New Israeli Tax Reform Targets Undistributed Profits

In an effort to curb the accumulation of undistributed profits in certain corporate structures, Israel has introduced a new tax reform targeting specific types of companies (privately held companies owned by small amount of shareholders), including personal service companies, single member companies, and holding companies. The tax reform introduces substantial compliance challenges and financial planning implications for almost all of the private companies in Israel. The introduction of mandatory profit distributions, and stricter reporting obligations underscores the Israeli government’s aim to increase tax revenues, even on the benefit of retained earnings. This is a far-reaching reform whose scope may extend beyond companies incorporated in Israel, impacting foreign companies controlled and managed from Israel, permanent establishments, and foreign shareholders. With temporary relief measures available for those considering liquidation in 2025, affected companies must assess their long-term viability and compliance options in light of this evolving regulatory landscape.

Prior to the reform (effective until the end of 2024), the Israeli Income Tax Ordinance included a mechanism, under section 62A, designed to fully tax shareholders who utilized companies as a vehicle for their personal activities. This measure was implemented to prevent the exploitation of the lower corporate tax rate while deferring the taxation of retained earnings within the company. The new reform is expending the old mechanism under section 62A of the Israeli income tax ordinance and aims to ensure a more equitable tax burden and prevent excessive tax deferral strategies employed by closely held businesses.

However, in practice, the scope of the newly implemented reform extends far beyond its initial targets. The mechanism established by the Israeli legislator effectively encompasses almost all private companies in Israel (from the neighborhood retail store to medium – large scale software companies), leading to significant compliance and financial planning implications for business owners.

The legislation itself is quite complex, necessitating an annual review of the activity of companies owned by no more than five individuals (while family members are treated as one) – from here forward we will address such companies as Private SMEs. Such needed review examines both the nature and sources of the Private SME‘s income and its profitability during the relevant tax year to determine whether it falls within the new provisions.

So, what has changed?

Amendment of the Previous Mechanism. Section 62A(a) removes the previously granted exemption for activities conducted through a company owned by a significant shareholder (holding more than 10%). Under the new provision, if a company derives more than 70% of its income from services personally provided by its shareholder, that income will be directly attributed to the shareholder, even if they hold full ownership of the service-receiving company.

New Taxation Rules for Private SMEs Under Section 62A(a1). A new section was added under the new reform, section 62A(a1). The new section determines that Private SMEs that are generating active sourced income with profitability of at least a 25% threshold are now taxed at the individual marginal rate, which can be as high as 50%. This applies to privately held businesses with an annual turnover below NIS 30 million per controlling or active shareholder (meaning, in case there are two controlling shareholders, the turnover cap is of NIS 60 million). Previously, these companies were taxed at 23% on profits and 30%-33% on dividends.

Taxation of Private SMEs Owning Rights in Partnerships. Under the new reform, Private SMEs owning at least 10% in a partnership (i.e., companies acting as general partners in a law firm, accounting firm, advisory firm, etc.) must account for the partnership’s income in profitability assessments. For Private SMEs holdings under 10%, 55% of the taxable income of such partnership will be subject to taxation at the individual’s marginal rate. It should be noted that some Private SMEs with retained earnings below NIS 750,000 or with specific ownership structures may qualify for relief.

Mandatory Profit Distribution and Retained Earnings Tax. A key aspect of the reform is the introduction of mandatory profit distribution requirements, compelling certain Private SMEs to distribute their earnings that might otherwise (or at least under the old legislation) remain retained within the business for future endeavors. Under the new reform, Private SMEs are subject to a 2% annual tax on their retained earnings. These retained earnings are calculated based on taxable income, excluding unrealized profits and revaluations, in accordance with the Israeli tax provisions but are limited to the retained earnings as determined in accordance with GAAP standards.

Under the new tax reform, Private SMEs subject to the 2% tax on retained earnings have alternative options to comply with the regulations. Instead of paying the extra tax, Private SMEs may choose to distribute their profits as dividends, provided that their profit exceeds the highest of their expense cap, asset cap, or NIS 750,000 (otherwise they are exempt from the mandatory profit distribution and the 2% tax). One such alternative is the distribution of at least 6% of retained earnings. Companies can evaluate their position and select their preferred option on an annual basis. Furthermore, Private SMEs that incur losses exceeding 10% of their retained earnings will be exempt from both the mandatory distribution requirement and the 2% tax.

In addition, the Israeli Tax Authority retains the ability to mandate the distribution of up to 50% of accumulated retained earnings. Recent amendments streamline the enforcement process, enhancing the authority’s efficiency in applying this measure.

Enhanced Corporate Reporting and Compliance Requirements. Ultimately, the legislation introduces updates to corporate reporting obligations, further increasing compliance burdens. It imposes detailed reporting requirements on affected companies, requiring businesses to prepare thoroughly and consult with tax advisors to ensure compliance before submitting their annual returns.

Temporary Relief Measures for Company Liquidations. Recognizing the sweeping impact of these changes, the Israeli legislator has implemented temporary relief measures to facilitate company liquidations, providing affected businesses with a transitional period to adapt. Accordingly, companies deciding to be liquidated during 2025 may benefit from specific tax exemptions on asset transfers to shareholders.

Firms liquidating in 2025 may benefit from specific tax exemptions on asset transfers to shareholders, subject to certain conditions. Pre-transfer gains are taxed at marginal rates, while post-transfer gains qualify for a reduced capital gains tax. Shareholders can choose to retain the original asset costs or allocate the company’s share costs among transferred assets. However, asset transfers not associated with liquidation will be treated as dividends, valued based on depreciated costs.

This new regulatory shift follows a broader trend in Israeli tax policy aimed at increasing tax revenues from passive income and accumulated corporate profits. Notably, a recent amendment raised the surtax rate on passive income exceeding NIS 721,560 (approximately USD 190,000) annually. Since this threshold is subject to annual adjustments, businesses and individual shareholders must stay informed about these evolving tax obligations to ensure compliance and optimize their tax planning strategies.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Adv. Amit Gottlieb is a senior partner and Head of the Private Wealth and Trusts Department and Adv. Dvir Saadia (CPA) is a partner at YETAX — Yaron-Eldar, Paller, Schwartz & Co. Law Firm.

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