Raveh Ravid - CPA in Israel

Taxes in Israel: Israel Tax Reform - 2003

Since January 2003, the Israel tax system has been subjected to a substantial reform.

Until that time in Israel, taxes were calculated based upon territorial affinity of a taxpayer to Israel. For example, an Israeli resident would usually pay no taxes in Israel on income accrued abroad.

Since January 1, 2003, Israel has based its taxation system primarily on personal affinity (i.e. Israeli residents are taxed on any income accrued both in Israel and abroad and foreign residents are liable for taxes on income derived from Israeli sources.

This article will give a short description of the major differences in Israel taxes between the two systems. Furthermore, this article will note some additional taxation changes which were introduced in this tax reform.

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The Israeli Tax reform 2003:

Until 2003, territorial location constituted the main factor in determining taxation requirements. All income accrued in Israel by both Israeli and foreign residents was taxed, yet many kinds of income which were derived by Israeli residents from sources abroad were exempt from taxation.

Unlike the United States, there were no regulations which applied to personal affiliation. Israeli citizens who received vocation income abroad, or income from investments made abroad didn't pay Israel taxes on those incomes.

Since the institution of the Israeli tax reform, individuals and companies are taxed based on residency. However, the Israeli legislature took many factors into account while planning the new taxation system and combined many elements of the territorial based system together with the personal based tax system.

Israeli residents and companies are subjected to taxes on income derived from both Israel and abroad, while foreign companies and individuals are subjected to taxes on income derived from sources inside Israel.

In addition to changing the basis for taxation from territorial to a personal one, some other major changes were initiated in Israel taxes. The following are a few examples of the substantial modifications and additions to Israel taxes:

Gradual reduction of income tax rates for individuals and also of corporate tax rates. Most tax rate reduction was aimed at the middle income brackets;
15% tax on stock exchange gains and other income from capital markets such as interest income and the introduction of a new mechanism for tax payments such as deduction at source by banks from interest and some capital gains;
Taxation on foreign revenues according to the so called 'Basket Method' when income from each source of income from all foreign countries is summed up separately per source;
Encouragement of business and technology entrepreneurs through more equitable taxation of capital gains, options and shares for employees etc.

Opinions vary regarding the effectiveness of the 2003 tax reform. Many accountants and economists claim that one of the main goals of the reform, to increase local investment, was not reached.

Many Israeli businesses still tend to prefer investing abroad, or in foreign companies. Moreover, personal based taxation led to an increase in taxation for certain groups of Israeli residents, mainly large capital holders, and made them consider transferring their residency abroad in order to avoid Israeli taxation of their incomes.

Certain concerns are expressed by different economists, tax specialists and investors regarding the complexity and lack of certainty regarding the Israeli residency determination for corporations – the so called “Control and Management” criteria.

Expanding Israeli residency criteria and the flexibility of its interpretation might lead to unnecessary disputes by foreign and domestic corporations with Israeli tax authorities and/or may lead to an expansion of taxation on certain categories of corporations which was not initially meant by the reform. Put together, all these factors might constitute a negative incentive for foreign investors.

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