Dear Clients, Colleagues and Friends,

Last week (1.11.2020), Judge Orit Weinstein of the Haifa District Court rendered its decision in the tax appeal of Beit Hossen Ltd. and its shareholders.[1] The main legal question in the ruling related to the taxation of a non-pro-rata redemption of shares. Specifically, the court was required to determine whether a redemption of shares constitutes a deemed dividend distribution for the shareholders whose shares were not redeemed.

The Haifa District Court accepted the taxpayers’ position ruling that the redemption is taxable only to the shareholder whose shares were redeemed. The Beit Hossen ruling provides that a redemption should generally be viewed as resulting in a capital gain only for the redeemed shareholder.

This is a precedent-setting ruling, deviating from previous rulings of the Tel Aviv District Court and the published position of the Israeli Tax Authority (the “ITA”). This determination has far-reaching implications. The position of the ITA so far has classified a share redemption as a combined event of capital gain and a deemed dividend distribution. This position has  significant implications both for non-redeemed shareholders (who are required to pay tax on a deemed dividend distribution without receiving any cash consideration) and for redeemed shareholders (whose consideration for the share redemption is at times partially classified as a dividend subject withholding tax, instead of a capital gain that is usually tax-exempt for a non-resident investor).

The Position of the ITA before the Beit Hossen Ruling
In the past, the ITA considered non-pro rata redemptions as taxable only to the selling shareholders.[2] This position was changed in Income Tax Circular 2/2018 (hereinafter: “Share Redemption Circular“), which stated that the consideration paid by a company in a redemption should be treated as a dividend distribution to the non-selling shareholders, because their holding percentages in the company increased. In some cases, the Share Redemption Circular even determined that a portion of the redemption consideration would be considered a deemed dividend to seller. According to the ITA, there are two approaches for determining the tax event:

1. Under the first approach,  a dividend equal to the consideration amount is initially distributed to all shareholders. The remaining shareholders then purchase the shares of the selling shareholder for the (gross) dividend amount that they received. This approach is particularly relevant in cases where only some of the shareholder’s shares are redeemed.
2. Under the second approach, the remaining shareholders first purchase the shares of the selling shareholder for the consideration amount according to their relative holdings in the company. They then sell the purchased shares back to the company in exchange for the consideration amount, so that it is in fact a pro-rata redemption by the remaining shareholders (and accordingly, the second stage is classified as a dividend distribution). This approach is particularly relevant in cases where all of the selling shareholder’s shares are redeemed.

We note that the ITA also published a reportable position (position No. 42/2017) that corresponds to its approach in the Share Redemption Circular.

The position stated in the Share Redemption Circular relied on two court rulings dealing with share redemptions on a non-pro rata basis. Both rulings were issued in 2014, the first is the Baranowski[3] ruling and the second is the Bar Nir[4] ruling. In both cases, the Tel Aviv District Court ruled that the share redemption constituted an artificial transaction, which the Assessing Officer could reclassify as a dividend distribution, because the redemption was motivated by the personal interests of shareholders rather than the interests of the company, and it did not benefitted the company.

Beit Hossen Ruling
As noted above, in the Beit Hossen ruling, the Haifa District Court rejected the position of the ITA, while taking the view that  a non-pro-rata redemption should be viewed as a capital gain for the selling shareholder, without triggering a deemed dividend to the other shareholders. In addition, the District Court took the principle position that a taxpayer may be subjected to tax on a deemed distribution, as the ITA argued, only where there is clear legislative authority to do so.
Following are the main determinations of the District Court:

1. The ‘enrichment’ of the remaining shareholders as a result of an increase in their holding percentages in the company is not sufficient to impose a tax liability on them, in light of the tax law realization principle. According to this principle, a taxpayer is liable to pay tax only when it realizes a built-in gain in its property, and so long as such built-in gain is not realized, the taxpayer  is only be liable to tax in exceptional cases. A share redemption does not constitute a realization of gain by the shareholders whose shares have not been redeemed.
2. In addition, whether there is ‘enrichment’ of the shareholders in the event of a non-pro-rata share redemption is questionable. The shareholders’ holding percentage in the company increased, but the value of their holdings in the company decreased by the amount paid by the company to the redeemed shareholder.
3. The establishment of a tax event should be set out clearly in primary legislation and not by interpretation of the ITA or a court.
4. Not every share redemption transaction can be classified as an artificial transaction intended to reduce the tax liability. It is actually the ITA’s position on this matter that seems more artificial than the straightforward redemption classification. The taxpayer is allowed to choose a low-tax alternative and it seems that the artificial classification of the transaction by the ITA was done in a manner intended to increase the tax liability relating to the transaction.
5. It is not sufficient that the shareholders in the company control its actions in order to classify the share redemption as a dividend. Purchasing a shareholder’s entire stake in a company by way of redemption may serve the interest of the remaining shareholders as well as those of the company.

The Beit Hossen ruling allows companies to redeem shares on a non-pro-rata basis where there is a valid business reason, without having to deal with the problematic tax consequences of taxing deemed income or classifying income from the sale of shares by a nonresident (who is typically exempt from Israeli tax under domestic law or the provisions of a double taxation treaty) as a dividend subject to withholding tax.

Considering the absence of legislative provisions relating to this complex matter, the differences in facts of various cases discussed by the District Courts, and the expectation that the ITA will appeal the ruling to the Supreme Court,  each share redemption should be analyzed on a case-by-case basis. This requires a substantive analysis of the tax results with respect to the unique fact pattern of each redemption.

[1] Tax Appeal 74155-12-18 Beit Hossen and others vs Assessing Officer Acre.
[2] This position was articulated in Income Tax Circular 10/2001 “The Effects of the New Companies Law on Tax Law”.
[3] T.A. 21268-06-11 Dan Baranowski v. Assessing Officer Gush Dan, Taxes 28/2 (April 2014) e-9.
[4] T.A. 1100-06 Bar Nir Tamar v. Assessing Officer Gush Dan, Taxes 28/6 (December 2014) e-7.

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Our tax department is available and will be happy to advise on the aforementioned matters and assist in dealing directly with the relevant units at the ITA. We are, of course, at your service and available for any inquiry you may have.

Sincerely,

The Tax Department

Herzog Fox & Neeman