Controlled Foreign Corporation (legal information from an attorney specializing in international taxation)
What is a controlled foreign corporation? In the wake of a new amendment to the Income Tax Code, Israelis with a controlling interest for at least two years in a foreign company which is not issued on the Stock Exchange are required to pay taxes accordingly, once the company is classified as a foreign corporation controlled by an Israeli.
The Israeli law presently includes a mechanism that allows a significant rate of taxation on companies that were established in foreign countries but are owned by Israelis. It is important to know that the classification of a company as a controlled foreign corporation is not done automatically, and it is based on a number of criteria which are used to decide whether a company should be recognized as a CFC for Israelis. What are these criteria and in what cases can this classification be prevented? In this article, attorney Michael Decker, a partner in our firm and expert on corporate law and international taxation, answers these questions.
Controlled foreign corporation – a change in approach for Israeli law
A significant number of Israelis establish businesses abroad by holding controlling shares in foreign companies in other countries, particularly in countries where taxation is lower. These companies, from which Israelis receive passive income (such as interest or rent) were considered in the past to be foreign companies in Israel. This situation enabled Israelis to postpone their tax payments until the date of withdrawing dividends from the company. The situation changed in 2002, when an amendment to the Income Tax Code took effect. This amendment created a mechanism which makes such tax planning more difficult, in that such companies should be classified as Israeli-owned. A company that is so classified is called a “controlled foreign corporation” (CFC). In terms of Israeli tax law, this classification has crucial significance for the company and its owners. Below we explain in more detail.
How does the mechanism work and what are the criteria for recognizing the company as a CFC?
In short – Section 75B of the Income Tax Code, which defines the conditions for classifying a company as a CFC, states that such companies should be taxed at a rate of 25%. This tax is considered “theoretical”, since it is actually levied on dividends that have not yet been distributed, via a fiction through which the shareholder is considered to have received the company’s profits as a dividend. The law does not classify every Israeli-owned foreign company as a CFC, but rather sets out 5 basic criteria to be met in order to merit that classification.
What are these criteria? First, the law states that the company must be considered as a “body of persons” according to the definition of this term in the Income Tax Code. In practice, this means that even bodies which are not officially incorporated, or corporations recognized by Israeli law, should both meet this definition. Second, the law requires that the shares of the foreign company not be registered for trade on any stock exchange, in Israel or abroad. Alternatively, if some of the company’s shares are registered for trade on the stock exchange and publicly offered, it is required that this should be no more than 30% of the total.
A third condition is that most of the company’s revenues in the tax year (that is, over 50% of the revenues) are passive. The Income Tax Code defines passive revenue as any revenue from interest, indexation differentials, dividends, royalties, rent, sale of assets that are not used by the company in a business or profession, or revenue that stems from any of the above sources, “even if it is income from a business or profession”. The fourth condition is that the taxation rate on the company’s passive revenues, in the country where it is considered a tax resident, is less than 20%.
The fifth and last condition is that the company be controlled by at least one Israeli resident for 2 consecutive tax years. Anyone who owns 50% or more of the company’s means of control meets this condition. These means include the right to profits, the right to appoint a CEO or members of the board of directors, the right to vote in the company’s general meeting, the right to receive part of the company’s assets when it is dismantled, and the right to instruct other bearers of these rights to activate their rights. Also meeting this condition is someone who has over 40% of one or more of the means of control, and over 50% ownership of one or more means of control together with a relative who is not an Israeli resident; or someone who has the right to block other entities in the company from making essential decisions regarding its management, including decisions concerning dismantling the company or distributing dividends.
What can be done to prevent classification of a company as a CFC?
It is important to know that the above conditions are cumulative. Accordingly, if even one of the conditions does not exist, the company will not be considered a CFC, and as a result, the Israeli residents with holdings in the company will not face a 25% theoretical tax on their profits. Thus, for example, it is possible to make a public offering of more than 30% of the foreign company’s shares (or all its shares) on some stock exchange in the world, and this should overcome the prohibition on tax planning. Alongside this avenue, there are other avenues to avoid classifying the company as a CFC, but it is important that they be carried out according to the law. Before taking any action or making any change, it is advisable to consult with an attorney specializing in corporate law and international taxation, in order to ensure that you are acting legally and to avoid sanctions in Israel or abroad.
CFC – contact an attorney specializing in corporate law and international taxation
In this article we explained in detail what is a CFC, what are the criteria for classifying a company as such, and what are the options for preventing this classification and their tax implications. If you have specific questions or need assistance on this issue, you can contact us and we will be happy to be at your service. Our legal offices, in Jerusalem and Tel Aviv, specialize in corporate law and international taxation of companies. Attorneys from our office provide ongoing counsel to Israeli and international companies, and advise them on matters of tax planning and day-to-day legal issues. You can contact us at the telephone numbers and email address below.
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