New rules for wallet companies may hit SMEs

The Budget Law for 2017-2018 contains bad news not only for owners of three homes or more, but also for many small and medium-sized enterprises (SMEs) in Israel. In many cases, their tax rate on corporate profits may increase from 25% in 2016 to rates approaching 50% in 2017. Here is an overview.

The rules relate to 10%-or-more shareholders (“material shareholders”) in so-called “wallet companies” – private companies closely held by five or fewer shareholders and their relatives, as defined.

The new rules affect personal services between companies, untaxed drawings and forced dividends.

Personal services: Income of a private closely held company derived from the activity of a an individual who is its material shareholder may now be taxed at rates of up to 50% if the activity is at another entity, related or unrelated, in two cases:

(1) as salary or business income “as applicable” for serving as an officer or for management services “and so forth”; or

(2) as salary income for operations of a type done by an employee for an employer – in particular if 70% of income or profit (excluding dividends and capital-gain transactions) in the tax year is for service to the other entity or its related party for 30 months in a period of four years, retroactive to day one where applicable (day one can be in 2013!).

This latter case does not apply if there are four or more “employers”; less than four hours a day counts as half an employment. In either case, the tax may be collected from the closely held company or from the individual.

These two cases do not apply if the individual is also a material shareholder in the other entity, directly or indirectly, or a partner in it in the second case.

Untaxed drawings in cash or in kind: Material shareholders are taxable on untaxed drawings of cash at the end of the year after the cash was drawn and on assets placed in their possession commencing at the end of the following year and each year thereafter until the assets are returned. Cash includes loans, securities, deposits and company guarantees for the material shareholder’s benefit directly or via a company.

Amounts below NIS 100,000 throughout the current and preceding years are disregarded. In the case of items returned to the company, usage until then is taxed at the higher of market value or a prescribed interest rate.

Assets include homes and their contents, art, jewelry, aircraft, boats and anything else that may be prescribed. The amounts will be taxed as dividends (25%-33% tax) or as salary or business or professional income (up to 50% tax). Any cash returned will be disregarded if it is taken out again within two years for more than 60 days as well as other assets returned but taken out again within three years.

In the case of company homes, material shareholders occupying them may choose between returning the home by the end of 2018, staying and paying the tax on usage, buying the home by the end of 2018 and paying the above tax, and buying the home and paying land-appreciation tax. Detailed rules for each are prescribed, which will need urgent evaluation now. Forced dividends: The tax director is empowered, after consulting a special committee, to tax a deemed dividend at rates of 25%-33% of retained profits of a closely held company. This applies to up to half the profits if they have been retained at least five years (which might have begun in 2012), if the company’s business will not be harmed, tax avoidance or reduction is involved, retained profits amount to at least NIS 5 million, and at least NIS 3m. of retained profits are left.

Optional dividends: If a dividend is paid by September 30, 2017, out of profits derived up to the end of 2016, the tax rate may be reduced to 25% including surtax instead of up to 33% for a material shareholder. But total salary, management fees, interest and linkage paid each year to the recipient should not exceed the average in 2015 and 2016. Comments: These rules will affect many SME owners in Israel. These new provisions impose tax commencing in 2017, but the lead-in periods begin in earlier years.

Tax officials have for years taxed cash drawings, but private use of company homes largely escaped tax until now.

Material shareholders with a 10% interest do not have to own all the shares concerned; they get caught if they have a voting agreement with another shareholder, for example, two 5% shareholders with a voting agreement.

People using company homes for private purposes should consider returning them without Israeli tax by the end of 2018. Failing that, the optional 25% dividend tax may be the cheapest way for clearing drawings balances, if there are sufficient profits.

Companies that are not closely held (have more than five shareholders) should be unaffected by the new rules.

It is unclear if National Insurance Institute payments apply to the newly taxable amounts (clarification is awaited from the NII).

As always, consult experienced tax advisers in each country at an early stage in specific cases.