Tax Reporting on a Cash Basis – Addressing the Mikud Israel Decision
The possibility to report for tax purposes on a cash basis has been raised in recent years in almost every assessment negotiation regarding a company which provides services without inventory.
For decades, the Tax Authority has recognized the possibility for companies that provide services without inventory to report for tax purposes on a cash basis, even if their financial statements are prepared on an accrual basis and the shift to a cash basis is executed in the reconciliation statement. In 2012, the Tax Authority decided to change its position, within publication of Execution Directive 8/2012 (the “Execution Directive”), according to which a company which prepared financial statements on an accrual basis, is not entitled to change the reporting basis for tax purposes to a cash basis in the reconciliation statement.
After many years in which no court decision had been handed down on the topic of cash basis reporting, the Mikud Israel decision was recently published, which includes the court’s first treatment of the Execution Directive (Tax Appeal 63590-02-20 Mikud Israel Security Services & Personnel Ltd. v. Tel Aviv Assessment Officer 1).
We might preface by stating that the court concluded that service companies with no inventory, which operate on a cash basis, are entitled to report on a cash basis for tax purposes, in contrast to the position of the Tax Authority, which argued that only companies that prepare their financial statements on a cash basis are entitled to report that way for tax purposes also. That is to say, the Tax Authority tried to empty out the group of companies entitled to report on a cash basis for tax purposes, because it argued that companies cannot report on a cash basis at all according to GAAP, but this argument was rejected by the court.
In the specific circumstances of the Mikud Israel decision, the court concluded that the company did not “operate” on a cash basis, and therefore was not eligible to report thus for tax purposes. A study of the decision indicates that the fact that the company distributed a dividend according to surpluses recorded in financial statements prepared on an accrual basis, without the company having taxable income, in a manner that violated the principle of two-stage taxation, constituted a central consideration in the court’s conclusion.
The court supported its decision by additional circumstances, inter alia the fact that the company prepared a statement on an accrual basis for the purposes of banks and participation in tenders. Yet the honorable court states in its decision that this fact alone cannot lead to a conclusion that the company is not entitled to report on a cash basis, in contrast to the Tax Authority’s position.
Although the honorable court states that the HaShomrim precedent remains in force, in our opinion the court added to its conclusion tests which contradict the HaShomrim precedent and other judicial decisions, and it stands to reason that these tests will be clarified in a Supreme Court appeal and in additional decisions to be handed down in the future with respect to pending proceedings.
In light of the decision, which did not accept the Tax Authority’s position in the Execution Directive, we recommend that service companies without inventory which have ceased to report on a cash basis in light of the Execution Directive and conducting assessment proceedings, now examine whether to return to reporting on a cash basis for tax purposes. For companies that report on a cash basis, we recommend examining how they can reinforce their legal arguments in light of the Mikud Israel decision, where in our opinion non-conformity with the conditions for reporting on a cash basis in previous years cannot prevent those companies from changing their modus operandi in a way that would enable them to start reporting on a cash basis in the coming years.
We might mention that our position is that reporting on a cash basis is not a tax benefit. It is a legal right reserved for every taxpayer who meets the terms set forth in the caselaw. Furthermore, this is basic fairness between the partners, which are the business and the Income Tax Division, which serves both sides. In many cases, imposing tax on income which has not yet been collected could ruin companies economically. The Tax Authority’s position reflects short-term thinking which focuses on the desire to collect taxes sooner, at the expense of the state’s long-term interest to make things easier for businesses, in order to enable economic growth and prosperity.
For additional information, contact Adv. (CPA) Shahar Strauss or CPA Erez Hagai from our firm.
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