New memorandum of law regulating the crypto sector in Israel

The Israel Tax Authority and the Ministry of Finance have published a memorandum of law to regulate the digital asset sector in Israel. This memorandum recognizes digital assets for the first time as capital assets subject to capital gains tax and is the first in a series of intended to advance the regulation of this sector. The memorandum of law, which seeks to develop the regulatory framework and infrastructure for digital assets, was published as part of Israel’s economic plan for 2023-2024.

The memorandum of law was published shortly after the State Comptroller published his annual report, which criticized the Tax Authority for its inefficiency in collecting taxes from crypto profits and for not analyzing the potential for tax collection in the crypto sector which, according to estimates, resulted in a loss of tax revenues totaling between ILS 2-3 billion.

Status of digital assets

One of the memorandum’s main proposals is to clearly regulate the status of a “digital asset” as a capital asset, which will be subject to capital gains tax upon its sale, unless the activity is classified as business income, which is subject to marginal tax. This will be achieved by including a detailed definition in the section addressing taxation of capital gains. The new definition defines a “digital asset” as “an asset that constitutes a digital representation of a value or right, which is transferrable and storable electronically using Distributed Ledger Technology or similar technology for recording or storing of information that the Minister has specified in the order.” However, the definition explicitly excludes the following assets from the definition of a “digital asset”: legal tender in Israel, foreign currency, securities or any other asset that the Minister will include in the order.

Lack of regulatory uniformity

One of the main problems in the Israeli crypto sector however, is the lack of uniformity in definitions between the various regulatory bodies. The Tax Authority, the Capital Market Authority Insurance and Saving, the Bank of Israel and the Israel Securities Authority use different terms, such as “virtual currency,” “cryptographic asset,” “digital asset” and “cryptographic tokens.” This lack of uniformity makes it difficult to create a clear regulatory framework, blurs the boundaries of enforcement and creates uncertainty for holders of digital assets.

Foreign currency

The memorandum of law also proposes an updated definition of “foreign currency” in the Income Tax Ordinance, so that it will be based on the Bank of Israel Law. According to the proposed definition, “foreign currency” will be defined as “banknotes or coins that are legal tender in a foreign country and are not legal tender in Israel,” but only currencies issued by a country’s national monetary authority will be considered foreign currency. The purpose of this change is to prevent an interpretation whereby digital assets used as a means of exchange in a foreign country will be included under the definition of foreign currency even though they were not issued by a central bank. The memorandum of law therefore anchors the Israel Tax Authority’s position, which was approved by a court ruling, whereby such digital assets will not be considered foreign currency under Israeli law and a tax exemption on linkage differentials will not be allowed.

Finally, the memorandum of law proposes to set clear rules, as part of an amendment to Section 89(b)(3) of the Income Tax Ordinance, for determining the country of issue or generation of capital gains from digital assets for the purpose of taxing them in Israel. The amendment seeks to provide a solution for the complexity of determining the source of digital assets, due to the absence of a physical location, and regulates the tax liability in a manner tailored to the unique characteristics of these assets.

The proposed rules for determining the source of capital gain

• Ÿ If the seller was an Israeli resident at the time the digital asset was purchased;
• Ÿ If the digital asset reflects a direct or indirect right to an asset located in Israel, then a portion of the proceeds deriving from disposal of the asset in Israel will be subject to capital gains tax;
• Ÿ If the digital asset reflects a direct or indirect right to a body of persons that is a resident of Israel.

The importance of the memorandum

The proposed memorandum is an important step towards regulating the digital assets sector and maximizing the taxation potential, but it also raises complex questions about its actual effectiveness. The State Comptroller pointed out that the ratio of those reporting crypto profits to the Tax Authority is negligible – only 500, compared to the estimate of between 200,000 and 1,670,000 holders of digital assets in Israel.

In our opinion, the real challenge is not limited to the reporting obligation. One of the main problems is the lack of cooperation on the part of the banking system, which often refuses to accept funds originating from digital assets. Paradoxically, it is precisely those willing to pay taxes who encounter obstacles on the part of the banks, which are refusing to deposit the funds into their accounts. If the banks do not remove these obstacles, merely amending the legislation will be insufficient to realize the economic potential of the crypto sector for the benefit of the public and the economy as a whole.