaning of this is that in most cases, gains derived upon "exit" by foreign resident shareholders will be exempt. An additional exemption in the Israeli tax law exempts gains earned by non-residents from the sale of shares in publicly-listed Israeli companies, whether traded on the Tel Aviv stock exchange or abroad.

There are also extensive provisions in the Israeli tax code allowing tax-deferred reorganizations, including mergers, share swaps, asset contributions and spin-offs.

One word of caution is necessary here: in cases where Israeli technology companies have been acquired by multinational enterprises and in subsequent transactions Israeli IP (intellectual property) has been transferred out of the country, the Israeli tax authorities have begun to aggressively challenge the transfer pricing of the IP transfers. As a result, such instances require careful consideration and planning. In addition, if the development of the Israeli IP was funded in part by the government of Israel (through the Office of the Chief Scientist), then the outbound IP transfer may entail regulatory issues and the repayment of funds to the government.

 

Employee Stock Option Plans 

Israel allows employee stock option gains to be taxed at a beneficial rate (25%) if the options are held in trust for a period of two years (subject to a number of conditions). Similar treatment is also available for a grant of shares.

 

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In sum , Israel offers an attractive tax regime for inbound investment and business activity which allows foreign enterprises to efficiently tap into Israel's outstanding human resources and know how. 

 

 

The Author is a Partner in Yigal Arnon & Co law firm.

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