Israeli tax law is a very complex subject but is similar to that of most English-speaking countries, where income tax is the prime source of governmental revenue. Taxable Income is defined as income from recognizable sources, including capital gains, after the deduction of expenses and disbursements. However, much of the tax collection system is based on the principle of withholding of tax deducted at the source from income. Since 1985, Israel taxes only real income, with adjustments made for inflation. While Israel appears to be a country with a heavy tax burden, numerous tax exemptions are available, especially to foreign investors.

The first Israeli income tax laws were based upon the 1941 "Palestinian Ordinance", passed during the British Mandate and based upon the British "Model Income Tax Ordinance." This code has been amended many times in the last fifty years, such as in the Inflationary Adjustments of 1985, and the Knesset Finance Committee passes new tax legislation every year. The Minister of Finance and the Income Tax Commissioner may also implement certain changes in the tax code with or without the approval of the Knesset. Other legislation, such as the Law for Encouragement of Capital Investments, may contain tax amendments as well.

Israeli taxation is based on the principle of territoriality, where Income Tax is levied on income derived or accrued in Israel and Income derived or accrued outside of Israel if it is received in Israel. However, there are many exceptions to this rule and Israel has signed Double Taxation treaties with several countries to prevent people from being taxed twice on the same income.

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Israel's tax year ends on December 31st, and tax returns should be filed within five months, unless an extension has been granted. Companies and self-employed individuals must make monthly advance tax payments, based on the previous year's assessment. Withholding taxes may be set off against these advance payments. Taxpayers must keep careful records for filing tax returns, and the Income Tax Commissioner may refuse to accept tax returns based on records not properly kept. Minors and salaried employees who receive less than a certain amount do not have to file tax returns, since their tax is deducted at the source.

Monthly advance payments of 45% must be made on certain nondeductible expenses, such as excessive motor vehicle, foreign travel, or entertainment. Capital gains tax advance payments of 30%, or the full tax if less, must be made within thirty days of the sale of the asset.

After deducting advances and withholding payments, the balance of the tax must be paid on the tax return. This is linked to the Consumer Price Index and accrues at 4% per year. In the event of an overpayment, the balance also gains interest at the same rate. Overpayments that are advance payments on nondeductible expenses are not refundable and do not earn interest, although they may be offset against future tax liabilities.

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Double Taxation

Whenever a taxpayer is taxable both in Israel and abroad for the same income, double taxation relief may be available either with a bilateral treaty or unilaterally. Double taxation relief in Israel usually involves a credit for tax paid overseas. The country of residence, usually the place where the taxpayer lives or where their business is managed, credits the investor for taxes paid on income in a foreign country. This allows a foreign investor to withdraw profits earned in Israel under more favorable tax treatment. If the foreign resident receives little or no double taxation relief, the Ministry of Finance is empowered to permit a partial or full refund of the Israeli tax paid.

Many of Israel's Double Taxation treaties include a "tax sparing" clause to preserve the special tax incentives given by Israel to encourage foreign investment. Even if foreign investors gain tax benefits for investing in an Approved Enterprise, they are still entitled to claim the full original amount of the tax as a foreign tax credit. Some of the Double Taxation treaties also allow taxpayers to receive credit for Israeli company tax on income from which dividends have been paid, as well as crediting the tax withheld from the dividends. Generally, withholding tax rates for dividends, interest, and royalties are reduced under Israel's tax treaties.

Income derived by a foreign investor from Israel, or from a business controlled in Israel, will generally be taxable in Israel. Israeli business that are controlled and managed abroad, but remit their income to Israel, may be permitted by the Ministry of Finance to pay Israeli income tax at a special maximum rate of 15%, or even to be completely exempt from Israeli taxation. They may also exempt foreign employees assigned to Israel for up to 183 days in a year if the foreign employer does not charge the employee's salary against the profits of the Israeli branch. Many tax treaties also exempt foreign residents from capital gains tax on Israeli source capital gains, such as the sale of shares and securities listed on the Tel Aviv Stock Exchange, although gains from Israeli real estate interests and from assets owned by a foreign company's permanent establishment in Israel are still subject to Israeli taxation.

The foreign income of an Israeli resident which is remitted to Israel is taxable at the lowest of three rates: Israeli tax at regular rates on gross income, at a rate below 25% of the amount of foreign tax received in Israel, or Israeli tax that results in a combined rate of foreign and domestic tax up to 45% for a company or 48% for an individual. Credit for foreign taxes paid will usually be available to Israeli residents who dispose of overseas capital assets.

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As of 1996, Israel maintained bilateral tax treaties with the following countries:

Austria	Finland	Jamaica	South Africa
Belgium	France	Japan	Sweden
Canada	Germany	Netherlands	United Kingdom
China	Hungary	Norway	United States
Czech Republic	Ireland	Poland
Denmark	Italy	Singapore

Treaties with India, the Philippines, Romania, and Thailand had been signed, but not yet ratified as of January 1996. A treaty with Turkey was scheduled to be signed in March 1996.

The Double Taxation Treaty with the United States

One example of a bilateral double taxation treaty is the one signed in 1995 by Israel and the United States of America after twenty years of negotiation. This was especially important, since the United States is Israel's largest foreign trading partner. Although the treaty substantially improves the climate for investment between the two countries by reducing withholding rates, they still tend to be higher than those between many other countries. Generally, the United States taxes its residents for their worldwide income while granting double taxation relief by crediting them for tax paid in other countries up to a certain limit. U.S. source interest, dividends, and interest received by U.S. permanent residents living in Israel may be subject to taxation by both states without relief unless it is resourced to the United States by treaty.

In the United States, individual taxpayers are taxed at both federal and state government levels at rates between 15% and 39.6% of their income. Long term capital gains are taxed at a maximum rate of 28%. Since U.S. law declares that capital gains are sourced to the place of residency, Israeli tax imposed on the sale of Israeli shares may not be creditable against the U.S. tax on that same gain. American corporations are also taxed on their worldwide income, on both federal and state levels, at rates of 15-35%. Unlike individual taxpayers, U.S. corporations may claim credit for direct and "indirect" foreign taxes paid by affiliated subsidiaries. U.S. corporations pay capital gains tax at the individual rates, with sales of shares in a foreign company considered U.S. source income. Anti-deferral tax laws, designed to prevent the use of foreign corporations to defer American taxation, requires the inclusion of income from foreign corporations controlled by American shareholders, although there is an exception if they have paid foreign tax equal to at least 90% of the highest U.S. tax rate. However, an "approved enterprise", which gets substantial tax breaks in Israel, will probably not qualify for this exemption.

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U.S. foreign credit tax rules are quite complicated and are limited to the lesser of the foreign tax paid or the U.S. tax imposed on the foreign source income after deductions. Tax credit is calculated separately for each "basket" of income and while interest is assigned to the "passive income" basket, it may be "kicked out" to the "general limitation" basket if it is over the highest marginal U.S. tax rate. U.S. taxpayers are subject to a 17.5% withholding rate on outgoing interest payments, although the new treaty reduced interest-withholding rates to 10% on American loans extended to Israel. U.S. residents may elect to be taxed on Israeli source interest as if it was attributable to a permanent establishment in Israel. Israeli residents generally use the 17.5% withholding rate on their U.S. source income, instead of the normal statutory 30% rate, although U.S. source interest paid to an Israeli bank is withheld at 10%. Israeli residents may choose to be taxed in the United States on a net basis with respect to their U.S. source income, but the specific rules for this vary by State.

U.S. individuals and corporations owning less than 10% of the voting shares in an Israeli corporation are subject to a 25% Israeli withholding tax on "portfolio dividends". While this can be placed in the "passive basket" for foreign tax credit toward double taxation relief, it cannot be counted toward the "indirect foreign tax credit" for foreign subsidiaries. Israeli residents making a "portfolio investment" in a U.S. corporation will also be subject to a 25% withholding tax (the normal American rate is 30%) which will be credited by the Israeli government.

Israel may impose a capital gain tax on foreign investors who sell shares in an Israeli corporation if they have owned more than 10% of the voting stock in the past year, although these gains will be considered to have originated in Israel. Capital gains by foreign residents owning less than 10% of voting shares will be exempt from Israeli taxation. In the United States, foreign investors are generally exempt from American tax on the sale of shares in an American company, unless it is a "U.S. Real Property holding company".

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The normal Israeli withholding rate for royalties is 25%, although this treaty reduces certain copyright and film royalties to 10% and other types of royalties (such as patents and trademarks) to 15%. The normal U.S. withholding rate for source royalties is 30%, but the treaty also reduces copyright and film royalties to 10% and "industrial royalties" to 15%. Double taxation credit can be obtained through each country’s standard methods.

U.S. investors purchasing and selling Israeli real estate will be subject to Israeli taxes and may be credited in the United States, up to certain limits. If this is through investment in an Israeli real estate company, they will be taxed on the sales of their shares in this company. Although Israel has no gift or estate tax, a U.S. resident who inherits Israeli property from another U.S. resident will have to pay American estate tax. Israeli residents will also have to pay the standard U.S. taxes on the purchase, sale, and capital gains stemming from American real estate. Again, they may choose to be taxed on a "net basis" regarding their U.S. real property income. Since the double taxation treaty does not cover gift and estate tax, Israeli residents inheriting property in the United States will be subject to American estate tax.

U.S. corporations conducting business in Israel are exempt from taxation unless it is a "permanent establishment". Taxes paid to Israel for the operation of an Israeli branch of an American company will be credited in the U.S. Branch remittances to the "head office" are not subject to a "branch profits tax", unless it is an "approved enterprise", in which case it will be 15%, although the treaty limits it to 12.5% of the "dividend equivalent amount" of the branch's profits. Israeli corporations conducting business in the United States will be subject to U.S. taxes if they constitute a "U.S. trade or business". In the U.S., "branch level interest tax" is U.S. tax on the excess of interest paid by a branch over its total deductible interest expense. The treaty reduces the amount of U.S. branch profits tax to 12.5% and the branch level interest tax to 5%.

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If a U.S. corporation invests in an Israeli subsidiary corporation and holds at least 10% of the outstanding voting shares, the company is subject to normal Israeli corporate income tax rates and a dividend withholding tax of 12.5%, unless it is an approved enterprise, in which case the withholding tax rate becomes 15%. Israel may tax capital gains from the disposal of such a corporation. These profits will be considered Israeli source gains, ignoring most sourcing rules, and be creditable against U.S. taxes. For Israeli companies owning at least 10% of the voting stock in an American subsidiary, the U.S. withholding tax is 12.5%, instead of the standard rate of 30%. Israeli corporation selling these shares will be exempt from U.S. taxes, unless it was a "U.S. Real Property holding company". Israel will grant a credit for U.S. withholding taxes on dividend income and will grant an "indirect" credit with respect to the U.S. tax paid on the earnings and profits of U.S. corporations paying the dividend.

A cash grant from the Israeli government is one of the optional benefits available to a foreign investor in an "approved enterprise". This grant is generally not taxable under either Israeli or U.S. law, where it is considered a capital contribution, although the amount of the grant generally reduces the basis in the assets for Israeli tax purposes. U.S. taxpayers may also elect to treat the cash grant as non-taxable for U.S. purposes as well - in which case it reduces the basis in property of the corporations' Israeli assets.

Salaries paid to U.S. resident employees assigned to Israel are generally considered to be Israeli source income and taxable in Israel. Yet, U.S. residents are exempt if the following conditions are met: the individual is present in Israel for less than 183 days in a year, the individual is an employee of a permanent establishment maintained in the United States, the compensation is not borne as such by a permanent establishment of the U.S. employer in Israel, and the compensation is subject to tax in the United States. U.S. residents are generally subject to tax on their worldwide income regardless of the place of physical residence. They may claim foreign tax credits for Israeli taxes and may exclude up to $70,000 of compensation earned outside the United States if abroad for more than one year. However, the double taxation treaty does not cover social security and a U.S. resident working in Israel may be subject to taxes from both countries.

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Value Added Tax (VAT)

The Israeli Value Added Tax Law of 1975 established a 17% VAT tax payable on all goods and services purchased within the State of Israel. It is added to the sale price and collected from the buyer at the time of the sale. The total amount, after the seller has deducted the VAT paid on inputs related to income production, is paid monthly to the VAT authorities. If the VAT on inputs exceeds the amounts collected during any given period, the excess is refundable.

Some financial institutions, like banks and insurance companies, do not collect VAT on their inputs and services, but pay the 17% tax on their payroll and profits. Importers pay 17% on the value of goods for customs purposes when cleared although there is no VAT charged on exports paid for in foreign currency. Nonprofit organizations pay a VAT of only 8.5% on their payroll costs, and may not set VAT off against inputs. Residents of Eilat, and companies doing business there, are exempt from VAT.

Since international tourists, by definition, are not Israeli residents and are not paying tax in Israel, they are exempt from many VAT charges if they pay with foreign currency, such as hotel services and automobile rentals. Some businesses, such as souvenir dealers and duty-free shops, will also exempt foreign residents from VAT if they pay with foreign currency. Unprocessed fruits and vegetables, intangible assets, certain services purchased in Israel by a nonresident, and transportation of cargo to or from Israel by air or sea are also VAT exempt.

Some other transactions are exempt from VAT, but related inputs may not be claimed as deductible. They include rents received on a private residence for less than ten years, sale of a previously-owned apartment by a non-realtor, proceeds from the sale of a rental building, import of a new immigrant's personal effects, letting of real estate for "key money", exported goods that are reimported, income from deposits with financial institutions, and the import and export of unset diamonds and other semi-precious stones.

Estate Duty, Inheritance, and Gift Taxes

There is no estate tax in the State of Israel, nor is there an inheritance tax or a "death duty". Gifts are usually tax exempt, especially when made to a relative or to the State of Israel, but may be subject to capital gains tax in certain circumstances, such as if the gift is resold by the recipient.

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National Insurance (Social Security) and Social Benefits

Although real wages are relatively low in Israel, compared to many other industrialized nations, social benefits paid by employers can account for 7-35% of the worker's salary. These benefits come from statutory obligations, collective bargaining agreements, and generally accepted conventions.

Israel's National Insurance Institute provides residents with a comprehensive series of Social Security benefits, financed by mandatory contributions from both employers and employees. Payments are based on the employee's monthly salary, based upon the taxable income counted for income tax purposes. As of 1995, employees earning less than 2,042 NIS or US $676 per month, were contributing 7.52%, with 2.66% from the employer and 4.86% from the employee. Employees earning between 2,043 and 16,332 NIS, or US $677 and $5,408 were contributing 11.78% per month, with 4.9% from the employer and 6.88% from the employee. Limited social security benefits, with reduced national insurance contributions, are available to non-residents currently working in Israel.

Cover includes unemployment insurance, maternity benefits, work injury compensation, child allowances, old age pensions, some medical care costs, and reserve military duty compensation. Some types of employment income are exempt from paying national insurance contributions up to prescribed limits, such as employee automobile maintenance allowances, the "usage value" of automobiles placed at the employee's disposal, telephone allowances, recreational allowances, commuter travel allowances, employers' contributions to employees' advanced training funds, and meals in the industrial sector.

Employees are entitled to severance pay on dismissal or reaching retirement age, which is 65 for men and 60 for women. Severance pay is usually one month's salary per year of employment, based on the last salary received. Employees who resign voluntarily do not always receive severance pay, although they may be entitled to it by clauses in collective bargaining agreements. Employees who left due to poor health, maternity, or the bankruptcy of the employer may also be entitled to severance pay. Since Israeli tax laws do not distinguish between compulsory and voluntary severance payments, all are tax deductible.

In addition to the social security arrangements provided by the National Insurance Institute, Israel has many private pension funds. Many labor agreements require employers to make contributions of 5-6% of their employee's salaries to these funds, with the employees contributing 5-5.5% as well. These contributions are usually excluded from an employee's taxable income, as long as they are within prescribed limits. These funds are also usually tax exempt, although they may be taxed if the funds are over a certain limit or withdrawn prematurely.

Advanced training funds are part of some collective bargaining agreements, which encourage employers and employees to set aside a monthly contribution toward further education and training of senior and academic employees. Generally, the employee contributes 2.5% of their salary while employers contribute 5-7.5%. The employer's contributions may be tax exempt within certain limits, although the employees' are not, although the fund may be if withdrawn at certain periods.

Israeli employees are also entitled to certain other benefits, such as an annual recreational allowance, a paid sick leave, and yearly paid vacations of two to four weeks, depending on their length of employment. Although it is not required by law, many employers make up the difference between their employee's salaries and the National Insurance compensation for days lost to mandatory military reserve duty. Some employers also pay for their employees' commuting costs.

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