Filing a low tax return with the tax authority can lead to a sanction that makes the attempt to save on taxes not worthwhile, emphasizing the importance of legitimate tax planning. Section 191 of the Income Tax Ordinance grants the tax assessor the authority to impose a penalty on the tax deficiency in cases where the tax amount owed by the taxpayer exceeds the declared amount by 50%.

Calculation of the Penalty:

• 15% Penalty: If the taxpayer does not satisfy the tax assessor that the deficiency was not due to negligence, the penalty will be 15% of the total deficiency.
• 30% Penalty: If the assessor or their representative has reasonable grounds to believe that the deficiency was due to an intention to evade tax, the penalty will be doubled to 30% of the total deficiency.
• 30% Penalty in Special Cases: If the deficiency exceeds 500,000 ILS per year and constitutes more than 50% of the taxpayer’s total tax liability, a 30% penalty will be imposed under the following conditions:
• Failure to report an action required to be reported under Section 131(z) of the Ordinance.
• Acting contrary to a specific and reasoned tax ruling received in the three years preceding the tax return year, without reporting it on a dedicated form.
• Undisclosed tax planning determined in a final assessment to be an artificial or fictitious transaction.
• Failure to report an opinion that requires reporting.
• Failure to report as required on a position that requires reporting.

The section also states that the penalty is treated as an assessment, meaning the tax assessor must specify the penalty amount and allow the taxpayer to appeal the decision. If an indictment is filed against the taxpayer for any of the above reasons, they will not be additionally liable for the deficiency penalty for the same reason. If the taxpayer has already paid the deficiency penalty, the amount paid will be refunded (with interest and linkage differences).

In recent years, the tax authority has increasingly used deficiency penalties. On July 12, 2023, a ruling was issued in the case of Yayinot Bitan. According to the standards for imposing a deficiency penalty, it was ruled that Yayinot Bitan was negligent in preparing the reports submitted to the tax authority. The court determined that in assessing negligence, one must consider the overall picture as reflected in the taxpayer’s reports, noting any defects and placing the burden of proof for non-negligence on the taxpayer.

The court distinguishes between defects arising from a legitimate position held in good faith, even if contrary to the tax authority’s position, and defects resulting from lack of attention, inadequate diligence in reporting, or failure to conduct necessary inquiries. The application of these standards led to the conclusion that the appellant’s conduct justified the imposition of a deficiency penalty due to their negligence. Moreover, the conduct suggested a deliberate attempt to present a false factual representation to justify their taxable income report and reduce their tax liability.

The Supreme Court upheld the lower court’s ruling, where the district court extensively reviewed the grounds for the tax assessor’s authority to impose a deficiency penalty.

“The purpose of the deficiency penalty set forth in Section 191 of the Ordinance is to create an incentive to submit a complete report detailing all income and complying with the provisions of the Ordinance… primarily because the assessment is based primarily on the taxpayer’s reports, and in most cases, the submitted report is the final assessment upon which the tax is paid.”

Over the years, the courts have adopted the tests established in earlier rulings. The court has ruled that a deficiency penalty will be imposed if the following criteria are met:

• The taxpayer fails to provide satisfactory evidence or explanation for the deficiencies found in their reports, and the cumulative weight of the deficiencies is significant.
• The manner of reporting presents a picture of deficiencies indicating a lack of proper attention, even if some of the taxpayer’s claims are accepted by the court.

In this ruling, the court noted that the non-invalidation of books does not imply that the taxpayer was not negligent. In the case of Yayinot Bitan, mentioned earlier, the Supreme Court ruled that holding a different position from that of the tax authority is legitimate and, if done in good faith, does not constitute negligence.

“In my opinion, as long as the matter has not been clearly resolved in case law or by the legislature, or there is another uncertainty regarding the application of the law, it is legitimate for the taxpayer to hold a different position from that of the tax assessor. There is no reason to determine that the taxpayer was negligent merely because their position was not accepted.”

The additional argument made by Yayinot Bitan in its Supreme Court case was that the imposition of the deficiency penalty was illegal because the tax assessor did not adhere to the procedural rules required for an assessment process, which impaired the assessor’s judgment that must be exercised according to the grounds set out in Section 191. As a result, Yayinot Bitan argued that their right to appeal was denied, and the tax assessor “skipped” the dispute stage – an appeal discussed before the tax authority, which is an additional step before appealing to the court.

The Supreme Court addressed this argument and determined that no defect justified the cancellation of the deficiency penalty, as the right to appeal was satisfied by the parties’ discussion in court. “The picture emerging from the proceedings in the district court is that the tax assessor’s conduct in this case indeed raises significant difficulty… It seems appropriate to clarify that generally, after informing the taxpayer that a deficiency penalty will be imposed, there is no reason to delay the decision regarding the penalty amount until the outcome of a tax appeal that may be filed.”

“The picture emerging from the proceedings in the district court is that the tax assessor’s conduct in this case indeed raises significant difficulty… It seems appropriate to clarify that generally, after informing the taxpayer that a deficiency penalty will be imposed, there is no reason to delay the decision regarding the penalty amount until the outcome of a tax appeal that may be filed.”

“From the district court’s judgment, it is clear that the appellant was at least negligent in preparing the self-report submitted. Although there was a defect in the form of the tax assessor ‘waiting’ for the court’s ruling, hoping it would allow him to impose a higher deficiency penalty if the court reached conclusions enabling this under the conditions set out in Section 191 of the Ordinance. It would have been better if things had been handled differently, but this does not change the outcome.”

In this ruling, the discussion brought before the court remedied the harm caused to Yayinot Bitan by denying the right to appeal granted to taxpayers concerning the deficiency penalty. However, this is not a solution for all taxpayers, as the right to appeal an assessment is provided not only to present their arguments but also to limit or resolve disputes with the tax authority outside the court. In this specific case, it is difficult to see how arguments in a separate appeal process would have overturned the conclusion that Yayinot Bitan was negligent. Therefore, the court did not support Yayinot Bitan’s arguments for canceling the penalty. However, it is implied that in other cases, the result might differ, and a flawed process related to the deficiency penalty might affect its outcome and even lead to its cancellation under certain circumstances.

Our office has extensive experience and expertise in managing tax assessment procedures. Recently, we have encountered more cases where the tax authority’s conduct has impaired taxpayer rights, and an appropriate procedure was not followed regarding the deficiency penalty. Taxpayer rights in assessment procedures are very important and can be critical in some cases, as they affect the outcome of the procedure.