How to avoid mistakes when offsetting losses in a merger, split, or asset transfer - and what the Israel Tax Authority actually reviews in practice
In most businesses, Corporate Restructuring is a legitimate managerial and commercial step: companies merge in order to manage operations jointly, split activities to sharpen focus and reduce risk, transfer an asset to a dedicated company, or carry out a merger by way of share exchange as part of an investment.
Part E2 (in Hebrew: ”Helek Hei 2”) of the Income Tax Ordinance allows a range of such transactions to be carried out under a tax deferral framework – meaning no immediate tax liability on the date of the restructuring, but rather at a later time.
Income Tax Circular 05/2026 of the Israel Tax Authority, published on 25.3.2026, is intended to bring order and clarify how the loss offset rules are applied in practice under Part E2: when losses may be offset, what limitations apply, and in which situations the Israel Tax Authority may restrict or deny offsetting in order to prevent tax avoidance or an improper tax reduction.
Part E2 was materially amended under Amendment 242 (which entered into force on 6.8.2017) and later under Amendment 279 (which entered into force on 1.5.2025). Alongside the reliefs and flexibility available in corporate restructurings, Part E2 also includes “braking mechanisms” for loss offsets. For example, in a statutory merger the central mechanism appears in Section 103H of the Ordinance, which limits how losses may be offset in the years following the merger and grants the Director authority to intervene in sensitive cases.
Before carrying out a merger, split, or asset transfer where there are carried-forward losses in the background, it is important to understand in advance the circular and the Ordinance. This makes it possible to build a structure and documentation that align with a genuine business purpose, reduce uncertainty, and avoid surprises at the assessment stage, after the transaction has already been completed.
Who Is This Circular Particularly Relevant For?
The circular is particularly relevant for:
- Companies carrying out a statutory merger or a merger by way of share exchange, as part of an operational consolidation or an acquisition transaction.
- Groups of companies transferring assets to a company or transferring an asset between sister companies as part of a reorganization.
- Companies splitting activities (horizontal or vertical), for example to separate risks, sharpen business focus, prepare for investment, or prepare for a sale.
What The Israel Tax Authority Actually Reviews in Corporate Restructurings
In a statutory merger, a key condition for tax deferral is that the merger is carried out for a business and economic purpose and for joint management and operation – and not for the purpose of tax avoidance or an improper tax reduction. This is not a technical condition. If the Director is convinced that the merger lacks commercial rationale, the Director may determine that the transferring company’s losses may not be transferred to the absorbing company.
What documentation and materials are important?
In mergers and corporate restructurings, the quality of documentation is sometimes the difference between an excellent transaction and years of uncertainty in discussions with the tax assessment office:
- Management and board resolutions: what is the business purpose, what is the synergy, and what is the benefit.
- An integration plan and joint management: consolidation of systems, employees, customers, operations, and financing.
- Valuation reports or economic analyses: especially where it is necessary to demonstrate a value ratio.
- Tax returns and financial statements supporting the amount of the losses, their source, and their classification.
The circular addresses situations where expenses or deductions were accrued before the merger date but were not allowed for tax purposes, and if they had been allowed, they would have created a loss on the eve of the merger. In such a case, the Israel Tax Authority may treat them as part of the pre-merger losses and apply the limitations of Section 103H, even if they are only allowed as a deduction after the merger.
Statutory Merger: The Loss Offset Limitation Mechanism in Section 103H
Can all carried-forward losses be offset immediately after a merger?
Generally, no. Section 103H provides for a spreading limitation: losses under Sections 28 or 29 that were generated before the merger date (of both the transferring company and the absorbing company) will be offset from the year after the merger. However, in each year it will not be permitted to offset more than 20% of the total accumulated losses, and also not more than 50% of taxable income (before the offset), whichever is lower.
What counts as “taxable income” for purposes of the 50% limitation?
According to the definition in the circular, “taxable income” for purposes of this section is taxable income before offsetting losses generated before the merger under Section 103H, but excluding income against which a capital loss was offset under Section 92. The 50% limitation is calculated on total taxable income from all sources.
What if the loss cannot be offset due to the 50% limitation?
The circular notes a carryforward mechanism: a loss that could not be offset in a given year due to the 50% limitation will be carried forward to subsequent years, one after another, still subject to the 50% cap in each year.
Capital losses in a merger (Section 92) have a parallel mechanism: 20% per year (for five years) and up to 50% of the capital gain, whichever is lower. However, there is a significant relief: a carried-forward capital loss of one of the companies prior to the merger may be fully offset against a capital gain or betterment tax (Shevach) of the absorbing company from the sale of an asset that, on the eve of the merger, was owned by that company (or the absorbing company, as applicable). The spreading mechanism will apply to the remaining balance.
Section 103H(g) grants the Director authority to determine (within the relevant periods) that a loss or capital loss will not be offset at all, or will be offset only in part, if the Director is satisfied that as a result of the merger an improper tax reduction will occur due to the offset
Merger By Way of Share Exchange (Section 103K)
In a merger by way of share exchange, there are unique limitations, mainly regarding the offsetting of a profit or loss arising from the sale of the shares that were transferred to the absorbing company:
- In the year of sale and during the two tax years following it – it is not permitted to offset that profit/loss against a profit/loss in the absorbing company.
- In the three years thereafter – it is not permitted to offset it against a profit/loss from the sale of assets whose acquisition date preceded the merger.
In addition, the circular notes that, with the necessary adaptations, the provisions of Section 103H(g) will also apply with respect to losses that the absorbing company had before the share transfer.
Transfer Of Assets to A Company (Sections 104)
A transfer of assets to a company (for example, under Sections 104A or 104B(a)) is intended to allow tax deferral where there is a change in legal ownership but no material change in economic ownership.
As of Amendment 242, Section 104H(c) provides that the offsetting of a capital gain or capital loss from the sale of an asset transferred under Sections 104A through 104G will be subject to limitations similar to those in Section 103K(b1) and (b2), with the necessary adaptations.
Company Split – How Are Losses Allocated?
In a horizontal or vertical split, the splitting company’s losses on the eve of the split are allocated among the companies based on the equity ratio, while preserving the nature and classification of the loss.
The circular also warns against artificial timing of losses around the split. This includes delayed or accelerated recognition of losses in order to influence the loss allocation. In such situations, an adjustment may be required so that the period’s losses will be allocated according to the formula in the Ordinance.
Illustrative Example: The 20% And 50% Limitations
Assume a statutory merger was completed at the end of a year, and the companies have business losses that accrued before the merger. Under Section 103H, in each tax year after the merger it is possible to offset at most 20% of the total accumulated loss, and at the same time no more than 50% of taxable income before the offset – whichever is lower.
In the example in the appendix to the circular, when in a certain year taxable income is low, the 50% limitation may cause part of the loss to “get stuck” and be deferred to later years. Only after the restriction period ends may the remaining loss be offset without the Section 103H limitation (subject to the general rules).
In summary, Circular 05/2026 is an important reminder: a corporate restructuring is a legitimate business tool, but losses are a key test point where the Israel Tax Authority examines “substance over form”. Anyone entering into a transaction without understanding the offsetting limitations, without sufficient documentation, or with problematic timing of expenses and losses may later discover that the losses are not available for offsetting as anticipated, or that the Director restricts them.
Nimrod Yaron & Co. specializes in Israeli and international taxation. Our team is made up of professionals with years of experience at the Israel Tax Authority, alongside experience at leading firms and law offices, and brings a combination of legal and economic perspectives. We advise private and public companies, Israeli and foreign, global venture capital funds, and also clients seeking focused advice in clear, accessible language. We also work with a professional network of accounting firms and law offices around the world to provide a full solution in cross-border matters.
If you are considering a merger, split, share exchange, or asset transfer – especially where there are carried-forward losses – it is advisable to conduct an advance tax exposure review, map the types of losses and the ability to offset them, and prepare an action plan that aligns with Circular 05/2026 and the provisions of Part E2 of the Ordinance. We would be pleased to hold a strategic consultation meeting and assist in building a structure, documents, and reporting process that reduce uncertainty vis-a-vis the Israel Tax Authority.
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FAQ
Does a merger automatically transfer losses to the absorbing company?
Not always. There are limitations, and in some cases the Director can restrict or deny the offset.
What is the main offset limitation after a statutory merger?
As a general rule, 20% per year and no more than 50% of taxable income, whichever is lower.
Does a transfer of an asset to a company create limitations on offsets upon sale of the asset?
Yes. As of Amendment 242, limitations apply under Section 104H(c) and its cross-references.
How are losses allocated in a company split?
Based on the equity ratio, while preserving the character of the loss.
Does a restructuring change the source of the loss (business/capital)?
No. Losses retain their character and classification.
