12-34-56-78 Chekhov v. State of Israel, P.D. 51 (2)
The Two-Stage Model of Corporate Taxation - Its Advantages and Disadvantages
- The starting point of tax law is that a company has a separate legal personality, and therefore it must be taxed separately from its shareholders. In accordance with this starting point, the taxation of a company's income is done in Israel, as in many other countries around the world, in two stages. In the first stage, the company's taxable income is subject to corporate tax, which currently stands at 23% (section 126(a) of the Income Tax Ordinance). In the second stage, when the company's profits are transferred to its shareholders through the distribution of dividends, they are subject to income tax at the rate of 25% or 30%, depending on the shareholder's holding in the company (section 125B of the Income Tax Ordinance). Hereinafter: The two-stage model. See also: Civil Appeal 7566/13 Assessor for Large Enterprises v. Zhurbin, paragraphs 14-15 [Nevo] (June 22, 2015); Civil Appeal 8511/18 Tax Assessor Netanya v. Delek Hungary Ltd., para. 3 [Nevo] (January 26, 2020) (hereinafter: Delek Hungary case)).
- Although the tax regime that applies to companies is different from that which applies to individuals, in practice, after the company's profits have been distributed to its shareholders through a dividend, the tax rate imposed on its income is approximately similar (even if not identical) to that which applies to individuals. In doing so, the legislature sought to maintain "tax indifference" - i.e., a situation in which the taxpayer's choice whether to act on his own or through a company will be made on the basis of economic considerations, regardless of the tax regime that will apply to him (Civil Appeal 8847/13 Shapira v. Gush Dan Tax Assessor, para. 3 [Nevo] (September 5, 2016); the Hungarian Delek case, at paragraphs 3-4). However, even in these circumstances, the two-stage model allows companies, as opposed to individuals, to enjoy a significant tax benefit - the ability to defer payment of about half of the tax until the date on which the company chooses to distribute a dividend (hereinafter: the tax benefit). This is, in fact, a kind of loan that the state gives to companies, without paying interest and for an unlimited period of time.
- Why, then, did the state choose to allow companies, as opposed to individuals, to control the date on which the tax charge would apply? The logic underlying this choice is that the company has the option to make use of the profits accumulated in its coffers for the purpose of investing and expanding its business activity. In the long term, the assumption is that the company's use of these profits will lead to growth and increased social welfare, as well as an increase in the state's tax revenues (Ministry of Finance, Report of the Team for the Examination of Undistributed Profits 7 (2024) (hereinafter: the Report of the Team for the Examination of Undistributed Profits); the Economic Efficiency Bill (Legislative Amendments to Achieve the Budget Targets for 2025) (Taxation of Undistributed Profits), 5785-2024, the Search Order / Government Entry Order 1808 (hereinafter: the explanatory notes to the Law)). To be precise, the justification for allowing companies the tax benefit involved in deferring its payment to the State Treasury arises only when the company uses the profits accumulated in its coffers for the purpose of its business activity. In other circumstances, the tax benefit may serve the interests of the shareholders, but it clearly undermines the public interest.
- The typical case in which the tax benefit is used for a purpose other than the purpose for which it was established is when the establishment of the company is intended to provide its shareholders with a tool for accumulating profits, which will be invested in assets unrelated to its field of activity (such as investment in the capital market or real estate assets), and will be distributed only after a long period of time (if at all). In these cases, the company serves, in practice, as a wallet in which the assets of its shareholders, who benefit from the tax benefit in their investments (hereinafter: wallet companies). It is customary to distinguish between two common types of wallet companies - an occupation company and a holding company:
Occupation Company It is a company whose income is based mainly on the personal business of its shareholders, who provide services through it. For example, a lawyer or accountant who provides his services through a company he established for this purpose, and it is the one who receives the payment on their behalf. As a result, instead of the individual providing the service being obligated to pay income tax at the rate prescribed by law, it is the company that bears the tax burden in the first stage - and as mentioned, until a dividend is distributed, this is a relatively low rate of corporate tax. To be precise, one of the most prominent characteristics of occupational companies is that the expansion of their business activity does not depend, as a rule, on a significant capital investment. Therefore, as long as the company chooses not to distribute dividends, the main use made of the profits accumulated in its coffers is for private investments that are not related to its field of business (for example, the purchase of real estate assets for rent or investment in the capital market). In this situation, the tax benefit does indeed serve the company's shareholders, but the purpose underlying its granting is not achieved.