Taxation of Loans, Withdrawals and Benefits Between Companies, Shareholders and Related Parties
A company that provides a loan to a shareholder, a shareholder who withdraws funds from a company, or two related companies that transfer financing between them may view these actions as internal matters that do not necessarily create a tax event. However, under tax law, the mere fact that no interest was paid, no dividend was distributed, and no money was received as income does not necessarily prevent a tax liability.
In certain cases, the Income Tax Ordinance attributes income to a taxpayer due to an economic benefit received, interest that was not charged, or a withdrawal made from a company. This is one of the main forms of notional income – income created for tax purposes even when no monetary payment was actually received.
What Is Notional Income?
Notional income is income that tax law attributes to a taxpayer due to a benefit or economic value created for the taxpayer or for a related party, even if no money was actually received
The simplest example is an interest-free loan. When one party provides another with a loan on terms that are more favorable than those prescribed by law or than those that would have been customary between unrelated parties, an economic benefit may arise. Depending on the identity of the parties and the nature of their relationship, the law may treat the interest differential as taxable income of the borrower, or attribute interest income to the lender.
However, not every interest-free loan is taxed in the same way. It is necessary to distinguish between a loan to a shareholder or employee, a loan between related companies, a withdrawal of funds from a company, and a financing transaction between related parties in different countries.
Notional Interest on Loan to a Shareholder or Employee – Section 3(i)
Section 3(i) of the Income Tax Ordinance addresses a situation in which a person receives an interest-free loan or a loan bearing interest lower than the rate prescribed in the regulations. In such a case, the difference between the interest actually paid and the interest required for tax purposes may be treated as income of the borrower.
The classification of the income depends on the relationship between the parties. Where the loan is connected to an employer-employee relationship, the benefit may be treated as employment income. Where it was provided in connection with the provision of services, it may be treated as business or professional income. Where the loan was received by a controlling shareholder from a company under their control, special provisions set out in the Ordinance apply.
The interest rate for the purposes of Section 3(i) is updated in accordance with the mechanism set out in the regulations. In the 2026 tax year, the interest rate was set at 6.53%. The text of the Income Tax Regulations (Determination of Interest Rate) can be found in the government legislation database of the National Insurance Institute.
For example: if a controlling shareholder holds an interest-free loan of ₪500,000 from the company for an entire year, notional interest income of approximately ₪32,650 may be attributed to that shareholder, subject to the circumstances and the precise calculation.
Loans Between Related Companies – Section 3(j)
Section 3(j) addresses other cases, in which the focus is on the lender. When a loan is provided between parties that have “special relations”, without interest or with interest lower than the relevant rate, interest income may be attributed to the lender as if it had actually been charged.
Special relations may exist, among other cases, where one party controls the other, where the same person controls both parties, or where other connections prescribed in the Ordinance exist.
In 2026, the interest rate under Section 3(j) is 4.90%. However, the application of the section and the calculation are not determined solely by reference to the interest rate. The characteristics of the loan and the relationship between the parties must also be examined.
It is also important to distinguish between a loan and an ordinary commercial debt. Not every customer or supplier balance between related parties automatically triggers the application of Section 3(j). The substance of the debt and its terms must be examined.
Withdrawal of Funds From a Company – When Can the Principal Itself Become Taxable?
When a shareholder withdraws funds from a company, Section 3(i1) of the Ordinance sets out special rules regarding withdrawals by a substantial shareholder from a company. In certain circumstances, it may result in taxation of the withdrawal amount itself.
The provision applies to a “withdrawal from a company”, which includes, among other things, a loan, lending or another debt. It also applies, in certain cases, to making company assets available for the use of the shareholder or their relative. With respect to a withdrawal of funds, there is a rule under which the provisions of the section do not apply where the aggregate withdrawal amount does not exceed ₪100,000, subject to the conditions and periods set out in the Ordinance.
The Israel Tax Authority Published Income Tax Circular 7/2017 – Taxation of a Substantial Shareholder Due to a Withdrawal from a Company. The circular includes details regarding the definition of a withdrawal from a company, the tax event date, the classification of the income, the return of funds and their subsequent withdrawal, and the calculation of taxable income.
In the case of a withdrawal of funds, the tax event date is generally at the end of the tax year following the year of the withdrawal. At that time, the withdrawal may be classified, depending on the circumstances, as a dividend, as employment income, or as business or professional income. The Israel Tax Authority also requires appropriate reporting in the annual tax return where the relevant conditions are met.
This means that a shareholder debit balance is not necessarily an “open loan” that can be left outstanding without limitation. Until the tax event date, notional interest may be attributed to the shareholder under Section 3(i). Later, the withdrawal amount itself may also become taxable income. Section 3(i1) also includes provisions designed to address cases in which funds are returned to the company and then withdrawn again. Therefore, a temporary repayment of a debit balance does not necessarily neutralize the tax event.
Loans to Related Parties Abroad – Section 85A
When a loan is provided between related parties in different countries, Transfer Pricing rules come into play.
Section 85A of the Ordinance requires an international transaction between related parties to be examined according to the terms that would have been set between unrelated parties. Therefore, an Israeli company that provides a loan to a subsidiary, parent company or sister company abroad cannot necessarily rely on nominal interest or on the interest rate applicable to a domestic loan.
In such a case, the appropriate market terms for the transaction must be examined, including the characteristics of the loan, its term, the currency, the borrower’s financial position and the collateral provided.
The Israel Tax Authority sets out the transfer pricing principles and the application of Section 85A in Income Tax Circular 3/2008 regarding transfer pricing. The circular also addresses the relationship between Section 85A and other provisions of the Ordinance that relate to transactions between related parties.
There are also special cases in which a loan between related parties abroad may meet the conditions set out in Section 85A(f), including certain loans that do not bear interest. In these cases, there is also a dedicated reporting obligation using Form 1485 – Declaration Regarding Loans in International Transactions.
Before providing a loan or making a withdrawal, it is advisable to review the parties, purpose, classification of the amount, interest rate and repayment dates in advance. Shareholder debit balances should be monitored regularly, and international transactions should also be reviewed for documentation and transfer pricing requirements.
In summary, notional income clearly illustrates why the absence of an actual payment does not necessarily mean the absence of a tax event. An interest-free loan, a withdrawal of funds from a company, or financing between related companies may create a tax liability for one of the parties and, in the case of a shareholder, may even result in taxation of the withdrawal itself.
Therefore, when transferring funds or providing benefits between a company, shareholders and related parties, it is important to examine the structure and the tax implications in advance, and not only after the balance has already been created.
Nimrod Yaron & Co. specializes in Israeli and international taxation. Our team is composed of professionals with years of experience at the Israel Tax Authority, as well as experience at leading firms and law offices, bringing together both legal and economic perspectives. We advise private and public companies, Israeli and foreign companies, global venture capital funds, and clients seeking focused advice in clear and accessible language. We also work with a professional network of accounting firms and law offices around the world, enabling us to provide comprehensive support in cross-border matters.
If you are considering providing a loan to a shareholder or to a related company, if you have an existing debit balance, or if fund transfers are taking place between companies in Israel or abroad, it is important to examine the tax implications and the loan terms in advance. Proper planning of the interest, repayment dates, documentation and legal structure can reduce tax exposures and prevent unexpected charges. Our firm’s team advises companies and shareholders on loans, withdrawals, related-party transactions and transfer pricing matters, both in Israel and in cross-border transactions.
Frequently Asked Questions
Can a company provide an interest-free loan to a shareholder?
A loan may be provided, but an interest-free loan or a loan bearing low interest may create notional interest income for the shareholder under Section 3(i). In addition, if it is a withdrawal by a substantial shareholder that was not repaid in accordance with the rules, Section 3(i1) may also apply and result in taxation of the withdrawal amount itself.
What is the difference between Section 3(i) and Section 3(j)?
In general, Section 3(i) focuses on the benefit created for the borrower, while Section 3(j) may attribute interest income to the lender in a loan between parties that have special relations.
What is the notional interest rate in 2026?
In 2026, the interest rate under Section 3(i) is 6.53%. For loans to which Section 3(j) applies, the shekel interest rate for 2026 is 4.90%. However, it is first necessary to identify which section applies to the transaction, as these are different tax mechanisms.
Does paying interest prevent taxation of a shareholder withdrawal?
Not necessarily. Paying interest may address the issue of the benefit arising from the use of the money, but Section 3(i1) deals with a separate question – whether the withdrawal itself should be treated as income of the shareholder.
Does returning the money to the company cancel the tax liability?
This depends on the timing of the repayment and the circumstances. Special rules apply to funds that were returned and then withdrawn again. Therefore, it should not be assumed that a temporary repayment of the balance automatically cancels the tax event. For further information, see the Israel Tax Authority circular regarding shareholder withdrawals.
Must a loan between two related companies in Israel bear interest?
Where the conditions of Section 3(j) are met, an interest-free loan or a low-interest loan may result in the attribution of interest income to the lending company. However, it is necessary to examine whether the balance is a loan, a commercial debt, or another type of balance between the parties.
Must a loan to a related company abroad be on market terms?
Where the transaction is an international transaction between related parties subject to Section 85A, the starting point is that the loan terms must be examined in accordance with the arm’s length principle and transfer pricing rules. Certain exceptions are set out in the law, and each loan must therefore be examined according to its characteristics.
