Proposed classifications of foreign companies as Israeli tax residents and proposed presumption of “Passive Income” with respect to Controlled Foreign Corporations (CFC)
In the field of international taxation the proposed tax legislation includes two important far reaching provisions. One provision is connected to a new classification when a foreign company is considered having its tax residence in Israel. The other provision deals with a new classification of “Passive Income” with respect to the taxation of a controlling shareholder of a Controlled Foreign Corporation (CFC). The good news is that a third proposed provision which called for the cancellation of the 10-year reporting exemption for foreign source income and assets for Olim or long-term returning residents has been removed from the legislative proposal for the year 2016/2017. Accordingly, New Immigrants will continue to enjoy the reporting exemption at least for the near future.
I. Tax Residence of corporations – Proposed Presumption of Management and Control
Under the Israeli Tax Regime an Israeli corporation is taxed with its worldwide income. Under the existing para 1 of the Israeli Income Tax Ordinance a company is considered having its tax residence in Israel, if the company is either incorporated or has its control and management in Israel. This definition has proven to open all kind of different interpretations, and some Israeli residents established foreign corporations, however left the ultimate control and management in Israel. The Israeli courts have ruled that the statutory “control and management” test is a cumulative test, so that the sole formal and technical holding of the shares in Israel is not sufficient to justify the tax residence of the corporation in Israel. Rather, in addition it must be examined, whether the business policy is determined and the substantial strategic decisions are taken in Israel.
The proposed legislation contains a “rebuttable presumption” according to which a foreign corporation will be considered controlled and management in Israel, if 50 % or more of the corporation is controlled directly or indirectly by Israeli residents and the final tax rate for the profits of that company is 15 % or less in the foreign country and either the company is situated in a country with which Israel has no Double Tax Treaty ( DBA) or is situated in a treaty country, however the country does not tax foreign source income.
This proposed presumption has a far reaching impact on foreign corporations and might lead to the result that more foreign corporations will be considered Israeli tax residents, and therefore being taxed on their worldwide income in Israel, exposed to extensive withholding obligations and subject to filing requirements to the Israeli Tax Authority.
In addition to the “rebuttable presumption” there is a reporting obligation introduced in the legislative proposal. Foreign corporations, which view themselves not being Israeli residents, although the conditions of the prescribed presumption are met, are obligated to report their contrary view to the Israeli Tax Authority. This reporting obligation is designed to assist the Israeli Tax Authority to identify foreign corporations, which might be controlled and managed in Israel and subject to Israel tax on their worldwide income.
II. Taxation of Controlling Shareholders of Controlled Foreign Corporations (CFC) – Proposed Presumption of “Passive Income”
Under the existing law, controlling shareholders of foreign controlled corporations with undistributed profits are treated as if they have received deemed dividends based upon their proportional share on such profits. Undistributed profits are thereby defined as profits from passive income generated in the respective tax year and for which the controlling shareholder did not pay taxes in Israel. A CFC is a corporation, whose majority of income is “Passive Income”.
For the determination of a Controlled Foreign Corporation and the amount of deemed dividend the existing law especially stated that “Passive Income” does not include income which if generated in Israel would be considered business income or income from employment. Up until now, taxpayers in most cases classified interest income and income from linkage differentials, royalties and rental income as business income even though these income items are inherently passive income.
The proposed legislation introduces a rebuttable presumption according to which interest income, linkage differentials, royalties and rental income are considered passive income, even if these items are business income, unless the following conditions are given:
- Interest income and income from linkage differentials:
The proposed legislation determines that these income items will be considered “passive”, unless such income is received from an unrelated party and it has been proven to the satisfaction of the assessing officer that it is business income.
- Royalties
According to the proposed legislation royalties are considered passive income, unless the royalties are received for an asset developed by the receiving company, they are received from an unrelated party, and it has been proven to the satisfaction of the assessing officer that it is business income.
- Rental Income
According to the proposed legislation, rental income will be considered passive income, unless the income has been received for an asset that has been leased for less than one year and it has been proven to the satisfaction of the assessing officer that it is business income.
This new proposed definition of Passive income is very broad and will have the result that the number of foreign corporations, which will be considered “Controlled Foreign Corporations” for purposes of taxation of deemed dividends will definitely increase, and so will the Israeli taxation of undistributed profits of those CFCs.
These two mentioned proposed changes, if enacted will have a drastic impact in the field of international taxation. Foreign corporations are advised to closely follow these developments and plan accordingly before these changes might become effective in 2017.