Dear Clients, Colleagues, and Friends,

New Court Decision Addresses Key Tax Aspects of Dividend Distribution

The Tel Aviv District Court recently issued a ruling on a tax appeal filed by Oz Technologies (1972) Ltd. (the “Taxpayer“). The case concerns a notice of deficiency issued by the Israel Tax Authority (the “ITA“), asserting that a dividend distributed by the Taxpayer’s Israeli subsidiary (the “Dividend” and the “Subsidiary“, respectively), is not exempt from tax at the Taxpayer’s level under the general exemption for such dividends.

The ITA argued that because the Subsidiary did not pay income tax on the income from which the Dividend was distributed due to tax deductions for depreciation (which were not reflected in financial accounting), the exemption should not apply. The District Court rejected this position, ruling that dividends distributed from income included in the Taxpayer’s income, even if not fully taxed by the distributing company, remain non-taxable for the recipient company.

The Facts in Brief

The Taxpayer, an Israeli private company, holds approximately 18.7% of the Subsidiary’s shares.

The Subsidiary owned commercial real estate. It generated income from lease and from management services to its tenants (the “Regular Income“). In its books, the Subsidiary recorded the real estate in accordance with the Fair Market Value Method. As a result, it did not record depreciation for accounting purposes, but rather recorded revaluation income or loss in accordance with the value of the relevant assets (the “Revaluation Income“).

During the relevant years, the Subsidiary generated Regular Income of approximately NIS 150 million and Revaluation Income of approximately NIS 170 million. Although the Subsidiary did not record depreciation for accounting purposes (due to the application of the Fair Market Value Method), it deducted depreciation costs for tax purposes amounting to approximately NIS 120 million. Consequently, the Subsidiary reported significant accounting profits from Regular Income (~NIS 150 million) but paid tax on a considerably lower taxable income (~NIS 30 million). The table below highlights the differences between the results for accounting purposes and those for tax purposes (rounded figures, in NIS millions):

The Subsidiary distributed a dividend in an amount of approximately NIS 120 million, attributing the entire amount to its Regular Income.

The Main Legal Background and the Dispute between the Taxpayer and the ITA

Under Israeli tax law (Section 126(b) of the Income Tax Ordinance), dividends received by an Israeli company from its Israeli subsidiary are not included in the tax base (for ease of reference we refer to them herein as “tax-free”) if certain conditions are met, including that the dividend derives from income generated in Israel and the distributing company is taxable in Israel.

According to a 2020 Supreme Court precedent (in the matter of MCL Drorim Mall v. Tax Assessment Officer Petach Tikva), dividends distributed from revaluation profits are not exempt under Section 126(b) because such profits were not part of the distributing company’s income for tax purposes. In this case, the Taxpayer argued that since the Regular Income was part of the Subsidiary’s income for tax purposes (even if not part of the taxable income), dividends from this source should not be taxable.

The ITA argued that the depreciation recorded by the Subsidiary for tax purposes reduces the profit that can be distributed tax-free. Consequently, the ITA reduced the tax-exempt dividend to approximately NIS 30 million.

The Court’s Ruling

The Court ruled that the accounting profit amount eligible for tax-free distribution should not be reduced by depreciation expenses recorded for tax purposes, even in cases where no depreciation expenses were recorded due to the application of the Fair Market Value Method. The Court’s reasoning was that such accounting profit is included in the tax definition of “income.” Thus, the Court distinguished the profits in this case from revaluation income, as addressed by the Supreme Court, which is not included in the tax definition of “income” and, therefore, is not eligible for tax-free distribution.

On a side note, we mention that during the legal proceedings, the ITA expressed its general position (which is not relevant to this specific case) that, for determining accounting profit for tax-exempt distribution purposes, accounting depreciation expenses can be deducted. This applies even in cases where there are temporary differences between accounting depreciation expenses and tax depreciation expenses (such as accelerated depreciation).

It is noted that the ITA may still appeal the Court’s decision to the Israeli Supreme Court.

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The Oz Technologies ruling underscores the importance of expert tax guidance in corporate decision-making, throughout all stages of a company’s lifecycle, including matters that may initially appear to be financial accounting issues (such as the implementation of the Fair Market Value Method). The ruling may have implications, inter-alia, on multinational firms with Israeli subsidiaries that have accumulated profits and on Israeli companies in the real-estate sector.

Our tax department has extensive experience and expertise in these matters. Our team members possess broad legal and accounting qualifications, which can be very valuable when analyzing various legal and financial issues. We invite you to discuss the implications of the Oz Technologies ruling or seek advice on related tax issues.