Shareholders of a company agree on the exit of one of them and because the company has cash, they also agree that the company will purchase his shares. The shareholders really like the idea but it turns out that the Tax Authority likes it even more because it deems it a taxable dividend to all shareholders... Dividend? But the remaining shareholders did not meet with money!
The Israeli corporate legislation enables a company to purchase its own shares, but the Tax Authority deems this an event equivalent to the distribution of a dividend. This is because the distribution of a dividend actually constitutes giving an asset to a shareholder as a right of the shares. When a company purchases its shares, a situation is created where even if the amount of shares in the hands of the shareholders has not changed, the relative holding percentage of the shareholders changes as a result (and with the financing of the company) and therefore, the event is deemed a dividend distribution to all shareholders and will be taxed accordingly.
Let's take a simple numerical example: In order for the remaining shareholders to pay the money to the outgoing shareholder, the company needs to distribute a dividend to all and then they will use the money to pay the outgoing shareholder. If the company has only one asset and it is a bank account with ILS 90 in it and the company has 3 shareholders, the share value of is ILS 30. Now it is agreed that instead of two purchasing the third out at the amount of ILS 30, the company will pay him. The meaning is the same as a situation where the company distributes a dividend of ILS 10 to each and then the two remaining shareholders transfer their share to the outgoing one.
In December 2017, the Israeli Supreme Court decided a case in which two brothers inherited a company and decided on a division in which one purchased the shares of the other. The Court held that this move has no business logic related to the conduct of the company and therefore the two brothers are to pay tax on the purchase, which was deemed as a dividend in the amount of the purchase price. In a case decided in February 2023, the Supreme Court found that a separation transaction in a company that is managed as a partnership, in which the company bought out one of the shareholders, is deemed for tax purposes as if the company first distributed a dividend equal to the purchase price of the shares to all shareholders and then the remaining shareholders transferred their share to the outgoing shareholder. Therefore, each of the shareholders pays tax on the proportional part of the dividend that he would have received if the transaction had been done in the aforementioned two stages. Another result, in which only the remaining shareholder is charged with tax on the dividend in the amount of the entire purchase value, may impose an unjustified liability on him.
A separation transaction in a company is an action that requires a lot of attention, as this type of action may be significant from both a legal and a tax point of view. The classification of the transaction for tax purposes may be affected on a case-by-case basis, depending on the circumstances. Therefore, to the extent that a shareholder in a company is considering initiating a process of separation, it is recommended not be accompanied by an accountant, but also to consult with a lawyer knowledgeable in the field of mergers and acquisitions who will be able to propose different mechanisms, which will also be examined with the tax advisor, to ensure that the action is carried out in the best way, in accordance with the provisions of the law applicable to the case in a manner that will lead to the prevention of unnecessary and expensive tax accidents.