Recent Israeli developments regarding 'Trapped Earnings,' changes to Preferred Enterprise regime require year end analysis

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EY Global

10 Dec 2021
Subject Tax Alert
Categories Corporate Tax
Jurisdictions Israel

Executive summary

On 15 November 2021, Israel released its 2021-2022 Budget Law (the Budget Law). The Budget Law introduced a new dividend distribution ordering rule to cause the distribution of earnings that were tax exempt under the historical Approved or Beneficial Enterprise regimes (Trapped Earnings), to be on a pro-rata basis from any dividend distribution, which is applicable to distributions starting from 15 August 2021 onwards. Meaning, that the corporate income tax (CIT) claw-back will apply upon any dividend distribution, as long as the company has Trapped Earnings.

In parallel, the Budget Law also includes a Temporary Order to enhance the release of Trapped Earnings by reducing the claw-back CIT rate that is applicable upon such a release or distribution by up to 60%, but not less than 6% CIT rate, during a one-year period beginning from 15 November 2021.

Also, a recent District Court decision in the case of Teva Pharmaceuticals1 concluded that the use of Trapped Earnings for the acquisition of foreign companies (as well as other uses of those earnings) is a prohibited use that should be regarded as a deemed distribution of those earnings, which triggers CIT claw-back.Lastly, companies should analyze the impact of the changes to the Preferred Enterprise regime following the end of the intellectual property (IP) box regime grandfathering rules as of June 2021, and with respect to year end.

Detailed discussion

Stimulating the release of “Trapped Earnings” from historical tax regimes

As a result of a Temporary Order that was included in the Budget Law, Israeli companies that have tax-exempt earnings (so-called “trapped earnings”) under the historical Approved and Beneficial Enterprise regimes, that are generally subject to a claw-back of the CIT that was not paid on such earnings upon their distribution (at a rate of 10%-25%), will be able to distribute/release such earnings with up to a 60% “discount” of the applicable CIT, but not less than a 6% CIT rate. The applicable CIT rate is determined based on a formula that considers the ratio of the “released” earnings out of the trapped earnings and the historical CIT the company was exempt from, and allows the maximum benefit if the entire amount of trapped earnings is to be released.

In order to enjoy that benefit, the company must meet the "designated investment" requirement within five years from the tax year in which it distributed/released the trapped earnings. The amount of such required investment is the company’s released trapped earning amount, multiplied by 30%, the release ratio and the CIT from which the company was tax exempt. This amount should be invested in the purchase of productive assets, research and development (R&D) expenses in Israel or the salaries of additional employeesthat are employed by the facility.

This Temporary Order is in force for earnings that will be released (without the requirement to distribute those earnings) during a one-year period from when the Order was enacted (15 November 2021). This is the second time in the past several years that Israel is offering a limited time relief to release trapped earnings.

In parallel, the Budget Law introduces a new rule to eliminate companies’ ability to elect the type of earnings they distribute, in a way that allows the tax-exempt earnings to become trapped in those companies. Accordingly, as of 15 August 2021, every dividend distribution will be regarded as if it was made on a prorated basis from all types of earnings, with the said claw-back applicable to the distribution of the prorated trapped earnings. Meaning that every dividend distribution will trigger the CIT claw-back, as long as the company has retained earnings.

District Court rules on prohibited uses of Trapped Earnings in the Teva Pharmaceuticals case, along with additional decisions on cash pooling, allocation of R&D expenses and more

On 26 October 2021, the Central Lod District Court ruled on the use of trapped earnings for the acquisition of non-Israeli companies in the Teva Pharmaceutical case, as well as on other disputes regarding cash pooling, R&D and financing expenses, among others. As this is a District Court case, the parties may still appeal this ruling to the Supreme Court.

Use of tax-exempt profits in favor of acquiring foreign subsidiaries

During 2006-2011, Teva Pharmaceuticals Industries Ltd (Teva), directly or indirectly through its subsidiaries, acquired four non-Israeli companies. To the company's approach, these acquisitions have made a significant contribution to Teva's activity in Israel.

From the Israeli Tax Authority’s (ITA) perspective, the use of these funds for the acquisition of those companies is prohibited and triggers the expropriation of the exemption under the Encouragement of Capital Investment Law (the Law) since the profits are no longer used for the promotion and development of the Beneficial Enterprise.

The Court accepted the position of the ITA and ruled that the use of the trapped earnings to acquire foreign companies constitutes a violation of section 51(h) and 51B(b)(1) of the Law, the result of which being the expropriation of the tax exemption in respect of those earnings. That is, since both according to the language of the Law as well as its purpose, the profits of the enterprise are to be directed to the benefit of economic activity in Israel and to the promotion of local enterprises.

Management of joint accounts of the group companies (cash pooling) by the parent company

In order to gain an advantage in size and for business considerations, Teva as the parent company centralized cash of its group companies under a cash pooling arrangement so that credit balances were created in the books of its subsidiaries towards Teva.

According to the ITA, the transfer of funds was "one-way" from the subsidiary to the parent company, with Teva using these funds as an owner, without having sufficient non-tax exempt earning funds to conduct its investments and activity, and with no real possibility of repaying the payable balance other than through dividend distributions from the subsidiary. De facto, Teva was the entity bearing the risks and rewards that were embedded in that cash managed in the joint accounts, and there was no agreement that anchored the relationship between the parties.

The Court accepted the ITA position on this issue and ruled that the group companies did not lift the required burden to prove that indeed, the funds managed were intended for the use of both Teva and other group companies. Moreover, eventually, these balances were repaid by way of a dividend distribution, which implies the original intention. Accordingly, the Court ruled that these balances should be classified as dividend income by the parent company.

R&D expense allocation and denial of financing expense deduction

The Court ruled on additional disputes mostly in favor of the ITA, such as the attribution of R&D expenses to both regular and tax-exempt earnings on the pro-rata method as determined by Section 18(c) of the Income Tax Ordinance. The Court also denied financing expenses (interest and foreign exchange expenses and the loss from a hedge transaction) in connection with the acquisition of foreign companies, as those are at the capital level and are not integral to Teva’s business activity.

Changes to the Preferred Enterprise regime as of June 2021 to be analyzed with respect to year end

As the transition period of the IP box regime (the Preferred Technological Enterprise regime) came to an end in June 2021, the impact on the Preferred Enterprise regime should be analyzed with respect to year end. The applicable changes relate mainly to the definition of "Preferred Income" entitled to benefits.

Following Amendment 73 to the Law, the definition of "Preferred Income" was changed in a way that the rules that are applicable to Preferred Technological Income must also be applied to the Preferred Enterprise regime.

The amendment to the law introduced transitional provisions for a Preferred Enterprise (which was entitled to benefits on 30 June 2016), so that the said change will apply from 30 June 2021.

Under the new definition, the principles set out in the OECD3 report on harmful tax regimes that are currently in force under the Preferred Technological regime also apply to the Preferred Enterprise regime as of the end of the transition period.

Accordingly, the following changes, among others, are applicable to the Preferred Enterprise regime:

  1. The tax benefits will be granted with respect of income from manufacturing activity (generally, based on cost plus 10% per the regulations, while this mechanism may be challenged by both the taxpayer or the ITA based on a transfer pricing study) or with respect to technological income which results from a "Beneficial Intangible Asset" such as patents, software, generic drugs, etc.
  2. Income derived from a marketing IP such as a brand, trademark, customer relations, etc., that exceeds 10% of the company's profits, will not enjoy the tax benefits and will be subject to tax at the headline CIT rate (currently 23%).
  3. Technological income will enjoy benefits in accordance with nexus rules.
  4. Documentation requirements are applicable.

Industrial facilities that have technology that is not included on the list of Beneficial Intangible Asset, may be subject to the standard CIT rate for profit that is attributed to that technology. Companies should consider the impact of these changes and consider alternatives to reduce a potential increase in the effective tax rate, together with the appropriate documentation that is required.


Companies with Trapped Earnings are encouraged to review the make-up of their earnings and the opportunity resulting from the Temporary Order for a one-year period beginning on 15 November 2021, together with the impact of the new ordering rule that is expected to trigger CIT claw-back from every dividend distribution as of 15 August 2021. Companies should also consider the impact of the Teva case on the use of such earnings, especially in the context of acquisitions of and loans to foreign companies.

In addition, companies under the Preferred Enterprise regime should closely review and analyze the impact of the changes to the rules as of June 2021 as well as the impact on their effective tax rate for 2021 and going forward, and consider opportunities to maximize the tax incentives available under existing regimes.


For additional information with respect to this Alert, please contact the following:

EY Israel, Tel Aviv
  • Ziv Manor

  • Lior Harary-Nitzan

  • Gilad Shoval

  • Sigal Griba

Ernst & Young LLP (United States), Israeli Tax Desk, New York
  • Lital Haber

For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.

  • Show article references#Hide article references

    1. CA 57133-01-15 + CA 31518-02-16 + CA 29910-02-17 Teva Pharmaceuticals Industries Ltd and others vs, Jerusalem Assessing Officer (the Teva Pharmaceuticals case).

    2. Additional employees are measured in comparison to the number of employees employed by the facility at the end of TY2020, excluding salaries of officers in the company.

    3. Organisation for Economic Co-operation and Development.