This year Israel introduced new rules for taxing personal “wallet companies” that pay company tax at a rate of 24% in 2017, but no more if profits are left in the company’s bank account. These rules tax deemed dividends, loans to major shareholders and personal services provided via such a company.
The Israel Tax Authority recently issued a circular on personal- service companies (Circular 10/2017 of November 7, 2018).
The personal-service company rules especially target executives who use their own company to bill their services to larger companies they don’t own, enabling them to pay 24% company tax rather than receive a salary paycheck with up to 50% in taxes withheld. The new rules in Section 62A of the Income Tax Ordinance (ITO) aim to level the playing field.
This is only a tax deferral until the shareholder extracts a bonus or dividend. But the deferral could last many years. And in the case of a dividend, National Insurance Institute (NII) payments could be avoided. That has now become harder.
The main rule: According to Section 62A, taxable income of a closely held company, owned by five or fewer shareholders, will be treated as the income of an individual (tax up to 50%) in certain circumstances if the income is derived from the activity of a material shareholder who holds 10% or more of any means of control in the company. Dividends paid out as such income are exempt from tax. Other income of the company is unaffected by the Section 62A rules.
Losses from Section 62A activities cannot be offset against income from other activities, according to the circular. Separate rules apply to certain foreign professional companies (ITO Sec. 75B1). The circular does not discuss the NII position.
Officer and managerial activities: Section 62A may cause full personal tax (up to 50%) on income from activities of a closely held company by an individual: (a) as an officeholder in another entity, or (b) providing management services “and so forth.”
This applies only if the individual is a material shareholder (10% or more) in the service provider but NOT the service recipient. Such income will be taxed at rates up to 50% as business or salary or other income. An officeholder is the chief operating officer (CEO) or his deputy, or the chief operating officer (COO) or his deputy, anyone performing such roles under another name, a director reporting to the CEO, or similar roles in an amuta (charity) or a partnership.
If the individual provides services to a partnership in which he is a partner, Section 68A may not apply. But the ITA will run a good-faith check: Is the partnership interest minimal? Was he already a partner?
Employment-type activities: In addition to the above, Section 62A may cause full personal tax (up to 50%) on income from services of a closely held company that are customarily done by an employee for an employer. Again, an exception is made if the individual providing the services is a material shareholder or partner in the service recipient.
This can be a bit vague, so the law specifies a situation that will trigger full Section 62A tax. This is generally so if 70% or more of revenue or taxable profit (other than capital gains, land depreciation and dividends) of the income are from services of the individual, his relatives and employees of the closely held company to one recipient for at least 30 months within any four-year period. If the 30 months are exceeded, the Section 62A tax liability is retroactive to day one.
The circular provides an important let-out for insurance agents and singers, among others. An insurance agent may bill one company, and a singer may bill one impresario, but many people may enjoy their services. But when it comes to doctors, the circular says anything is possible; the circumstances need checking.
The law contains a let-out if there are more than four hirers. Less than four hours per day for a hirer counts as half a hiring. Work done part of a year is counted pro rata. The circular says the ITA may check that the hirings are not phony.
Other clarifications in the circular: A director is not subject to Subject 62A unless he is also a material shareholder. A person may hold only 1% of a closely held company but cross the 10% line “together with another,” e.g. due to a voting agreement between them. A partnership in which each partner services separate clients may be ignored by the ITA; this is unfortunate because partners in large professional firms typically have their own books of business. Section 62A does not apply to rental income nor the sale of goods.
Comments: These are complex rules that will affect the Israeli SME sector, and they appear to differ from some of the tax-reform measures just enacted in the United States.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
firstname.lastname@example.org The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.