Passive Losses, Business Losses and Capital Losses
Many Israeli residents hold assets, investments, companies or businesses outside Israel. When such activity generates a loss, the offset rules must be examined according to the type of loss, its source, the identity of the taxpayer and the manner of reporting.
Section 29 of the Income Tax Ordinance establishes a special mechanism for offsetting losses sourced outside Israel, notwithstanding the general offset rules in Section 28. Section 92 of the Ordinance deals with capital losses in Israel and abroad. The starting point is the classification of the loss: a business or professional loss, a passive loss or a capital loss.
Offsetting a Passive Foreign Loss Against Passive Foreign Income
A passive foreign loss generally arises from a source that is not a business or profession, such as rental income, interest, linkage differentials, dividends or royalties. Under Section 29(1) of the Income Tax Ordinance, such a loss may be offset against taxable passive income from outside Israel. If the taxpayer cannot offset the full loss in the same tax year, the balance may be carried forward to subsequent years and offset against taxable passive income from outside Israel, provided that if the loss could have been offset in a particular year, it may not be offset in the following year.
An important exception applies to a loss from rental income derived from leasing a building outside Israel, where the loss is attributable to depreciation. Such a loss may also be offset against a capital gain from the sale of that same building, including where the loss was carried forward from previous years.
Offsetting a Foreign Business Loss Against Income Abroad and in Israel
A foreign business loss is examined under Section 29(2) of the Income Tax Ordinance. For the loss to be recognized, it must be the case that, had a profit been generated instead of the loss, that profit would have been taxable in Israel. The order of offset is mandatory: first, the loss is offset against taxable income, including a capital gain, from a business or profession outside Israel in the same tax year. If a loss balance remains, it is offset in the same year against taxable passive income from outside Israel remaining after the offset of passive losses under Section 29(1).
If, after these two offset stages, a loss balance remains, and the loss is from a business outside Israel whose control and management are exercised in Israel, the taxpayer may, if requested, offset the balance also against taxable income in Israel in the same tax year. This is an exception to the rule that a foreign business loss is first offset against foreign income. The option applies to a current loss of a controlled business, and only after the offset against business income and passive income outside Israel has been exhausted. If, after the offsets, a loss remains unutilized, and provided that the taxpayer elected the Israeli offset route under Section 29(2)(c), the balance may be carried forward to subsequent years and generally offset against taxable income, including a capital gain, from a business or profession outside Israel. In the case of a controlled business, a carried-forward loss balance may, if the taxpayer so requests and subject to the conditions of Section 29(2)(e), also be offset against income from a business or profession in Israel, including a capital gain or real estate appreciation in the business or profession. This does not permit the carried-forward loss to be offset against any income in Israel, such as salary, interest, dividends or other passive income.
Offsetting a Foreign Capital Loss Against Capital Gains Abroad and in Israel
A foreign capital loss is mainly governed by Section 92 of the Income Tax Ordinance. A foreign capital loss may arise, for example, from the sale of shares in a foreign company or from the sale of an asset outside Israel at a price lower than its cost for tax purposes.
A basic condition for offsetting the loss is that, had a capital gain been generated instead of the loss, that gain would have been taxable in Israel. Therefore, for example, a loss incurred during a period of exemption from Israeli tax on foreign capital gains may not allow an offset in Israel.
A foreign capital loss is offset according to a fixed order. First, the loss must be offset against a capital gain from the sale of an asset outside Israel in the same tax year. Only if a loss balance remains after this offset may it be offset against a capital gain in Israel, including real estate appreciation.
The loss is first offset against an ordinary capital gain, meaning the real gain generated from the sale of the asset. Only if a loss remains thereafter may it also be offset against taxable inflationary gain. In such a case, each ₪1 of loss reduces ₪3.5 of taxable inflationary gain.
Where the loss arises from the sale of a security during the tax year, it may also be offset against income from interest or dividends paid with respect to that same security. It may also be offset against interest or dividends from other securities, provided that the tax rate applicable to the income does not exceed the rate prescribed by law.
If a capital loss balance remains at the end of the tax year, it may be carried forward to subsequent years and offset against capital gains only, including real estate appreciation. Where the loss is from the sale of an asset outside Israel, in the carry-forward years as well it must first be offset against a capital gain from the sale of an asset outside Israel. A carried-forward capital loss may not be offset against interest or dividends. To carry the loss forward to subsequent years, a tax return must be filed with the assessing officer for the tax year in which the loss was incurred.
Basic Conditions for Offsetting a Foreign Loss
A basic condition for offsetting a foreign loss is that, had a profit been generated instead of the loss, that profit would have been taxable in Israel. Section 29(3) expressly provides that a loss outside Israel may not be offset if, had it been a profit, no tax would have been payable in Israel in respect of it. Therefore, as a general rule, a loss from an activity or income source that would have produced tax-exempt income in Israel may not be offset. For example, a loss incurred during a period in which tax benefits apply to foreign income and assets should be examined carefully. In addition, Section 29(4) applies, mutatis mutandis, the provisions of Section 28(c) also to foreign losses. Therefore, in certain cases, a taxpayer may request not to offset a loss against an inflationary amount, and in the case of an individual, also against a capital gain, interest or dividend to which a tax rate not exceeding 25% applies. This choice may affect the loss balance carried forward to subsequent years, and should therefore be examined according to the taxpayer’s tax circumstances.
Summary Table
Type of loss | Example | Order of offset in the tax year | Unutilized loss balance |
Passive foreign loss | Rental income, interest, dividends or royalties that are not business income | Against taxable passive income from outside Israel | Carried forward to subsequent years against taxable passive income from outside Israel |
Loss from rental income from a building abroad attributable to depreciation | Depreciation on a leased property abroad | Against taxable passive income from outside Israel | May also be offset against a capital gain from the sale of that same building, including where the loss was carried forward from previous years |
Foreign business loss | Business or profession outside Israel | First against business income from outside Israel, including a capital gain in the business or profession, and thereafter against taxable passive income from outside Israel | Generally carried forward against income from a business or profession outside Israel, including a capital gain in the business or profession |
Loss of a controlled business | A business abroad whose control and management are exercised in Israel | After exhausting offsets against foreign income, the taxpayer may request to offset the loss also against taxable income in Israel in the same tax year | Subject to the conditions of Section 29 and at the taxpayer’s request, the balance may also be offset against income from a business or profession in Israel, including a capital gain or real estate appreciation in the business or profession |
Foreign capital loss | Loss from the sale of shares in a foreign company or an asset outside Israel | First against a capital gain from the sale of an asset outside Israel, and thereafter against a capital gain in Israel, including real estate appreciation. A loss from the sale of a security during the tax year may also be offset against interest or dividends, subject to the conditions set out in Section 92. | Carried forward to subsequent years against capital gains only, including real estate appreciation. In the carry-forward years as well, a loss from the sale of an asset outside Israel is first offset against a capital gain from the sale of an asset outside Israel. |
Conclusion
Offsetting foreign losses first requires proper classification of the loss as passive, business or capital, followed by an examination of the relevant section of the Ordinance. Section 29 establishes a special mechanism for passive and business losses from outside Israel, while Section 92 applies to capital losses. In the case of a foreign business loss, the offset routes against foreign income must first be exhausted. Only if the business is controlled and managed from Israel may an Israeli offset be considered, in accordance with the special conditions set out in Section 29. In any event, it is important to substantiate the place of management with real evidence, and not to rely solely on the fact that the controlling shareholder is an Israeli resident.
Nimrod Yaron & Co. advises individuals, controlling shareholders and companies on international tax matters, loss offsets, reporting of foreign activities and assets, examination of control and management from Israel, and handling complex questions before the Israel Tax Authority. When foreign losses are involved, it is important to review in advance the classification of the loss, the order of offset, the holding structure, the reporting obligations and the required evidentiary basis, in order to reduce exposures and build a sound position already at the reporting stage.
To schedule an initial consultation on offsetting foreign losses, click here
Frequently Asked Questions
Can every loss incurred abroad be offset in Israel?
No. The loss must be classified as passive, business or capital, and it is necessary to examine which section applies to it, the source of the income against which the offset is sought, who bore the loss, and whether, had a profit been generated, it would have been taxable in Israel.
Can a rental loss abroad be offset against salary in Israel?
Generally, no. If the loss is a passive foreign loss, its offset must first be examined against taxable passive income from abroad, in accordance with Section 29. A possible exception is a loss from rental income from leasing a building that is attributable to depreciation, which may also be offset against a capital gain from the sale of that same building.
Is a foreign loss that is not utilized in the tax year forfeited?
Not always. A passive foreign loss may be carried forward to subsequent years against taxable passive income from outside Israel. A foreign business loss may generally be carried forward against income from a business or profession outside Israel, including a capital gain in the business or profession. In a controlled business, there may be a limited possibility of offsetting the remaining loss also in Israel, subject to the conditions set out in Section 29 and at the taxpayer’s request. In any event, a tax return must be filed for the tax year in which the loss was incurred.
Can a passive foreign loss be offset against passive income in Israel?
Generally, no. Section 29(1) limits the offset of a passive loss to taxable passive income generated outside Israel. The main exception concerns a loss from rental income from leasing a building outside Israel that is attributable to depreciation, which may also be offset against a capital gain from the sale of that same building.
Can a foreign capital loss be offset against real estate appreciation in Israel?
Yes, subject to the conditions of Section 92 and the order of offset prescribed therein. First, a foreign capital loss must be offset against a capital gain from the sale of an asset outside Israel. If a loss balance remains, it may also be offset against a capital gain in Israel, including real estate appreciation.
Is it mandatory to file a tax return in Israel in order to offset a foreign loss?
Yes. Section 29(5) provides that a foreign loss may be offset only if a tax return was filed with the assessing officer for the tax year in which the loss was incurred. It is therefore important to report the loss already in the year in which it arises and to retain the supporting documentation.
