Dear Clients, Colleagues and Friends,
On May 6, 2018 a revolutionary decision was published by the Supreme Court in the Or Sarah case. The decision determines that capital gains of Family Companies should be calculated in New Israeli Shekels (NIS), with the cost basis adjusted to the Israeli Consumer Price Index, and not to the foreign currency in which the security is denominated. This calculation creates a situation in which the "built in" appreciation of the foreign currency is subject to tax, whilst losses arising from the depreciation in the value of the currency can be offset.
It is strongly recommended that taxpayers who own Family Companies should examine the implications of this decision on their tax liability, as well as their entitlement to submit amended tax returns and to request a refund for previous years.
Background
The calculation of capital gains. In general, in a transaction for the sale of securities, the “real” capital gain is calculated as the difference between the “adjusted cost price”, and the sale price of the security. The "adjustment" of the initial cost price can be made in a few ways, depending on the classification of the asset which is being sold and the identity of the seller. Generally, the cost price should be linked (adjusted) to the Israeli Consumer Price Index ('CPI') last published by the Israeli Central Bureau of Statistics prior to the purchase. However, in the case of a security held by an individual and denominated in a foreign currency or the value of which linked to a foreign currency, the currency exchange rate is treated as the index for linkage purposes. In other words, the adjusted cost price for individuals is the original cost price linked to the relevant exchange rate, and for companies it is the original cost price linked to the CPI.
It should be noted that according to recent case law, a loss which derives from the decrease in the exchange rate cannot be offset against any gain, in the same manner that a gain which derives from the increase in the exchange rate is not taxable.
What is a Family Company? A Family Company is a company whereby all shareholders are "relatives" (generally, a close family member). Under Israeli tax law, a company such as this can elect to allocate its income to any shareholder with the right to the largest part of the company's profits. In this way, the company is taxed as an individual. In the recent years, many individuals have established family companies to hold their portfolio; as such a company is considered a regular company in foreign jurisdictions and provides for estate tax protection, and on the other hand, is subject to tax as an individual in Israel.
The Court Decision
The issue discussed in the Supreme Court Decision. The issue raised in the Or Sarah Ltd. case is whether a Family Company should be treated as an individual (and accordingly, make the calculation based on the foreign currency) or as a company (and to make the calculation based on NIS and the change in the CPI) for the purpose of the calculation of capital gains derived from the sale of securities denominated in non-Israeli currency.
The Supreme Court determined that for the purpose of the calculation of the capital gains of a Family Company, derived from the sale of securities which are denominated or linked in a non-Israeli currency, the cost basis of the security should be adjusted to the CPI (in the same manner applicable to an ordinary company) rather than to the foreign exchange rate (applicable to individuals).
Examples:
Positive change of the exchange rate, CPI does not change:
|
Price in US$ |
Exchange rate NIS/$ |
Price in NIS |
| Purchase |
100 |
3.5 |
350 |
| Sale |
100 |
4 |
400 |
In this example, although the nominal US$ value of the security has not changed, a Family Company entering into this transaction would be considered as having a capital gains of NIS 50, whilst an individual would record no capital gain.
Negative change of the exchange rate, CPI does not change:
|
Price in US$ |
Exchange rate NIS/$ |
Price in NIS |
| Purchase |
100 |
4 |
400 |
| Sale |
100 |
3.5 |
350 |
In this example, although the nominal US$ value of the security has not changed, a Family Company entering into this transaction would be considered as having a capital loss of NIS 50, whilst an individual would not be able to record any loss.
As stated above, in the case of an individual, the above examples would have no effect, as the entire gains and losses, which derive solely from the change in the exchange rate, are not taxable in the case of the gain (in example 1), or deductible in the case of the loss (in example 2).
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Should you require any further information or clarification regarding the issues discussed in this circular, please do not hesitate to contact us.
Tax Department
Herzog Fox & Neeman
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