Understanding Israel’s new ‘Locked Profits Law’

In January 2025, the Economic Efficiency Law (known as the “Locked Profits Law”) came into effect, significantly increasing the tax imposed on small Israeli companies with revenues of less than 30 million NIS. This legislation requires every company owner to take steps to preserve their capital. In this article, we will mainly discuss the implications of the new law and also mention some potential solutions that can reduce your tax.

Imposition of marginal income tax of up to 50 percent on the profits of companies with a “profitability” of more than 25%

A small company (controlled by up to 5 shareholders) with revenues of less than 30 million NIS per year will be assessed a marginal tax of up to 50% on its profit that exceeds 25% of total revenue. This tax may be supplemented by National Insurance and Health Tax at a rate of 18% (if the annual National Insurance ceiling of 608,340 NIS is not exceeded). This section will not apply to a small company that has accumulated profits of less than 750,000 NIS or to a company that is recognized as a technological enterprise under the Investment Encouragement Law.

What does this mean in practice? Before the new law, you as a small company owner could keep all your profits within the company, pay only a 23% corporate tax and then invest the money in stocks or real estate within the company. After the law comes into effect, if your “profitability” is higher than 25%, you will need to pay a tax of more than 50% on your profits that exceed 25% of turnover. Alternatively, you can withdraw a dividend on your full profit at the end of each year after the company’s accumulated profit exceeds 750,000 NIS. Professionals who usually achieve a profitability of more than 25%, such as accountants, lawyers, private doctors, architects, and advertisers, will be significantly affected by this change in legislation.

Imposition of a flat tax of 2% on undistributed profits of companies with “profitability” of less than 25%

A small company (controlled by up to 5 shareholders), even if its profitability is less than 25%, will be assessed an additional tax of 2% of the amount of excess profits after deducting dividends distributed during the tax year. This tax will not apply in the following cases:

A. The amount of the company’s losses in the tax year exceeds 10% of the amount of profits accumulated at the end of
the previous tax year.
B. The company distributed a dividend at a rate of more than 50% of the amount of the previous year’s excess profits.
C. The company distributed a dividend at a rate of 6% or more of the amount of profits accumulated at the end of the
previous tax year. This tax will also not apply to a company that is a technological enterprise according to the Investment Encouragement Law.

What does this mean in practice? Even if you are in a sector that does not have a 25% profitability (such as retailers, wholesalers, restaurants, non-technological manufacturers, etc.), you will have to pay an additional 2% corporate tax or distribute dividends of at least 6% of the accumulated profit (or 50% from the previous year’s profit.

An additional 2% tax on passive income

Under the old tax regime, an additional tax of 3% is imposed on all income exceeding the ceiling of 721,560 NIS per year. Under the new law, an additional tax at the rate of 2% will be imposed on all passive income (interest, dividends, capital gains, etc.) exceeding that ceiling.

Potential solutions for companies with profitability of more than 25%

If your business achieves a profit higher than 25% of your turnover, you can consider the following options to reduce your tax:

A. Convert your company into a non-minority company (controlled by at least 6 shareholders) by executing a merger with other companies or by adding shareholders. For this purpose, a person and his relatives will be considered one person. It is important to note that no fewer than 6 shareholders can hold the majority of the company’s shares. This option is not realistic in most cases, as at least 10 shareholders must be added to prevent being defined as a minority company.

B. Relocate legally from Israel and operate through a foreign company. A non-Israeli resident is someone who has been outside Israel for at least 183 days each year or someone whose center of life is abroad. The center of life is determined by the location of a number of factors, including the location of the taxpayer’s permanent home, his and his family’s place of residence, his place of employment, the location of his substantial active economic interests such as his bank accounts, medical insurance, etc.

C. If you are engaged in a special profession (medicine, law, accounting, architecture, management services, brokerage, etc.), you can establish a foreign company that meets the definition of a “foreign professional company” and operate through it. In order to meet this definition, the company must meet all of the following conditions:

1. The company must be a minority company (controlled by 5 shareholders or less)
2. At least 75% of the company shares must be held by Israeli residents
3. The controlling shareholders who own at least 50% of the company must be engaged in a special profession.
4. Most of the company’s income in the tax year must be derived from a special profession.

Here it is important to emphasize that the company must be a foreign (non-Israeli) company, so its main management must be based outside of Israel.

D. Try not to reach a profitability of 25%: After your company has already accumulated NIS 750,000 in undistributed profits, you can slow down collections towards the end of the year or increase certain expenses in such a way that profitability does not exceed 25% of total company revenues. There are expenses that are actually tax benefits, such as a keren hishtalmut for shareholders or important employees. In addition, you can pay bonuses to employees and invest in fixed assets. The goal of all these actions is clear: to accumulate NIS 750,000 starting in 2025 and then generate profits of up to 25% of annual turnover and keep them within the company.

Potential solutions for companies with profitability of less than 25%

If your company achieves a profitability of less than 25%, in most cases, withdrawing a dividend of 6% of the accumulated profits will not harm you from a tax perspective and will also allow you to keep almost all of your profits within the company and invest them in stocks or real estate. In addition, if the previous year was not successful and the profit was very small, a dividend of 50% of the previous year’s profit may be lower than 6% of the accumulated profits in some cases. In either case, the new law does not significantly harm small companies whose profitability is less than 25%.

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The content of this article is intended to provide general information on the subject and does not constitute legal or tax advice. You should consult a tax profession where appropriate.