Tax Implications of Non-Pro Rata Share Redemptions in Israeli Companies – New Supreme Court Ruling
15 February 2023
Dear Friends, Clients and Colleagues,
The Israeli Supreme Court issued its long-awaited ruling in the Beit Hosen appeal bringing an end to the debate surrounding the Israeli tax consequences of a disproportionate (non-pro rata) share redemption, including to shareholders that did not participate (or partially participated) in the share redemption.
The Beit Hosen ruling is the first ruling by the Supreme Court on this matter, after several conflicting rulings that were rendered by the District Courts in previous years. The ruling addresses only the issue of share redemptions in closely-held companies, and its applicability to other types of companies is still unclear. As discussed more fully below, while the ruling provides needed clarity regarding the potential tax implications of disproportionate redemptions, it leaves certain points unaddressed.
The Facts of the Appeal
The Beit Hosen appeal combined two separate appeals in which the same legal question was discussed.
The first appeal was brought by Beit Hosen Ltd. and its shareholders. Beit Hosen Ltd had only 4 shareholders. The ex-wife of the company’s founder, who was a minority shareholder holding 18.75% of the share capital of the company, sued the company and two of its shareholders and officers, alleging that the company and its officers deprived her of her rights as a minority shareholder. The parties eventually signed a settlement agreement in which the company undertook to acquire the shares of the minority shareholder. The assessing officer decided to tax the remaining shareholders of the company, who did not participate in the redemption, as if they received a dividend from the company by virtue of increasing their holding percentages. The Haifa District Court ruled in favor of the taxpayers holding that the redemption should not be viewed as a dividend to the remaining shareholders (see our client update on the District Court’s ruling here). The assessing officer appealed to the Supreme Court.
The second appeal was filed by Mr. Meir Seida, who held 50% of the share capital of Hashatil Management and Holdings Ltd together with his brother who held the remaining 50% of the share capital. Following disagreements between them on how the company should be managed, it was eventually decided that the company would acquire the shares of Mr. Seida’s brother; the redemption of shares and a waiver of any mutual claims were documented in a written agreement. The assessing officer issued a notice of deficiency to Mr. Seida on similar grounds as in the Beit Hosen ruling, namely, that he should be deemed to have received a dividend equivalent to the entire consideration paid for the shares, which he then used to purchase his brother’s shares. The Be’er Sheva District Court agreed only partially with the assessing officer and ruled that Mr. Seida should be viewed as having received 50% of the consideration amount, in accordance with his portion of the share capital prior to the redemption. Mr. Seida appealed to the Supreme Court.
The Israel Tax Authority’s Circular
As noted above, the issue of taxation of disproportionate share redemptions is not new. In 2018, the Israel Tax Authority (the “ITA“) issued an income tax circular in which it presented its views on disproportionate share redemptions. According to the circular, such redemption should be analyzed under one of two alternatives:
Under the first alternative, the disproportionate redemption is viewed as a two-step transaction, whereby in the first step, the company distributes a pro-rata dividend to all its shareholders in accordance with their holding percentages. In the second step, the non-selling shareholders use the proceeds from said deemed dividends to acquire the shares from the redeeming shareholders.
The second alternative also contemplates a two-step transaction, yet under this alternative, there is initially a deemed acquisition of shares of the redeeming shareholders by the non-selling shareholders, followed by a pro-rata redemption by the company of the acquired shares, which is treated as a dividend. The ITA’s circular also states that the second alternative is more likely to apply in cases where the redeeming shareholder sells his/her/its entire holding in the company.
The Supreme Court Ruling
The opinion of the majority was issued by Justice Ruth Ronnen, who based her ruling on the need to set out a bright-line rule with respect to disproportionate redemptions of shares. Justice Ronnen rejected the minority opinion, according to which a disproportionate redemption of shares will result in a dividend to the non-selling shareholders only if the “dominant purpose” of the redemption was to benefit such shareholders. Justice Ronnen notes in this context that unearthing the dominant purpose is a difficult task with respect to “partnership-like” private companies. Partnership-like companies, according to Justice Ronnen, are “private companies with a small number of shareholders that have personal relationships based on mutual trust, who agree to jointly manage the company’s business.”
Justice Ronnen believes that in partnership-like companies, it is not feasible to distinguish between the interests of the shareholders and the interests of the company with respect to the share redemption and that such distinction will allow shareholders to structure a deal as if it is for the benefit of the company in order to avoid tax liability. Accordingly, Justice Ronnen rules that in partnership-like companies a redemption will be treated as a dividend distribution to the non-selling shareholders.
Justice Ronnen goes on to discuss the taxable income amount of the non-selling shareholders. In this case, Justice Ronnen rules that all shareholders should be deemed to have received a pro-rata dividend, and the non-selling shareholders are viewed as if they used their portion of the dividend to acquire the shares of the redeemed shareholder. Thus, Justice Ronnen accepted the first alternative in the ITA’s circular and seem to have rejected the second alternative presented therein.
Eventually, we note that Justice Ronnen emphasizes that her ruling applies only to partnership-like companies and that the taxation of other private companies or publicly traded companies will be decided in future cases. Justice Fogelman, who concurred with Justice Ronnen, also emphasizes that the ruling is restricted to the circumstances of partnership-like companies.
Key Takeaways and Open Questions
The most important takeaway from the Beit Hosen ruling is that share redemptions may have adverse tax results to shareholders that did not participate in the redemption (who are deemed to have received a dividend) and to the company who redeemed its own shares (which may be subject to withholding tax liabilities). These potential adverse tax results should be taken into account when structuring transactions and drafting deal documents, in order to minimize the risk of phantom income to certain shareholders.
However, despite the bright-line rule adopted by the Supreme Court in its ruling, there are still many open questions that will need to be decided in the future:
First, the tax treatment of redemptions by publicly traded companies and private companies which are not partnership-like companies, was not discussed or decided by the court. We note that the position of the ITA, as presented in its circular, is that redemption of shares in publicly traded companies that is done from time to time at a percentage that is “not significant” will be classified as capital gains at the hands of the redeeming shareholder only.
Furthermore, it is unclear what constitutes a partnership-like company for the purposes of the Beit Hosen ruling. The two companies whose matters were discussed by the Supreme Court had two and four shareholders, all of which were family members. It is unclear if the same rule should apply to a company, for example, with 10 shareholders whose sole relationship is a business relationship.
The ruling also leaves some open questions with respect to “pre-determined” redemptions or other changes in ownership percentages of shareholders. For example, it is unclear whether all company shareholders may be subject to tax on dividends in cases of a redemption of shares subject to reverse vesting or increase in ownership due to application of certain rights included in the company’s articles of association.
The ruling also does not address the potential effect of this tax treatment on the cost basis and acquisition date of the shares held by the non-selling shareholders.
Certain planning opportunities can be considered if redemptions are characterized as dividends. For example, in certain circumstances, shares can be dropped down (tax-free) or sold (in a taxable event) to an Israeli corporation, which should be exempt from Israeli tax on the deemed dividend amount. Other planning opportunities may include an acquisition of the shares by subsidiaries of the company or other affiliates. The ITA circular generally characterizes such share acquisitions as giving rise to capital gains to the selling shareholder but allows the assessing officer with discretion to decide whether the other shareholders should be viewed as receiving a deemed dividend.
We note that tax planning schemes in Israel are subject to specific and general anti-avoidance rules and should not be entered into without receiving proper legal advice in advance.
Our tax department has extensive experience in the issues discussed in this update and associated planning opportunities. We are at your disposal and would be happy to provide comprehensive advice regarding the potential tax implications of redemption transactions, and possible ways to mitigate such tax implications.
The Tax Department
Herzog Fox & Neeman