June 24 2011
In recent years the
Israeli currency - the new Israel shekel - has gained considerable strength against
the US dollar. Israeli exporters have been seriously damaged by the flow of
'hot money' to Israeli capital markets in order to exploit the differences in
prevailing interest rates.
In an effort to curb
the flow of foreign funds into Israel with the purpose of purchasing short-term
government bonds and notes, the government recently brought a bill before the
Israeli Parliament (Proposed Amendment 186 to the Income Tax Ordinance). If
enacted, the bill would abolish the present exemption granted to non-residents
with respect to capital gains derived from securities traded on the Israeli
Stock Exchange (ie, gains derived from the sale of short-term government bonds
and notes). In this context, 'short term' is defined as a term of one year
before redemption of the government security.
The proposed bill
misses its mark.
Taxation of trading
First, profits derived by non-residents from trading in short-term government
bonds and notes are generally trading profits. As such, they should be
classified as ordinary income.
Most of the 'hot
money' flowing into Israel has its source in developed and industrial
countries. Israel is a signatory to more than 50 treaties for the prevention of
double taxation. This treaty network includes all wealthy nations, with each
treaty providing an exemption for trading profits that were not generated by a
permanent establishment (eg, an office or dependent agent). The net result is
that these trading profits are unrelated to the capital gains exemption granted
to non-residents on capital gains derived from gains realised on the Israeli
Stock Exchange. Thus, non-residents from treaty countries will continue to be
tax exempt as long as their activities reach the degree of a trade and they
refrain from establishing a permanent establishment in Israel.
Interestingly, the tax
authorities have not attempted to use the ordinary income classification to tax
non-treaty non-residents. Perhaps the latter did not appear on the tax radar
Taxation of capital
The second problem arises with respect to capital gains derived by
non-residents from the realisation of short-term government bonds and notes on
the Israeli Stock Exchange. Once again in the case of funds flowing into Israel
originating from developed and industrialised nations, the treaties for the
prevention of double taxation will again exempt these gains from Israeli taxes,
as under these treaties, capital gains are to be taxed exclusively by the
country of residence. The lack of an Israeli exemption will not do away with
the treaty exemption.
The end result is that
removing the present exemption will extend the tax net to reach the trading
profits and capital gains of non-residents who reside in countries with which
Israel has not entered into a double taxation treaty. These are likely to
include foreign tax havens employed by residents of wealthy countries to
speculate in Israeli short-term government bonds and notes or to derive capital
gains from their realisation.
The proposal would
require treaty-exempt non-residents to apply for a tax withholding exemption.
At present, such an exemption is not required as any capital gains are
statutorily exempt. In short, bureaucrats will gain work, but the government
will gain no income from the proposed bill, if indeed it becomes law.