Dear Clients, Friends, and Colleagues,

Further to extensive discussions during recent weeks, the Finance Committee of the Knesset (the Israeli Parliament) approved a new Bill which imposes a new regime for the taxation of undistributed profits and Personal Service Companies (hereinafter referred to as “the Bill“).[1] The Bill is now pending the final approval of the Knesset.

The Bill introduces significant changes to Israel’s corporate tax regime, primarily aimed at reducing 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. The proposed legislative amendments are expected to take effect from January 1, 2025, and may impact taxable income calculations as well as future tax planning strategies.

The Bill follows earlier legislation that increased the surplus tax rate by an additional 2% on individuals whose passive income exceeded the annual threshold of approximately 721,560 NIS (approximately $190,000).

The Bill contains numerous challenges as well as opportunities for effective tax planning. Accordingly, it is highly recommended that every company shareholder seeks professional advice regarding the potential impact of this legislation as soon as possible, and before the end of 2024.

Below are the main proposed changes, categorized as follows: (1) Taxation of personal service companies; (2) Taxation of companies generating income from labor-intensive activities; (3) Taxation of holding companies; (4) Forced profit distribution (Section 77 of the Ordinance);
(5) Temporary provisions regarding company liquidations.

 

1. Taxation of Personal Service Companies

Generally, personal service companies are companies which employ fewer than four employees, derive more than 70% of their income from a single client, and whose controlling shareholder provides services through that company. Such companies are subject to income tax at the individual marginal tax rate.

Three significant amendments are anticipated under the new tax regime:

 

• Currently, where the controlling shareholder of the company receiving payment holds at least 10% in the company making the payment, the above provision does not apply to the sum of the payment. This is a mitigating provision that allows many payments to bypass the application of this regime. Under the proposed Bill, to qualify for this exception, the shareholder must hold at least 25% in the paying company.
• Currently, services provided by a partner to a partnership are exempt from the provisions above. The Bill eliminates this exemption and introduces an alternative regime for partnerships (see below).
• Currently, actions taken by an individual will be considered as the type of actions typically carried out by an employee for their employer if they account for 70% or more of the income of the personal service company over a 30-month period within 4 years. Under the Bill, this period is proposed to be shortened to 22 months within 3 years.

 

2. Companies Generating Income from Labor-Intensive Activities

The Bill introduces a new tax regime for ‘freelancer’ labor-intensive companies. Under this regime, an individual who is an active shareholder in a closely held company (generally, a non-public company controlled by fewer than five individuals) with a profitability ratio exceeding 25% and an annual turnover below 30 million NIS will be taxed at an individual marginal rate on profits exceeding the 25% threshold (as a transitional measure, for determining the profitability ratio for the 2025 tax year, taxpayers may elect to use the average profitability ratio for the 2023–2025 tax years instead of the ratio for 2025 alone).

This tax regime applies not only to personal service companies but also to any closely held company (e.g., companies generating income from the sale of inventory). However, these provisions do not apply to income from investments (e.g., dividends, rental income, capital gains, etc.).

For closely held companies holding partnerships, a slightly different tax regime is proposed:

 

• If at least 10% of a partnership’s profits are attributed to a closely held company, the partnership will be treated as a transparent entity, and the above profitability tests (profitability ratio, etc.) will be applied based on the partnership’s profitability. The company will then be taxed at the marginal rate on profits exceeding the 25% profitability threshold.
• If less than 10% of a partnership’s profits are attributed to a closely held company , it will be taxed at the marginal rate on 55% of its taxable income from the partnership.

 

These provisions do not apply in the following scenarios – (1) a company with retained earnings below 750,000 NIS, provided the controlling shareholder does not serve as a controlling shareholder in another company; (2) the company has a “Substantial Holder” (an individual resident of Israel holding at least 30% of the company), and it is proven to the tax assessor that the shareholder is not a “Beneficial Holder” (an individual whose retained earnings in all companies where he is defined as a Significant Holder is less than 750,000 NIS); (3) Foreign companies classified as Foreign Personal Service Companies (FPSCs) or Controlled Foreign Companies (CFCs).

The new regime operates in parallel with the tax regime applicable to personal service companies, as detailed in Section 1 above. However, income from ‘freelancer’ labor-intensive activities, already taxed under Section 1, will be deducted from the taxable income under this regime.

 

3. Taxation of Holding Companies

For holding companies classified as closely held companies (as mentioned above, non-public companies controlled by fewer than five individuals), the Bill proposes an additional 2% annual tax on the Accumulated Retained Earnings that have not been distributed (this serves as a quasi “interest” on deferring the taxable event resulting from profit accumulation). This measure is intended to encourage closely held companies to distribute their profits or reinvest them in real economic activities.

In principle, the Accumulated Retained Earnings are calculated based on the company’s taxable income over the years (excluding, for example, unrealized profits and revaluations) but are capped at the company’s retained earnings available for distribution as recorded in its financial statements. From this amount, the “Exempt Income” and “Safety Cushion” should be deducted –

(i) Exempt Income. The higher of the following:

• The accumulated profits from preferred enterprises, certain income of industrial companies from the sale of the enterprise, financial institutions, and specific income of contractors, less the cost of their assets; or
• The accumulated profits from all the above-mentioned sources over the past seven years without deducting the cost of the assets.

 

(ii) “Safety Cushion”. The higher of the following:

• 750,000 NIS (this amount will be divided by the number of companies in the group under the control of a single shareholder);
• The higher of the company’s total expenses in the tax year or the average of its expenses over the past three tax years; or
• The cost of the company’s assets, minus the cost of “Special Assets” (mostly financial assets, real estate rights, cash, or cash equivalents), equity (share capital or premium), and the balance of loans from related parties, plus the cost of an underlying company (should the parent company be entitled to more than 10% of the underlying company’s profits).

 

However, according to the Bill, a closely held company may choose one of two alternative routes to avoid paying this tax:

 

• A distribution of dividends in an amount exceeding 50% of its Accumulated Retained Earnings at the end of the previous tax year. Here, Accumulated Retained Earnings are calculated as outlined above (by subtracting both Exempt Income and the Safety Cushion); or
• A distribution of dividends in an amount exceeding 6% of its Accumulated Retained Earnings at the end of the previous tax year (or 5% if the dividend is distributed by November 2025, and the tax on it is paid by December 2025). Here, Accumulated Retained Earnings are reduced only by Exempt Income, without deducting the Safety Cushion.

 

Additionally, the provisions of the Bill will not apply to a closely held company with losses exceeding 10% of its Accumulated Retained Earnings of the previous tax year.

The additional tax paid under this amendment will be classified as corporate tax paid by the closely held company and will not be deductible. Moreover, the closely held company must report the additional tax paid under this amendment and the method of calculation in its tax return (even if no tax liability arises).

The application of this provision, particularly in cases involving chains of companies, is complex. Accordingly, the implementation of these provisions should be evaluated for each company based on its unique circumstances.

 

4. Section 77 of the Ordinance (Forced Distribution of Profits)

The new legislation does not repeal the provisions of Section 77, which allows the head of the Israel Tax Authority to empower a public committee to compel the distribution of up to 50% of a company’s Accumulated Retained Earnings, provided the committee determines that such a distribution would not impact the company’s business negatively. However, the thresholds for applying this provision have slightly increased (from five million to ten million NIS and from three million to six million NIS).

In other words, despite the new provisions of the Bill attributing a significant portion of the company’s profits to its individual shareholders, taxpayers remain exposed to the possibility of being compelled to make a larger distribution under these provisions.

 

5. Temporary Provisions Regarding Company Liquidations

A temporary provision has been included in the Bill concerning the liquidation of closely held companies in 2025. Under this section, the transfer of a liquidating company’s funds and assets to its shareholders will be exempt from tax, except for taxes applicable to the distribution of the company’s retained earnings (based on the tax rates in the Ordinance and subject to the retained earnings available for distribution). In this context, the transfer of real estate held by the company to its shareholders would also be exempt from tax, notably from purchase tax.

Regarding the assets transferred, a linear mechanism is proposed whereby the real capital gain accrued until the date of transfer will be subject to marginal tax rate, while the gain accrued from the transfer date until the date of sale will be subject to a reduced capital gains tax.

Additionally, the remaining original cost, acquisition value, and acquisition date of an asset transferred as part of such liquidation will remain as they were in the closely held company, as if the asset had not been transferred unless the shareholder elects to use the cost basis of the company’s shares whilst allocating it between the company’s assets.

In addition, a provision is included allowing a closely held company to transfer an asset to a shareholder with significant control without liquidation of the company. In this case, the transfer will be treated as the dividend income of the shareholders with significant control, based on the depreciated cost, and in certain cases even deducting the value of loans. In other words, a company will be allowed to transfer assets to its shareholders without liquidation, while paying tax on a dividend basis equal to that remaining depreciated cost (i.e., the reduced cost of the asset).

This temporary provision will apply to closely held companies and shareholders who meet the following conditions: (1) The company’s assets were transferred to its shareholders without consideration, and the classification of such assets (i.e., from fixed assets to inventory and vice versa) were not altered as part of the transfer; (2) The closely held company and its shareholders submit a request for this provision to apply.

 

It should be noted that tax planning strategies in Israel are subject to specific and general anti-avoidance rules, and the implementation of such strategies should not be undertaken without prior legal advice.

 

Our tax department has extensive experience in the issues discussed in this update. We are at your disposal and would be happy to provide comprehensive advice regarding the potential tax implications of the matters discussed herein.

 

 

Sincerely,

The Tax Department

Herzog

 

 

This client update should not be considered legal advice, and it should not be relied upon without proper legal counsel.

 

 

[1] Economic Efficiency Bill (Legislative Amendments to Achieve the 2025 Budget Targets) (Taxation of Undistributed Profits), 5784-2024.