In short
Under Section 94B of the Israeli Income Tax Ordinance, a seller of shares can treat part of the capital gain as a dividend, up to the company's distributable earnings. A restructuring usually resets the acquisition date of the shares, so the rules in Part E2 aim to preserve the distributable earnings the shareholder had just before the restructuring – no loss and no windfall. The rules are scattered: some are in the section itself, some in regulations, and some only in tax rulings. In Feller, the court held that under Section 104A the distributable earnings do not pass to the shareholder but remain in the transferred company.
A judgment was recently handed down in the Feller case (Tax Appeal 70919-01-23, Haifa District Court). From a business restructuring perspective I did not find anything significantly new in it, but one of the issues it dealt with is the calculation of distributable earnings (Section 94B of the Income Tax Ordinance) after a restructuring. Without getting too complicated: the court held that on the sale of shares allotted in a restructuring under Section 104A, the original acquisition date is preserved only for the linear calculation of the capital gain, and not for distributable earnings. This is a good opportunity to take stock of how distributable earnings are treated in business restructurings.
Why does it matter?
Under Section 94B, a person selling shares can treat part of the capital gain as if it were a dividend, up to the amount of the distributable earnings. For a company selling shares of an Israeli subsidiary, this can be the difference between full corporate tax and an exemption. The calculation rests on two factors: the acquisition date of the shares and the holding percentage.
The problem in a restructuring
Almost every type of restructuring provides that the acquisition date of the allotted shares will be the date of the restructuring, and sometimes it also changes the holding percentage (for example, in a merger). Without a special rule, the distributable earnings accumulated up to the restructuring would be wiped out, and a restructuring that is meant to be tax-neutral would harm the taxpayer.
The guiding principle
Preserve the distributable earnings the shareholder would have had if they had sold their shares just before the restructuring. No loss, and no new benefit gained as a result of the restructuring.
Where are the rules?
The rules on distributable earnings are scattered across Part E2 of the Ordinance:
- In the section itself – for example, in a share exchange under Section 104H and in a spin-off under Section 105D.
- In regulations and rules – for example, in a merger and in a transfer of assets between sister companies under Section 104B(f).
- Only in the tax ruling – sometimes there is no statutory rule at all, and the matter is settled only in the tax ruling (for example, in a distribution of subsidiary shares under Section 104C).
- Section 104A – there is no express rule. In Feller, the court held that the distributable earnings do not pass to the shareholder on the sale of the allotted shares; they remain in the transferred company, and the receiving company will be able to benefit from them when it sells that company. In my view the circumstances there were specific, and this outcome does not always sit well with the preservation principle.
- Cross-border restructurings – the Israel Tax Authority sometimes provides in the tax ruling that distributable earnings derived from profits that were not taxed in Israel will be erased, so as not to "import" a tax benefit into Israel.
The Bottom Line
In every restructuring it is worth calculating the distributable earnings just before the transaction and keeping the calculation for the future sale. Where there is no rule in the law or the regulations, it is worth setting out expressly in the tax ruling how the distributable earnings will be treated, to avoid a future dispute with the assessing officer. Planning a restructuring? Send me a message and we'll look at this point together in advance.