Itai Ran and Yael Hadad
On December 22nd 2017, a historical tax reform was passed – the US Tax Cuts and Jobs Act of 2017. The primary objective of the reform is to encourage job creation and to spur investments in the US using the carrot and stick approach.
The carrot – in an effort to encourage new company launches and the relocation of operations to the US, federal corporate tax in the US was significantly reduced from a progressive tax rate of 15- 35% to a single flat rate of 21%. It is important to note that in the US, state and local taxes must be added to the federal tax rate. As a result, the inclusive effective tax rate (federal, state and local) currently stands at an average of 27%. In comparison, Israel’s corporate tax rate (currently 23%) is still lower than the US corporate tax rate; however, the gap between the countries’ tax rates has narrowed, as has Israel’s competitive edge.
The stick – laws regarding the US taxation of CFCs (Controlled Foreign Corporations) have been toughened. For US taxation purposes, a CFC is a non-US company (Israeli, for example), with over 50% of its value or voting power controlled by or affiliated with US persons. The laws were toughened in two primary tracks: first, the reform expanded the breadth of situations in which an Israeli company would be considered a CFC; second, the tax ramifications imposed on US stockholders would be more severe if the company is defined as a CFC for US tax purposes.
As a result, since the legislation of the tax reform, some US funds have expressed concern over investing in non-US companies (including Israeli companies). In rare instances, funds even stipulate their investment in Israeli companies on corporate inversion (establishing a US parent company of which the Israeli company would be a subsidiary). The classification of the Israeli company as a CFC would not impact the company itself; rather, it would impact the American stockholders. As such, the Israeli company is indifferent to whether or not investors are American, and would favor an investor making the better offer.
The establishment of an American parent company could provide relief to US stockholders, but it could also cause the company itself significant tax leakage because it would subjugate the company and the group to the US tax network. Exiting this network at a later date could prove impossible.
Understanding the issue and its ramifications, the Israeli Tax Authority recently unleashed its Green Track, which simplifies the corporate inversion process while offering a tax exemption in Israel. The objective of the track is to allow entrepreneurs and early-stage startups to incorporate as an Israeli company, while offering flexibility to establish an American parent company in the future, if so required by business demands such as attracting investors and foreign capital. In certain instances, there may still be a preference for the structure of an American parent company from the date the group is established, and not through retroactive corporate inversion. This would depend on a company’s business plan for raising capital from US and non-US funds, on the anticipation that an entrepreneur would relocate to the US, on profit and loss forecasts of the upcoming years, and on other data.
The extent of the impact that the US tax reform will have on Israeli companies is still uncertain. Following the reform, there is no generic solution or structure that suits all situations, and each startup needs to make these decisions on a case-by-case basis. nonetheless, the more Israel is able to offer regulatory and taxation solutions that benefit companies and that allow them to be competitive in Israel, the smaller the impact of the US tax reform will ultimately be.
Written by Itai Ran, Partner, US tax desk; Yael Hadad, Partner, US tax desk, Kost Forer Gabbay & Kasierer of Ernst & Young