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What tax implications should be attributed to self-purchase of shares executed by a limited company in Israel?

This question was recently examined by Israeli Supreme Court in the recent ruling on Civil Appeal 9380/20 and Civil Appeal 8116/21. In both cases disagreement between shareholders led to necessity of one of the shareholders to sell his share of company in order to leave. In the first example, Beit Husan case, there was a conflict between shareholders, which caused confrontation between one of the shareholders and Beit Husan ltd. Management, including his refusal to abide by the General Assembly’s resolutions and even a court action taken by him against the company and its directors. Other example, Saida case, was more peaceful: two brothers with equal shares in a limited company mutually decided to separate their ways due to controversies about further business development. In both cases the companies purchased their shares from the outgoing shareholders’ hands by using the companies’ funds. As a result, remaining shareholders earned additional benefit and control over their companies due to increase of their shares’ proportion in the companies’ shared capital.   

According to the Tax Authority’s position, where a company purchases its shares from all of the shareholders, proportionately, the purchase will be viewed as the distribution of a dividend, whereas on a self-purchase other than “pro-rata” first, the remaining shareholders will be viewed as if they have purchased the shares from the selling shareholders, in the amount of the purchase in accordance with their relative shares in the Company. Afterwards, they will be viewed as if the remaining/ purchasing shareholders have transferred the shares that they purchased to the Company, in consideration for the amount of the purchase in an exchange transaction, so that a dividend will arise for them in the amount of the purchase. Therefore the remaining shareholders are due to pay tax on this income.

The Supreme Court Justices were divided on the correct approach to the tax outcome of such self-purchase. Justice Stein, in a Minority opinion, ruled that the Tax Authority’s position demanding taxation of remaining shareholders in all cases of self-purchase of shares by private companies contradicts one of the basic principles of Israeli Taxation Law stating that tax should be paid on actual income in contrast to the potential income. To Stein’s mind, not all self-purchase transactions of private companies generate actual income for remaining shareholders. Stein suggests a criterion to distinguish between taxable and non-taxable self-purchase transactions: dominant goal of transaction. To implement this criterion, one must examine what was the main goal the shareholders wished to achieve by making a decision resolution on self-purchase: whether there was a business reason to perform this transaction for a benefit of the company and its business, or the reasons were personal benefit of the shareholders who wished to gain personal advantage from this transaction. Based on this criterion Stein ruled that Beit Husan transaction should be held non-taxable, because there was a valid business reason for the self-purchase, that was aimed to resolve the internal conflict within the company, to execute a negotiated settlement in order to terminate a court dispute and to relieve the company from the deadlock caused by the conflict. It is possible, Stein admits, that the remaining shareholders also received certain benefit from this transaction, however it was minor compared to the main goal. On the contrary, Saida case is an example of self-purchase intended to achieve shareholders’ personal benefit as the main goal. The transaction was executed in order to allow the remaining shareholder to obtain full control over the company without investing his personal funds. Therefore, the Tax Authority’s decision to tax him as if he had received dividend from the company seems correct and justified. 

Nevertheless, the Majority (Vice-President of the Supreme Court Fogelman and Justice Ronen), has rejected the approach of Stein, as impracticable and unimplementable in business reality. The Majority ruled that in private companies with few shareholders, company’s interest and shareholders’ interest and benefit are not distinguishable , so the shareholders almost always profit from their company’s benefit. The Majority deemed preferable to establish one clear and simple rule regarding self-purchase tax implications in order to allow the shareholders to predict and to calculate their steps while taking decision about self-purchase by their companies without speculating and making non-productive efforts to pretend it to look like aimed to achieve business goals. It seems that mainly because of this argument the Majority restricted its ruling to companies with few shareholders, and ruled in favor of the Tax Authority’s position in both cases.

As the Supreme Court panel has not been unanimous on this significant issue, it is likely that a leave for the Additional Consideration by an expanded panel of the Court may be applied for and granted in this matter.