LLC (Limited Liability Company) is a U.S. specific form of a private limited company entity; it has both "corporate" characteristics when it comes to its limited liability, and "partnership" characteristics, when it comes to its tax status.

Since the Israeli law does not recognize LLC, Israel Tax Authority (Hereinafter: "The ITA") defined it in ITA's circular 03/2002, as a "Body of Persons", referring to this definition in section 1 of the Israeli Income Tax Ordinance (New Version), 5721-1961 (Hereinafter: "The Ordinance"). In other words, the ITA classifies LLC only as a corporation. As a result, distribution of the profits of the LLC's to its members will be considered in Israel as dividends, which is different from the U.S. fiscal treatment, taxing the LLC similar to a partnership as a disregarded entity.

The conflict noted above caused a problem regarding foreign tax credit in Israel: when an Israeli resident is investing in a U.S. asset using an LLC, he will pay the U.S. tax as a sole proprietor on the income, while in Israel, the income will not be considered as his own income, but rather the income of the LLC. When the investment's profits will be distributed to the LLC's members, the ITA will consider those gains as dividends without granting any foreign tax credit as no actual tax was withheld at source in the U.S. on the dividends. This issue causes miscorrelation between Israel and the U.S. with regards to the income's attribution, and causes a problem with regards to the foreign tax credit- Israel sees the U.S. tax paid in the U.S. by the LLC and does not grant any foreign tax credit on the distribution of profits from the LLC to its Israeli members as it is classified as dividend income.

In order to deal with this problem of the foreign tax credit, the ITA published Circular 05/2004. According to this circular the Israeli member has the right to choose whether the LLC will be considered in Israel as a corporation or as a disregarded entity. In case the LLC is managed and controlled from Israel, it will be classified as an Israeli corporation subject to Israeli corporate tax. The LLC will report its income and will pay corporation tax with the right to deduct the tax it already paid in the U.S., and when the income will be distributed as dividend, the member will be taxed on that dividend.

If the LLC is not managed and controlled from Israel the member can choose to classify the LLC as a foreign corporation (even if it is classified as a disregarded entity in the U.S.). As long as the LLC's income is not distributed to the member, it will not be taxed in Israel (provided it is not classified as a Controlled Foreign Company or as a Foreign Vocational Company). If the LLC distributes the dividend to its Israeli member, the dividend will be taxed at the hand of the member and no foreign tax credit will be granted as in the U.S. there was no withholding as source on the dividend.

In case the member will choose to classify the LLC as a disregarded entity whose income flows through to its member, he will report the LLC's in Israel, will be taxed accordingly, and will have the right to claim the credit for the tax he already paid in the U.S..

The ITA's approach described in Circular 05/2004 refers only to profits made as a result of the LLC's activity. When it comes to losses that had been made as a result of the LLC's activity, losses can only be offset at the level of the corporation and cannot "flow through" and be offset at the level of the Israeli members.

Recently, Jerusalem's District court ruled in Greenfeld case, which dealt with the offset of losses as a result of the activity of LLC's, according to Israeli Tax Authority's (ITA) Circular 05/2004. In Greenfeld, judge Dorot ruled that Israeli residents who had invested in real estate projects in the U.S. using LLC's, will pay the capital gains tax in Israel on the one hand, but on the other hand, will not be able to offset their losses from the U.S. real estate activity against Israeli capital gains.

In Greenfeld, one of the other legal questions was whether it is possible to offset the losses from different LLC's, held by the same member. The facts in this case were that Greenfeld was investing in 15 different real estate projects in the U.S., each one held a different LLC. Some of the projects were profitable, but some were losing. Greenfeld chose to report the income from the activities above as a sole proprietor, according to Circular 05/2004. Greenfeld offset the income from the profitable LLC's with the losses of the losing LLC's. He claimed that since all of the LLC's activities were the same – investing in real estate, it will be right to offset the loss from one investment against gains that had been made in similar investment, only through a different LLC's. The ITA rejected Greenfeld's claim, arguing that when it comes to losses the ITA's approach is that every LLC is a different entity and that the losses remain at the entity's level, meaning that the taxpayer will not able to offset losses from the losing LLC's against income of the profitable LLC's. The District Court embraced the ITA's opinion, and ruled that there is no possibility to offset the LLC's losses from gaining LLC's.

This judgment is a by-product of another judgment of the District court in similar manners (confirmed later by the Supreme Court). In the Harel case, Harel, the taxpayer, was a member of a LLC, which generated U.S. effectively connected income from insurance services. Harel did not act according to Circular 05/2004 instructions, meaning he did not choose the LLC to be considered as a disregarded entity, but as a corporation in Israel. However, Harel claimed a foreign tax credit on tax paid in the U.S. against the Israeli tax liability on the dividend income.

The Tel Aviv District Court's ruled that since Harel did not act according to the Circular's instructions, the member will not be able to claim a foreign tax credit in Israel for the taxes he already paid in the U.S. The court determined that the taxable income is different: In the U.S. the LLC was classified as a disregarded entity. However in Israel, the taxpayer shoes to classify the LLC as an opaque entity (i.e., as a corporation) and therefore he should be taxed on the dividend income without receiving any foreign tax credit as no tax was withheld at source in the U.S. on the dividends.  This judgment was confirmed in the Israeli Supreme Court.

In Greenfeld, the court allegedly applied the same rationale as in Harel, while stating that the ITA approach in Circular 05/2004 cannot be deviated from. Since the Circular says that the LLC's losses are attributed to the corporation and cannot be attributed to the members, there is no possibility to offset the losses of an LLC against personal gains. When an LLC incurs a loss, the taxpayer cannot offset this loss against a profit that had been made in another LLC.

In my opinion, the ITA approach regarding the offset of LLC losses, as it is described in Circular 05/2004 is rigid and wrong. Accordingly, I find the court's ruling in Greenfeld, which had been established according on the Circular's instructions, as also wrong. In my opinion, Israeli court should implement the OECD guidelines regarding partnerships according to which the residence country should respect the classification of the entity in the source country.

Firstly, there should be a matching between the right of the taxpayer to offset his losses including the LLC's losses, to the way he chose to report his income. If the taxpayer chose that the LLC is classified in Israel as a disregarded entity, the ITA needs to allow him to offset his losses like an individual that incurred the losses directly, since the LLC's income is considered as the individual's income. Accordingly, if the Taxpayer chose to report the LLC as a corporation, the ITA's approach regarding the prohibition of the offset of losses is reasonable.

Secondly, the Israeli case law adopted a liberal approach regarding the offset of losses in favor of Taxpayers. In the Modol-Beton case, Supreme Court judge Y. Amit ruled that once the court needs to determine either to allow the Taxpayer to offset his losses or to prohibit such an offset, the court must consider the justice consideration, economic consideration, averaging consideration and the liquidation consideration. The weighting of all benefits and considerations, brings to the conclusion that it is better to allow the Taxpayer to offset his losses.

Thirdly, the Israeli legal system approach is to acknowledge losses as an economic asset. In the Gazit case, the court acknowledged accumulated losses as an independent asset, which deserves almost the same protection as property. Furthermore, in the absence of a specific legal law or regulation which authorized the ITA to "harm" the Taxpayer's property, the ITA must not object to the taxpayer's right to offset his losses. In our opinion, the ITA and the court's rejection to allow Greenfeld to offset his lose from the LLC is damaging Greenfeld's property. Hence, the ITA and the court had to allow Greenfeld to offset the losses.

Another point mentioned in Judge Dorot judgment in Greenfeld is worth mentioning. Greenfeld argued that the director of the International Tax Department in the ITA told him that had he owned one LLC, holding other LLC's owning real estate, the ITA would have allowed the offset of the losses. The taxpayer argued that if that styrcture would have made the offset of losses possible, he should be granted the offset of losses under the existing structure since there is no real economic difference and all entities are disregarded anyway. Judge Dorot rejected this claim, saying that "The law instructs the court to rule according to what the taxpayer actually did and not according to what he could have done". The judge did not actually determine whether the taxpayer could or could not have deducted his losses in case that there was a holding LLC.

In our opinion, Judge Dorot's determination is wrong. In Migdalei Hayam Hatichon case, the then president of the Supreme Court, Judge Aharon Barak applied the "Actual Economic Essence" doctrine when determining that: "The tax aspect of a business transaction must be made according to the actual economic essence of it and not according to how it looks on the outside". In our opinion, it seemingly looks like each LLC acted separately from each other, but in reality all had been doing the same activity – investing in real estate, and each one of them should be taxed as a disregarded entity. Hence, the actual economic essence of each LLC's activity is flowing through of income as well as of losses. Therefore, Judge Dorot should have rulled in favor of the taxpayer.

In summary, our opinion is that when an Israeli member holds different LLC's, some with profits and some with losses, the taxpayer should be allowed to offset the losses against the profits.


* I once heard an IRS official saying that the U.S. domestic law has created the LLC as the simplest entity to work with, so they find it astonishing that all foreign jurisdictions got huge complications with the classification of this entity.

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