Mass hysteria is not a concept normally associated with the local tax community, but the hype in recent months around an impending change in partnership tax law is having its effect. The situation is analogous to a hot air balloon, into which hot air continues to be injected until, eventually, the balloon leaves the ground – some tax practitioners are finding themselves with their feet planted firmly in the air. This is worrying.

An update in Israel’s partnership tax law has been overdue for decades. It is not that there is anything particularly wrong with the current legislation, it is just that, if a prospective lawyer or CPA were thinking of cheating in an exam, they could write it on the palm of one hand with room to spare for crib notes. That has inevitably led to the courts effectively deciding the law, with one case in particular dominating the scene. Furthermore, beyond the technicalities of regular partnership taxation, the start-up nation has developed an industry of private tax rulings for venture capital and private equity funds seeking certainty for investors, especially foreign ones. The time for clarity had arrived long ago.

Enter the proposed change in the law.

While much of the proposal (which continues to be a work in progress) is really about codifying widely accepted current practice, some is positively horrifying (for example the admittance of a foreign resident to a partnership could imply a capital gains tax liability to existing partners), and some is horrifying depending on where you are standing (a VC fund general partner would have a different view of his situation than the pilot of that hot air balloon staring down at him ).

It is the role of tax professionals, through their professional bodies, to examine critically the proposals, and push for change where necessary or desirable. It is also their job to prepare their clients for their worst-case scenarios. But they must keep their feet on the ground.

Recently, as the passing of the law has looked imminent, the term LLC has been bantered about a little too freely. Translating rumors into tax logic, the idea seems to be to circumvent some of the nastier elements of the upcoming partnership law by replacing the partnership structure with a US Limited Liability Company, especially where investments in the US are concerned. The simple thinking behind this – the current income of partnerships is treated as the income of the partners under Israeli law, and a US LLC can attract similar (but not identical) treatment in Israel, while not being restricted by the change in legislation.  

The main driver of this approach appears to be the anticipated requirement under the law for all partnerships with Israeli partners to file a partnership return with the tax authorities. As such, US income (and other foreign income) would need to be rebased under Israeli law, as opposed to the current wide practice of filing a K1 (a partner’s share under US law) and paying tax accordingly – thus benefiting from the generally more liberal approach of US (and other) tax laws.

That all may sound pretty hunky dory, but – before advising clients – advisors need to convince themselves of the justification of a complete U-turn in advice on foreign partnerships v LLCs. Until now, there has been a clear preference, from an Israeli tax viewpoint, for partnerships over LLCs other than in very specific circumstances. Partnership tax treatment is defined in statute and case law (however badly), and permits complete transparency on current income. LLCs, on the other hand, are only considered ‘transparent’ in Israel under a Circular of the tax authorities from 2004. That transparency is restricted to giving tax credits for the tax paid on foreign income of that LLC, while losses cannot be set off against other income of the taxpayer. There is no guarantee whatsoever that the Israel Tax Authority would not wake from its slumber one morning and cancel what is, essentially, a concession – condemning the LLC to two-level taxation. And, in any event, the practice of filing partnership K1s without rebasing to Israeli tax law has no legal basis; it can be challenged at any time by the authorities. Furthermore, the ‘transparency’ does not apply to income sourced in Israel. The delicate nature of the LLC was highlighted in a fairly recent court case, in which a taxpayer claimed that the tax authority was wrong in denying him transparency due simply to a technical reporting error on his part – something that could well have been overlooked as of no substance in a situation involving the tax code. The judge unceremoniously sent the guy packing.

None of this is to say, that in specific situations the expense and complication of an LLC could never be worthwhile. But, when hysteria sets in, people behave illogically. The hot air needs to be let out of the balloon, and advisors and clients need to make their decisions with their feet planted firmly on the ground. With the news this week that the legislation has been delayed, largely thanks to legitimate pressure from the tax fraternity, they have a little longer to do so.