Big business is out, small business pays

The intention of the Tax Authority to re-examine the law on undistributed profits should be welcomed. As part of the Economic Efficiency Law for 2025, a law was approved that imposes a tax on undistributed profits. This is a controversial law that imposes an additional tax on the allegedly "trapped profits" of companies, on which corporate tax has already been paid.

Closely-held companies that over the years have purchased real estate assets from accumulated profits and decided to rent them out on the free market are now required to distribute part of their accumulated profits annually — including profits invested in rented real estate assets — and pay a dividend tax on them, or alternatively, a "penalty tax" of 2%. However, the provisions of the section do not apply to contractors who build and sell properties as part of their inventory in their ongoing operations, nor to companies whose annual turnover exceeds 30 million shekels, usually large and publicly traded companies.

This is a distortion that discriminates between small and medium-sized business owners, who are significantly harmed by the legislative amendment, and large business owners, who are not included in the scope of the section. This is a blow to a broad sector that is an engine of economic growth. Moreover, the law's provision does not only relate to company profits from now on, but also applies the new tax mechanism to profits generated in the past. In fact, the rules of the game were changed mid-stream.

The distortion is sharpened when comparing assets intended for "self-use" versus income-generating assets. A company that purchased an asset and uses it for its own needs receives protection for the asset, while a company that rents the asset to a third party is required to bear the tax payment annually on the profit component that financed the asset. This creates an unnecessary incentive to purchase assets for self-use instead of renting them.

The law exempts the profits of companies that own an industrial plant, which originate from income from manufacturing activity. Thus, a situation is created where a company that owns an industrial plant and manufacturing activity that rents an asset from another company will be exempt from tax as an industrial company, while the renting company will pay tax on the "trapped profits" component that financed the asset.

Recently, the Director of the Tax Authority, Shai Aharonovich, noted that the trapped profits reform should be examined to see if it has a negative impact on the economy. The re-examination of the law's provisions is a necessary step to provide certainty to taxpayers and their representatives. Until a legislative amendment is made, small and medium-sized business owners are forced to turn to tax planning, which may create disputes with tax assessors in the future.

The authors are Adv. (CPA) Ehud Barzely and Adv. Liron Ben Mayor.