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Newsletter 10/2023

The Encouragement of Capital Investment Law – How Many Employees Does an Enterprise Need?

 

The Encouragement of Capital Investment Law, 5719 -1959 (hereinafter: the “Law”) grants Israeli companies substantial tax benefits, reflected both in a reduced corporate tax rate and a reduced tax rate on dividend distributions, either for a “Preferred Enterprise” or a “Preferred Technological Enterprise”.

A basic condition for requesting benefits under the Law is the existence of an “Industrial Enterprise” of the company. According to the definition in the Law, enterprises in Israel whose primary activity during the tax year is production activity are considered an “Industrial Enterprise”. For this purpose, the production of software and development products is considered production activity.

Therefore, it appears that companies engaged in software development should be entitled to be considered an Industrial Enterprise for the purposes of the Law’s definition. However, the Israel Tax Authority’s approach over the years has been that an Industrial Enterprise requires a minimum amount of production/development employees.

In the past, the ITA’s position has been that an Industrial Enterprise must employ at least ten production employees. Yet in recent years, along with changes in the nature of the work and the development of a hi-tech industry which is modern and differs from the classic enterprises that won recognition in the past, the ITA has changed its approach. Now, its position is that an Industrial Enterprise should have at least three production/development employees (at least with respect to the hi-tech industry), provided they work from the company’s offices.

Despite this, it is important to remember that the Law does not contain any requirement with respect to the minimum number of employees. Moreover, Amendment 73 to the Law, which entered into force in January 2017, set forth benefits for a “Preferred Technological Enterprise”. When referring to companies engaged in technology, despite prescribing numerous criteria for eligibility for “Preferred Technological Enterprise” tax benefits, including a specific reference to employees, the legislator did not stipulate that a minimum threshold of employees must be met to be eligible for benefits under the law.

There have also been changes in the caselaw, where in the past few years courts have chosen to place emphasis on “transformations that have occurred in the areas of economics, industry, commerce, and employment” and have underlined that “modern industry differs materially from traditional industry, and one must take this fact into consideration.” The Supreme Court stated that the caselaw has expressed a certain flexibility with respect to the definition of an “Industrial Enterprise”.

In a judgment handed down in 2018, the District Court concluded that the nature of modern industry justifies a position that, for an Industrial Enterprise, a relatively small number of employees is sufficient. However, in the circumstances of this judgment, where the founders did not withdraw a salary from the company and were engaged in additional work concurrently with the software development, the court held that the company should not be seen as engaging employees and therefore it denied its eligibility for benefits.

In our opinion, the honorable court’s position can be disputed, since in some cases this is merely a technical detail. One example might be the case of a new company, which has five shareholders, who in practice work as production and development employees in the company, yet do not withdraw a salary from the company. This might be because of a preference to withdraw the revenues as a dividend rather than as a salary, or because the company is in its initial stages and they do not wish to deplete its funds on an ongoing basis. According to the position presented by the court, such a company would not be eligible for benefits under the Law, since it does not have a single salaried “employee”. Clearly this would be absurd, and this was neither the intent of the court nor the legislator.

Therefore, our position is that each case must be examined individually. Thus, for example, in the circumstances described above it should be determined whether there are parties that work and act for the company, even if they are not salaried “employees”. In addition, there may be additional cases that should be examined, and it certainly might be possible to claim benefits under the Law even where no “employees” are engaged at all, and even if development is executed without the company having an office.

For additional information, contact Adv. (CPA) Shahar Strauss or CPA Erez Hagai from our firm.

This memo’s objective is to inform you of general information on various topics. The law’s provisions themselves are more complex and include additional exceptions. Accordingly, the foregoing in this memo should not be implemented without consulting the relevant professional

 

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