Israeli tax reform in relation to “closely held companies”

At the end of 2024, the Knesset enacted significant legislative updates within the framework of the Arrangements Law that completely revamp how “closely held companies” are taxed in Israel.

Section 76 of the Income Tax Ordinance defines a “closely held company” as a company controlled by a maximum of five unrelated people in which the public has no substantive interest (i.e. the company is not listed for trading on the TASE).

This new reform, which comes into effect from 2025 onwards, will also impact profits previously accumulated in those companies. The purpose of the reform is to eliminate the possibility of “closely held companies” accumulating profits according to the two-stage tax mechanism whereby companies are able to refrain from distributing profits in order to also refrain from paying the tax on dividends for many years.

Taxation of undistributed profits

The amendments included in the Arrangements Law (relating to section 81 of the Income Tax Ordinance) stipulate that “closely held companies”, as defined in section 76 of the Ordinance, holding accumulated profits exceeding ILS 750,000 (according to the formula for calculating accumulated profits) could be subject to a 2% tax surcharge on the closely held company’s “excess profits” without any possibility of tax offsets or deductions.

The excess profits will be calculated according to the total undistributed profits by the end of the previous tax year (“accumulated profits”) less exempt profits (excluded within the framework of the encouragement laws) and less a tax shield, which will be determined according to the higher of: (1) ILS 750,000; (2) the company’s expenses; (3) the cost of the company’s assets, net of the cost of passive assets.

The tax surcharge will not be imposed in a year in which one of the following conditions has been fulfilled:

1. the company had no excess profits;
2. the company incurred losses exceeding 10% of the accumulated profits;
3. the company distributed a dividend at 6% of its accumulated profits (5% in 2025);
4. the company distributed a dividend exceeding 50% of its excess profits.

The purpose of this section is to encourage the distribution of profits (and the payment of tax accordingly), since the tax surcharge eliminates the tax advantage of deferring payment of the tax on dividends by refraining from distributing profits.

Wallet companies (“salaried employee in disguise”)

In 2017, an amendment to section 62A of the Income Tax Ordinance was passed in relation to “wallet companies”, which prescribed conditions designed to eliminate salaried employees’ incentive to incorporate and provide services through a company for the sole purpose of avoiding high tax rates. Section 62A of the Income Tax Ordinance prescribes that a closely held company’s income, which derives from services provided by its controlling shareholder to another company in which he holds office or in which employment relations are apparent, is taxable at a marginal tax rate (i.e. the closely held company’s revenue will be deemed tantamount to the controlling shareholder’s income and will be taxed according to the shareholder’s marginal tax brackets).

The conditions of section 62A were amended in the current Arrangements Law and expand its application by constricting the two exceptions specified in the original legislation:

1. Holding percentage. Originally, section 62A of the Ordinance excluded instances when the “wallet company” provided service to a company through a service-provider who is one of the customer company’s controlling shareholders (holding more than 10%). The exclusion has now been reduced and will apply only when the service-provider holds more than 25% of that customer company, and provided that the service he provides is in his capacity as an officer and not as a regular salaried employee.
2. The section’s applicability to partnerships. In its original version, the section did not apply to income in respect of a service provided to partnerships (as opposed to ordinary companies). The amendment indeed prescribes that the section will not apply in the instance whereby a wallet company is a member of a partnership (which is entitled to its profits), but the section will now apply to a service-provider to a partnership through a wallet company that is not a member of the partnership, and income paid for the service will be subject to marginal tax.

The amendment also changes the way in which a service-provider will be deemed a “salaried employee in disguise”. Prior to the amendment, the presumption was that if 70% of a closely held company’s revenue turnover originated from services provided by the controlling shareholder to another company during a period of 30 months within 4 years, then at issue is a wallet company. Following the amendment, the presumption shortened the period to at least 22 months within 3 years.

Profitable closely held companies (“self-employed person in disguise”)

While “wallet companies” refer to salaried employees who incorporate as a company, the new legislation prescribes provisions addressing self-employed people who incorporate as a company for tax purposes. According to the new amendment to Section 62A(a1) of the Income Tax Ordinance, in “profitable closely held companies” with a turnover of less than ILS 30,000,000 (provided that the company’s accumulated profits exceed ILS 750,000), income attributed to the personal exertion of a shareholder of the company will be taxed at a marginal tax rate according to each shareholder’s share of the income.

“Profitable closely held companies” will be deemed companies whose profitability rate (taxable income from personal exertion divided by income from personal exertion) exceeds 25%, in which case, profits up to this rate will be taxed in two stages: (1) corporate tax and tax on distributed dividends); and (2) the balance at a marginal tax rate.

In the instance of a partnership, a “closely held company” entitled to more than 10% of the partnership’s profits will be subject to marginal tax according to the personal income of its shareholders. Concurrently, the partnership itself will be taxed in a similar manner to a profitable company that is not a partnership – up to 25% of profits will be taxed in two stages, while the rest of the partnership’s profits will be taxed at a marginal tax rate according to each member’s share (each of whom is entitled to more than 10% of the said profits). In the instance of a closely held company entitled to less than 10% of the partnership’s profits, 45% of the profits will be taxed according to two-stage taxation in the closely held company, while 55% of the profits will be taxed at the marginal tax rate of the closely held company’s controlling shareholder.

Please note: the section does not apply to a foreign trade company, controlled foreign company (CFC), preferred enterprise, beneficiary enterprise or to an approved enterprise.

The expected regulations and circulars

Draft regulations were published on January 20, 2025, which will regulate the mechanism through which a company can pay tax on dividends (even without an official distribution) in order to comply with the provisions of the new legislation.

The Israel Tax Authority is also expected to publish circulars within the coming months, beginning with provisions regarding company liquidations that are specific to 2025, followed by clarifications concerning all other amendments to the law.

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Our tax department is at your service for any questions regarding the Israeli tax reform and its impact on ‘closely held companies.