Taxation of Retained Earnings in Israel’s 2025 Economic Arrangements Law

Taxation of Retained Earnings in Israel’s 2025 Economic Arrangements Law

Corporate taxation in Israel operates under a dual-tier system. Initially, current earnings are subject to corporate tax, which is set at 23% as of this writing. Upon distribution to shareholders, these earnings are then subject to a dividend tax, at a rate of 25% to 30%.

This two-tier structure incentivizes businesses to incorporate, thereby enabling them to pay corporate tax on profits and reinvest the after-tax amount into the corporation rather than distributing it as dividends, thus deferring the second tier of taxation on dividend payouts.

The 2025 proposal for taxing retained earnings, often referred to as "trapped profits," outlines conditions under which tax authorities would deem retained post-corporate-tax earnings as having been distributed as dividends, thereby triggering dividend tax even if no actual distribution has occurred.

The proposed legislation distinguishes between retained earnings earmarked for genuine reinvestment in the company's operational activities, such as R&D, capital expenditures, and workforce expansion, versus retained earnings allocated to passive investments, such as real estate acquisitions or financial market investments.

The proposed amendments primarily target two types of corporations:

1. Personal Service Corporations (PSCs)

• Active PSCs - These are companies whose primary earnings are derived from the personal services of the shareholder, such as medical practices or legal firms. In these cases, shareholders typically draw a salary for personal expenses, which is subject to personal income tax. The remaining earnings are taxed at the corporate rate (generally lower than the individual income tax rate) and any post-tax retained earnings are often accumulated for passive investment purposes.

2. Holding Companies

• These entities engage in limited active business operations and derive most of their revenue from passive sources such as dividends, interest, and capital gains. Frequently controlled by a small group of individual shareholders, these holding companies often receive tax-free intercompany dividends from active operating companies. The retained earnings are subsequently funneled into passive investment activities.

For active PSCs, the proposal recommends implementing a progressive tax, whereby retained earnings exceeding a certain profitability threshold would be taxed as if they were individual income for the shareholder, effectively subjecting them to the progressive individual tax rates.

For holding companies, the amendments propose additional restrictions to limit the use of these structures as tax planning vehicles.

This reform is anticipated to take effect in 2025, with transitional provisions allowing companies to adjust to the new regulatory framework.

Source link: https://did.li/LpYCN

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