- As detailed in the background to the report of the team for the examination of undistributed profits, in the early 2000s, and against the background of significant gaps in the marginal tax that applies to individuals compared to companies at the time, a significant advantage was created for operating through a company over operating as an individual in terms of tax liability. Accordingly, during that period, thousands of new companies were established in Israel, the purpose of which was to bring about the fact that the self-employed or salaried employees would be taxed according to the lenient tax regime that applies to companies, and in doing so, they would benefit from the tax benefit (ibid., at p. 9). This issue preoccupied the government in those years, and was later placed on the table of the Committee for Economic and Social Change (headed by Prof. Manuel Trajtenberg), which was established in 2011 against the backdrop of the social protests, with the aim of formulating measures that would ease the burden of the cost of living in Israel (hereinafter: the Trajtenberg Committee). As part of the many issues dealt with by the Trajtenberg Committee, the issue of tax equivalence between activity as an individual and activity through a corporation was also discussed, including the phenomenon of wallet companies. Although the Trajtenberg Committee did not formulate concrete recommendations for dealing with the phenomenon, it recommended the establishment of a team to examine tax policy in relation to wallet companies (Report of the Committee for Economic and Social Change 101 (2011)).
- In accordance with this recommendation, in 2012 a "Wallet Companies" team was established headed by the then Director of the Tax Authority, Adv. and CPA Moshe Asher (hereinafter: the Wallet Companies Team). Among his recommendations that were published for public comments (although no final recommendations were published later): attribution of companies' revenues to their shareholders in cases where there is an employee-employer relationship between the shareholders and the company; imposing a tax of 1% of the company's surplus accumulated profits (profits exceeding 25% of its total revenues), which were not distributed as dividends; and amendment and simplification of section 77 of the Ordinance (the document is available for viewing at the following link: https://www.gov.il/he/pages/sa-28102013-5).
- Following the work of the Wallet Companies Team, in 2016 Amendment No. 235 to the Income Tax Ordinance (hereinafter: Amendment 235) was determined. As part of this amendment, section 62A was added to the Ordinance, which, as will be detailed below, allows in certain cases to attribute the company's income to its shareholders (a response intended to deal with the wallet companies). In addition, section 77 of the Ordinance was amended in order to strengthen the Tax Authority's ability to deal with holding companies that choose not to distribute dividends (it should be noted that a petition was filed against Amendment 235 that was rejected out of hand - High Court of Justice 1716/19 Friedman v. Director of the Tax Authority [Nevo] (June 18, 2020)). At the same time, during 2017, it was decided to provide a one-time benefit ("dividend promotion") in the form of a reduction in the tax rate on dividend distribution (25% instead of 33%). Although this decision led to a significant increase in the collection of taxes on dividends (ILS 20 billion instead of ILS 6 billion that year), it also led to a significant decline in the scope of distributions in the following years.
- Despite the steps taken and described above, the phenomenon of accumulating profits in wallet companies has not been solved (for more information, see: State Comptroller's Report on Taxation of Undistributed Profits (2020)). Against the background of the above, in 2024 a team was established- the team for examining undistributed profits - with the participation of representatives from the Tax Authority and the Ministry of Finance. After examining various alternatives for dealing with the phenomenon, as well as the ways in which different countries around the world operate, the team found to recommend three main steps: amending section 62A of the Ordinance in order to expand the range of cases in which a company's income will be attributed to its shareholders; imposing a new 2% tax on excess profits accumulated in the companies' coffers that were not distributed; and amending and simplifying section 77 of the Income Tax Ordinance In order to enable the Tax Authority to conduct an individual proceeding vis-à-vis companies with a high surplus balance. The team estimates that the potential for collection from these measures is about ILS 5 billion per year (of which about 99% will be collected from the top income decile).
- The team's recommendations were adopted mainly in the framework of Amendment No. 277 to the Income Tax Ordinance , which, as may be recalled, is the focus of the petition at hand. The main provisions of the Constitution will be detailed below.
Undistributed Profits Taxation Law
- The Undistributed Profits Taxation Law has led to two major changes in the tax regime that applies to "few companies" - a company that is controlled by a maximum of five people, and is not a subsidiary or company in which the public has a real interest (including public companies). See: sections 62a(d) and 76 of the Ordinance). In summary, the first change, which was determined in section 62A of the Income Tax Ordinance, is intended to deal with occupational companies by expanding the range of cases in which the company's income will be attributed to the individuals who hold it; while the second change, which was determined in sections 81a-81f of the Income Tax Ordinance, is intended to deal with holding companies by imposing a tax of 2% on excess profits accumulated in the companies' coffers and not distributed as dividends. Now in more detail.
- Section 62A of the Ordinance is intended to deal with the phenomenon in which salaried employees of companies or officers thereof artificially terminate their employment as employees, but continue to provide the company with the same services through a company under their control. In these cases, since the establishment of the company is intended, as a rule, to enable that individual to benefit from the beneficial tax regime that applies to companies, without any economic justification for this, it was determined that the existence of the company in this regard should be ignored, and the shareholder (the service provider) should be charged directly with tax on all the income deriving to the company from his personal labor. The central arrangement was determined, as noted, in the framework of Amendment 235, while the current amendment is intended to address a number of "loopholes" that remain. I will discuss the main points of the arrangement, including the changes made in the framework of Amendment No. 277 to the Ordinance to the extent that they are relevant to our case.
- Section 62A(a) of the Ordinance states that "the taxable income of a minority company, [except for taxable income attributed to the minority company from the income of a partnership in which it is a partner, which is not a foreign occupation company as defined in section 75B1 of the Ordinance], which derives from the activity of an individual in which he is a controlling shareholder, will be considered as the income of the individual" in the following cases:
An individual acting as an officer or providing management services: The income of the minority company will be attributed to the individual as personal income (according to Section 2(1), 2(2) or 2(10) to the Ordinance), if the income of the minority company derives from the individual's activity as an officer or from the provision of management services and the like in another company (and see the details In section 62A(a)(1) to the Ordinance). The changes made to this alternative in the framework of Amendment No. 277 to the Ordinance are not the focus of the petitions.