Trapped profits in approved, benefited and preferred enterprises

Companies that enjoyed benefits under the Law for the Encouragement of Capital Investments — an approved or benefited enterprise under the alternative track, a preferred enterprise or a preferred technological enterprise — sometimes hold profits on which full corporate tax was not paid. These are known as "trapped profits": as long as they stay in the company no further tax applies, but a tax liability arises when they are distributed.

Approved / benefited enterprise — alternative track (exempt profits)

On distributing exempt profits, the company is liable for corporate tax ("top-up") on the distributed profit. The rate depends on the company's status: 25% for a company that is not a foreign-investors company, and reduced rates for a foreign-investors company (20%, 15% or 10%, depending on the level of foreign ownership).

In addition, the dividend recipient is liable for dividend tax — according to their identity (individual, Israeli-resident company or foreign parent company) and the reduced rate that applies to the enterprise.

Preferred enterprise and preferred technological enterprise

In these tracks the tax on the profit is paid at the reduced rate in the year it is earned, and a reduced dividend tax rate (usually 20%) applies on distribution to an individual shareholder.

Surtax

For an individual, the dividend is included in taxable income for surtax purposes: 3% on the part above the income threshold, plus 2% on income that is not from personal exertion — 5% in total on the part of the dividend above the threshold.

The link to section 81

Exempt profits are also treated separately when computing excess profits under section 81. There are two alternatives for computing them, and the calculator compares them and chooses the more favourable one.

Considerations in deciding on a distribution

Deciding whether to distribute trapped profits requires comparing the tax cost of distribution — the "top-up" corporate tax and the dividend tax — with leaving the profits in the company. This includes the effect of exempt profits on computing excess profits under section 81, since exempt accumulated profits are deducted from accumulated profits for that computation.

Recommended work order

• Identify the enterprise's benefit track and the years in which the profits were earned.
• Determine the company's status (regular company or foreign-investors company) and the corporate tax rate that applies on distribution.
• Identify the dividend recipients and the dividend tax rate for each.
• For individuals — review the effect of the surtax.
• Compute the total tax burden and compare it with the alternatives.

Frequently asked questions

Can the profits be left in the company without tax? As long as the exempt profits are not distributed, no further tax applies; however, their effect on computing excess profits under section 81 should be reviewed.

Is the dividend tax rate the same for all recipients? No. It depends on the recipient — an individual, an Israeli-resident company or a foreign parent company — and on the benefit track.

Notes

• The reduced tax rates depend on the benefit track, the year the profit was earned and the company's status — they should be reviewed for each enterprise.
• This article does not exhaust the provisions of the Law for the Encouragement of Capital Investments.