The district court recently ruled that when determining a business’s correct reporting method to the Israel Tax Authority (ITA)—on an accrual or a cash basis—it is insufficient to examine the technical question of a business’s ability to report compared to its sector. Rather, a substantive examination is necessary to examine if the method appropriately reflects the business’s income, with a focus on its economic essence.

Accrual or Cash

The accounting standards enable several methods for recording transactions in the books of every business or company. These methods differ, inter alia, in terms of the recognition date of each “income” and each “expense”.

According to the accrual basis, each income and each expense is recorded when the right to receive it is formed. Under this first method, recognition is made at the time the liability is incurred.

According to the cash basis, each income and each expense is recorded only when actually received. Under this second method, recognition is made at the time of the actual charge. 

The Court’s Ruling

The court’s ruling follows an appeal filed by Mikud Israel Security Services and Personnel Ltd., a company that provides security and cleaning services, with no business inventory.

The assessing officer rejected the company’s self-assessments, made on a cash basis. It instead issued its assessments on an accrual basis and also imposed a deficit penalty on the company. The company filed an appeal against the income tax assessments issued to it for 2013-2017. The appeal mainly revolved around the question of how the company should report its income to the ITA – using the accrual method or the cash  method.

In the appeal, the court ruled that according to acceptable accounting standards in Israel, there was no obstacle to the company reporting on a cash basis. This is possible when the essence of the company in question corresponds to the cash method and when consistency is maintained in such reporting.

The court also noted there was no obstacle to the company reporting on a cash basis in view of the well-known ruling in the “Kvutsat Ha-Shomrim” case and considering the company provides services (and does not hold business inventory). Concurrently, however, the court ruled that when examining an individual case, the company’s area of business will not serve as an exclusive condition, and a substantive examination is required to determine if the cash method does indeed reflect the company’s income. The purpose of the substantial examination is to show that the reporting to the ITA is compatible with the company’s actual economic conduct and adequately reflects its income situation.

Results of the Appeal

After the court conducted a substantive examination of the company, it reached the conclusion that, under the circumstances, reporting on a cash basis does not adequately reflect the company’s income. Therefore, reporting to the ITA on this basis should not be allowed.

The court reached this conclusion after it became aware of the fact the company was in the habit of preparing two “sets” of accounting reports. The first and main one was on an accrual basis. This report was used to secure credit from banks, examine the profit criterion for dividend distribution, examine profitability rates and make managerial decisions, present turnovers for competing in tenders, etc. The other set, calculated on a cash basis, only served the company for tax purposes and for filing its reports to the ITA. Namely, the appellant’s business and commercial conduct was based on the accrual method, whereas only its income reports to the Income Tax Authority were on a cash basis.

In addition, the court’s decision stemmed from the fact that other than filing reports on a cash basis with the assessing officer, the company did not use the cash-basis report for any other purpose.  Objectively, such report must thus be viewed as one intended to reduce the company’s tax liability. Insofar as it cannot be proven the preparation and filing of the report on a cash basis had any other material commercial purpose, this constitutes an artificial transaction.

Two Sets

In this context, we note that in March 2005 the ITA published a press release stating that reports may be prepared on an accrual basis, with adjustments made on a cash basis for tax purposes, as part of an adjustment report for tax purposes.

This approach found further expression in 2012 under execution order 8/2012. Pursuant to this order, the ITA permitted the making of an adjustment from an accrual basis to a cash basis in the tax report (reconciliation report for tax purposes) up to the year 2012, i.e., the publication date of the execution order.

However, for the years following the execution order’s publication, the litigants’ opinions regarding the policy were divided. The assessing officer argued that the practice of operating on an accrual basis and filing a report on a cash basis was prohibited, while the company argued that only an adjustment to a cash basis via the tax report when no parallel reports were prepared was forbidden. However, it argued, the preparation of parallel accounting reports (in other words, two sets), one on an accrual basis and the other on a cash basis, was not prohibited.

Holier than the Pope

The court raised the point that it would have been appropriate for the ITA to clarify its intention to prohibit the practice of companies operating on an accrual basis but reporting on a cash basis, and that a company should not “make it harder on itself” or be “holier than the Pope”. For this reason, among others, the court cancelled the deficit penalty imposed on the company. However, it ultimately ruled that, under the circumstances, reporting on a cash basis does not adequately reflect the company’s income and accordingly the company cannot use this method to report to the Income Tax Authority.

The court’s ruling clarifies it is necessary to understand the business essence of the company and the method of reporting suitable to it in an optimal and informed manner. If possible, it is important to understand the nature of the company’s economic industry and establish substantive explanations that justify the reporting method to the ITA.

Such tax planning may lead to a better tax results, and help the company to avoid any potential tax exposures and fines in this respect.

[View source.]