Experts fear last-minute corporate tax law could have unintended, costly consequences
The so-called ‘trapped profits bill’ that took effect on Jan. 1 aims to curb tax avoidance amid expensive war, but some worry it’ll be hard to implement and discourage investment
Sharon Wrobel is a tech reporter for The Times of Israel.
In a whirlwind action, the Knesset on the last day of 2024 passed a key budget law designed to make changes to the corporate tax regime and collect billions of shekels for the state’s coffers as the government struggles to finance the costs of the ongoing war with the Hamas terror group.
The so-called Trapped Profits law, which took effect on January 1, addresses the release of earnings that are retained by private companies and are not distributed as dividends to shareholders. Until the new legislation was passed, private companies were paying lower taxes on undistributed, or “trapped,” profits intended for reinvestment into business development, infrastructure, and research and development centers.
The new law seeks to clamp down on private companies in general and holding companies and so-called wallet companies in particular, which in recent years have accumulated undistributed profits to save tax and use the monies to make passive investments in the capital markets or real estate assets, which they were not intended for. In other cases, companies refrained from distributing dividends, did not reinvest the retained profits in Israel, and kept them locked up within their companies.
This in turn has led to a loss of dividend tax revenue for the state of an estimated NIS 5 billion ($1.37 billion) to NIS 6 billion ($1.64 billion) per year, according to data by the Israel Tax Authority. In the years 2013 to 2021, Israel-based companies have accumulated more than NIS 700 billion ($191 billion) in trapped profits.
Tax experts and lawyers who spoke with The Times of Israel voiced concern and anger, saying the new legislation will be complex to implement and may reduce the appetite for investment into businesses and the economy.
“We have many clients that are trying to figure out what exactly is happening,” said Eric Benishay, a tax partner at financial consulting firm PwC Israel. “The process of legislation was very last minute as it was introduced in early December and pushed hard in order to complete it by the end of December, which is outrageous.”
“There was no sufficient discussion with the market in order to be able to come up with a much more reasonable and simple legislation,” Benishay lamented.
Israel’s corporate tax regime is governed by a two-tier system. In the first stage, earnings are subject to a 23% corporate tax, and in the second stage, a dividend tax of around 30% is payable when distributed to shareholders.
The purpose of the two-stage taxation is to allow companies to postpone the second stage of corporate tax payment, encouraging the investment of their accumulated retained earnings into business development instead of distributing them as dividends. In most Western countries corporate income is taxed twice — once at the company level and once at the shareholder level.
“It has become a very common vehicle for tax deferral for individuals, service providers, or CEOs who are not hired as direct employees of their corporations, or professionals such as accountants or doctors,” said Doron Mutai, partner and head of the Israel tax practice group at Pearl Cohen law firm.
The tax system has led to a rise in two types of companies, wallet companies — also known as personal service companies — and holding companies, which exploit the two-stage system by either investing undistributed profits in financial assets rather than in real business activity, or by retaining and accumulating them within their companies.
Wallet companies are wholly owned companies established by individual professionals, who instead of receiving their income as salaried employees, collect their income through a corporation to try to reduce their tax burden. Personal income collected via the company is reclassified as corporate earnings subject to corporate tax of 23%, and only once they are distributed as dividends is a 30% tax payable. That’s instead of paying direct income tax of up to 50% as a salaried employee, especially for high-earning individuals.
“Over the years, many companies, in particular those that are a one-man show, paid the 23% corporate tax and for years retained earnings within the corporation and didn’t distribute dividends, which means they didn’t pay the dividend tax. This is a failure in the system, which the government is trying to resolve,” said Ronen Solomon, CEO of Israel’s Crafts and Industry Association, which represents 100,000 small and medium-sized businesses including furniture, footwear and leather goods manufacturers, hairdressers, beauticians, and printing houses.
“We are in a war and the Finance Ministry needs to find sources to finance it, and that’s the main reason behind the legislation,” said Solomon. “Most hurt will be freelance professions such as accountants, doctors, or advisers who established a one-man company and will now have to pay more taxes.”
The new legislation seeks to reduce the ability to defer tax payments indefinitely by retaining profits within a company rather than reinvesting them in real economic activities within the Israeli economy. It applies to companies with up to five shareholders with an annual turnover of up to NIS 30 million ($8.2 million) per year.
The Finance Ministry said that the new tax rules target two types of companies: active wallet companies, which often have a single shareholder and most of their profits derive from the activity of that shareholder; and holding companies without significant business activity and mostly passive income, which are used by their owners as a tool for making investments without paying the full tax.
According to new rules, controlling owners of active wallet companies will be subject to a marginal tax for undistributed profits that exceed 25% of the turnover. Companies will be able to choose each year to either pay a 2% tax on their accumulated trapped earnings or distribute at least 5% in 2025 and 6% thereafter of their retained profits and pay dividend tax on them.
“First of all, the new rules are likely to reduce the appetite of companies to invest in more risky operations,” said Benishay. “Secondly, company owners or a shareholder may consider whether they still want to operate in the same manner in Israel or take their business outside of Israel, for example a venture capital fund manager who has investments abroad.”
“So it could be a lose-lose situation,” he cautioned.
Exempt from the tax changes are small businesses that have accumulated undistributed profits of less than NIS 750,000 ($205,000), or when the amount of retained earnings is lower than the average expenses of the company in the last three years. Preferred enterprises — industrial and construction companies and factories that fall under the Capital Investments Encouragement Law, including large multinational corporates such as Intel, and Microsoft, that receive grants from the government — are also exempt.
“The government wanted to catch professionals or companies that are using this mechanism for tax deferrals, but they are using a sledgehammer to swat a fly to do this,” said Mutai. “The intention was to levy tax on very specific problems but the legislation will apply to almost each and every company that is held by up to five individual shareholders.”
“The implementation of the complex changes will require very technical analysis in order to verify whether a company is subject to the legislation or not,” he said.
Similarly, Benishay noted critically that the law goes too far with no distinction as to the scope of the companies’ investments, which is triggering confusion.
“This is a massive reform in the tax system and it should have been introduced through discussions with the business community and all stakeholders in order to come up with something that is more tailored and that is going to tax directly the place that it should tax,” said Benishay. “This is how the negative impact could have been reduced dramatically.”
“A tax system should be as simple as possible in order to promote business activity but this law is taking us backward,” he said.
