New Israeli Court Ruling: Companies with Accumulated Losses May Recognize Distributable Profits

An Israeli district court recently issued a ruling in Tax Appeal 36830-07-23 Av-Shal Investments and Trading Ltd. v. Haifa Tax Assessor. This ruling expands the interpretation of the accounting alternative for distributable profits in Section 94B of the Income Tax Ordinance. The court held that distributable profits will be included in the calculation of the tax benefit even when the company being sold has a balance of accumulated losses, provided that those profits accumulated during the holding period and actually contributed to reducing the balance of the accumulated loss.

This is a significant departure from the position presented by the Israel Tax Authority in the past, with a focus on the objectives of Section 94B of the Income Tax Ordinance to prevent double taxation and create tax indifference. This ruling has material implications for companies looking to realize tax benefits when selling shares. We therefore recommend that companies take this ruling into account at the planning stage of relevant transactions.

Definition of “Distributable Profits” in Section 94B

One of the objectives of Section 94B of the Income Tax Ordinance is to create tax indifference when selling shares. In other words, a shareholder may choose between two alternatives: to withdraw dividends (which would reduce the consideration from the sale of shares accordingly), or to sell the shares together with the company’s accumulated profits.

The section states that, when selling shares, the component of the consideration representing distributable profits will be taxed as if it had been distributed as a dividend—i.e., at the tax rate applicable to a dividend—and not as a capital gain.

The definition of “distributable profits” in Section 94B(b) is the lower of the following two alternatives:

1. Accounting alternative – This relates to the profits accumulated in the company since the end of the tax year preceding the purchase of the shares until the end of the tax year preceding their sale (known as the period of distributable profits), according to the company’s statement of financial position at the end of the tax year preceding the year of the sale.
2. Taxation alternative – This relates to taxable profits (after deducting taxes paid, dividends distributed, and losses not yet offset, and after adding tax-exempt profits, if any).

The tax significance: when the seller is a company, the distributable profits component may be taxed as an intercompany dividend and thus will be tax exempt, as opposed to capital gains tax, which will be charged at the time of sale, at the rate of 23% (corporate tax).

The Dispute: Can Distributable Profits Be Recognized When the Company Has Accumulated Losses?

The case concerned the sale of 19% of the shares of Israel Shipyards Ltd., which was held by Av-Shal Investments. Israel Shipyards accumulated significant losses prior to Av-Shal’s purchase of the shares. However, during the period of distributable profits, Israel Shipyards accumulated profits that reduced the losses by more than ILS 238 million.

Av-Shal argued that, notwithstanding the accumulated loss, the profits generated during the period of distributable profits (for which Israel Shipyards paid corporate tax) and which contributed to reducing the loss, should be considered distributable profits for the purposes of the accounting alternative. With this argument, Av-Shal sought to determine the distributable profits according to the (lower) taxation alternative and reduce the capital gain accordingly.

The tax assessor disputed this reasoning and argued that since Israel Shipyards had negative retained earnings, the total of distributable profits representing the accounting alternative was zero, in accordance with the profit test in Section 303 of the Companies Law. Therefore, the entire sale should be taxed as a capital gain.

The Court’s Ruling: Distributable Profits May Be Recognized Even If the Company Has Losses

The court accepted Av-Shal’s position in its entirety and established, for the first time, a judicial interpretation of the accounting alternative, while stating that the Israel Tax Authority’s position may lead to double taxation and undermine the purpose of tax indifference in Section 94B. Accordingly, the court ruled that distributable profits may be recognized even when a company has accumulated losses, provided that the profits accumulated during the holding period and actually reduced the loss.

The court also ruled that:

• Although Section 94B of the Income Tax Ordinance and the profit test in the Companies Law both address distributable profits, these are different legal aspects that should be interpreted as independent legal frameworks.
• The wording of Section 94B prescribes that accumulated profits must be examined over the period of distributable profits, according to a company’s statement of financial position.
• Section 94B does not consider whether profits may actually be distributed, only the nature of the profits.
• Taxation of distributable profits, for which corporate tax was already paid upon generation, will undermine the two-tier taxation mechanism, since the first stage was already taxed. Denying the recognition of profits will lead to over-taxation and frustrate the principle of tax indifference.

Practical Implications for Companies: Broader Possibilities for Exercising the Tax Benefit

This court ruling contributes to tax certainty during transactions for the sale of shares or companies and provides broader possibilities for benefiting from the distributable profits mechanism, even when the company has accumulated losses, while preventing double taxation. In contrast to the approach used until now by the Israel Tax Authority, companies holding other companies with accumulated losses that also accumulated distributable profits during the holding period may now:

• recognize those distributable profits even without actually distributing dividends;
• benefit from taxation as an intercompany dividend (even in instances such as illiquidity or equity profits);
• reduce the capital gain component of the sale transaction.

The court ruling clarifies that even when a company has accumulated losses, the existence of distributable profits for tax purposes should not be ruled out automatically. Therefore, when planning a share sale transaction, we recommend re-examining the structure of profits and losses during the holding period, as well as the possibility of implementing the distributable profits mechanism in a way that reduces the company’s tax liability.

When it comes to complex situations, and especially when a company has both losses and profits accumulated over time, we recommend examining the transaction structure and tax implications in advance, as they may materially affect the transaction’s economic outcome.

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Adv. Hanna Daher is a partner in our Tax Department.

Adv. Itay Edelstein is an associate in the department.

Barnea Jaffa Lande’s Tax Department has extensive experience in supporting Israeli and multinational companies in various acquisition, sale, and restructuring transactions. The department’s team provides comprehensive legal advice on all tax aspects of both commercial activities in Israel and international transactions, including strategic planning and the creation of optimal tax structures tailored to the unique needs of each client, while ensuring compliance with all applicable tax laws (including international tax treaties). The team also handles issues related to VAT and other indirect taxes.