Deductions

 

 

Deputy President E. Rivlin

Is a person’s expenditure for childcare  while at work deductible as an expense incurred in the production of income,? This is the legal question before us. Apparently, the existing law offers us one, and only one, answer.

The facts

1.    The respondent (the counter-appellant) is the mother of two children, and a lawyer in private practice.  She and her life partner – the father of the children - are jointly raising their children.  During the tax years under appeal – 1999-2001 – the respondent requested to deduct expenditures for her children’s  pre-school and day care from her taxable income. The respondent’s daughter Maya was born in 1994, and her son Guy was born in 1997.  The respondent sought to deduct pre-school payments for Guy for the years in dispute. She also sought to deduct pre-school payments for Maya up to July 2000, and payments for afternoon day-care after Maya began attending elementary school that year. The respondent did not request a tax deduction for clubs that the children participated in during the afternoon, nor for day camps during the vacation summer months when the day care center was closed. The respondent declared that had her two children not been looked after in these frameworks until the afternoon hours, she could not have continued to work as a lawyer in private practice. The appellant refused to allow the deduction of the disputed expenses, and the issue was brought before the District Court. This is an appeal against its decision.

       The Israel Bar Association requested to join the appeal proceeding as amicus curiae. We see no need to grant that request, inasmuch as the Bar Association has no unique interest in the questions in dispute, despite the fact that the respondent is an lawyer by profession and occupation.  Nonetheless, the written position of the Bar Association, and its oral statements were all before us when we wrote our opinion.

The District Court judgment

2.    The District Court granted the respondent’s appeal in part, ruling that the part of the expenses incurred for her children’s care should be allowed as a deduction from income, in accordance with certain rules that it specified. The court ruled that the parental obligation to  care for children is established both by law and natural imperative. The District Court stated that “evidently the parties do not dispute that placing the [respondent’s] children in supervisory frameworks was a necessity, without which she would not have been able to maximize income”. The District Court therefore ruled:  

 

'The basic assumption is that each of the individual spouses is entitled to realize his professional ambitions, his right to realize his desire to work in his occupation and to produce income for himself and his family members. The entrustment of children requiring adult supervision, including by dint of law, enables the parents to go to work and do their work. As distinct from food and medicines, as claimed by the respondent, the children would not have been under another person’s supervision for the aforementioned times and for the aforementioned number of days per year, had the spouses not been busy in the production of income... in that sense, this not an expense which "is absolutely private”…’

 

Nonetheless, the District Court noted that the child's presence in the various supervisory frameworks also contributes to the child's development and education.  The contribution stems from the very fact of children spending time with toddlers their own age, from spending time in the presence of non-parental adult figures, and from educational and enrichment activities.  This has been ruled  a "benefit" that accrues to the parents from the very fact of their children being in the different supervisory frameworks. Regarding this point, the District Court accepted the respondent’s claim that "were it not for the need to spend long hours at work, both she and her children would benefit from spending as much time as possible with one another, and certainly for a period of time in excess of the time required for their education, development, imparting of knowledge, etc."  That benefit, according to the District Court, "would also have accrued from spending a few hours during a smaller number of days...especially for toddlers".  In this context, the District Court noted that "it is undisputed that the company of children in the day-care center, and the activity there, replace entertaining friends at home, or participating in clubs, but this could be accomplished through other, more limited means than spending no insignificant number of hours every day outside the house, in the school."

The District Court therefore ruled that the total payments made for supervision should be classified in accordance with two categories of payments. The first reflects payments that should be ascribed to "enrichment" activities, while the other should be ascribed to “supervision" costs. Only the latter should be permitted for deduction as an expense in the production of income:

 

‘First of all, supervision expenses that are not enrichment expenses are not expended by reason of personal or individual taste. The assessee is forced to make these payments in order to be able to produce his income. It is, however, clear that having been compelled to do so, he will choose supervision in accordance with his own taste, which is where the personal preferences play a role.  Were it not for the need to purchase  supervisory services for the children, in order to provide for personal needs, he would choose different, more limited frameworks.  To be clear: the need arises initially in order to facilitate the production of income, and only after that are the personal considerations factored in, relating to the best interests of the child, the appropriate framework etc.  This is not comparable with the direct purchase of enrichment services, such as hobby clubs, private lessons, or other enrichment programs.’

 

   3. The District Court distinguished between expenses for "direct enrichment" and expenses for "indirect enrichment". It therefore ruled that there is no basis for permitting payments made for all categories of enrichment, however,  the mechanism for identifying the costs is different. Expenses incurred for "direct enrichment" include payment for education, clubs and other clearly enriching activities. The court ruled that the central element of "direct enrichment" is the granting of lasting benefits to the child, whereas the supervisory component in this particular context is secondary to the main component - education and enrichment.  If a certain payment can be identified as intended for an activity classified as "direct enrichment" - it will not be permitted as a deduction.  On the other hand, "indirect enrichment", as defined by the District Court, is that enrichment from which children derive from frameworks that are primarily the supervisory.   In this context, the court ruled that expenses imputable to supervision should be separated from expenses attributable to indirect enrichment.  The District Court noted that:

  

'In this computerized, documented era, in which all activities can be monitored and reconstructed, assuming the existence of economic and other models that allow it, it would seem that the aspiration for an accurate assessment requires that where an assessee can prove that a certain expense should be attributed, under  s. 17 of the Ordinance,  to the production of his income, and that component can be quantified as a part of the total in a manner that distinguishes it from the portion that does not serve for the production of income, that portion should be permitted for deduction.'

 

The District Court observed that the supervision and enrichment costs can be quantified based on the data collected by organizations that run day care centers, such as Wizo and Na’amat.  The District Court also noted that the day care centers managed by these organizations "can also serve as a point of reference for the reasonability of an expense". In this context the District Court noted that the question of the reasonability of the expense as prescribed by section 30 of the Ordinance was not adjudicated in the appeal before it. The District Court further stressed that supervisory expenses not incurred for the purpose of parents going to work could not be deducted.

4.  Equipped with these determinations, the District Court proceeded to classify the expenses that the responded sought to deduct.  The court ruled that payment to a babysitter or a care-giver in the home was payment for supervision, and was fully deductible, subject to the principle of the reasonability of the expense.  Regarding the after-school center where the respondent's daughter spent the afternoon , the District Court ruled that the expense was primarily for purposes of supervision. As such two thirds of it should be permitted for deduction (while the other third “takes into account the personal benefit, including the meal"). As for the payments to the pre-school (where the children also received lunch), the District Court ruled that one half of the sum would be regarded as an expense for indirect enrichment and personal components such as food, and would not be permitted for deduction. The [other] half of the payments, which the District Court attributed to supervision expenses, would be deductible. The District Court further ruled that where separate payment was made for the children's meals, two thirds of the payment would be regarded as an expense for supervision.

5.    The District Court rejected the appellant's claim that,  at the very most, the claimed expense merely prepared the ground for generating income, but was not an expense "in the production of income", as required under s.17 of the Ordinance. The District Court distinguished childcare expenses from expenses for the purchasing of food and medicines, arguing that food and medicines are required at all events, even where a person does not generate income. The court was also of the opinion that in the case at hand one could not draw an analogy from case law that determined that travel expenses to a workplace were not a permitted deduction, and that in the case at hand, the expenses also met the test  that they serve their purpose at the time the income is created.  When the respondent is at work - it ruled – "she is only able to earn her income by virtue of the fact that her children are under supervision." The District Court held that childcare expenses for the children are connected to the creation of income, and are incidental to the creation of income, because had the children not been under supervision, the respondent would not have been able to produce income. It therefore held that the expenses were not just "a preliminary condition for her to go out to work", but rather that the expenses were required “for every hour during which she makes money". The court further ruled that if expenses intended to increase the yield of workers at the place of work were permitted for deduction, then "the supervision of the children must at least be considered as increasing output from a situation in which the parents are unable or limited in their capacity to produce income, to a situation where, for as long as the children are under supervision, they can operate at an increased output for the sake of producing their income."

6. Finally, the District Court dismissed the appellant's claim that the credit points given to the working mother (in conjunction with child allowances) constitute an exhaustive arrangement, and that the deduction of expenses in addition to that arrangement constitutes a double benefit. The court ruled that this claim was only raised by the appellant in  summations, and that it constituted an impermissible broadening of the scope of the dispute. On the merits, the District Court ruled that absent an explicit statutory provision, there were no grounds for denying permission to deduct an expense that fell within the ambit of s. 17. Furthermore, the District Court opined that credit points and child allowances are arrangements that serve an extra-fiscal purpose that is external to that of the Ordinance, . The court held that this result held true even when taking into consideration the fact that, over the years, various Knesset Members had made explicit proposals, which were not accepted, to recognize the deduction of child-care expenses related to their parents' work.  It ruled that this legislative history does not impugn the fundamental principle whereby an expense incurred in the creation of income is a permitted deduction.

This judgment is the subject of the appeal before us

 

The Appellant's claims

7.  The appellant brought an arsenal of claims contesting the permission to deduct supervisory expenses of children while their parents are at their place of work. The appellant's view is that "the expense will only be recognized for deduction if it is an integral part of the natural structure of the business and constitutes part of the business process itself" (hereinafter: the "incidentality test"). The appellant claims that the "if not for" test that served the District Court (in other words: if not for the payment of childcare expenses for the children, the respondent would not have been capable of producing income) is not the accepted test in case-law. The appellant claims that the appropriate test is the incidentality test, and the requirement that there be a close, tight and direct connection between the expense and the income. The appellant therefore claims that childcare expenses do not satisfy the conditions of this test, given that at the most it can be considered only a "preliminary condition" for earning income, and is not an integral part of the process of producing income. This expense does not bear the close, tight and direct connection required for purposes of deduction. The District Court’s judgment, according to the appellant, blurs the boundaries between business and non-business expenses, and between revenue expenditure and capital expenditure, which likewise bear a connection to the production of income. The appellant further claims that permitting the deduction of an expense that is neither directly nor tightly connected requires explicit grounding in a statutory provision (such as the provisions of ss. 17 (11)  - 17 (13)).

Even were it to be held that childcare expenses involve a business component, the appellant claims that this does not mean that these expenses should be permitted, given that they are mixed expenses, and the business component of is not clearly discernible. The appellant refers to the District Court's rulings concerning the personal benefit to the children from merely being in the supervisory framework. Its view is that if the expense is determined as being a mixed one, then its components are inseparable because "each and every act of supervision…..benefits the child and the parent whose child is learning and developing at a time he can also work". The appellant opines that given the respondent's failure to provide a clear and accurate basis for differentiating between the private and business components, the expense should not be permitted "based on guesswork and all manner of calculations". In its view, where the components of a "mixed" expense cannot be determined precisely, an explicit provision is necessary, such as the regulations enacted by the Minister of Finance under section 31 of the Ordinance concerning the deduction of expenses for maintaining a car (see: Income Tax Regulations) (Deduction of Car Expenses), 5755-1995, telephone expenses, refreshments at the place of business location, and clothing expenses (see: Income Tax Regulations) (Deduction of Certain Expenses), 5732-1972). On the merits, the appellant claims that there is no basis for the determination that the total amount of expenses to be ascribed to indirect enrichment expenses is lower than the amount of expenses to be ascribed to supervision.

The appellant argues that the matter at hand is comparable to that of expenses for traveling to work - meaning that if it has been determined that the latter are not permitted for deduction, then a fortiori this must be the conclusion regarding childcare expenses.   

8. The appellant claims that its position is also supported by the legislative history, which shows that childcare costs are not deductible, and that the current legislative arrangement with respect to credit points and allowances is exhaustive. The appellant noted that prior to the passage of Amendment No. 22 to the Ordinance (in 1975), the Income Tax Ordinance contained a specific arrangement by which child care expenses could be deducted up to prescribed ceilings. The appellant stresses that this arrangement was replaced by the arrangement based on credit points and allowance points.  It refers to the Explanatory Notes to Amendment No. 22 which indicate that the credit was given to working mothers as "an additional incentive for married women to go out to work".   It also cites the report published by the Tax Reform Committee concerning the Recommendations for Changing Direct Tax – 5735-1975 (hereinafter: Ben Shachar Report), which states that the credits system was preferred, inter alia by reason of its simplicity. Based on all these, the appellant argues that, ab initio, the legislature viewed childcare expenses as private expenses, because from the very outset the deduction was specifically permitted by virtue of a specific section. The arrangement adopted in 1975 is thus unique and exhaustive, and replaces the deduction of childcare expenses. The appellant maintains that granting the credit and allowance points to a woman constitutes "partial recognition" of childcare expenses. It claims that there can be no deduction of an expense that already confers credit.  The appellant bases this claim on judgments given in  regard to National Insurance payments.  The appellant argues that recognition of the expense as a deduction would constitute a double benefit, which was not the legislature's intention. The appellant also pointed out the various legislative proposals made over last decade, with respect to childcare expenses, which were ultimately rejected by the legislature. It argues that the failure of these numerous attempts to grant a tax deduction for  childcare expenses also supports the conclusion that these expenses are not deductible.

9. The appellant further argues that the District Court's judgment "ignores its expected economic implications", and that "it does not achieve its aims and even impairs the efficiency of resource allocation in the economy".  According to the appellant, the financial cost of the judgment amounts to three billion shekels a year, and as such substantially affects the entire state budget. The appellant repeated these claims in writing in its supplementary pleadings on 22 December 2008. The thrust of the argument that the director general of the Finance Ministry intended to bring to our attention concerning a number of economic matters, was set out in the notice that was submitted on the appellant's behalf on 7 January 2009. In that, notice the appellant claims that the current economic crisis is liable to cause a significant reduction in tax collection, and that the dimensions of the additional burden on the public coffers are still unclear.  The appellant stated that covering the budgetary costs of the judgment will probably necessitate a raise in taxes – "a step which is regressive and inevitably harms the weaker sectors". The appellant also maintains that permitting the deduction of childcare costs constitutes a deviation from the policy of "broadening the tax base, cancellation of sectorial exemptions, and lowering of tax rates – a policy intended to "create the possibility of economic growth in the economy, while constructing a simple, transparent, and fair tax system thay projects certainty while emphasizing the reduction of tax rates".  The appellant raises the fear of a "slippery slope": permitting the deduction of childcare expenses may compel the deduction of additional expenses only remotely connected to production of income, such as commuting expenses, rent  paid by the assessee for purposes of his work, clothing expenses, food expenses, etc.

10. The appellant believes that it is for the legislature to decide upon the manner by which women should be encouraged to go to work. It claims that the legislature, and not the court, should decide matters that have significant, broad implications. The appellant also stated that the State of Israel operates a "governmental assistance network in all matters related to child care". In the framework of the arrangements established for that purpose, it cites the credit points given to working women for each child; subsidies for day care centers; negative income tax; child allowances, and a compulsory education system.  The appellant claims that permitting the deduction of childcare expenses will mainly benefit the wealthy, and economically secure sectors of the population, among which the proportion of working women is already high.  This – it argues – would yield a regressive result. Recognizing childcare costs as tax deductible is inefficient in the appellant’s view, because it increases the friction between the citizen and the tax authorities, and because it necessitates extensive resources. Permitting the deduction of childcare expenses will result in a significant broadening of the scope of reporting, because numerous assessees who do not currently file tax returns will begin to file them in order to obtain the tax deduction. These expenses are not recorded on the books, which makes tracking and verification difficult. The appellant believes that the deduction cannot be made through the employers, because that would require conducting an assessment. The end result  will be an increase in the costs of  abiding the law for assessees, and an increase in the administrative costs of the tax authorities.

The Respondents Arguments

11.  The respondent maintains that chilcare costs are permitted deductions under the opening clause of s. 17 of the Ordinance.  The respondent notes that under the provisions of this section, the expenses incurred in the creation of particular income can be deducted from that income. Where the legislative intention is not to permit the deduction of certain expenses –the respondent argues – they are explicitly disallowed under the Ordinance and  its associated regulations.  According to the respondent, childcare expenses fall within the scope of s. 17 of the Ordinance, in accordance with the accepted tests for recognizing expenses. The respondent argues that the expenses are all related to maintaining the existing situation, and bear a concrete connection to the relevant income yielding activity.  As such, they relate to income and fulfill the incidentality test.

The respondent further stresses that childcare expenses are not private expenditures comparable to food and medicine. They also differ from travel expenses. They are expended exclusively by reason of going to work.   They are expended in order to enable the production of income, and would not otherwise have been spent. As far as “mixed” expenses – which combine a business expense with a personal expense – are concerned, the respondent argues that the components must be distinguished so that only the appropriate part  be permitted as a deduction.

12.       The respondent requests that we reject the appellant’s argument that the solution to the economic ramifications of going to work is to be found in the credit points granted for dependent children. She argues that this is a social benefit intended to enable the assessee to enjoy a higher disposable income when she has dependent children.  Credit points are intended to preserve financial resources for the assessee’s “private” expenses. According to the respondent, they are entirely unrelated to childcare expenses, which are deductible to ensure the payment of true tax  on the assessee’s business activity.  The respondent argues that this deduction satisfies both the test of preservation of the productivity of an asset intended to produce income, and the “incidentality test” – in other words, it is an expense related to the process of producing income.

13.       The respondent argues that the appellant’s claims pertaining to the financial, budgetary and national economic ramifications of the lower court’s ruling cannot alter the proper interpretation of the Ordinance’s provisions. It is her position that once it is determined that the Ordinance’s provisions  permit the deduction of childcare expenses, the appellant can no longer challenge the implementation of those provisions. The provisions can only be amended by legislation.  Furthermore, the respondent claims that the forecasts regarding the grave consequences of the judgment are unfounded. The is no real fear of an increase in tax in the wake of the judgment, and even were there to be a tax increase, it would not necessarily be regressive.  The respondent maintains that the appellant’s claim that the judgment is not exhaustive should prompt the appellant to enact supplementary regulations. The respondent also seeks to minimize the appellant’s concerns regarding the “retroactive” effect of the ruling, inasmuch as expenses that were not reported as a caregivers’ wages, and for which taxes were not withheld, would not be deductible. This would be the case for various other reasons, such as a lack of  appropriate documentation, or due to prescription.

We have decided to dismiss the appeal, subject to the following specification.

 

Deduction of childcare expenses - General

          14. The dispute grounding the appeal that we decide raises a number of issues. The first is whether an expense for  childcare can be defined as “an expense in the production of income”. The second pertains to the question of characterizing an expense as a “mixed expense”. The third concerns whether the arrangement for allowances and credit points, to which the appellant refers, is exclusive and exhaustive, such that no additional expense can be deducted. Finally, there is the question of whether the law applies prospectively or retroactively. We will examine these questions in order.

 

Childcare expenses – An expense incurred in the production of income

15.  In the absence of a statutory provision specifically addressing the possibility of deducting childcare expenses, the question of whether such an expense is deductible must be examined in accordance with s. 17 of the Ordinance, similar to the examination of other expenses for which there is no special arrangement. The opening section of s.17 of the Ordinance states:

 

‘In ascertaining the chargeable income of any person, all disbursements and expenses that person incurred during the tax year wholly and exclusively in the production of his income shall be deducted – unless the deduction is limited or disallowed under section 31 [emphasis added – E.R.].

 

As noted by the District Court, “the parties do not dispute that the placement of the (respondent’s) children in a supervisory framework is a necessity in the absence of which she would not be able to maximize income”.  The parent’s duty to provide supervision for their young children is not just an imperative of nature; it is also legally prescribed (see: Capacity and Guardianship Law, 5722-1962, ss. 14,15,17; Penal Law, 5737-1977, ss. 361,362).  It is not disputed that had the respondent not gone out to work, her children would not have required particular supervisory frameworks, such as after-school day care , and that at least some of the respondent’s expense would have been saved. Needless to say, herein lies the fundamental and substantive, albeit not the only, difference between supervisory expenses for children and expenses for food and medicine. Whereas the latter are expended irrespective of whether a person works, the former are not required where a person does not work, and tends to his children himself (see A. Likhovsky, “Gender Categories and Status in the Laws of Income Tax”, 24 Tel-Aviv U. Law Review  205 (2000)).

16.    The appellant is of the opinion that it is not sufficient that an expense serve to produce income in order to permit its deduction, but that  it must also be incidental to the production of income, in other words - involved in it. The test of incidentality was defined by Justice A. Witkon in CA 284/66 Kopilovitz v. Assessment Officer for Large Factories, Tel –Aviv, [1], at p. 718, in the following manner:

 

‘The test of “incidentality” means viewing the source of income – in this case the employer-employee connection – in an organic sense, and asking whether the said expense arises from the natural course and structure of the source. To be deductible, it can be regular or irregular, but it cannot be an expense that is external to the nature and framework of the income. The difficulty of applying this test was already noted in the well-known Strong v. Woodifield case: “Many cases might be put near the line, and no degree of ingenuity can frame a formula so precise and comprehensive as to solve at sight all the cases that may arise”.’

 

This test was adopted into Israeli Law from English Law, where it served as an old, well-established rule. This Court has implement the rule even where it lead to problematic results. For example, we may cite the dispute that emerged in CA 190/61 Borek v. Assessment Officer  [2],  at p. 1801.  That case discussed whether to permit the deduction of travel and food expenses of the appellant, who was the employee  of two separate employers, and was required to travel by shared taxi from one place of work to the other. The Supreme Court affirmed the ruling of the District Court, which rejected the assessee’s claims:

 

‘The aforesaid is legally well-founded, and correctly reflects the long-established rule, even though criticism has been leveled at the narrowness of the test, from time to time. See the incisive comments of the Royal Commission on the taxation of profits and income (1955) Cmd. 9474, secs. 238-241), but this is the law….it is true that such a person too is “forced” to incur travel or food expenses “in the production” of his income that stems from his second source of income. This, however, is not the decisive test set forth in s. 11 (1) of the Income Tax Ordinance, 1947. We must ask ourselves whether the assessee incurred the expense “in the production” of his income, and that question can only be answered in the negative…

As such, and not without misgivings, we must reject the appeal’ [emphasis added - E.R].

 

In our case, as mentioned, the District Court viewed childcare expenses as satisfying the conditions of the incidentality text. The court ruled that childcare costs are incidental to the production of the income, because had the children not been under supervision, the respondent would not have been able to produce income at all. As such, it ruled that the expenses are not just “an initial condition” for going to work, but are also required “hour-by-hour in the course of producing income”.  The District Court added that just as expenses intended to increase the productivity of workers at their workplace are deductible, “so too, supervision of children at least raises productivity from a situation in which parents are unable to produce income, or in which their capacity to do so is limited, to a situation in which, for as long as the children are supervised, they can operate with increased productivity in the production of income” and the expense should therefore be a permitted deduction.

 

The “Incidentiality” test

    17. My view is that even were we to accept the appellant’s claim that the expense under discussion does not fulfill the conditions of the traditional incidentality text, and that it does not “arise from the natural course and structure” of the income producing source, it would not necessarily disallow the expense as a deduction. The character and the status of the incidentialy text must be examined in light of current rules of interpretation, and in keeping with the purpose of s. 17 of the Ordinance. The test is, indeed, based opon a century-old rule, but its vintage does not per se justify a deviation from the currently accepted rules of interpretation (see: CA 165/82 Kibbutz Hatzor v. Assessment Officer Rehovot [3], at p. 70). The interpretative question concerns the proper construction of the term “expenses …in the production of income”. These words do admit of a number of interpretative possibilities. “Production of income” is a process that is not always clearly delineated. For example, one could argue that only expenses that are located directly on “the production line” of the income – if the productive unit is compared to a factory – would be defined as “expenses … in the production of income”. This is a narrow interpretation of the term “production of income”. On the other hand, the production process could be viewed as including not only the “production line”, but also additional components necessary for production purposes, and which serve the need of producing income.

The purpose, which guides the interpretative task,  is the purpose of the provisions of s. 17 itself, i.e., the obligation to pay true tax (see: CA 1527/97 Interbuilding Construction Company v. Assessment Officer T.A-1 [4] at  p. 699). In other words, the taxation of  the assessee’s  real income, which is the income after deduction of the expenses incurred in order to produce it (and cf: : CA 4271/00 M.L. Investments and Development v. Director of Land Appreciation Tax  [5], at p. 959.  Charging tax for an amount that does not reflect a person’s real income cannot be defined as “income tax”. If an assessee is not permitted to deduct an expense incurred in the production of his income, it is tantamount to ”over taxation”, because the income taken into account for purposes of determining his tax liabililty is higher than his real income (see: Yoram Margaliot, “Fictitious Regressiveness in Family Taxation,” 2 Maazaney Mishpat   358 (2002)).  The legislature is entitled to deviate from this fundamental principle, and determine that a particular expense, incurred in the production of income, is not deductible, but in view of the aforementioned purpose, this must be done explicitly. The aforementioned purpose indicates that nothing compels the conclusion that only an expense “which arises from the natural course and structure of the source” will be a recognized expense, if there are other expenses that are incurred exclusively in the production of income. By the same token, deduction of an expense is not permitted when the deduction would create a situation in which the assessee’s income for tax purposes would be less than his real income. For example, consumer expenses of the assessee (which may, occasionally, bear some connection to the production of income), as well as expenses which are only indirectly and remotely connected to the production of income. Taxation of the true income is the purpose, and the incidentiality test is meant only to serve that purpose.

For our purposes, we can seek some guidance from accounting practices, which provide that “recognized expenses in a profit and loss report – where there is a reduction in future economic benefits related to a reduction in the asset or an increased undertaking which admits of reliable measurement”; and also: “recognized expenses in the profit and loss report based on the direct connection between the costs incurred by the entity and the production of particular items of income (see ss. 94 and 95 of the “Conceptual Framework for Preparing and Presenting Financial Reports” of the Israeli Accounting Standards Board (2005), [emphases added - E.R.]. These rules mandate a direct connection between the expense and the production of items of income. They also require reliable measurement of the expense. They do not require that the expense  “arise from the natural course and structure” of the income producing source.

18.  All of this leads to the conclusion that there must be a real, direct  connection between the expense and the production of income as a condition for allowing the deduction of the expense.  The borders of the production process lie beyond the “production line”, and their precise delineation is in accordance with the concrete circumstances and the aforementioned purpose. The emphasis is not on the location where the expense is incurred – in the “factory” or external to it. This distinction loses its importance in an era in which the boundaries between the “factory” and the ”house” have become blurred. As indicated by s. 17 of the Ordinance, the requirement is that the expense be incurred exclusively in order to produce income. An expense that a person would have made even had he not produced the income will not, so it would seem, be permitted (see examples above regarding medicines and food). In other words, the incidentality test should be (only) an auxiliary test for the identification of revenue expenditures in the production of income. Other expenses, too, proved by the assessee as bearing a real and direct connection to the production of income, and which were expended exclusively for the production of income, may be permitted for deduction.

 

Intermediary Cases and the Accepted Test

19.  As stated in Kopilovitz v. Assessment Officer [1]: “Many cases might be put near the line, and no degree of ingenuity can frame a formula so precise and comprehensive as to solve at sight all the cases that may arise”. Indeed, certain expenses are categorically incurred in “the production of income” and expenses that are not categorically “the production of income”; there is also a variety of intermediary cases. There can be no doubt that in terms of certainty of the law, the legislature would do well by clarifying the law in these latter cases. In the absence of clarification by the legislature, the court is required to decide, and this indeed has occurred more than once in the past. The rulings in those cases indicate that the ab initio the test of incidentality deviated from its original borders. A few examples will demonstrate this.

In terms of the prevailing law, a number of expenses are permitted as deductions even though they are not really incidental to the production of income. An example of this is the permitted deduction of study expenses, which are considered as “preserving what already exists”. Thus in CA 141/54 Wolf –Bloch v. Jerusalem District Assessment Officer [6], Justices A. Witkon and Y. Sussman ruled, in opposition to the dissenting opinion of Deputy President S.Z. Cheshin, that the overseas travel expenses of the appellant – a dentist by profession – to a professional training seminar should be permitted. The reason was that these expenses could be defined as “preserving what already exists” in the sense of maintaining the doctor’s professional level. Justice Witkon noted that:

         

‘I have already commented that if the expenditure was made in relation to a capital asset, but not for the purpose of its production or improvement, but rather in order to maintain it – within the framework of activities that are organically a part of the income – then there are grounds for permitting the deduction of that kind of expense. In my view, the question is ultimately whether the purpose of the expense was to create a new product, or to improve an existing product, or whether its purpose was to maintain the asset in its current condition’ [emphasis added – E.R.].

It could have been argued that maintaining one’s professional level constitutes a condition for the continued production of income in the future, but cannot properly be viewed as an “organic” part of the income producing process. One could claim that for a dentist, the process of producing income for purposes of the incidentality test is providing medical treatment to patients, and that when a doctor engages in further studies she is not treating her patients and is not performing any action that produces income as a direct result.  The Supreme Court, per Justice Witkon, took a different view, finding, as stated, that professional studies abroad may be conducted “within the framework of activities that are organically a part of the income”.  This is as it should be, despite the doubt regarding whether this expense satisfies the case-law test of incidentality.  There is, however, no doubt that that an expense for studies abroad intended for the purposes of maintaining one’s professional level constitutes an expense in the production of income, in view of the purpose of s. 17. The expense bears a real, direct connection to the production of income, inasmuch as failure to maintain one’s professional level will prevent the production of income in the future (even if not immediately); the expense is expended for the sole purpose of producing income for the person studying; it is neither a capital nor an appreciation expense (in accordance with the tests established by case law, see Wolf –Bloch v. Jerusalem District Assessment Officer [6] ibid.). The conclusion is, therefore, that in view of the goal of paying true tax, and taxation of the assessee’s real income, this expense should be permitted for deduction. The Supreme Court arrived at the correct and appropriate result in accordance with the purpose of s. 17, even in a case in which it was questionable whether the expense satisfied the requirements of the incidentality test.

20.  To complete the picture, it bears mention that there were cases in which it was held that even an expense incurred in order to “preserve what already exists” must satisfy the test of incidentality in order to be permitted for deduction (see: CA 358/82 Alco Ltd v. Assessment Officer for Large Factories [7]). The learned Amnon Raphael criticized this ruling (Income Tax, vol.1 – 291-292 (3rd ed. 1995)), writing:

 

‘A revenue expenditure is generally, but not always, incidental to the process of producing income… It seems to us that it the test established under s. 17 of the Ordinance includes both revenue producing expenses and revenue expenses that are not incidental, such as expenses recognized by reason of preserving what already exists. In our view, there is no necessity that these expenses be incidental to the production of income, and their deduction will nonetheless be permitted […] Our opinion is, as stated, that the “incidentality test” is just one of the tests for purposes of examining whether an expenses is for the production of income or not, but not the only one.

Finally, we should remember that there is no single, conclusive test in accordance with which the nature of each and every expense can be examined’

 

            I concur with this view. I too believe, as mentioned, that the incidentality test is an auxiliary test which is not exclusive, and that particular expenses may be permitted for deduction even if not satisfying that condition, provided that they satisfy the requirements set forth above.

Naturally, this interpretative conclusion does not alter the case-law rules pertaining to the non-deductibility of capital expenditures, or those that touch upon the questions of the actual classification of expenditures as revenue or capital . The prohibition on the deduction of capital expenditures and appreciation expenditures was explicitly prescribed in the Ordinance (see the provisions of ss. 32 (3) and 32 (4) of the Ordinance). The incidentality test may serve, inter alia,  in drawing a distinction between capital and revenue expenditures (see: Raphael,  ibid  at p. 291; A, Witkon and Y. Neeman, Tax Law,   4th ed., p. 151 (1969); CA 735/86 Zvi Ben Shachar Seeds Ltd v. Assessment Officer Tel-Aviv 3 [8]). However, these questions do not arise in the case before us, and we will not address them.

 

From the Principle to the Question in Dispute

21. We now turn to the implementation of the above in the case before us. The District Court’s view was that childcare expenses satisfy the incidentality test given that they are necessary “hour by hour in the course of producing income”. The court compared these expenses to expenses to improve worker productivity, concluding that if the latter were deductible, then it was appropriate that the same rule  apply to the former, the absence of which precluded production altogether. It is conceded that the application of the incidentality test in this case is somewhat contrived. It is doubtful whether the expense for childcare “arise from the natural course and structure” of the income producing source. However, this does not determine the fate of the expense. The childcare expense bears a real, direct connection to the production of income. It is expended to enable the parent to produce income. Placing the children under supervision is a necessity, the absence of which renders the parent unable to produce income, – due to the parents’ natural responsibility for their children,  which is also a duty imposed on them by law. To the extent that one can quantify childcare expenses, there are grounds for holding that this is an expense exclusively for the purpose of producing income. This being so, even were we to accept the appellant’s claim that childcare expenses do not satisfy the incidentality test, in its narrow construction, it would not prevent our permitting the expense as a deduction as an expense “in the production of income”. At the same time, and by force of the same rules, in a family unit consisting of two parents, the expense childcare would not be permitted if one of the parents were not working (and  would, therefore, be capable of supervising his children), for it would not be an expense incurred “in the production of income”.

 

Childcare costs as a mixed expense

22.  In addition to the requirement that the expense be incurred in the production of income, there is also a requirement, as stated, that it be "for that purpose only". This requirement adopts the requirement of English Law that the expense must be expended "Wholly and exclusively in the production of income” (Raphael, ibid, p. 287).  Prima facie, it could have been argued that a "mixed" expense, containing a component of revenue (expense in the production of income) and a non-revenue element, would not satisfy that requirement and would not be allowed as a deduction (see Yair Newdorf, "Mixed Expense", 22 (3) Taxes A-68, A-70 (2008) (Hebrew)). This however is not the case. In this context, accounting principles do not have a parallel requirement regarding the "exclusivity" of the expense.  Where a certain expense comprises a component that satisfies the requirement and a component that does not, that part of the expense which satisfies the condition specified in the definition may be allowed as an expense. The deduction of that part is even an obligation in accordance with accounting principles, because the non-deduction of expenses (when they can be quantified reliably) distorts the financial results of the reporting body.

An examination of the circulars issued by the income tax authorities shows that the they, too, are of the opinion that the requirement of "exclusivity" should not be given too literal an interpretation, and that in various situations in which the expenses are mixed, an effort should be made to distinguish between the revenue component and the non-revenue component, and to permit the former for deduction (see: I.T. Circulars 17/89, 35/93, 37/93). For example, Income Tax and Appreciation Tax Circular 35/93 determined that: "it is possible that in respect of a particular asset, expenses are mixed, in the sense that some of them are intended to repair that which exists, while the other part is intended to improve the asset.  In such a case, an attempt should be made to distinguish between the  two components of the expenditure, so that only the first component is permitted for deduction under s. 17 (3) of the Ordinance". In Circular 17/89, rules were established for permitting the deduction of trips abroad, including the relative manner of permitting the deduction of a mixed expense of which the income production component which was the main component. Another example is the Directive to the Administration of the Tax Authority under which one third of the expense incurred in purchasing a newspaper would be permitted as a deduction, for a person whose profession or position required use of the economic information appearing in the newspaper (Newdorf, ibid, p. A-71).

23.  The approach, which permits the assessee to extract from a mixed expense the income producing component from a mixed expense, and allows its deduction, was adopted by this Court in CA 580/65 E. Ben-Ezer and Sons Ltd. v. Assessment Officer for Large Factories  [ 9 ].  Justice Mani ruled that travel expenses incurred for going overseas were not permitted if they included the travel expenses of the managers' family members, whose trip was not for the purpose of producing income. Justice Silberg concurred with this result, "Since those expenses also included the expenses of the wife, the husband's report did not distinguish between his expenses and those of his wife". Justice Kister concurred with this result, and did not see any need to "express an opinion on whether and to what extent it was possible to distinguish between the overall travel expenses of a number of people". In view of this reasoning, it has been claimed that this judgment too, which prohibited the deduction of a mixed expense, created an opening for the recognition of part of a mixed expense (Newdorf, ibid). In CA 35/67 Shtadlan v. Tel-Aviv Assessement Officer 4 [10], Justice Mani ruled that attorneys fees paid by an appellant to his lawyer constituted a mixed expense – both revenue and capital. All the same, this result did not lead to the dismissal of the appeal, but rather to the file being returned “to the assessment officer to determine, having given the appellant the opportunity of stating his claims and producing evidence, which part of the fees should be attributed to revenue expenditure”.

Over the years, this rule has been implemented in numerous decisions. In Tax App. (T.A) 22/67 Eliyahu v. Tel-Aviv Assessment Officer 1 [11] the District Court (per  Judge S. Asher) accepted the recommendation of the Assessment Officer to permit 50% of the assessee's car maintenance costs as an expenditure for the production of income. In Tax App. 45/97 Levav v. Assessment Officer [12], the District Court (per Judge B. Ophir-Tom) ruled:  “Although, as explained, the expense is a mixed one…. having found a reasonable way of dividing it and neutralizing the component permitted for deduction, it would be appropriate for the respondent to adopt an approach that would enable the deduction of the portion meriting deduction, as dictated by economic and tax logic”. In that case, the court applied a particular method of attribution in order to distinguish between the revenue and personal components of the expense.

This approach also found support in academic writing from four decades ago. In their book (ibid., at p. 137), A. Witkon and Y. Neeman note that:

 

‘[I]n fact, where the expenditure admits of division, such as an expense for maintenance of a car that serves both business and private purposes, it is permitted to deduct the portion appropriate to business use’

 

In his aforementioned article (ibid,  p. A-72), Newdorf analyzes the significance of that example – the distinguishing of the car–maintenance expenses – noting: “Conceivably, Justice Witkon was hinting that even in mixed expenses in which the separation of the revenue component from the others is not simple, a method must be found to recognize the revenue aspect, for otherwise it is unclear why Witkon chose an example in which the separation is particularly difficult if not impossible”.

   24.  This interpretation, which has been adopted by the courts over the years, is linguistically possible, and is consistent with the purpose of s. 17. The purpose, as stated, is to tax the true income of the assessee - accurate taxation. The question is what constitutes an “expense” that must be examined through the lens of s. 17. Where it is possible to quantify the amount spent in the production of revenue, that portion may be regarded as an “expense” to be evaluated under s. 17. The portion expended in the production of income – the “expense” – was made “for that purpose only”. This portion satisfies the requirement of exclusivity, and should therefore be a permitted deduction. This is a linguistic  possibility within the semantic field of sec. 17. It does not inappropriately stretch the borders of the language. This is shown by the fact that this interpretation has been applied in practice for decades, even during the period when literal interpretation reigned supreme. As mentioned, it is also the desirable interpretation in terms of the purpose of s. 17. Failure to permit the deduction of an expenditure made for the production of income leads to the assessee being taxed in excess of his real income, which is an unsuitable consequence in terms of the purpose of income taxation in general, and the provisions of s. 17, in particular.

 

Identifying the permitted deductible expense in a mixed expense

25.  The assessee bears burden of proof for identifying the portion of a mixed expense that constitutes an expense in the production of income. Should he fail to discharge that onus, the expense will not be permitted as a deduction. (Raphael, ibid, p. 288; CA 2082/92 Shacham v. Assessment Officer Tel-Aviv 2 [13]; TaxApp (Tel-Aviv)  97/85  Peretz Ettinger Ltd v. Assessment Officer Tel Aviv 1 [14]). The burden of proof is that generally applied in civil law, and its elements are determined in accordance with the matter at hand and the concrete circumstances (see, for example, how this burden was met in Levav v. Assessment Officer [12].

    The legislature and the delegated authority adopted various arrangements allowing the partial deduction of mixed expenses.  Section 31 of the Ordinance states:

 

The Minister of Finance may, with approval by the Knesset Finance Committee, make regulations – whether in general or for particular categories of assessees – on the limitation or disallowance of the deduction of certain expenses under sections 17 to 27, and in particular on –

 

(1) the method of calculating or estimating expenses;

(2) the amounts or rates of deductible expenses;

(3) the conditions for allowing expenses;

(4) the manner of proving expenses.

 [emphasis added - E.R.]                                                       

 

 Section 243 of provides:

 

The Minister of Finance may make regulations for the implementation of the provisions of this Ordinance, especially including regulations on –

…(3)  any matter on which the Ordinance authorizes him to  prescribe.

   

By force of these provisions, the Minister of Finance enacted various regulations, including Income Tax Regulations (Deduction of Certain Expenses), 5732-1972,  and Income Tax Regulations (Deduction of Vehicle Expenses), 5755-1995. These regulations quantify the deductible component to be allowed as an income producing expense  in various mixed expenses, such as expenses for vehicle maintenance (which may serve both for the production of income and for personal use), different expenses attendant to trips abroad, bed and breakfast expenses, telephone expenses, etc. A certain difficulty may be posed by the fact that, in these regulations, “expense” is defined as “an expense permitted for deduction  in accordance with ss 17- 27 and s. 30 of the Ordinance…” in accordance with the wording of s. 31 which confers the Minister of Finance with the authority to enact regulations regarding “the limitation or disallowance of the deduction of certain expenses under sections 17 to 27”. If indeed the legislature’s view was that mixed expenses could never be permitted for deduction under s. 17, and inasmuch as the expenses under the Regulations must be deductible under s. 17, how is it that the Regulations permit mixed expenses? (see:  Newdorf, in his aforementioned article, at pp. A-75-77; TaxApp. 539/03 Agbaria Maarof Abd el-Kadr v. Assessment Officer Hadera [15].  Even if there is come clumsy drafting in this collection of provisions, they shed light on the legislature’s position on this matter: Where a mixed expense may be separated into its components, the part constituting an expense in the production of income will be permitted for deduction. The portion permitted for deduction was stipulated in the Regulations at a particular rate or a fixed, determined sum, which serves the interests of certainty, simplicity, and saves administrative and costs (CA 280/99 Kima v. Assessment Officer Dan Region [16], at p. 530). The advantages of clear, explicit determinations in the regulations are obvious, but where such determinations in secondary legislature are absent, the Court will address the matter, as we will now do.

     26.  The District Court held that expenses for “direct enrichment” are not permitted as deductions. The District Court defined “direct enrichment” as including “studies, compulsory studies, various clubs, and classical enrichment activities, etc”. As noted by the District Court, the primary, central component of these frameworks is the education and enrichment of the children. In tax jargon, this means the granting of an “enduring advantage” to the children. As such, the expenses are of a private character, and are not allowed for deduction. Indeed, as the District Court held, even if the child is supervised while being in an enrichment framework, the supervision component is secondary to the principal component – personal enrichment – and expenses occasioned thereby will not be permitted for deduction. In that regard, the lower court was strict with the assessee, but that issue is not in dispute between the parties.

     The District Court further held that the payment to a babysitter or a caregiver, at home, is given as salary for supervision, and the entire expense should be permitted for deduction, subject to the principle of the reasonability of the expense. This result is appropriate and raises no grounds for intervention. The entire expense incurred for paying a babysitter or a care-giver while the parents are at work constitutes an “expense in the production of income” that is spent “exclusively for that purpose”. Even though the children may gain lasting advantage from being supervised by a care-giver or baby sitter, this advantage is marginal and limited to the extent of not meriting any weight (all, naturally, subject to the proviso that that the caregiver does not carry out additional tasks or roles that go beyond tending the children)..

   27.  The question becomes more complex when it relates to supervisory frameworks that carry added value for the children, such as staying in kindergartens, after-school programs, and the like. The expense incurred by the parent in paying for the children to stay in these frameworks, is, in general terms, a mixed expense, which includes both income producing and the private expenditure. (See Margoliot, in his article, ibid, at p. 354). On the other hand, under no circumstances can we accept the appellant’s claim that the expense is a mixed one that is indivisible.  The child staying in a supervisory framework simultaneously benefits both from “indirect enrichment” and from supervision, but this is not the question. The question is whether it is possible to extract the supervision expense from out of the total expense. The answer to that question cannot be sweepingly negative. For the sake of simplicity, let us assume that a business venture is established in which two, separately owned companies operate. The first provides care and supervision for the children and nothing else. The other provides the children with a variety of enrichment activities, while they are under the supervision of the first company. It provides them with games, crayons for drawing, and one of the company’s workers tells the children stories and plays with them. Let us assume that the parents pay each company separately for its services. In that situation, it cannot be said that the payment for supervision is unquantifiable.  A similar quantification can be conducted even when the various services are all supplied to the children by the same entity.  This kind of quantification is not substantively different from the methods adopted in various judgments, some of which were cited above. Such quantification may, indeed,  comprise some element of arbitrariness, whether it is the result of legislation or of a judgment. Either way, if the assessee proved, to the required degree, the relative part that should be regarded as an income producing expense, that part should be allowed as a deduction.

    It seems that the District Court rightly ruled that in this case it was proven that the expense was primarily for supervision, subject to the principle of the reasonability of the expense (under section 32 of the Ordinance). As noted by the District Court, expenses for a supervisory framework are made first and foremost to enable the parent to produce income. Once a parent knows that he must incur that expense, he will choose the framework according to his personal taste and preferences. In the hearing before the District Court, the question of the reasonability of the expense did not arise, and we accept the principled approach of the District Court that the various public supervision frameworks may serve as a standard for the reasonability of the expenses, at least with respect to frameworks intended for relatively older children.

    Having held that expenses for the supervision of children fall within the definition of expenses for the production of income, and that, in principle, they admit of quantification and are therefore permitted as a deduction, the path is open for the legislature, the delegated authority and the Tax authorities, should they so choose, to take actions intended to clarify the rules for extracting the expense permitted as a deduction.  The legislature and the delegated authority, and perhaps even the Tax authorities, will also be able to address the question of which partner should be granted the deduction.  Until then, it would seem appropriate for the tax authorities to grant the deduction at equal rates against the income of each spouse. A provision of this kind not only prevents unjustified fiscal manipulations; it  also dovetails precisely with the principles of fairness and equality, which we have stressed in this judgment.

 

    The credit  arrangement for working mothers – Is it comprehensive?

   28. The appellant argues that the arrangement established under the Ordinance for credit and allowance points is exclusive and exhaustive, replacing the legislative arrangement that preceded it which permitted the deduction of supervision expenses for children, and was repealed. This being the case, the appellant argues that deduction of supervision expenses for children cannot be allowed in addition to the credit, in as much as “where an expense confers a credit, it cannot be deducted under section 17 of the Ordinance (see: CA  30/73 Roth v. Haifa Assessment Officer [17].  This claim is unfounded.

This is the wording of section 40 before it was amended in 1975:

 

           (a) (1) In the calculation of the chargeable income of an individual resident of Israel, who proved to the satisfaction of the assessment clerk that during the tax year there were living children who he supported and who were not yet 20 years old, he will be permitted a deduction of 250 Lirot for the first child, 300 Lirot for the second child, 325 Lirot for the third child and 375 Lirot for each additional child.

          (2) An individual entitled to a deduction under paragraph (1) but who is not entitled to a deduction under section 37, will be permitted an additional deduction for the sum of 700 Lirot; this paragraph shall not apply to an individual who would have been entitled to a deduction under section 37 were it not for the provisions of section 66 (a)(2);

          (3) Parents living apart and for whom the child support is divided between them, shall divide the deductions under paragraphs (1) and (2) in accordance with the support expenses made by each one of the parents; where the parents were unable to agree upon the relationship of support expenses, it shall be determined by the assessment clerk

 

The appellant seeks to infer from this arrangement that the legislature regarded childcare expenses as non-deductible, and that an explicit provisions is required in order to permit them for deduction.  An examination of this arrangement indicates that this is not the case. Prior to its amendment in 1975, s. 40 permitted the deduction of expenses for “children’s maintenance”.  Today, as in the past, it is not disputed that a person’s basic support, expenses for a person’s sustenance, are not deductible. This is entirely unrelated to the matter under discussion.  More precisely, our concern is not with maintenance of  children in general, but rather with a specific, far more restricted issue – expenses for supervision of children, - expenses made for purposes of the production of the parents’ income. The cancellation of the specific arrangement that existed in the past, and which permitted the deduction of specific private expenses, carries no implications for permitting the deduction of expenses that were determined to be deductible under s. 17 of the Ordinance.  It bears note that even the deduction under s. 40, before its amendment, was also granted for cases in which the children were not in any supervisory framework. This being so, the cancellation of that arrangement is of no relevance for the matter before us.

 

29.  An analysis of the existing arrangement for credit and pension points yields a similar conclusion. The provision of section 40, in its current wording, reads as follows:

 

 

‘(a) An individual Israel resident is entitled to pension points for each of his children, as prescribed in section 109 of the National Insurance Law [Consolidated Version], 5728-1968; the pension points shall be paid by the National Insurance Institute under the National Insurance Law.

(b) (1) If an Israel resident individual, who is the parent of a single parent family, has children who during the tax year had not yet reached age 19 and were maintained by him, but is not entitled to credit points under section 37, then, in calculating his tax, in addition to the pension points under subsection (a) in respect of the children who live with him, 1/2 credit point shall be taken into account in respect of each child in the year of its birth and in the year of its maturity, and one credit point in respect of each child beginning with the tax year after the year of its birth until the tax year before the year of its maturity; and in respect of his being the parent of a single parent family – one additional credit point only;

(2) If parents live separately and the maintenance of their children is shared by them, then the parent who is not entitled to a credit point under paragraph (1) shall receive one credit point or part thereof, according to his share in the maintenance.

(3) For purposes of this subsection:

"year of birth" – the tax year in which the child was born;

"year of maturity" – the tax year in which the child reached the age of eighteen.

 

The provision of section 66 (c)(3) states:

 

The following provisions shall apply to the separate tax calculation:

…. (3) only the registered spouse shall be entitled to pension points under section 40(a); the woman shall be entitled to half a credit point under section 36A, and – further against the tax due on her income from personal exertion – to credit points for her children as follows:

(a) half a credit point for each of her children in the year of its birth and in the year of its maturity;

 

(b) one credit point for each of her children beginning with the tax year after the year of its birth until the tax year before the

year of its maturity;

For this purpose: "year of birth" and "year of maturity" – as defined in section 40(b)(3).

 

It is not disputed that granting credit points constitutes an incentive for both spouses to go to work outside the household (see Margliot, in aforementioned article, at p. 336). But this is irrelevant to the case in point. The question requiring an answer for our purposes is whether the credit points arrangement is exhaustive in the sense that it bars any possibility of an assessee deducting  childcare expenses. This question must be answered in the negative. First,  in order for an expense to be disqualified for deduction by reason of the granting of a credit, the  credit must be given for that specific expense. Credit points are given from the year of birth until the child reaches the age of 18, i.e., even for ages at which the child does not require supervision in order for the parent to go to work. The credit points under s. 40 are also given when only one of the parents goes to work. Second,  the legislature did not explicitly determine that granting credit points was intended to replace the deduction of childcare expenses. Third, an analysis of the purpose of the credit points arrangement does not lead to the conclusion that the appellant seeks to draw.  Many hold the view that in imposing income tax, consideration should be given for child-raising costs that do not fall within the definition of expenses in the production of income. This point was made by Margaliot (see article, ibid,  at pp 353-354):

 

 

There is extensive literature treating of the need to have consideration for the general expenditure for raising children when calculating the tax burden, since it is accepted that children are not a consumer product but a part of the tax payint unit (the assessee). This means that there is a need to calculate the income of the family liable for tax having consideration for the number of children. An assesee with children should pay less tax than another assessee with the same income, but who has no children. The reason is that income tax is imposed in accordance with ability to pay and the ability of an assessee without children is greater, because he does not bear the expenses of raising children…and they should therefore be taken into consideration when determining the tax chargeable income of the assessee-parent.

 

 

The purpose revealed by the aforementioned arrangement regarding the credit points - which bears no direct relation to childcare expenses -  may definitely be consistent with the imposition of income tax according to the ability to pay, having consideration for the number of children. There is no basis for the claim that the central goal of the credit points arrangement is to replace the permitted deduction of childcare expenses incurred in the production of the parent’s income.

 

30.  The appellant maintains that support for its construction can be found in the very fact of the non-adoption of various bills proposing the explicit recognition of childcare expenses. But that does not lead to the conclusion that the appellant seeks to draw. The question requiring this Court’s decision concerns the interpretation of the existing statute law. Having concluded that a particular expense should be recognized for deduction according to our interpretation of s. 17 of the Ordinance, the existence of incomplete legislative proceedings does not change that conclusion. Obviously, if the legislature chooses to allow and expense that is currently not allowed, or to disallow a currently permitted expense, it has the ability and authority to do so by explicit legislation.

 

   “Regressivity”, equality and other issues

 

31.                   The appellant claims that the main beneficiaries of permitting the deduction of childcare expenses will be the upper, well- established social echelons, among which the rate of working women is high, in any case. In its view, this result is regressive. Making this claim requires precision. Allowing the deduction of an expense in the production of income is neither a benefit nor a sectoral subsidy. Permitting the deduction of an expense in production of income derives from the goal of income tax, which is to tax a person’s real income. The fundamental principle deriving from that goal - that an expense incurred in production should be permitted -  is implemented in the same manner for the rich and the poor.  Regarding the alleged regressivity, there are numerous factors that may result in a tax being progressive or regressive.  Hence, should it be determined that  certain assessees from among a group of high-income assesses, cannot deduct part of their expenses, it would have a progressive effect. On the other hand, establishing a rule that would prevent some of the high-income assesses from deducting an expense incurred in the production of income would be inappropriate, for it would violate the equality in the distribution of the tax burden among the group of high-income assesses. This is so because the tax burden would not be determined exclusively in accordance with the assessees’ income, but rather as a factor of the manner in which they produced it (see Margaliot, in his article,  p. 361).   By the same token, were we to assume that the majority of those benefitting from the deduction of financing and administrating expenses are the holders of capital in the top percentile, would avoiding the deduction of such costs in that situation be an appropriate progressive step, or perhaps a discriminatory, inefficient distortion of the tax system?  Alternatively, if two assessees - one with children and the other without -  earn the same gross salary, and one of them is forced to pay childcare costs in the production of his salary, then obligating them to pay an identical tax, without permitting the deduction of the income-producing expense, would distort the tax system, and create wrongful inequality between the assesees.  In fact, this is the question of equality relevant for our purposes – equality in the application of the tax law, and equality in the imposition of tax on real income, and permitting the deduction of an expense that serves in the production of income. The equal imposition of tax laws removes various distortions in decisions, which stem from over taxation.  The practical result of the removal of these distortions is likely to induce  women who do not to work because of the tax distortions, to go out to work.  Such a result is also likely to be efficient in economic terms, because by their work these woman increase the economic product  (and the state’s income from taxes, even if only in the long term). Encouraging woman with children to enter the workforce need not come at the expense of other woman who enjoy a high income. If the legislature wishes to grant a subsidy or a benefit to woman who are unable to earn large salaries, the economic cost of that subsidy could be financed by a tax imposed equally to all of the high-income assessees. At all events, there is no justification for creating distortions and inequality in the high-income sector by determining that only assessees with children will bear the funding burden (by not permitting the deduction of expenses from their income).    

 

32.    The consideration of encouraging women to enter the work force is neither a guiding, nor even a secondary consideration in our conclusion. As explained, our conclusion derives from the basic principles of tax law, and from the goal of taxing the real income of the assessee. The social goal goes beyond these principles. Recognition of the  contribution of women to the labor market crosses the boundaries of income levels, and is not limited to the tax or financial advantages that they gain by reason of the balance of income over expenditure. Failure to recognize childcare expenses is a valueless  - and in this case illegal - relic of the archaic division of roles between the spouses, in which the nature of things was that the female was entrusted with care giving and supervision. According to that conception, releasing the wife from that duty by hiring a care giver was regarded as a private expense that was deemed a luxury. Accordingly, in a judgment handed down in the United States one generation ago (but never overturned), the tax court maintained that child care expenses, like other aspects of family life and maintaining the household, should not be treated differently from any other private expense. It clarified its position as follows:

 

‘The wife's services as custodian of the home and protector of its children are ordinarily rendered without monetary compensation. There results no taxable income from the performance of this service and the correlative expenditure is personal… Here the wife has chosen to employ others to discharge her domestic function and the services she perform are rendered outside the home’ (Smith v. Commissioner of Internal Revenue [ ]).  

 

The “private” duty imposed on the wife confers a private status upon the care-giving expenses.  זו גם This, even if we ignore the feminization of the work. This archaic conception also leads to the question of whether it is economically “worthwhile” for the woman to go out to work, and to the proposed distinction between woman of high economic status and others. This distinction is not relevant to the question of the social recognition of childcare expenses, because such recognition is a result of the equality of the spouses with respect to the right and the duty to work. A hint of this archaic conception can also be found in our midst by the fact that credit points were only granted to the woman. The deduction, on the other hand, according to our interpretation is bi-sexual.  Abandoning the archaic conception, in our case, is consistent with the basic principles of tax law, and with the purpose of taxing the real income of both the male and the female assessee. These principles stand at the basis of the interpretation we propose for the provisions of s. 17 of the Ordinance.

We do not presume to replace the legislature or the executive branch in the creation of arrangements intended to encourage women to enter the labor market. The legislature also has the authority to determine that a particular expense which serves in the production of income will not be allowed as a deduction. However, in the absence of an explicit determination on the legislature’s part, it is not possible to reach the conclusion that an expense in the creation of income cannot be deducted.

 

 

Application

33.    The bottom line is that the appeal is denied. Regarding the method of deduction, if at all, and the manner of extracting the permitted expense for deduction from the overall “mixed” expenses, the legislature and the delegated authority would do well to give this matter their attention. In the absence of regulations, these topics will be treated at the level of the the assessee and the assessment officer. The deduction will be calculated using the methods used in the past with respect to mixed expenses.  The assessment officer will be the one to decide the portion that should properly be deducted, and that portion which is not permitted for deduction – and in the case of disagreement, the matter will be brought before the court, as in the past. In the matter before us, the concrete questions have already been decided by the trial court, and there is no need for them to be reconsidered.

All that we have decided today is that in the absence of legislation, there is a legal duty of deduction. The legislature may decide otherwise, but as long as it does not, we have done nothing other than declare the existing law. The question remaining for our examination is the date upon which this ruling goes into effect.

34.  In general, a new judicial rule operates both retrospectively and prospectively (LCA 8925/04  Solel Boneh Construction and Infrastructures Ltd v Estate of Alhamid [18] (hereinafter: Solel Boneh). When interpreting a legislative provision, the court declares the existing law and does not create it: it declares what the law always was. Even when the court chooses prospective effect for its judgment, the accepted distinction is between the litigant who seeks to deviate from the previous law, for whom the new rule will have retroactive application, and other litigants whose matters have yet to be resolved, and in respect of whom the new rule will not apply (ibid, para. 7 of President Barak’s judgment). This distinction provides an incentive for the litigant arguing for a change in the law.

This is not the case when the previous law is not fundamentally flawed, and it is the change in the social and cultural environment in which the court operates that catalyzes the change in the law. In cases such as these, the effect may be purely prospective (the rule would not even be applicable to the litigant who initiated the legal proceeding in order to bring about the new case law), or qualified (the ruling applies to that particular litigant). A request for prospective effect may also arise in cases in which the parties relied on the previous rule for an extended period of time and regulated their relations in reliance thereupon (see ibid,  para. 12). The choice of non-retrospective change of the law thereby limits the harm to the reliance interest that might be caused by giving retrospective effect to a new rule. In the words of President A. Barak (ibid, para. 14), it prevents the need to decide between “truth” and “stability” (an expression coined by President Smoira), and it enables the attainment of both “truth” and “stability”.

35.  It seems that this case justifies giving today’s ruling only prospective effect , starting as of the tax year beginning in the January 2010, subject to one qualification regarding its application to the parties before us. There are a number of reasons for both the choice and its qualification.

The construction given today to the provision of s. 17 brings about a practical change in the way the appellant has treated assessees for many years. The need to protect the reliance interest in this case is a powerful one.  The old rule created a real, substantial reliance that precludes the retrospective application of the rule. Returning taxes collected undermines the tax collector’s reliance interest (ibid, para. 20).  In the present context, it is doubtful whether this interest can be protected by means of other legal doctrines. The proviso presented here to retrospective application would not apply to the case of the respondent in this case. The reason for this is the general need to provide an economic incentive to the litigant, in appropriate cases, to take steps to change the existing law. The concrete reason in this particular case is that a decision was already made concerning the respondent by the trial court. As stated,  as long as appropriate regulations have net been enacted, the question of how to implement the new rule will be an issue for case-by-case examination by the assessment officer, and in the absence of agreement, a subject for judicial resolution. In the matter of the respondent, this last stage has already been exhausted. The result is that, in this case, the general qualification frequently accompanying prospective application has been realized.

It should be emphasized that the criteria for distinguishing the appropriately deductible expenses from the overall “mixed expenses” were chosen in accordance with the particular circumstances of the respondent. They do not prevent other assessees, or the assessment officer, from reaching other results in appropriate circumstances.

In conclusion, the application of this judgment is prospective, but it will apply to the respondent in this case, whose claim succeeded in changing the rule.

 

 

Deputy President

 

Justice E. Rubinstein

 

A.    I concur with the result reached by my colleague the Deputy President, and his elucidative reasoning. I would like to add a few comments.

B.   In my view, the judgment of my colleague and that of the trial court bring the interpretation of taxation law, and for our purposes of section 17 of the Tax Ordinance (along with section 32 (1) which prohibits the deduction of home or private expenses), closer to social developments, in other words, closer to reality, and true tax can be levied only if anchored in reality. Reality, as any socially aware person knows,is a “gradual revolution” in relation to the past, now expressed by the fact that women work outside the home. This phenomenon crosses social boundaries and is expanding, fortunately, into social circles among which women did not previously work outside the home. I stress the expression “outside the home” because work inside the home, even for women who are only homemakers - or for a man who plays the same role at home - is difficult, taxing work. The expression “a working woman” is an archaic term. Maintaining a home is no trivial matter, and the woman who is a homemaker, or a man fulfilling that role, are working in the most basic sense of the word.  This reality has been partially recognized by the law in certain contexts. In any case, it is clear that the interpretation of tax law must reflect the dynamic social situation, just as the law itself must go hand in hand with social developments. Personally, with all due respect, I dispute the position expressed by the appellant that the recognition of the deduction constitutes, in and of itself, a benefit for the richer classes, and is regressive with respect to the weaker socio-economic sectors.   It is clear for all to see that young couples, even from relatively well established families, where both spouses work outside the home, are forced to spend considerable sums for childcare. Indeed, in the absence of a grandmother or grandfather who has the time, or is retired,  and who can voluntarily care for the children, the amount spent for that purpose constitutes a large portion of the couple’s expenses, or as expressed in the immortal aphorism attributed to the late Knesset Member Abraham Hertzfeld, “All  income is dedicated to expenses”. Taking the bull by the horns, it is clear that without incurring these expenses, one of the spouses would not be able to work outside the home.  Accordingly, it is quite obvious that childcare expenses are expenses necessary for the production of income, and the qualms regarding its regressive character can be allayed without difficulty, as also explained below.

C.    Needless to say, this was not the dominant approach in the past (see, inter alia, Asaf Lachovsky “Categories of Gender and Status in Income Tax Law”, 24 (1) Tel-Aviv Law Journal 205, 225 – 228 (2000), and references there (hereinafter: “Lachovsky”). The author criticizes the conception that views childcare expenses as private expenses, stating (p. 227)

 

‘It seems that the real reason for the special treatment of childcare expenses is the identification of this expense as a woman’s expense.’

 

 We will return to the gender issue further on. Regarding the deduction, in the article by Dr. Yoram Margaliot, cited by my colleague, he suggested disguising childcare costs as a “mixed expense” (p. 360).

D.   The learned Prof. Y. M. Edrey, in his (new) book “Introduction to the Theory of Taxation” (5769-2009), treated the subject at length, and similarly took issue with the "accepted theory" according to which study expenses, travel expenses, and childcare expenses are private expenses (pp. 221-112). In his view, this accepted view is based on "social assumptions that are no longer appropriate in a modern, egalitarian Israeli society" (p. 223), and that ignore the human capital and changing social conditions in different areas.  I will not address the issues that digress from the specific matter at hand, but I will only note that regarding expenses for academic studies, the author’s view is that developments in this area include the need to recognize advanced academic studies as expenses for maintaining existing economic value  (p. 210 and p. 215), and that in his view, the half-credit points granted in the Income Tax Ordinance are insufficient (p. 226). I had the opportunity in the past to address the issue of studying towards an academic degree in CA 350/05 Jerusalem Assessment Clerk v. Bank Yahav  (not yet reported) [19]. I stated there:

 

'(1) Academic studies, as with any other studies, are for the person's benefit, they contribute to his values,  broaden his professional and other horizons, and raise his level. However, the legislature chose to express this recognition by way of credit points, and not by way of deduction. We also learn this from the legislative developments in this area. On  10 August 2005, the Tax (Amendment No. 147) Ordinance, 5765-2005,  came into force. Section 9 establishes an arrangement for credit points based on expenses for academic and education studies (the addition of ss. 40C and 40D to the Ordinance, including "half a credit point for an individual who completed studies towards a first or second academic degree," and "half a credit point for teaching studies", respectively.  Prima facie, it may be inferred that studies towards an academic degree, until that time, were not allowed as a deduction from the chargeable income of the student, and hence the amendment. Furthermore, in Amendment 151, 5766-2006, the legislature went another step down the same path, and explicitly prohibited viewing academic studies as a permitted expense, stipulating among the "matters prohibited for deduction":  “educational expenses, including expenses for acquiring academic education or for acquiring a profession, and apart from expenses for professional advanced studies, which are not studies for acquiring academic education or a profession, for purposes of preserving that which exists"  (see s. 32 (15)).  This also appears in the explanatory notes: “It is proposed to clarify that deductions for educational expenses for the purposes of acquiring a profession or acquiring academic education are not deductible from a person’s taxable income unless they were expenses for preserving that which exists that do not confer the student with a permanent advantage. As stated, this is the existing situation, but in order to remove all doubt, it is proposed to establish this explicitly in legislation” (Government Draft Proposals,  5766, 236, pp.  305-306 (emphasis added – E.R.).

 

(2) The absolute majority of the workers in the bank in this case studied, as mentioned, towards a first or second degree in business administration, and with respect to studies of anthropology or geography, for example, the bank itself agrees that the expenses are not recognized for tax purposes.  The present case involves the study of business administration, which may be of benefit to the bank workers, but the academic degree as such cannot be regarded as fulfilling the required connection between itself and the function of the assessee.   To be precise - this does not constitute a rejection of the "substantial test" which the court must adopt when examining the recognition of academic degrees as allowable  expenses (see: R. Livnat, "Advanced Academic Degrees – as a Recognized Professional Studies Expense", Taxes  13/2 (April 1999); L. Newman, "The Parameters for Permitting the Deduction of Expenses for Academic Studies" Taxes 16/3 (June 2002)). The studies must be essentially connected to the assessee’s professional role, but they must also focus on, and be essential to his job. Furthermore, while academic study does provide the student with tools, in the current case these extend beyond the knowledge required for discharging his role. As such, they are in a field in respect of which the fiscal legislator adopted a different approach. This point was addressed by Judge Altovia in his comments on the second degree, but they are also applicable to a first degree:

 

“From the perspective of tax law, second degree studies are not different from studies towards a first or third degree. Second degree studies give the student, apart from the academic degree as such, academic tools, personal skills of analysis, study, research, data processing, analytical abilities, capacity for broad and focused perspective, ability to confront different and conflicting opinions, and others such life skills which cannot be enumerated, and which deviate above and beyond the particular subject being studied”(ITA (Tel_Aviv) 1122/03 Heichal Yair v. Assessment Clerk - Gush Dan  (not yet reported).

However, a broad perspective and the legislature's considerations, are separate issues. Even if we  are aggrieved by this situation and hope for its change, this is the current situation.’

E.  How does the issue of childcare differ from the aforementioned academic studies expenses (to which recognition should, ideally, be extended)?  At least in that  the legislature made his views patently and explicitly clear in regard to education, as shown above, and it has the capacity to do so, as mentioned by the Deputy President, in the matter concerning us, as well.  However, as distinct from the issue of educational studies, with respect to childcare we find ourselves in the more flexible realm of interpreting the subject of deductions, which is regulated, albeit laconically, in the Ordinance.

F.   As Edrey argues concerning the subject of childcare expenses, the solution provided was that of credit points – from birth until age 19 –  which is also the response of the state in the matter before us, “irrespective of whether the children require supervision or not. Furthermore, to the best of my knowledge, there has been no systematic discussion of the question of whether these credit points actually contributed to encouraging women to go to work, or whether they encouraged employers to discriminate against women and pay them a low wage” (p. 226). The author rejects the criticism levelled by the authorities against the District Court’s decision, and notes, inter alia (p. 226), that the authorities have the ability to provide appropriate solutions:

'One possible example of a creative solution to the question of deduction of expenses for the care and supervision of small children can be found in the examination of the accumulated cost to the state treasury of implementing the aforementioned judgment, and a courageous decision to direct these sums for the development of a network of quality daycare centers situated near places of work; to provide a real incentive to employers to invest in daycare centers for the children of their employees, and other similar solutions. Needless to say, a serious examination of the optimal solution requires the involvement of experts from the fields of early-childhood education, sociology, and economics.

 

G. With all due respect, I concur with these last comments, and personally, I cannot understand the claim that recognizing the deduction would not encourage women to work - or  couples to work. I have no doubt that, looked at from a broad perspective, it would provide that kind of encouragement, and to me, this appears as clear as day.

H. Indeed, initially, I was impressed by the aforementioned claim - that credit points are granted, and that the state had therefore provided an appropriate solution, and there was, therefore, no need for an additional solution relating to childcare expenses.  However, closer examination reveals that there is no correlation between the purpose served by credit points and that of the deduction, as explained by my colleague the Deputy President.  Furthermore, as also noted by the District Court, the proposal for the 1975 legislative reform (the Ben Shachar Reform) stated (Draft Amendment of the Tax Ordinance (No. 22) 5735-1975, Draft Laws, 5735, 319, 320): "The credit points will replace the deduction for residence and the deduction for a woman...allowance points will replace the deductions for children, and replace the child allowance paid by the National Insurance Institute". In other words, as the trial judge pointed out, the subject was the encouragement of childbirth. I am aware that there may be a certain overlap of the deduction and the credit during certain years of child rearing, and if we are really  intent upon true tax, that is inappropriate. But the challenge of regulating the matter so that the public coffer is not harmed falls to the authorities.

 

I.         Indeed, it could be claimed that, to a certain extent, our decision turns the back the clock, at least with respect to the burden to be imposed on the tax authorities - after the tax system underwent a reform in 1975, to a regime of credit points and allowances, as distinct from deductions, and  its life was made easier in this regard.    My colleague the Deputy President  gave a detailed description of the developments from 1975, in order to show that, in essence, our ruling does not turn the clock back. Of course, the multi-assessee dialogue with the tax clerks will certainly not be easy, and there will be additional work for tax clerks, work from which they were exempt over the years with respect to childcare.  Shlomo Yitzhaki, in his article “Tax Reform 1975” (in  David Glicksberg (ed.) Tax Reform, 5766-2005, p. 195, and see p. 215ff), points out that the 1975 reform was directed, inter alia,  and with special emphasis, to the streamlining of proceedings in the tax system (see: Draft Bills, 5735, 319; Tax Reforms, ibid., 226ff). Our judgment thus makes it necessary for the tax system to deal with numerous new details in every file, and one needn’t be an administrative genius to understand – and we state it quite frankly – that it involves a significant administrative burden.  However, as noted by my colleague, even if the Jordan flows slightly backwards, the legislature , the secondary legislator and the Tax Authority have a ”medicine cupboard”.  That is’ they can  establish norms to regulate the deduction to be recognized, in order to simplify, as far as possible, the individual auditing process. This is accomplished by determining  even such matters as what constitute reasonable childcare expenses, and the cost of “baby sitting”, which is hardly  beyond human capability. To my understanding, there are accepted market rates childcare costs, in addition to the other classifications mentioned by  my colleague (and see:  Margaliot, at pp. 360- 361, who suggests allowing the deduction of a certain percentage of the expense, or the setting of a ceiling , as per the practice with other items (office hospitality costs, telephone expenses) that were regulated by the establishment of presumptions).  Such regulation should be done earlier than later, in order to avoid local and individual “trench wars” between the assessees and the tax authorities regarding the amount of childcare expenses permitted for deduction. Regulation of this kind would resolve issues such as the distinction between supervision expenses and “enrichment” expenses, which were dwelt upon by the District Court, and would also quell the fears of deduction “out of all proportions”, which might lead to reduced taxation specifically of those who pay particularly high supervision expenses.

J.    My colleague the Deputy President rightly noted that our decision is not limited to one gender, but applies to both. This is similarly a part of the conceptual-social revolution in which this judgment is rooted, which militates against identification of the woman exclusively with private activity (Lachovsky, p. 225;  and see: Labor.App. (Jer) 2456/03 Bahat v. State of Israel [20]  where a man (a lawyer in the District Attorney’s Office) claimed and obtained a shortened work day, and a day-care supplement, etc.). There is no need to belabor the point that many more couples share the burden of childraising than in the past, so that the man’s role in family care, with its implications for his ability to work outside of the home is, in many cases, almost equal to that of the woman, the traditional house keeper, who now goes out to work herself, even if his status is  not yet entirely equal to hers, as there are also subjects that nature itself dictates (breast feeding). Perhaps the psalmist was referring to our times in writing (Psalms 102:13): “A person goeth out to his work and labor towards evening”. The first verse says neither “man” nor “woman”, but rather “person”[(adam ­–Heb.]. From my perspective, I think that the approach in this judgment brings it close to the spirit of the International Convention on Economic, Social and Cultural Rights, and the Convention on the Rights of the Child, which was ratified by  Israel in 1991 (and see also: Draft Bill – Basic Law: Social Rights (Draft Bills 3068, 23 Tevet, 5762-7.1.02) s. 4).

 

K.       This last matter brings us to consideration of social rights in general. A person has a right to human dignity (Basic Law: Human Dignity and Liberty)  and to freedom of occupation (Basic Law: Freedom of Occupation).  A person’s right to self-realization should and ought to receive expression in the practical possibility of fulfilling that right.  Our concern here is not with lofty words but with “basic sustenance”, in accordance with the simple equation that if a person is unable to go to work because the price of caring for his children (for obviously the “daily separation” from his children is in itself difficult) consumes the fruits of his labor, then that element of self-realization involved in his leaving the home will be severely impaired. (As for his social rights, see: Dafna Barak – Erez and Aeyal Gross, in Dalia Dorner Volume (S. Almog, D. Beinish, Y.Rotem, eds.),  5769-2009, p. 189). Tax law is an integral part of the economic-social fabric and, in my opinion, its interpretation should take these aspects into account.

L. It would not be superfluous here to mention that the obligation of charity in Jewish Law (for its basis, see Shulhan Arukh, Yoreh Deah, Laws of Charity, 247:1),  which is of such singular importance (see Midot Zedakah of the esteemed Hasidic rabbi, Menachem Mendel Schneerson of Lubavitch, 5754) is fixed as follows (Shuhan Arukh, Yoreh Deah, ibid,  249:1): “if he is financially capable, he should give in accordance with the needs of the poor, and if not, he should give up to one fifth of his assets, which is the ideal performance of the commandment, and one tenth is the mediocre and less than that is mean”. This commandment is known as “Tithing of Assets” The question is what constitutes the basis from which tithe (one tenth) is given and inter alia what is recognized as an expenditure to be deducted from the profit in its calculation. It has been ruled that  the cost of a child carer hired by the woman going to work, for purposes of her work, can be deducted from her profits which are liable for tithes of assets.  See inter alia the responsum of Rabbi Joseph Ginzburg in Pinat Ha-Halakhah, Weekly Session (Habad)  1164, 30 Nissan, 5769 (20.4.09) and references.  See also the responsum of Rabbi Chaim Katz “Tithing Assets – Offsetting Expenses” on the internet site of the Beth El Yeshiva, 11 Iyar 5768. See also Ahavat Hesed of the esteemed Rabbi Yisrael Meir Hacohen, the Hafetz Hayyim (ed. Rabbis D. Zicherman, and B. Zeligman, 5763, at 232): It seems that he should also have a special book, in which he records all of the profits bestowed to him by Hashem, after deduction of the expenses of his business”, and in the editors note, ibid 20, concerning “all of the expenses that are necessary for the business”, and references. The emerging picture is that Jewish law regards necessary expenses, including expenses for a caregiver, as appropriate for deduction from the basis of tithes (ma’aser kesafim),  and the analogy to our case is clear.

 

M.  After writing all of the above, I perused the article of Dr. Tzila Dagan “Recognized Expense” (31 (2) Tel-Aviv Law Review  257 (2009)). Among other things, the article addresses the subject of expenses for childcare, from the initial assumption (p. 293) that it is first necessary to establish who is the “normative assessee, through whom we can arrive at appropriate conclusions. By examining considerations of efficiency, division, community and identity, the author concludes (p. 300) that “permitting the recognition of expenses for childcare will, indeed, promote economic efficiency, and will contribute to equality between women and men”. She notes however that this may have problematic distributive consequences. For example, women whose tax rate is high will receive more of a benefit than those whose tax rate is low (pp. 296-297, 300). But in her view, this effect can be moderated by a ceiling that restricts the expenses permitted for deduction, and a bonus for women who earn less than the tax threshold. The spirit of the comments is consistent with our approach. Indeed, in my view, the significance of our judgment in this case is that there is a need to achieve a new balance, which accurately reflects contemporary Israeli society, taking into account the changes in the socio-economic environment, changes that are often – though not always –  for the better.

 

N.  As stated, I concur with the opinion of my colleague the Deputy President.

Justice

 

 

Justice E. Arbel

I concur with the judgment of my colleague, the Deputy President, and with his reasoning.  Indeed, as stressed by the Deputy President, the result whereby the deduction of working parents' childcare expenses are deducted from taxable income stems from, and does not deviate from the general principles of tax law. It leads to a result of true taxation, which is the central goal of tax law. At the same, it cannot be ignored that this particular decision concerning tax issues also raises other important social issues. The result reached by my colleague, the Deputy President, in my view, also achieves an important social goal that enables women to go out to work, or at least makes it easier. Should  a woman wish to work, whether for economic reasons or for considerations of self-realization and development, then society should not frustrate that desire by disregarding the significant economic burden of childcare while she is at work. One cannot ignore the social reality that this economic burden is usually borne by the female member of the family, for a variety of reasons.   As such, recognition of childcare expenses is a step towards a more egalitarian society (see: Tzila Dagan, “Recognized Expense”, 31 (3) ­Tel-Aviv Law Review 257, 297 (2009).

On the practical level, I find it proper to mention that in my view,  when both parents are at work, activities such as clubs and day camps that fall outside the usual childcare framework, may be regarded as partially deductible expenses because part of their purpose is the supervision of children while the parents are at work. It should be remembered that the hours of activity and holidays of the kindergartens and schools are not always identical to the work hours and holidays of the worker. As such, parents are often compelled to find frameworks for their children when the regular frameworks are not available. The fact that some of these frameworks also provide enrichment for the children does not prevent recognition of part of the expenses as intended for the supervision of the children, even though the rates paid for day camps or clubs may differ. Granting partial recognition will also prevent a situation in which the parents will opt for frameworks that do not provide any enrichment so that part of the expense will be recognized for tax purposes, rather than choose frameworks that provide some enrichment  but would not be recognized for tax purposes. On the other hand, in my view, consideration should also be given to additional factors, such as social interests, and considerations of the child’s best interests, which presumably support encouraging parents to spend  more time with their children. It may, therefore, be proper to consider the determining a limit to the number of childcare hours per day that would be recognized as an expense, for reasons of public policy. In addition, in the framework of establishing rules for this field, consideration should be given to the distributive implications as they relate to families from varying economic backgrounds, that spend varying sums on childcare (see: Dagan, p. 296).  In any case, establishing guidelines for implementing of the rule laid down in this judgment is a matter for the legislature, or the delegated authority, and they would do well in regulating the matter in a clear, prompt manner in order to prevent individual disputes with assessees.

 

 

Justice M. Naor

            1.         I concur with the principal conclusion of my colleague the Deputy President according to which childcare expenses are permitted for deduction. I also concur with the comments of my colleague Justice Rubinstein.

2.    Following an exhaustive hearing before this panel, the Director General of the Ministry of Finance requested to appear before us to present the budgetary implications of the rejection of the appeal.  There was no basis for that request. If – and this is our legal conclusion – the expense is one which is permitted as a deduction, then it cannot be expected that our conclusion will change due to the budgetary implications, serious as they may be. On the day of the hearing before this Court, we proposed that the state regulate the subject of deduction of childcare expenses in regulations, but that proposal was rejected. It would seem, in the wake of this judgment, that it would be appropriate to reconsider the arrangement of the subject in primary legislation (or, at least, in secondary legislation), which will establish clearly defined criteria for childcare expenses. Legislative arrangement will prevent the need for superfluous individual litigation for each and every assessee.

3.    I will not deny that I was disturbed, not from the legal point of view but from the social point of view, by the question raised by the state concerning whether the recognition of the deduction did not constitute a benefit for the more established social classes, and regressivity with respect to the weaker socio-economic sectors.  My colleague Justice Rubinstein also addressed this subject, disputing the appellant’s position on this matter.  Personally, I am unable to dismiss the appellant’s arguments.  As stated, this is a disturbing issue from the social point of view; however, the solution. cannot lie in the non-recognition of the possibility of deducting the expense, just as the burden on the state budget cannot distort the result. My colleague Justice Rubinstein cited, with approval, the comments of Prof. Edrei, who brings a possible example of a creative solution to the question of deducting childcare expenses for small children by opening a network of quality daycare centers near workplaces. I warmly endorse the proposal to examine the possibility of expanding the free education provided by the state to young children. Such a solution, if found feasible, would benefit all Israel children (and their parents), and might well broaden the circle of those who go out to work (including women), even among those in low tax brackets.

4.    Regarding the date upon which our judgment takes effect, unlike my colleague the Deputy President, my view is that the matter should not be decided in the framework of this proceeding. I think that the matter should be left pending for proceedings in which arguments can be heard on the matter. According to my colleague, although we are concerned with  a declaration concerning an “existing situation”, there is justification for giving our judgment only prospective effect (except with respect to the respondent). The question of when a judicial ruling comes into force is a complex one that cuts both ways. While our judgment is a “revolution” in terms of actual practice, to the best of my knowledge, this judgment is the first to address and decide the question of the deduction of childcare expenses in Israel. The appellant, too, agrees that the question has not previously been addressed directly in Israel. Our judgment is, therefore, not a deviation from existing precedent (which is also permitted). Even if the assessment officers were asked to recognize these expenses and refused, until today that refusal had never been subjected to judicial review.  The “revolution” is, therefore, not in the settled law, but rather in the practice of the assessment officers. Under these circumstances, when the matter at hand “has never been ruled on in the past, it cannot be said that there is a reliance interest worthy of protection” (LCA 8925/04 Solel Boneh Construction and Infrastructures Ltd v. Estate Ahmad Abd Alhamid  [18], para. 18) that justifies retroactive application. Furthermore, presumably, there are a substantial number of assessees who waited for a decision in the respondent’s case, and thus prospective application will not only prevent the restitution claims that worry my colleague the Deputy President, but will also hurt all of those whose claims are still pending regarding open tax years, without having had any opportunity of presenting their claims on the matter. Note that regarding the latter it is certainly not a matter of “restitution of taxes that were collected, [that] harms the reliance interest of the tax collector”  - an interest that was addressed by my colleague. Furthermore, even if the question of restitution of taxes arises, there may be other legal doctrines which provide us sufficient grounds for not determining prospective application (see, e.g: CA 1761/02 Antiquities Authority v. Mifalei Tahanot Ltd [21], para. 69).  Thus, the question can go either way, but since we have not heard arguments concerning application in respect to time, I would refrain from ruling on the question, and leave it for future resolution (cf: HCJ 2390/96 Karasic v. State of Israel [22], 694 a-b). Under the circumstances, the appropriate place for resolving the question of the date of application is  in future litigation, with any particular assessee, and not the current case.

 

Justice

 

 

Justice E. Hayut

I concur with the conclusion of my colleague the Deputy President E. Rivlin, that the appeal should be dismissed and we should uphold the ruling of the District Court, according to which s. 17 of the Tax Ordinance [New Version] should be interpreted to permit the deduction of a person’s childcare expenses from his chargeable income.  I also concur with his conclusion that these expenses should also be permitted in cases of a “mixed expense”, in other words, an expense that contains an additional, non-revenue component.

Regarding the effect of the new ruling, whether retrospective or prospective, my colleague feels that even if it should be applied to the appellant before us, due to the need to provide incentives for litigants in appropriate cases to take measures to change the existing law, the case at hand justifies only prospective effect for this judicial ruling (as of the tax year beginning in January 2010). The reason for his approach is:

 

‘The construction given today to the provision of s. 17 brings about a practical change in the way the appellant has treated assesees for many years. The need to protect the reliance interest in this case is a powerful one.  The old rule created a real, substantial reliance that precludes the retrospective application of the rule. Returning taxes collected undermines the tax collector’s reliance interest :’

 

Justice Naor, on the other hand, feels that the decision on the issue of the ruling’s effect (prospective or retrospective)  should be left for another proceeding, as the question being “a complex one which cuts both ways”, and because we have not heard the parties’ arguments on the matter. On this issue, I concur with the view of my colleague Justice Naor.  I, too, feel that the question is a complex one which should be examined in all its ramifications before we rule  categorically on the judgment handed down in this appeal. I will further add that, in my view, and even though the Court has not previously addressed the issue of deduction of child-care expenses from taxable income, the criterion implemented by my colleague the Deputy President in determining that these expenses are permitted for deduction, is a new test, which is broader than the incidentality test, which prevailed until today, and which the District Court sought to implement in the current case (and I concur with the comments of my colleague, in para. 19 of his opinion, that any attempt to apply the incidentality test to this case is somewhat contrived). Indeed, as held by my colleague the Deputy President, the incidentailty test should be an auxiliary test for identifying revenue expenditures in the production of income, but not an exclusive test. In its stead, a more sophisticated test should be endorsed, that of the real and substantial connection between the expenditure and the production of income (See para. 16 of the opinion of my colleague the Deputy President).  In that sense, we are handing down a new ruling that replaces the old one, and this being the case, in my view, there is even more of a need for a solid, detailed basis to justify deviating from the ruling in Solel Boneh Construction v. Estate of Ahmad Alhamid [18], according to which the point of departure is that a new judicial ruling goes into effect retrospectively. Finally, and in order to remove all doubt, I will add that, in any case, I concur with the position of my colleague the Deputy President according to which our new ruling should be applied to the case at hand.  In this context, it is not amiss to mention that it was for similar reasons that the Deputy President M. Cheshin, who was in the minority in Solel Boneh  [18], had difficulty in finding any case in which a successful plaintiff whose case had led to a change in the existing law and the creation of a new one, would not be found worthy of enjoying the fruits of the new ruling (See ibid, para. 26). This approach, as stated, is acceptable to me.

            For all of the above reasons, I join in the conclusion of my colleague the Deputy President, that the appeal should be dismissed.

Decided in accordance with the judgment of Deputy President E. Rivlin.

6 Iyar 5769 (30 April 2009)

 

 

 

 

CA 6726/05

and Cross-Appeal

 

Hydrola Ltd.

v.

Income Tax Assessor Tel Aviv 1

 

 

The Supreme Court sitting as the Court of Civil Appeals

 [5 June 2008]

Before Justices E. Rubinstein, E. Hayut, Y. Elon

 

Appeal and Cross-Appeal of the decision of the Tel Aviv District Court (Judge Bracha Ofir-Tom) on May 31 2005 in ITA 1068/00.

 

Israeli Legislation cited:

Bank of Israel Law, 5714-1954.

Court Regulations (Appeals Regarding Income Tax) 5739-1978, r. 10(b).

Currency Supervision and Trade with Enemy States Law.

Income Tax Ordinance ss. 17, 30-33, 32(12)-(13), 145(a)(2)(b), 152(b), 170.

National Insurance Law [Consolidated Version], 5728-1968, s. 179.

Penal Law, 5737-1977, ss. 7(b), 34, 290.

Wireless Telegraph Ordinance [New Version] 5732-1972.

 

American legislation cited:

15 U.S.C §§ 78m, 78dd-1 (1988).

Foreign Corrupt Practices Act (FCPA), 15 U.S.C §§ 78m, 78dd-1, 78dd-2, 78ff (1977).

H.R. REP. No. 640, 95th Cong., 1st Sess. (1977).

Internal Revenue Code, 26 U.S.C § 162(c)(1) (1958).

 

French legislation cited:

Loi de finances rectificative pour 1997 (Amending Law on Finances for 1997), Law No. 97-1239 of Dec. 29, 1997, J. O no. 302 Dec. 30, 1997, p. 19101; Code général des impost, article 39, 2 bis.

 

International conventions cited:

Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (Nov. 21 1997, 37 I. L. M 1 (1997).

United Nations Convention Against Corruption, Articles 12(4), 15 and 16.

 

Swiss legislation cited:

Bundesgesetz über die direkte Bundessteuer (DBG), (Law on Direct Federal Tax), 642.11 RS, Dec. 14 1990, Abs. 27, 59 (1990).

Bundesgesetz über die Harmonisierung der direkten Steuern der Kantone und Gemeinden (StHG), (Law on the Harmonization of Direct Tax), Dec. 14 1990, Abs. 10, 25 (1990).

 

Israeli Supreme Court cases cited:

[1]                           FH 22/61 HaOleh Loan Fund, Mutual Society Ltd. and HaPoel HaMizrahi Credit Fund, Mutual Society Ltd. v. Tax Assessor for Large Enterprises, Tel Aviv [1963] IsrSC 17, 533.

[2]                           CA 507-508/59 Credit Fund v. Loan Fund [1961] IsrSC 15, 2213.

[3]                           CA 380/75 Pardes Cooperative Association of Citrus Growers Ltd. v. Tax Assessor for Large Enterprises [1976] IsrSC 30(2) 312.

[4]                           CA 438/90 Tax Assessor Haifa v. Hed HaKrayot Ltd [1997] IsrSC 41(5) 668.

[5]           CA 661/88 Haimov v. Hamid et al. [2000] IsrSC 44(1) 75, 84.

[6]           HCJ 693/91 Efrat v. Population Registry Commissioner at the Ministry of the Interior [1993] IsrSC 47(1) 749, 779.

[7]           CrimA 2521/03 Sirkis v. State of Israel [2003] IsrSC 57(6) 337, 346.

[8]           CA 294/94 Jewish Burial Society v. Kestenbaum [1992] IsrSC 46(2) 464, 534.

[9]           CA 5258/98 A. v. B. [2004] IsrSC 58(6), 209, 222.

[10]         CrimA 7646/07 Cohen v. State of Israel (2007) (unreported).

[11]         LCA 8253/99 A. v. B. [2003] IsrSC 58(2) 213, 228.

[12]         HCJ 5413/07 Anon. v. State of Israel (2007) (unreported).

[13]         CA 522/63 Beit Zakai Ltd. v. Tax Assessor [1964] IsrSC 18(2) 548, 551.

[14]         CA 6416/01 Benvenisti v. Official Receiver [2003] IsrSC 57(4) 197, 206.

[15]         CA 3498/94 A. v. B. [1996] IsrSC 50(3) 133, 153.

[16]         CA 578/75 Ben-Tal v. Ben-Tal [1976] IsrSC 31(1) 57.

[17]         FCrimH 2980/04 Evico v. State of Israel (2003) (unreported).

[18]         CrimA 163/82 Moshe David v. State of Israel [1983] IsrSC 37(1) 622.

[19]         HCJ 4562/94 Abu Daka v. Lod Military Court [1994] IsrSC 48(4) 742, 748.

[20]         CrimA 2597/04 Roitman v. State of Israel (20040 (unreported).

[21]         LCA 1436/90 Giora Arad, Investment Management and Services Co. Ltd. v. Director of Value Added Tax  [1992] IsrSC 46(5) 101.

[22]         CrimA 8573/96 Mercado v. State of Israel [1997]  IsrSC 51(5) 481.

[23]         LCrimA 5905/98 Ronen v. State of Israel [1999] IsrSC 53(1) 728.

[24]         CrimA 733/07 Cohen v. State of Israel (2007) (unreported).

[25]         CSA 1/77 Klein v. State of Israel [1977] IsrSC 31(2) 164.

[26]         CrimA 5046/93 State of Israel v. Hochman [1996] IsrSC 50(1) 2.

[27]         HCJ 368/76 Gozlan v. Beit Shemesh Local Council [1976] IsrSC 31(1), 505.

[28]         CA 6585/95 M.G.U.R.  v. Municipality of Nesher [1996] IsrSC 50(4) 206.

[29]         FH 22/82 Beit Jules Ltd. v. Raviv Moshe and Assoc. Ltd. [1989] IsrSC 43(1) 441.

[30]         CrimA 7068/06 State of Israel v. Ariel Electrical Engineering Traffic Lights and Maintenance Ltd. (2006) (unreported).

[31]         CrimA 71/83 Flatto-Sharon v. State of Israel [1984] IsrSC 38(2) 757.

[32]         CrimA 355/88 Levi v. State of Israel [1989] IsrSC 43(3), 221.

[33]         CrimA 389/72 Zokaim v. State of Israel [1973]  IsrSC 27(2) 487.

[34]         CrimA 341/73 State of Israel v. Vita [1973] IsrSC 27(2) 610.

[35]         CrimA 126/76 State of Israel v. Shefer [1976] IsrSC 30(3) 466.

[36]         CA 101/74 Hiram Landau Road Construction and Development Works Ltd. v. Water Sources Development (Foreign Countries) Ltd [1976] IsrSC 30(3) 661.

[37]         CrimA 4596/05 Rosenstein v. State of Israel (2005) (unreported).

[38]         LCA 10231/04 Traum v. Gaidamak (2004) (unreported).

[39]         CrimA 4722/92 Markowitz v. State of Israel [1993] IsrSC 47(2) 45.

[40]         CA 1527/97 Interbuilding Construction Company Ltd. v. Tax Assessor Tel Aviv 1 [1999] IsrSC 53(1) 699.

[41]         CA 4030/03 Granot Enterprises – Central Agricultural Cooperative Ltd. v. Tax Assessor for Large Enterprises (2003) (unreported).

[42]         CA 900/01 Keles v. Tax Assessor Tel Aviv 4 [2003] IsrSC 57(3) 750.

[43]         CrimA 256/97 Lachman v. State of Israel (1997) (unreported).

[44]         CA 486/01 Hoter-Yishai v. Tax Assessor Tel Aviv 4 [2004] IsrSC 58(5) 326.

[45]         CA 1124/03 Ganei Ofer Construction and Investment Ltd. v. Tax Assessor Tel Aviv 1 [2005] IsrSC 59(5) 313.

[46]         CA 435/65 Nagid, Trustee Businesses Ltd. v. Income Tax Commissioner [1966] IsrSC 20(3) 287.

[47]         CA 647/79 Ivun v. Tax Assessor for Special Collections [1981] IsrSC 35(4) 645.

[48]         CA 274/84 Shapiro and Shweitzer v. Income Tax Assessor Tel Aviv 2 [1987] Taxes 2/a, 53.

[49]         CA 734/89 Pikanti Food Industries Ltd. v. Tax Assessor Gush Dan [1992] Taxes 6/f, 77.

[50]         CA 21/60 Levtov v. Tax Assessor Haifa [1960] IsrSC 14, 1606.

[51]         CA 506/71 Hafetz v. Tax Assessor Haifa [1972] IsrSC 27(1) 212.

[52]         CA 5709/95 Ben-Shlomo v. Director of VAT Jerusalem [1998] IsrSC 52(4) 241.

[53]         LCA 3476/04 Siman-Tov v. Gad (2004) (unreported).

 

Israeli District Court Cases Cited:

[54]         ITA (Jer) 54/84 El-Arabiya Hotels Ltd. v. Tax Assessor Jerusalem  [1987] Taxes 6/a, 63.

[55]         ITA (Haifa) 13/82 Frumkin v. Tax Assessor [1982] DC 5743(A) 410.

[56]         ITA (TA) 98/84 Frankel v. Tax Assessor Tel Aviv 1 [1985] DC 5745(C) 332.

[57]         ITA (Haifa) 40/95 Vered Recycling v. Tax Assessor Haifa [1996] Taxes J/3 172.

[58]         ITA (TA) 1143/01 Miller v. Tax Assessor Tel Aviv 3 [2006] Taxes K/2, 122.

[59]         ITA 5019/97 D. & D. Zra'im Ltd. v. Tax Assessor Haifa [2000] Taxes O/1, 131.

[60]         ITA 140/89 Dar v. Tax Assessor Haifa [1999] Taxes 4/D 116.

[61]         ITA 1015/03 Company Ltd. v. Tax Assessor Netanya (January 30, 2008).

[62]         OM (Jer) 2212/03 Gad v. Siman-Tov 920030(unreported).

 

United States Cases Cited:

[63]         Textile Mills Corp.‎ v.‎ Commissioner, 314 U.S.‎ 326 (1941).

[64]         Lilly v.‎ Commissioner, 343 U.S.‎ 90 (1952).

[65]         Camarano v.‎ United States, 358 U.S.‎ 498 (1959).

[66]         Bob Jones University v.‎ United States, Goldsboro Christian Schools, Inc.‎ v.‎ United States 103 S.‎ Ct.‎ 2017 (1983).

[67]         S.E.C. v. Lockheed Aircraft Corp., 1976 WL 779 (D. D. C. 1976).

 

Jewish Law sources cited:

[68]         Babylonian Talmud, Ketubot 17a.

[69]         Song of Songs Rabba 5:2.

[70]         Mishnah Hallah, 2:7.

[71]         Exodus 23:8.

[72]         Deuteronomy 16:19.

[73]         Shulhan Arukh, Hoshen Mishpat 9:1.

[74]         R. Zvi Hirsch Eisenstadt, Pithei Tshuva (Hoshen Mishpat 34:27).

[75]         R. Haim Yosef David Azulai, Birkei Yosef (Hoshen Mishpat 9:10).

[76]         R. Yehiel Michel HaLevi Epstein, Arukh Hashulhan (Hoshen Mishpat 9: 1).

[77]         Babylonian Talmud, Ketubot 105b.

[78]         Isaiah 1:23.

[79]         Ezekiel 22:12.

[80]         Babylonian Talmud, Sotah 47b.

[81]         Midrash Tanhuma (Warsaw Edition, Toldot, 8).

[82]         Book of Kings II 7:3.

[83]         Babylonian Talmud, Sanhedrin 107b.

[84]         Babylonian Talmud, Bava Kama 35a.

 

 

 

 

JUDGMENT

 

Justice E. Rubinstein

1.             This is an appeal and counter-appeal against the judgment of the Tel Aviv-Jaffa District Court (Judge Bracha Ofir-Tom) of May 31, 2005 in ITA 1068/00, in which the appellant’s appeal regarding its income tax assessment for the years 1992-1996 was partially allowed. The appeals are based on the appellant’s claim that the sums of money that it transferred to its agents outside Israel were expended to generate its income and the respondent must allow them to be deducted as expenses; the respondent argues, inter alia, that some of the expenses were illegal, in that they were for bribe payments.

Background

2.             (1) The appellant, Hydrola Ltd., engaged in various business activities in the states of the Former Soviet Union, primarily Russia; these activities included the sale of medical equipment and food products. Inter alia, the appellant was active there throughout the 1990s, after the Soviet Union was dismantled in 1991. Those were years of crisis and dramatic change in those states, due to the change of the political and economic regime; this historical background, it is claimed, is very relevant to our case and to the appellant’s mode of operation there.

(2) The appellant conducted its business through dealings with local agents; the nature of these dealings is described in the appellant’s statements of appeal and appendices, and in the testimony of the witnesses for the appellant, including the agents themselves, in the District Court. The appellant transferred significant sums of money to the agents, which were used both to pay the salaries of the agents themselves and for other purposes, including the transfer of sums of money to local bodies in order to promote the success of the deals, the exact significance of which we will address below. Due to the economic situation and the state of the banking system in the former Soviet states, so it is claimed, the agents opened bank accounts in Israeli banks in Israel, and some of them also gave the appellant’s managers powers of attorney to act as they saw fit. The payments designated for those agents were transferred to those accounts.

                (3) It will be noted, that for some of the payments to the agents, made prior to 1996, the respondent – at the appellant’s request – granted an exemption from deduction of tax at source, in accordance with s. 170 of the Income Tax Ordinance (hereinafter: "the Ordinance"), and we will address this below. The appellant also received permission from the Bank of Israel to send these sums abroad. The turning point came towards the end of 1996, when the respondent made the granting of a requested exemption – relating to a sum of $50,000 designated for one of the agents (Isaac Lipkin) – conditional on the presentation of an invoice for the aforesaid sum and an authorization from the income tax authorities in the agent’s country. The documents were not produced, and the respondent refused to grant the requested exemption. In 1997 it also denied an application for an exemption relating to a commission totaling $140,000 that the appellant was to pay to Cura Consulting Ltd. (hereinafter: "Cura") because the documents requested by the respondent relating to the transaction were not produced, and due to its suspicion that the connection between Cura and the appellant was not a genuine business connection. Following the denial of these exemptions, the appellant did not transfer the aforementioned sums to Lipkin and Cura, and in subsequent years the appellant’s payments to its agents in this manner ceased altogether (at least in 1997-1998 – as shown by the financial statements that the appellant submitted to the respondent).

3. The appellant subsequently requested that the aforementioned payments from the years 1992-1996 be recognized as expenses incurred in the generation of income.  The respondent refused the appellant’s request, and issued it with an assessment notice for those years in accordance with s. 145(a)(2)(b) of the Ordinance. In the explanation of the assessment, dated December 28, 1998, the reasons for not allowing deduction of the payments were given as follows: 

'(1) In the reports I did not allow the payments [to be considered expenses] because you did not provide the proper documentation proving that they were incurred in generating income.

(2) Alternatively, the ‘commission’ payments [quotation marks in original – E.R.] were illegal expenses that cannot be allowed.'

The appellant’s objections to the tax assessment were rejected, and another assessment notice was issued, in accordance with section 152(b) of the Ordinance, which repeated the original assessment.  Hence the appeal to the District Court.

The Deliberations in the District Court and the Judgment

4. (1) In its presentation of evidence before the District Court, the appellant's complex dealings and its business connections with its various agents were addressed down to the minutest detail. A recounting of all the details is not necessary here; as noted by the court in its judgment, the appellant’s manner of conducting its business in Russia, as emerges from the testimony, was questionable (p. 25 of the judgment). Of all that was said there, we will mention only a few details that are relevant to the appeal.  The appellant claims that the evidence it produced shows that payments were transferred to seven agents (excluding Lipkin and Cura: ultimately there was no claim that payments were made to these two). Four of these agents testified before the Court. The testimony of the appellant’s employees and its agents revealed that the appellant transferred large sums to its agents, which were designated, inter alia, to cover the costs of maintaining the equipment that was allegedly sold, and to pay the commissions of the agents themselves (i.e. their fees), at low rates relative to the large sums transferred. Most of the money, it seems, was transferred by these agents to various bodies, for what was defined as “transaction promotion” commissions, to which we will return later.

(2) It should be noted that the other three agents were not summoned to testify. The Court denied the appellant’s request to admit their depositions in place of testimony, due to the absence of any possibility of submitting them to cross-examination.

(3) In its judgment, the Court first ruled on the question of the burden of proof, which arose during the hearings. It ruled that with regard to recognition of expenses as deductible, the onus was on the appellant a priori, and that normally, relevant documentation and paperwork are required in order to fulfill this evidentiary requirement. Nevertheless, the court ruled that under the special circumstances that prevailed in the business environment in which the appellant was operating during that period, other forms of evidence were acceptable: 

'When dealing with a unique situation that is out of the ordinary, such as the one that prevailed in the business environment in which the appellant was operating in our case – a fact that has not been denied by the respondent – the appellant’s claim regarding its inability to produce the evidence required under normal circumstances must be taken seriously. The aforementioned difficulty, which has led to a lack of evidence, was sufficient, in my opinion, to justify allowing the requested expenses to be deducted, providing that these were proven by means of other forms of evidence, such as testimony before the court by trustworthy witnesses, whose credibility has not been called into question...

In our case, I heard about the extraordinary circumstances under which the appellant dealt with its clients in Russia from the Company’s director.... Those agents who appeared in Court also described it, and their testimony painted the same picture of chaos and confusion to which the director referred' (at pp. 16-17).

                (4) The Court therefore accepted the appellant’s appeal in a partial fashion, based on the testimony of the four agents who testified before it. As noted, the agents testified regarding the significant sums of money that the appellant transferred to them – even though their testimony was not totally consistent with the appellant’s reports – but the Court recognized only that portion of the money that was used, according to their testimony, to pay their fees. It was ruled that only these sums were proportionate to the value of the reported transactions, and that they (and they alone) were clearly used to generate the appellant’s income. Regarding the rest of the money, it was ruled that it was not proven that it had been expended in order to generate income, and therefore it should not be allowed. Furthermore, regarding the appellant’s other agents who had not appeared to testify (and whose depositions were not admitted, as noted), it was ruled that the expenses claimed in their regard had not been proven and should not be allowed. The appellant’s claim that their expenses should be allowed in light of the four testimonies that were heard, which indicated a recurring pattern or method of payment, was rejected.

(5) The expenses that the District Court recognized as allowable for deduction represented only a small fraction of what the appellant had requested.

(6) The court also addressed the question of the legality of the aforementioned expenses, and determined that some of the money had been used, according to the appellant’s director and the witnesses, to pay bribes (p. 28 of the judgment). Nevertheless, the court did not rule unequivocally on the question of recognition of expenses of questionable legality, referring to case-law whereby, on the one hand, expenses incurred in the context of breaking the law will not as a rule be recognized as deductible, whereas on the other hand, deduction of expenses of this kind will be allowed in certain circumstances. It was determined that in all events, in our case the bribery issue had not been sufficiently elucidated. This is a complex case involving an alleged violation of a foreign law; and nothing has been proven in this regard, and the Tax Assessor is not required to concern himself with its enforcement. We will return to this later, too.

The parties’ claims

5.               (1) An appeal and cross-appeal were filed on the District Court’s judgment. The appellant contends that the court erred in allowing the appeal only in relation to the commission payments that according to the agents' testimony, they had received as fees, arguing that the respondent should have allowed deduction of all of the commission expenses declared, particularly since it issued exemptions from deduction of tax at source in their regard. It is claimed that based on these authorizations, the appellant was entitled to assume that the payments would constitute recognized expenses, and that non-recognition constitutes a retroactive retraction, which causes disproportionate damage to the appellant’s property. It is further claimed that the respondent lacks the tools to make a sound assessment of the appellant’s income with regard to its expenditures in Russia.

                  (2) It also argues, from the procedural aspect, against the court’s decision not to admit the depositions of the three agents who did not appear to testify before it. According to the appellant, the provisions of r. 10(b) of the Court Regulations (Appeals on Matters of Income Tax) 5739-1978 (hereinafter: "the Regulations"), make admission of the depositions obligatory, since they were submitted as evidence to the respondent at its request.  It is further argued, in this regard, that the court should also have accepted the appellant’s claims because the agents’ testimonies and the depositions proved the payment of the commissions as a "modus operandi".

 (3) The cross-appellant, i.e. the respondent to the appeal (for the sake of convenience, hereinafter referred to as “the respondent”), claims that the District Court erred when it recognized the commission payments to a limited extent, as noted above. It claims, on the evidentiary level, that regarding all of the payments, including those payments that were determined to have been incurred for the agents’ fees, the appellant has neither demonstrated nor proved that they were incurred only to generate income. This, in the respondent’s opinion, is due to the lack of adequate documentation regarding the business relationships between the appellant and its agents and regarding the payments it made. It contends that the arguments regarding the inability to produce documentation due to the prevailing circumstances in Russia should be rejected in view of the arrival of the appellant’s agents in Israel during the said period, and that the allegedly abnormally high commissions – both in relation to the value of the transactions reported and in relation to the agents’ testimonies – are an indication of the evidentiary problem with accepting the appellant’s claims.

                                (4) The respondent further argues, on the normative plane, that even if the appellant satisfied the burden of proof standard, there would be no reason to recognize its expenses – including the agents’ fees – due to their illegal nature. It claims that there is a clear evidentiary basis for determining that the payments were bribe money. It is further argued that according to case-law and academic opinions, illegal expenses may not be deducted – and certainly not if they are tainted by criminality, as in the present case, according to the respondent. In this regard, the respondent cites the United Nations Convention Against Corruption (hereinafter: "the Convention Against Corruption"), although its signing post-dates the relevant period. Still, the respondent claims that it elucidates the legal situation that prevailed even prior to its signing.

                                (5) The appellant responded to this last point by claiming that the payments were commissions to its agents in Russia and not bribe money, and that in any case, the bribery allegations have not been proven. It also claims that even if it was proven that the payments were bribes, they are still not an illegal expenditure, since paying a bribe in Russia does not constitute a crime in Israel, and it has not been proven that under the circumstances it was even a crime in Russia, certainly not during the period relevant to the appeal.

Deliberations

6.             We will first address the appellant’s position that the respondent should have allowed deduction of the full amounts as expenses. The respondent, as noted, based his decision not to allow deduction of the expenses on two alternative reasons: the evidentiary reason – the failure to properly prove the expenses; and the normative reason – the illegality of the expenses. The lower Court partially accepted the respondent’s position for the evidentiary reason, and did not issue a clear ruling on the normative question, notwithstanding its determination that the expenses were used to pay bribes. I will say at the outset that as far as I am concerned, the appellant’s arguments should not be accepted and I am of the opinion that the evidentiary reason alone is sufficient to uphold the respondent’s position that the expenses claimed by the appellant should not be allowed as deductions, since they have not been properly proven. However, I think that the outcome would be the same based on the illegality issue as well; due to its significance, I will elaborate this point below.

The nature and purpose of the commissions that the appellant transferred to its agents

7.             (1) To dispel any doubts, we shall describe the nature, character and purpose of the payments made by the appellant to its agents before discussing the issue at hand. As noted, the District Court determined that these were, at least in part, bribe payments, even though their exact nature was not fully clarified. The said nature of the payments is evinced directly, and even explicitly, by the testimony before the Court. It is clear that the payments involved bribery of officials, sometimes senior ones, who by virtue of their positions were involved in transactions with the appellant – despite the attempt by some of the witnesses to present the nature of the transactions as “providing a discount.” For example, in the cross-examination of the witness Josef Garbuz, who acted as an agent for the appellant in a transaction for the sale of medical equipment to Poliklinika (a clinic of the  Russian Foreign Ministry), he said as follows:

'$313,000 was the price according to the contract, and after the contract was drawn up, a discount of $52,400 was obtained... What I suggest is not to call it a discount but rather a brokerage fee, but according to the contract I retained $10,000...

Q.  The $52,400 was a brokerage fee or a discount?

A.  A brokerage fee. Commission. I received a brokerage fee of $52,400.

Q.  What was the discount you obtained?

A.  As far as I understand it, the 42,000 that I forwarded to Poliklinika was the discount I obtained. Correct, previously I defined the NIS 52,000 [error in original - E.R.] as a brokerage fee, it could be that these are the accepted terms in Russia and therefore they are not precise' (p. 61 of the protocol).

The witness does not specify to which individuals the “discount” or “brokerage fee” was forwarded. The testimony of the witness Svetlana Koznitzova sheds light on the matter:

'During those years there were many offers from all the states that came to us to supply products, whoever had money and wanted to buy products wanted assurance that they would get something too.

Q.  Who were the ‘they’ who were involved in the story?

A.  Whoever had control of the money wanted to get a piece of the payment...

Everyone - one wanted to get 10%, one 5% or 15% of the payment. There were many like that.... There was one deal between that factory [Kronichev Space Center - E.R.] and Muchinik [one of the directors of Hydrola - E.R.], and Levdiev [Deputy-Director of the Factory - E.R.] asked me if I would receive his share in the amount of $62,000, so that it would be as if I received this amount, and he would give me 10% of the amount.

Q.  Why didn’t he contact Hydrola directly?

A.  He didn’t want to be exposed' (p. 69 of the protocol).

Later in her testimony, she said, inter alia: 

'The commissions are for the customers. The thing is that it is not private individuals who are ordering. The customers are institutions. These are people who represent the customers. The customers ordered and the people representing them received commissions.

Q.  That [payment of] $122,000 went to those customers who represented the institutions, whoever they were ….

A.   Yes. The Director-General of the Geological Association called on the phone, can you supply some equipment to the northern areas, I will make an order of $150,000 but $10,000 is for me' (p. 73).

The testimony of the agent Yaakov Lutzky was similar: “I would give a certain amount of money, so that they would... trust me, at the moment that we would do this deal” (p. 21 of the protocol). It was even more pronounced in the testimony of the agent Vladimir Friedman, who presented the matter without painting it as a “discount” or a “brokerage fee” and without “embellishment and dressing-up” (as referred to in the Babylonian Talmud Ketubot [68] 17A):

'Why do you pay more – in order to get authorization for that equipment I need to pay a bribe to every official at every level.... In answer to the Court’s question – are you paying a bribe – what, is bribery a bad word? It’s a way of saying thank you for signing the authorization. I gave bribes to dozens of people. And not just me...' (p. 29).

          (2) Thus, the payments that were transferred to the appellant’s agents and recorded in its books as expenses for “‘agents’ commissions outside Israel,” did not serve only as fees for the agents for their brokerage of the transactions. In actuality, these fees were a relatively small component of the payments; a significant part of it was handed over to public servants in order to guarantee them a private profit from transactions with the public institution in which they worked. It is inconceivable that the appellant’s management was not aware of this, even if it turned a blind eye to the destination of the money and the conduct of its agents. This is evident from the testimony of one of the appellant’s directors, Mr. Shimon Muchnik:

'Some of the money was spent for bribing people in Russia but I didn’t know who or what. I could only guess. We determine the amount that we need to send to Russia before we sign the contract' (p. 45 of the protocol).

'There were discussions [with the respondent – E.R.] about commissions for the agents, but commissions to the agents were not just commissions to the agents, technically they were recorded as commissions to the agents, part of it was the commissions to the agents and part of it was money that was refunded in accordance with earlier agreements based on the Income Tax Authority’s consent to give us authorizations for these payments...

To the best of my knowledge, Freidkes [the appellant’s accountant – E.R.] concluded this with the Income Tax Authority in the first case that arose. That it would be termed ‘commission to agent outside Israel’ even though it also referred to other components. I did not have to go into these components. During the conversations and communications between us, they explained to us where the money was going so that we would not think that all the money was for commissions. I also did not care where the money was going' (pp. 43-44). 

Moreover, Muchnik’s lack of knowledge did not prevent him from advising others on how to successfully navigate the business maze that then prevailed in Russia. One of the witnesses on behalf of the appellant was Mr. Aryeh Carosh, a director of a different company that was involved in similar deals. In his testimony, he too claimed that “the main concern of all the officials was what they personally would earn from the deal, including the acquisition clerks” (p. 34 of the protocol). He also stated that he enlisted Muchnik's help to “seal the deal,” as he put it, and that he acted in accordance with the instructions he received from the appellant (ibid.). 

The deductibility of illegal expenses

‎8.  (1) 'Normally, it can be said that a problem relating to expenses that have their source in illegal activities is not necessarily within the bounds of tax law. Two contradictory principles collide in such a case. One demands an accurate determination of income, without taking considerations of law and ethics into account, and the other is based on considerations of “setting the world aright” (public policy). This latter principle – which is usually the decisive one – recoils from recognizing and authorizing expenses incurred through illegal activities, in order that crime not pay' (Alfred Witkon and Yaakov Neeman, Laws of Taxation - Income, Inheritance and Betterment Taxes (Fourth Edition, 5729), at p. 157 (hereinafter: Witkon and Neeman)).

        (2) S. 17 of the Income Tax Ordinance (hereinafter: "the Ordinance"), which governs the issue of deductibility of expenses, states that “in order to determine a person’s income, deductions will be made... for expenses that were incurred entirely for the generation of his income during the fiscal year, and for this purpose alone.” Ss. 30-33 of the Ordinance (part D of chap. 2) contain several provisions restricting and limiting the deduction of expenses. Included among them, in s. 32, is a long list of expenses that will not be allowed. Expenses involving a violation of the law, or resulting therefrom, are not included in this list. However, according to the case-law, deductions for expenses incurred while violating the law may be prohibited.

9.             (1) The issue of deductibility of expenses involving a violation of the law has been addressed over the years by Israeli courts as obiter dicta, in several cases relating to legitimate expenses stemming from illegal activities, e.g. financial sanctions and legal costs. In the nature of things, cases in which recognition of tax deductibility is sought for payments involving a violation of the law cross the threshold of the courtroom quite rarely. One of these rare cases in which the question of deducting expenses made illegally was addressed in Israel in ITA (Jer.) 54/84 El-Arabiya Hotels Ltd. v. Tax Assessor Jerusalem [54], at p. 63. Judge Prof. Bazak said as follows in that case:

'It can be assumed that the problem with recognizing illegal expenses is more theoretical than practical. Usually someone making illegal payments will be in no hurry to admit this in an official document for fear that this will lead to criminal prosecution for his involvement in those activities.... Another reason that the problem of illegal expenses is a theoretical issue is that in general, it will be difficult for the assessee to adequately prove that he did indeed make the illegal expenditure. After all, the party who received the payment will not confirm this in writing or orally, for fear of the law. For these reasons, it would seem, there are so few precedents on the subject' (at pp. 69-70).

       (2) In FH 22/61 HaOleh Loan Fund, Mutual Society Ltd. and HaPoel HaMizrahi Credit Fund, Mutual Society Ltd. v. Tax Assessor for Large Enterprises, Tel Aviv [1], at p. 533, the Court addressed the possibility of recognizing, for tax purposes, a payment that the appellant was liable to pay to the Bank of Israel for contravening the instructions of the Governor of the Bank of Israel under the Bank of Israel Law, 5714-1954. Justice Berinson (in a majority opinion) noted in his conclusion:

'For reasons related to the public welfare, we cannot allow an income tax deduction for an expense incurred while breaking the law, or which is liable to undermine policy stemming from the law of the State or from a legitimate action of the government regarding a matter of public importance' (at p. 551).

It will be mentioned that in that case, Justice Witkon's (minority) opinion was that a punitive function should not be attributed to the relevant section of the Bank of Israel Law (at p. 549); this was also his approach in the previous incarnation of the case, in CA 507-508/59 Credit Fund v. Loan Fund [2], at pp. 2213, 2217. Justice Dr. Witkon reiterated the majority court ruling that he originally disputed in CA 380/75 Pardes Cooperative Association of Citrus Growers Ltd. v. Tax Assessor for Large Enterprises [3], at pp. 616-617. (That case dealt with the deduction of legal costs for a transaction involving illegality; however, the primary reason for not allowing the expenses was that they were not interest payments and were not made in the regular and normal course of business.)

(3) In El-Arabiya Hotels Ltd. v. Tax Assessor Jerusalem  [54], as we have said, payments which were illegal in themselves were addressed – i.e. loan repayments paid to Jordanian banks, in violation of the provisions of the Currency Supervision and Trade with Enemy States Law. Following a review of the cited laws, Justice Bazak stated:

'The problem is not a simple one and it should not be assumed that it has a simple, unequivocal and comprehensive solution, since the matter is extremely dependent on the circumstances of the case. I would say that the rule is that it all depends on the nature and the degree of severity of the illegality involved.... There are illegal expenses that could never be allowed, such as bribing a public servant or payments to burglars and thieves. On the other hand, there is no reason not to recognize some illegal expenses, such as grossly-inflated rent payments, etc. This is the case regarding payments made in violation of the laws controlling foreign currency, as in the present matter. No hard and fast rules can be set. It very much depends on the circumstances of the case' (at pp. 69-70).

                (4) This issue has subsequently been addressed once more, again incidentally, in CA 438/90 Tax Assessor Haifa v. Hed HaKrayot Ltd. [4], at p. 668. The issue in that case was not illegal payments per se; rather, Justice E. Goldberg mentioned, inter alia, the law regarding the non-deductibility of expenses that are contrary to public policy, and noted the relationship between this law and the partial arrangements found in the Ordinance, in ss. 32(12) and 32(13) (the prohibition on deducting sums financing or assisting sea-based transmissions, as defined in the Wireless Telegraph Ordinance [New Version] 5732-1972, and the prohibition on deducting payments paid as fines and linkage differentials in accordance with s. 179 of the National Insurance Law [Consolidated Version], 5728-1968, respectively). In light of the circumstances in which these amendments were enacted, Justice Goldberg concluded that they did not constitute a negative arrangement (for a different opinion, cf: Amnon Rafael and Yaron Mehulal, Income Tax – Volume One (3rd edition, 1995) at p. 429 (hereinafter: Rafael)). He said:

'Is there a basis in the law for economic logic being overruled by public policy? There is no general provision in the Ordinance that permits taking public policy into account when determining an assessee's taxable income. Instead, there are several partial arrangements found in the law that restrict the deduction of an expense due to the said considerations.... The preliminary question is: are the partial arrangements in the Ordinance exhaustive of the tax authorities’ competence to take considerations of public policy into account in determining a person’s taxable income? According to case-law, considerations of public policy are appropriate considerations in the tax assessment process, and the deduction of an expense may be prohibited for their sake. For example in FH 22/61 HaOleh Loan Fund v. Tax Assessor [1] … the provisions of s. 32(12) and s. 32(13) of the Ordinance should not be viewed as exhaustive of considerations that the tax assessor is entitled to take into account when determining a tax-payer’s taxable income... Public policy is a relevant consideration for the process of determining the taxable income of an assessee...' (at pp. 712-713).

10.          (1) If so, the principle of public policy (“public welfare” as Justice Berinson calls it in HaOleh Loan Fund v. Tax Assessor for Large Enterprises case [1], or “setting the world aright” as Witkon and Neeman call it) is a relevant consideration when determining taxable income, and it stands in opposition to recognition of expenses for tax deduction purposes (see also Nitsa Uretzky, Illegal Income and Expenses in Taxation Law (1990) at pp. 13-18, 57-59 (hereinafter: Uretzky); Aharon Namdar, Taxation Law [Income Taxes] - Income Tax, Company Tax and Capital Gains Tax (Part A, 1993) at pp.  35, 229 (hereinafter: Namdar)). The term “public policy” has been defined in our judgments on more than one occasion:

'Public policy’ signifies the primary and essential values, interests and principles that a given society at a given time wishes to uphold, preserve and develop... public policy reflects the elemental foundations of the social contract... (per President Shamgar in CA 661/88 Haimov v. Hamid et al. [5], at pp. 75, 84).... Public policy is a central tool through which the legal system safeguards the essence of its values against various loci of power that wish to create legal norms or pursue physical activities that contradict these values. This is a tool through which the "proper functioning of the judicial institutions essential to society" is maintained (I. Englard, “The Status of Religious Law in Israeli Law (Part 3)" Mishpatim 4 (5732-33) at pp. 31, 57; HCJ 693/91 Efrat v. Population Registry Commissioner at the Ministry of the Interior [6], at pp. 749, 779, per Justice Barak).

                (2) This is straightforward. It should, however, be borne in mind that public policy is itself a broad concept, a “meta-principle, an overarching consideration” (CrimA 2521/03 Sirkis v. State of Israel [7], at pp. 337, 346, per (then) Justice M. Cheshin) and there are those who call this concept a “legal safety-valve” (CA 294/94 Jewish Burial Society v. Kestenbaum [8], at pp. 464, 534), per (then) Justice Barak). This concept embraces various considerations as well as the balance between them – “in determining the scope of ‘public policy’ there must be an internal balancing between conflicting values and interests” (CA 5258/98 A. v. B. [9], at pp. 209, 222, per President Barak, and the other references cited there). Obviously, these are cases that public integrity, in a state purporting to be moral, cannot tolerate (see, by analogy, the issue of money laundering in the explanatory notes to the Prohibition Against Money Laundering Bill, 5769-1999 at pp. 420, 423; see also CrimA 7646/07 Cohen v. State of Israel [10]). Public policy is the “principle that reflects the fundamental social credo of the judicial system” (President Barak in LCA 8253/99 A. v. B. [11], at pp. 213, 228; cited in HCJ 5413/07 A. v. State of Israel [12]). Therefore, in my humble opinion, in any discussion regarding illegal expenses, an examination of any claims that are incompatible with the principles mentioned above is required.

11.  (1) One of the central considerations in considering the deductibility of illegal expenses is the concern that permitting these kinds of deductions makes a mockery of the law. This point was already made in the above-cited words of Justice Berinson in HaOleh Loan Fund v. Tax Assessor for Large Enterprises [1], as well as in the words of Justice Goldberg in Tax Assessor Haifa v. Hed HaKrayot Ltd. [4]:

'The concern is for conflicting trends in the two bodies of law and the conveying of a mixed message to the tax-paying public, whereby from the perspective of criminal law, the tax-payer's conduct is reprehensible and should be penalized, whereas  ‘the expenses incurred’ in committing the crime are recognized under taxation law. In her book [cited above – E.R.], N. Uretzky discussed this, writing (on p. 58) that "[a]llowing the deduction of an expense stemming from business activities that are premeditated and preplanned, and that knowingly violated the law, undermines the legal and moral foundation upon which the legal system is founded"' (at p. 715; see also Rafael, at p. 427; see also CA 522/63 Beit Zakai Ltd. v. Tax Assessor [13], at pp. 548, 551, per Justice Witkon).

This consideration is extremely weighty, and it combines with the meta-principle of safeguarding the rule of law, which is also based in public policy: “Public policy includes, inter alia, the importance of safeguarding the rule of law (both formal and substantive). Therefore, safeguarding public policy also means upholding the law and its provisions and deterring criminal activity and law-breaking” (CA 6416/01 Benvenisti v. Official Receiver [14], at p. 197, 206, per (then) Justice Barak). Certainly, non-recognition of the deductibility of illegal expenses does not mean that the taxation laws serve as tools for penalization or deterrence; rather they protect such tools – which are designed to protect serious public interests enshrined in other bodies of law – from neutralization, or at least impotence due to exploitation by criminals by means of the taxation laws. This is also a matter of common sense. I will add that I agree with Dr. Uretzky’s narrower definition, which she quoted from Justice Goldberg, and I do not count myself among the more lenient in this matter. We would do better to express our reservations about the opposite stance, lest we fall victim to the perils of a slippery slope. A tiny chink in the proverbial armor could gradually widen until “wagons and coaches could enter through it” (Song of Songs Rabba [69] 5:2). I will add here that by their very essence, the “judicial genes,” the DNA in every fiber of the judge – the hidden, internal compass of conscience within him/her – demand that a judge refrain from giving his/her seal of approval, be it explicit or implicit, to any illegal activity or to the benefit therefrom.

                (2) Another consideration, deeply enmeshed in the first one, is the public policy principle that “crime must not pay” (based on the Mishnah, Hallah [70] 2:7; CA 3498/94 A. v. B. [15] at pp. 133, 153, per Justice Dorner; Benvenisti v. Official Receiver [14], at p. 206). The essence of this principle is that one who breaks the law should not enjoy his ill-gotten gains – and permitting the deduction of an illegal expense would allow a law-breaker to reap the rewards of his illegal act (see Witkon and Neeman, at p. 157; Beit Zakai Ltd. v. Tax Assessor  [13], at p. 551; on this principle in Jewish law in relation to property matters, see Eliav Shochetmann, Ma'aseh Haba Ba'avera (1981), at pp. 250-254).

(3) Other considerations that may be taken into account relate to the specific character of the illegal activities in the particular case. We will address this, in relation to our case, below.

(4) Indeed, opposed to all of these considerations stands a basic principle of taxation law, i.e. accurate assessment. There are those who claim that the non-deduction of illegal expenses violates this principle; the violation is more serious in light of the law that illegal income will be taxed – in spite of its illegality. As well the economic illogic of this tax and the principle of accurate assessment, there are those who would claim that taxation laws should not be used as a method of penalization additional to the penal code, and that in any case the deterrent power of taxation laws is limited in its effect (see Tax Assessor Haifa v. Hed HaKrayot Ltd. [4], at p. 715, per Justice Goldberg; Uretzky, at pp. 58-59; 64-65; Namdar, at p. 229; Rafael, at pp. 427-430).

(5) I will note at this point that in my opinion, those considerations designed to maintain the values of the law and to preserve the incorruptibility of the government authority should prevail over the concern for appearing to collaborate or indirectly "authorize" illegal activities. I see no legal or moral problem with the fact that illegal income is taxed while illegal expenses are not recognized as deductible. Moreover, while it is true that the tax authorities deal with collection, and that is their main role, they are also an integral part of the wider spectrum of governmental authorities. As far as I’m concerned there is no particular reason why they should wash their hands of imposing sanctions, where appropriate, against those who act illegally, within the framework of the tax system. This is consistent with an approach that does not cast the entire burden onto the criminal law system, but rather complements it.

12.          (1) In the real world we find various categories of expenses related to illegal activities, regarding which deductions are sought. One such category includes payments the very making of which is illegal. Clear-cut examples of these are bribe payments, money paid to a hired assassin in order to “increase business profits” or a payment to finance burglary or theft from a competitor; however, there are also less clear-cut examples, such as payments made in violation of the provisions of the currency control laws (see El-Arabiya Hotels Ltd. v. Tax Assessor Jerusalem [54]). The second category includes expenses for legitimate payments incurred as a result of illegal activities, e.g. monetary sanctions such as fines and compensation, and court costs. In the nature of things, this category finds its way into the courtroom more often, and has been discussed relatively often (HaOleh Loan Fund v. Tax Assessor for Large Enterprises [1]; Tax Assessor Haifa v. Hed HaKrayot Ltd. [4]; and also ITA (Haifa) 13/82 Frumkin v. Tax Assessor [55], at pp. 410, 418-419, per Justice Dr. Bein; ITA (TA) 98/84 Frankel v. Tax Assessor Tel Aviv 1[56], at p. 332, per Justice Pilpel; ITA (Haifa) 40/95 Vered Recycling v. Tax Assessor Haifa [57],  at pp. 172, 177-181, per Justice  Dr. Bein; ITA (TA) 1143/01 Miller v. Tax Assessor Tel Aviv 3 [58]  p. 122, per Justice Altuvia). The third category includes “illegitimate expenses” – those that are incompatible with public policy, even though they themselves do not contravene the provisions of any law. There is a variety of examples of this:  repayment of a loan at a usurious rate of interest in violation of the law (see Beit Zakai Ltd. v. Tax Assessor [13]); expenses incurred in creating an illegal contract (see Pardes v. Tax Assessor [3]); legitimate expenses incurred by an illegal enterprise, such as an unregistered gambling establishment; commercial bribe payments (see CA 578/75 Ben-Tal v. Ben-Tal [16], at p. 57) and others, as far as the tax-payer’s imagination stretches (see other examples from US case law: Textile Mills Corp.‎ v.‎ Commissioner, 314 U.S.‎ 326 [63]; Lilly v.‎ Commissioner, 343 U.S.‎ 90 [64];  Camarano v.‎ United States, 358 U.S.‎ 498 [65]; Bob Jones University v.‎ United States, Goldsboro Christian Schools, Inc.‎ v.‎ United States 103 S.‎ Ct.‎ 2017 [66]).‎

(2) Even if the question of deductibility of expenses related to illegal activities is considered for each case on its merits and in direct relation to the nature of the illegal activities in the particular case, it is still only natural that insofar as the first category of expenses is concerned, the above-mentioned considerations militating against recognition for tax purposes will obviously carry significant weight. In these cases, which involve a direct monetary outlay for activities that the legislature has prohibited, as far as I am concerned the answer is clear, in accordance with a value-based judicial policy. Moreover, even though cases that fall into the second or third categories are widely disputed, my tendency in their regard is similar, and I think that in these types of cases the burden of persuasion borne by the assessee seeking the deduction is very heavy (see Uretzky, pp. 15-18, 89-94, 103; Namdar, at pp. 321-322; Rafael, pp. 430-435; Boaz Barzilai, “The Income Tax Authority – A Way of Collecting Taxes or a Tool for Regulating Public Conduct: A Review of the Issue and its Development based on the Hed HaKrayot Judgment” Missim XII/1, p. 65a (1998); Lior Neuman and Ofir Kaplan, “The Deductibility of Legal Defense Costs in Criminal Law” Missim XVIII/3, at p. 1a (2004); "Deduction of Business Expenses: Illegality and Public Policy", 54 Harv. L. Rev. 852 (1940-1); Donald H.‎ Gordo‎n, "The Public Policy Limitation on Deductions from Gross Income: A Conceptual Analysis", 43   Ind. L. J. 406 (1967-8); Cathryn V.‎ Deal, "Reining in the Unruly Horse:‎ The Public Policy Test for Disallowing Tax Deductions", 9 Vt. L. Rev. 11 (1984).

The deductibility of illegal expenses incurred outside Israel

13.  (1) The question of the deduction of illegal expenses incurred outside Israel adds further weight and complexity to the issue currently under discussion, since for the purposes of the necessary balancing between the two bodies of law – penal law and taxation law (and I have already indicated which way the scales are tipped in my opinion) – the question of how to relate to the law in the foreign state must be considered (see Uretzky, at p. 142).

(2) Regarding this issue, counsel for the appellant claimed that it had not been proven that the payments made by the agents were bribes, and even if they were bribes – it was not proven that paying bribes is a crime in Russia (referring to the words of Vice-President Cheshin in FCrimH 2980/04 Evico v. State of Israel [17], at para. 3). Counsel for the  appellant claimed that at the very most, it could be said that these activities contradict public policy; but – so he claims – why should Israeli public policy be concerned with Russian public policy, since [the two states] do not share the same “values, interests, and central and essential principles, which a given society at a given time seeks to establish, to maintain and to develop” (Efrat v. Population Registry Commissioner [6], at p. 779), and in any case,  “the content of public policy varies in different societies” (per President Barak in the abovementioned A. v. B. [9], at p. 222). This claim, captivating though it may be, holds no charm for me.

Expenses relating to illegal activities conducted outside Israel could fit into each of the three categories reviewed above, and could be examined within the framework of each. Indeed one could encounter difficulties in relation to the non-deductibility of expenses incurred in a legal and legitimate manner in country A, due to public policy in country B. In this case, however, we are dealing with a situation that falls within the first category, that of expenses which in themselves constitute a violation of the law, even though they were incurred outside Israel, as I will explain below. Furthermore, there are matters of public policy that are universal, in principle if not in practice, and bribery – a biblical prohibition that is also part of the cultural heritage of the Russian nation – is included among them.

       (3) On the other hand, neither should we be overly impressed by the argument of counsel for the respondent in his summation, that this is a case of an extraterritorial crime (see the definition of “extraterritorial crime” in section 7(b) of the Penal Law, 5737-1977), and that Israel's extraterritorial jurisdiction applies, by virtue of s. 15 of the Penal Law – and therefore the said payments may not be deducted. It seems to me that in the response summations, counsel for the respondent abandoned this argument, or at least expressed some reservations. In any case, I am doubtful whether there are grounds for this position. First of all, the question of whether as a rule, there can be an extraterritorial application of Israeli law with regard to the acts in the present case is a serious one, particularly in light of the nature of the crime – bribery – which includes a patently local connection in the definition of a “public servant” (see ss. 34 and 290 of the Penal Law; see in this context S. Z. Feller, Principles of Penal Laws (Vol. 1, 5747-1987) at pp. 216-217 and pp. 291-292). Secondly, statements are one thing and actions another: my doubts also stem from practical considerations in that I am doubtful whether we will actually see indictments of this kind filed any time soon. And thirdly, another important question relates to the treatment of the legality of expenses incurred outside Israel, for the purposes of the question of tax deductibility, when they constitute extraterritorial crimes by virtue of extraterritorial application. However, I think that there is no need to address these questions, since the illegality of the expenses becomes clear by another way, as will now be explained.

14.  (1) The payments made by the appellant’s agents outside Israel are, in my opinion, illegal expenses for the purpose of tax deduction since, as will be explained in detail, they are not legal in the country in which they were made – or at least it is so presumed as long as the appellant has not proved otherwise – and they would not have been legal had they been expended in the taxing state, i.e. Israel. In other words, they are, if you will, a case of “double illegality” (in the sense of the term “double criminality” in the area of extradition law), both in Israel and in the foreign state. You’re damned if you do it in Russia, and you’re damned if you do it in Israel.

 (2) Regarding the question of the hypothetical legality of the expenses in Israel: In spite of the fact that the payments were made outside Israel, we must hypothetically examine the legality of the expense in Israel, i.e. what would be the situation had the deed taken place in Israel (see also Uretzky, at p. 142). Vice-President Cheshin called this a "transplanting of foreign events into Israeli law” (Evico v. State of Israel [17]). “Hypothetical criminality means that the deed would constitute a crime in the perpetrator’s country of origin too, if it includes the factors that form the basis for effective criminality, in abstracto and in concreto, in the country in whose territory the crime was committed” (Feller, at pp. 219-220). Even in cases in which the expenses incurred outside Israel involved, according to the definitions of criminal law, elements that are based on a clear local connection, such as in this case, the circumstances of the deed can be substituted and examined as though they took place in Israel. Vice-President Cheshin’s words in Evico v. State of Israel [17] are particularly apposite in this matter, and even though the statement was made in a different context, it is almost as if it were written for us:

'How can we carry out this transplantation into Israel of an event that took place outside Israel? Close examination will reveal that it is possible to perform this transplantation without any particular difficulty. This is the case, for example, in relation to crimes that are not "local" ¬– floating crimes, if you will – i.e. crimes that are not, by their very nature, dependent on the place of commission of the crime.... The procedure is different in a case in which one of the components of the deed (that was committed outside Israel) is a "local component," a component characterized by a specific local context. Such, for example, is the component of the crime of bribery in Israel if the person receiving the bribe is a "public servant." This concept is defined in the Penal Law (s. 34(24)) and its nexus is specific to the State of Israel. A "public servant" in Israel is not the same as a "public servant" in the country in which the event took place (inasmuch as the concept exists in that country). The question that therefore arises is how to effect the transplantation in these kinds of cases, and the answer given was – and is – that we must adopt a "conceptual approach" (as per (then) Justice Barak in Moshe David v. State of Israel [18]) or one of "hypothetical criminality" (in the words of Feller). The technique for transplantation is that of a "conversion of factors", and the act of conversion will be effected by exchanging "the actual factual circumstances [that existed outside Israel] for corresponding hypothetical Israeli circumstances" (Moshe David v. State of Israel [18], at p. 636). In these cases of "local" circumstances we will, therefore, examine whether it is possible to transfer the circumstances that pertained in another country to corresponding, hypothetical, circumstances in Israel' (paras. 13-14, and see also Moshe David v. State of Israel [18], at p. 622, cited by the Vice-President; see also Feller, at pp. 213-220).

I will add that for the purposes of this examination, we should recall the process of globalization that is sweeping the world, and with it the international war on corruption that finds expression inter alia in the United Nations Convention against Corruption, which we shall address below. In our case there can be little doubt that the agents used the money that they received from the appellant to bribe public officials and civil servants in public institutions in Russia – who pocketed the money in exchange for closing deals with the appellant. There is no doubt that had these expenses been made in Israel, they would have constituted an act of calumny falling within the bounds of the crime of bribery.

 (3) The question of the legality of the expense in the foreign country: This question is examined as a factual-evidentiary question. As elaborated above (para. 8), the appellant’s agents themselves testified that they “gave bribes.” Indeed, some of them claimed that at that time this was a common phenomenon, though this may not necessarily attest to its legality – “anyone who had control of the money wanted a share of the payment...” (as stated by the witness Koznitzova, see above). These words speak for themselves, and indicate illegality. The Russian President, upon his recent retirement, noted that the war on corruption had not made much progress, and he hoped that it would be more successful in the future. Apparently a problematic basic situation had been created in Russia whereby public servants received low salaries, which constituted an incentive to seek additional sources of income; this coincided with a period of huge spending, the opening up of profitable commercial avenues and new opportunities; in terms of corruption, this is a lethal combination. Edward Shevardnadze, who was Foreign Minister of the Soviet Union in the 1980s before he became President of Georgia, first made his name as a crusader against corruption.

Returning to Israel: on the legal plane, the question of the status of the deed under the law of the foreign country required proof through the regular methods of the foreign law, i.e. testimony from a suitable expert (see HCJ 4562/94 Abu Daka v. Lod Military Court [19], at pp. 742, 748; CrimA 2597/04 Roitman v. State of Israel [20],  paras. 69-73; Menashe Shawa “The Nature and Manner of Proving Foreign Law in Anglo-American Law and Israeli Law,” Tel Aviv U. Law J. (Iyunei Mishpat) 3 at p. 725 (1973)). In our case, no expert witness was summoned by either party. Since the burden of proof regarding an expense incurred in generating income falls on the appellant (see LCA 1436/90 Giora Arad, Investment Management and Services Co. Ltd. v. Director of Value Added Tax [21], at p. 101), the appellant also bears the burden of proof of the legality of the expense: “the burden of proof encompasses both the actual performance of the act and the goal served by its performance” (ITA 5019/97 D. and D.  Zra’im Ltd. v. Tax Assessor Haifa [59], at pp. 131, 142, per Deputy President Dr. Bein). In our case, allegations regarding the legality of the expenses have been raised both through the respondent’s investigations and through the questioning of the appellant’s witnesses in the lower Court. Certainly under these circumstances the onus was on the appellant to prove its contention that this was not an illegal expense under the foreign law, inasmuch as this is indeed its claim, via the accepted methods mentioned. Since it did not do so, the expense will be considered illegal for purposes of tax deduction.

(4) From the aforesaid it transpires that the said expenses were tainted by “double illegality” – in concreto, in the country in which they were incurred, and in abstracto, had they been incurred in Israel. In this case I am of the opinion, as noted, that these expenses are subject to the same law as expenses incurred through a violation of the law, and therefore extra weight should be assigned to the considerations denying them recognition when determining taxable income. It would appear that this outcome should not, as a rule, be different from other cases in which this kind of overlap does not exist, and of these, too, it has been said that the deductions may possibly be disallowed for reasons of public policy, although it was said that this should appear in explicit statutory provisions (and see extensively in Uretzky, at pp. 142-146). These cases must be addressed on a case-by-case basis.

On bribery and corruption in Israel and abroad

15.            (1) Above we addressed questions relating to the framework for the deductibility of illegal expenses incurred outside Israel. We will now fill in this framework with the particulars of the illegal activity in the present case, i.e. the payment of bribes. The value that is protected by the law prescribing the offense of bribery is dual-faceted (see CrimA 8573/96 Mercado v. State of Israel [22],  at p. 481 (1997), at pp. 505-506, per Justice Turkel; LCrimA 5905/98 Ronen v. State of Israel [23], at pp. 728, 735; CrimA 733/07 Cohen v. State of Israel [24], per Justice Grunis, para. 13, and the references there; see also Mordechai Kremnitzer, “Are we Short of Crimes?”  Mishpatim, 13 at pp. 159, 161-162 (5743-5744), hereinafter: Kremnitzer; also cf:  Liat Levanon and Mordechai Kremnitzer, “How Far will the Crime of Bribery Extend – In the Aftermath of CrimA 8573/96” Alei Mishpat (Bikurim Volume, Booklet 2) at pp. 369, 372-375 (2000)): first, ensuring the proper functioning of the public administration, such that it serves the public interest and acts without bias and without foreign influences swaying governmental discretion; this includes protection of the integrity of the public administration (there are those who see this as a separate goal, see Justice Grunis in Cohen v. State of Israel [24]); secondly, preservation of the public’s trust in the administrative authorities and of the prestige of the administration in the eyes of the public, as President Shamgar said:

'These phenomena can seriously erode the trust with which a citizen regards those who have been appointed to serve the public, it fouls the atmosphere and sows the seeds of disappointment and frustration.... Distorted standards in human relationships and the relationship between the government and the citizen emerge and grow, posing a latent danger to society as a whole' (CSA 1/77 Klein v. State of Israel [25], at pp. 164, 167).

In my opinion, these concerns are ultimately two sides of the same coin for a society wanting a fair system of governance that it can trust.   This is evident to every intelligent and decent person.

 (2) In Ronen v. State of Israel [23], Justice Strasbourg-Cohen commented:

'The act of bribery is one of the most serious crimes. It has the power to corrupt the public administrative system, and to lead it to act in ways contrary to relevant criteria, contrary to the norms worthy of a proper public administration, and contrary to the law. The act of bribery corrupts the character of public servants and damages the delicate fabric of the relationship between individuals and public servants, which is based on fairness, relevance, impartiality, equality and more. It eats away at the foundations of the societal construct; it damages the public’s trust in the administration, which is a necessary basis for the existence of a proper society' (at p. 734).

President Barak summarized the dual-faceted value as follows:

'The basis of the law of bribery is the concern that receiving a gift will affect a public servant’s decisions on the one hand, and the public’s trust in the government authorities on the other' (CrimA 5046/93 State of Israel v. Hochman [26], at pp. 2, 10).

 (3) In relation to bribery in commercial contexts, it seems that in most cases, including the present case, this occurs in the context of contracts with public authorities, which as a rule ought to be awarded through tenders. In such cases, the bribery adversely affects other values that the public would wish to uphold, such as efficiency and thrift in the expenditure of public funds, as well as fair competition. As is known, the mechanism of the public tender is designed to facilitate the existence and combination of two fundamental objectives – proper administration and equal and fair treatment, by ensuring fair competition and equal opportunities for all; and economic efficiency in the management of the economy and the use of public funds (see HCJ 368/76 Gozlan v. Beit Shemesh Local Council [27], at pp. 505, 511-512; CA 6585/95 M.G.U.R. v. Nesher Municipality [28], at pp. 206, 212; Gabriela Shalev, “Public Tenders since the Mandatory Tenders Law 5752-1992", Mehkarei Mishpat 12 at pp. 393, 396-397 (1995)). It will be mentioned that some divide the first objective into two objectives – proper administration and the maintenance of the integrity, on one hand, and the granting of equal opportunity, on the other: see Omer Dekel, Tenders, Vol. 1, at pp. 92-98 (2004)(hereinafter: Dekel)). It is clear that a bribe paid to secure a biased outcome of a tender impacts negatively on these objectives. We have explained the importance of proper administration above, and there is no need to say any more; in addition, however, “in the nature of things, corruption and bias also entail serious economic damage to the public and the economy in general, both immediately – due to the decreased efficiency of contractual arrangements, and in the long-term – due to the loss of trust in the system of governance” (Dekel, at p. 118; see also regarding the interface of  bribery and tenders ibid. at pp. 197-199).

 (4) The value of fair competition – which Justice Berinson defined as “integrity in commerce” (Ben-Tal v. Ben-Tal [16], at p. 61) – is also a public interest of great significance, and the law protects it in various ways, including through the laws of tenders (see, for example, FH 22/82 Beit Jules Ltd. v. Raviv Moshe and Assoc. Ltd. [29], at p. 441; see also, in a criminal context, CrimA 7068/06 State of Israel v. Ariel Electrical Engineering Traffic Lights and Control Ltd. [30]). In our case, even if the damage to fair competition is not one of the interests protected by the criminal prohibition against paying bribes, there is no doubt that when this kind of payment is made in a commercial context, damage to fair competition ensues as a side-effect.

16.            (1) It is impossible to address this issue in the State of Israel without reference to Jewish law. In the law of Israel and the tradition of Israel, the prohibition on bribery and the negative attitude towards it are anchored in biblical law. In the Torah portion of Mishpatim (Laws), it is written: “And you shall take no bribe; for a bribe blinds they that have sight, and perverts the words of the righteous” (Exodus [71] 23:8; see also Deuteronomy [72] 16:19; Shulhan Arukh, Hoshen Mishpat [73] 9:1) Even though the biblical prohibition relates to judges, the later commentators applied it, based on the words of earlier commentators, to public officials as well. R. Zvi Hirsch Eisenstadt (Poland, 19th century), author of Pit'hei Tshuva [74], cites the Pilpula Harifta (R. Yom Tov Heller, Prague, 17th century):

'Another great thing is understood from the words of Rosh [R. Asher, Germany-Spain, 14th  century – E.R.], that bribery is prohibited not just in the courts but also for all types of fines... And I write this to instruct those appointed by the public, even though they are not judges and have not been accepted as such, even so they should avoid accepting gifts for their decisions' (Hoshen Mishpat 34:27).

In other words, an official who holds a public office other than in a rabbinical court is also forbidden to accept unlawful gifts. In Birkhei Yosef [75], R. Haim Yosef David Azulai (known by the acronym HIDA - Israel and Italy, 18th century) noted:  “Public officials, even though they are not judges in a court of law and have not been accepted as such, must still avoid accepting gifts for their decisions” (Hoshen Mishpat 9:10, p. 26). R. Yechiel Michel HaLevi Epstein (Russia, 19th and early 20th centuries), author of the renowned halakhic work, Arukh Hashulhan [76], wrote:

'It does not necessarily mean that only a judge is forbidden to accept bribes, but rather anyone who is appointed and who deals with public affairs, even if he is not a judge in a court of law, is forbidden to pervert and distort an issue due to feelings of love or hatred and certainly not by taking a bribe” (Hoshen Mishpat 9:1; see also in this regard R. Avraham Tzvi Scheinfeld, “Bribing a Public Servant,” Tchumin V, at pp. 332, 333 (5744), which discusses a case with circumstances somewhat similar to ours (hereinafter: Scheinfeld); Nahum Rakover, The Rule of Law in Israel, at pp. 96-99 (1989 R. Itamar Warhaftig, “A Gift to an Employee from Another – His or His Employer’s?” Tchumin XVII at pp. 293, 297-299 (5757); Eliav Shochetmann “For a Bribe Blinds the Eyes of the Wise, and Perverts the Words of the Righteous: Integrity of Judgment and Integrity of Public Administration” Parashat Hashavua, Aviad Cohen and Michael Wigoda, eds. (Parashat Shoftim, 5763, Issue No. 135) (hereinafter: Shochetman); R. Shlomo Ishon, “Gifts to a Government Official,' Tchumin XXVI at pp. 335, 337-338 (5766)).        (2) The Talmud asks:  “What is shohad (bribery)? Shehu-had (they are one)” (Babylonian Talmud, Ketubot [68] 105b). Rashi explains as follows: “The giver and receiver are made to have one heart.” And further: “Rava said: How does bribery work? One who receives a bribe from another begins to agree with him and becomes like a part of him and no-one sees his own shortcomings.” These words (even though, as stated, they were said in relation to judges) illustrate the two-fold basis of bribery – the need to prevent “closeness” between a public official and a citizen giving a bribe, both for the sake of proper administration and for the sake of the public’s trust in its representatives and institutions (for more on bribery in Jewish law, see CrimA 71/83 Flatto-Sharon v. State of Israel [31], at pp. 757, 768-769; CrimA 355/88 Levi v. State of Israel, [32] at pp. 221, 230-232,  per Justice D. Levin in both these cases; Haim Cohn, “Reflections on Integrity,” Haim Cohn - Selected Writings, Aharon Barak and Ruth Gavison, eds., at pp. 417, 421-423 (2001), and the citations ibid.; Shochetmann).

17.  (1) The odious practice of bribery was widespread during various periods throughout history. Bribery was prevalent in Israel both in the times of the Prophets (see for example Isaiah [77] 1:23; Ezekiel [78] 22:12), and in the times of Talmudic Sages (Babylonian Talmud Sotah [79] 47B), and of course in many other societies and entities. In the early days of the State of Israel, the legislature was aware of a scourge of bribery, and addressed the issue several times by expanding the definitions of the crime and increasing the penalty it carries (see the Commentary to the Penal Law Amendment Bill (Bribery and Corruption), 5711-1950, Bill 60; Commentary to the Penal Law Amendment Bill (Amendment No. 3), 5724-1964, Bill 591, 54; see also Shimon Agranat, “Developments in Criminal Law,” Iyunei Mishpat 11 at pp. 33, 35-36 (1986); but see Kremnitzer). Over the years bribes have been accepted by public servants, in a variety of circumstances, whether due to personal need or to the desire for supplementary income (see, for example, CrimA 389/72 Zokaim v. State of Israel [33], at p. 487; CrimA 341/73 State of Israel v. Vita [34], at p. 610; CrimA 126/76 State of Israel v. Shefer [35] at p. 466 (hereinafter: State of Israel v. Shefer [35]); and many examples – most recently the aforementioned CrimA 766/07 Cohen [24]).      

                (2) The odious practice of bribery crosses geographical boundaries. Obviously, the phenomenon of bribery, as well as the need to fight it, exists in other countries besides Israel (see for example, the Commentary to the Penal Law Amendment Bill (Bribery and Corruption), 5711-1950). The more international commerce becomes in our generation, known as the “age of globalization,” the more opportunities there are for bribery to become “international” in nature. It is also clear that in years gone by, even well-respected and legitimate Israeli companies used to engage in bribery in foreign countries, and they were not too ashamed to bring their cases before the Israeli courts (see CA 101/74 Hiram Landau Road Construction and Development Works Ltd. v. Water Sources Development (Foreign Countries) Ltd [36], at pp. 661, 668, regarding bribes given in Uganda). In this context, which involves international economic activity and the “export” of bribes, harm is done - by the very nature of these kinds of activities - to the values of economic efficiency and fair competition, in addition to the damage to the values of integrity and public trust. Any kind of bribery is bribery and is damaging. As our Sages said: “To what can bribery be compared? To a stone. Wherever it falls – it breaks things” (Midrash Tanchuma [80] (Toldot, 8); see also Mercado v. State of Israel [22], at p. 592).

                   (3) The Hebrew poetess Rachel, in her poem “Day of Tidings,” writes of the reluctance, even in troubled times, to benefit from activities that pollute the moral-ideological atmosphere. This is the poem, which was based on a biblical story in the Book of Kings II  7:3 ff. It is cited here without interpretation or reference to the background material to its composition:

'In days past the terrible foe

Laid Samaria under siege;

Four lepers brought it glad tidings

They brought it tidings of liberty.As Samaria in siege – all the land is as one

And the hunger too heavy to bear.

But I do not wish for redemption’s tidings

If they come from the mouth of a leper.

 

 A pure one will tell and a pure one redeem

And if his hand is not found to redeem –

Then it has been chosen for me to fall

In the plight of the siege

At the dawn of day of great tidings.”

Even if a bribe in a particular country might be financially fruitful for Israelis, and through them for the Israeli economy – the Israeli economy should not thrive on the “fruit of the poisonous tree.”

18.  (1) To deal with corruption, and following legislative developments in various countries around the world, some of which we will address below, in 2003 the United Nations adopted the Convention against Corruption, some aspects of which are relevant to our case – i.e. the question of tax deduction of expenses incurred in a bribery situation. In the Preamble to the Convention, concern is expressed regarding the problems and threats that corruption poses to the stability and security of societies and democratic institutions; the Convention goes on to emphasize that international cooperation and a comprehensive, inter-disciplinary approach are essential in order to overcome this phenomenon: 

'The States Parties to this Convention,

Concerned about the seriousness of problems and threats posed by corruption to the stability and security of societies, undermining the institutions and values of democracy, ethical values and justice and jeopardizing sustainable development and the rule of law,…

Convinced that corruption is no longer a local matter but a transnational phenomenon that affects all societies and economies, making international cooperation to prevent and control it essential,

Convinced also that a comprehensive and multidisciplinary approach is required to prevent and combat corruption effectively…'

   (2) The Convention includes many articles prescribing a variety of methods of fighting corruption within member states and outside them. Chapter III of the Convention, subtitled “Criminalization and Law Enforcement,” provides, in arts. 15 and 16, that the states will act by means of legislation to criminalize activities intended to provide an undue advantage to public officials in an improper manner in order to influence their activities in their official capacity – both regarding the officials of the State itself (in art. 15) and regarding officials of a foreign state (or international organization, art. 16). Particularly relevant to our case is art. 12(4), which lays down provisions regarding recognition and deductibility for tax purposes: 

'4. Each State Party shall disallow the tax deductibility of expenses that constitute bribes, the latter being one of the constituent elements of the offences established in accordance with articles 15 and 16 of this Convention and, where appropriate, other expenses incurred in furtherance of corrupt conduct.”

These words are clear and require no explanation. 

 (3) The State of Israel signed the Convention against Corruption on November 29, 2005. However, it is yet to ratify the Convention, and indeed, even its signing of the Convention was marked by problems and delays (apparently primarily due to Israeli Ministry of Defense officials – see the protocol of the meeting of the Parliamentary Commission of Inquiry on Exposing Governmental Corruption, of November 16, 2005). Moreover, Israel’s signing of the Convention, and the Convention itself, post-date the events that are the subject of this appeal. In any case, we do not need to rely on the Convention as legal grounds in this case. Rather, it serves as a compass and a road map that show us the most desirable interpretation and the appropriate judicial policy in cases such as this – desirable and appropriate today, following the signing of the Convention, as at the time relevant to the appeal, prior thereto.

19.            In today’s world, the massive advances in transportation and communications, the technological innovations and the resulting global “proximity” have brought about the expansion and spread of international and multi-national economic and business activity. This has major implications for various areas of law; one such consequence is the transformation of corruption from a national and local matter to an issue of broad-ranging, international significance, which needs to be treated as such, including in relation to taxation. In CrimA 4596/05 Rosenstein v. State of Israel [37] I had occasion to comment: 

'"The Global Village" is not just a technological concept, relating to the expanding possibilities for communication and travel, which no one can dispute; in my opinion it is also an ideological concept, even though it is still an ongoing process and there remains much that is unclear about it…. However, our case falls clearly into the category in which the law will be interpreted according to what is appropriate, which in this case is also what is effective. Globalization therefore includes questions of terrorism on one hand, and of economics on the other, besides environmental issues and many other concerns. In more than one sense, the law lags behind the new technology and it must catch up materially and ideologically.'

It transpires that these words are applicable to various matters – including the case at hand, in the context of bribing the officials of a foreign state. In LCA 10231/04 Troim v. Gaidamak [38], Justice Arbel stated (albeit in essentially different circumstances): 

 'The contention that bribery in Kazakhstan should not be viewed as seriously as we would view this crime in a law-abiding state, but rather as the accepted mode of business conduct, has no leg to stand on. Even if it is acceptable somewhere, this does not vindicate bribery and certainly does not lead us to the conclusion that bribery should not be viewed as a criminal act' (para. 5). 

A clear and incisive approach here is inescapable. No one claims that the phenomenon of bribery does not exist in various countries. It is sometimes practically an open secret and the aforementioned Convention was initiated for good reason. But it should not be rationalized that it has always been that way. There will be Sisyphean struggles in the future, but we must persist, and there are tools to help us in our quest. 

Comparative law – expenses incurred for bribery in a foreign country from a tax perspective

20. (1) The specific phenomenon of promoting business interests in foreign countries through bribery and corruption is not a new one and, as stated above, various states have addressed it, inter alia in relation to the question of the deductibility of these kinds of expenses. In the USA, as early as 1958 a section in the US Internal Revenue Code was enacted prohibiting the deduction of expenses incurred through illegal payments to foreign governmental officials (Internal Revenue Code, 26 U.S.C § 162(c)(1) (1958)). 

                                (2) In 1977 a law was enacted expressly criminalizing the payment of bribes by US companies to government officials outside the USA: the Foreign Corrupt Practices Act (FCPA), 15 U.S.C §§ 78m, 78dd-1, 78dd-2, 78ff (1977). The aforementioned § 162(c) was amended to include direct reference to the FCPA. The background to this legislation was, on the one hand, the criticism leveled against § 162(c)(1) – primarily after it was extended – due to its lack of clarity and the fact that it had become a method of penalization through the taxation system (see, for example: Christopher A. Lewis, "Penalizing Bribery of Foreign Officials Through the Tax Laws: A Case for Repealing Section 162(c)(1)" 11 U. Mich. J. L. Reform (1977-78)); on the other hand, an investigation by the U.S. Securities and Exchange Commission found that the incidence of bribe payments to foreign governmental officials was extremely widespread, involving hundreds of US companies and payments worth hundreds of millions of dollars (Securities and Exchange Commission (SEC) Report on Questionable and Illegal Corporate Payments and Practices, CCH Federal Securities Law Reports No. 642, pt. II (1976), quoted in: Morgan Chu & Daniel Magraw, "The Deductibility of Questionable Foreign Payments", 87 Yale L. J. 1091 (1977-78; hereinafter: Chu & Magraw), in note 2; see also Uretzky, at pp. 149-151). The discovery of this phenomenon resulted, inter alia, from the exposure of a scandal relating to the aerospace company Lockheed, where it was found that the company had paid bribes worth tens of millions of dollars to senior foreign government officials  (S.E.C. v. Lockheed Aircraft Corp., 1976 WL 779 [67]. 

                      (3) As part of the policy considerations behind the enactment of the FCPA, it was explained that not only is bribing foreign governmental officials an unethical act that violates the moral and ideological expectations of the American public, but it also does damage to business by creating unfair competition, sabotaging public trust in the free market system and encouraging corruption at the expense of efficiency. It was stated that such an act is contrary to American interests, both because US companies not participating in bribery are at a disadvantage, and because the reputation of all US companies is tarnished, and also because of the serious difficulties it creates for US foreign policy with friendly governments and states (H.R. Rep. No. 640, 95th Cong., 1st Sess. (1977); Chu & Magraw, pp. 1095-97). 

           (4) It should be noted, nonetheless, that in subsequent years the FCPA was amended and the range of payments it criminalized scaled back, so that payments intended to smooth or expedite a “routine governmental action” would not be considered illegal under the FCPA; this also applies, in a case where it is proven that payments were legal in the country in which they were expended, or constituted good faith expenditures directly related to the promotion of products and services or execution of a contract with a foreign government (15 U.S.C §§ 78m, 78dd-1 (1988)).

21. (1) In 1997, member States of the Organization for Economic Co-operation and Development (OECD) and five additional States signed the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (Nov. 21 1997, 37 I. L. M 1 (1997)). In this Convention, the signatory states committed themselves, inter alia, to adopt measures to criminalize the bribery of public officials, using a relatively broad definition of the said term. As part of the Convention the signatory states undertook to uphold the Recommendation of the Council of the OECD on the Tax Deductibility of Bribes to Foreign Public Officials (April 11, 1996, 35 I. L. M. 1311 (1996)). 

 (2) Following the signing of this Convention, in 1997 France enacted a provision in its taxation code prohibiting the deduction of payments to foreign public officials, as defined in the Convention (Loi de finances rectificative pour 1997 (Amending Law on Finances for 1997), Law No. 97-1239 of Dec. 29, 1997, J. O no. 302 Dec. 30, 1997, p. 19101; Code général des impost, article 39, 2 bis). 

 (3) Similar provisions were also legislated in Switzerland, prohibiting tax deductions of bribes paid to Swiss or foreign public officials – whether on the federal level or the cantonal level (Bundesgesetz über die direkte Bundessteuer (DBG), (Law on Direct Federal Tax), 642.11 RS, Dec. 14 1990, Abs. 27, 59 (1990); Bundesgesetz über die Harmonisierung der direkten Steuern der Kantone und Gemeinden (StHG)  (Law on the Harmonization of Direct Tax), Dec. 14 1990, Abs. 10, 25 (1990). 

 (4) It will be mentioned that the American FCPA was amended one further time to align its provisions with those of the OECD Convention, which defined bribery in a broader manner than the pre-amendment US law (15 U.S.C. § 78m (1998). 

Interim summation

22.          (1) All the abovesaid indicates that the payments transferred by the appellant to its agents and used for bribes should not be deductible, due to the illegality of the expenses. These payments, which were intended to bribe and corrupt public officials in a foreign country, would have been illegal had they been made in Israel, and by presumption – at least – were illegal in the country in which they were made. They will therefore be considered as expenses made illegally. Recognition of these payments as tax deductible contradicts public policy. It would make crime pay. It would make this court into a partner in whitewashing a crime and rendering the law an empty vessel. This outcome, prohibiting deduction of the payments, is also inevitable in light of the protected interests that are compromised by bribery – proper public administration and public trust in the government authorities and the law. The fact that the illegal act was perpetrated outside Israel does not detract from the force of these interests. On the contrary, in the context of the development of international business activity, the damage caused by bribery extends beyond the concerns of the national and the local communal domains – it undermines proper and trustworthy administration throughout the world. An additional consideration is the concern for compromising the State of Israel’s foreign relations and image (cf. CrimA 4722/92 Markovitz v. State of Israel [39], at pp. 45, 49-50). Moreover, this outcome is reasonable in terms of the rules of fair competition – which are particularly important in the context of international economic activity; of encouragement of economic efficiency and the saving of public funds; and of common decency. 

(2) It could be claimed that this outcome puts Israeli investors active in certain locations outside Israel at a competitive disadvantage vis-à-vis investors from other states whose policies allow these deductions (regarding considerations of competition in questions of international taxation, see Tzili Dagan, International Taxation, at pp. 19-22, 49-66 (2004)). However, the consideration of the economic benefit to the assessee – and to the State itself, through taxation of the assessee – in no way justifies such deductions, in light of the counterbalancing list of grave concerns mentioned above. This is especially true in light of the existence of a similar legislative mechanism in other developed countries. This can also be said in relation to the principle of “exact taxation,” which is liable to be compromised by the prohibition on deducting illegal expenses. As stated, in my opinion, no heed should be paid to the argument against “imposing sanctions” via taxation law, since the non-recognition of deductibility does not constitute “penalization” per se, but rather a normative necessity, a natural extension and complement to policies reflected in other bodies of law. Otherwise the law would be contradicting itself: “the left hand pushes away and the right hand draws close” (Babylonian Talmud Sanhedrin [82] 107B).

(3) This outcome is also consistent with the purpose which underlies taxation law. Indeed, the particular purpose of the Income Tax Ordinance is exact collection of tax: “The payment of exact tax is the essence and purpose of the law” (CA 1527/97 Interbuilding Construction Company Ltd. v. Tax Assessor Tel Aviv 1 [40], at pp. 699, 719, per Justice Ariel; see also CA 4030/03 Granot Enterprises – Central Agricultural Cooperative Ltd. v. Tax Assessor for Large Enterprises [41], per Justice Adiel, para. 30). At the same time, the principle of exact tax serves the need for tax collection – which in itself is a mechanism for financing government and state activities. The principle of exact taxation is intended to serve justice, by upholding the first of the four principles of the “good tax” as defined by Adam Smith – “tax must be equal and just” (see Joseph M. Edrey, “An Overall Tax Base in Israel,” Mishpatim 12, at pp. 431, 432 (1983); see also CA 900/01 Keles v. Tax Assessor Tel Aviv 4 [42], at pp. 750, 765-766). But what is the justice in legal recognition – in the sense of allowance – of an expense incurred through crime? Indeed, taxation laws do not exist in a vacuum. Prof. Barak explained their purpose in his article “Interpretation of Taxation Laws,” Mishpatim 28, at pp. 425, 434-436 (1997): 

 The first-order purpose is to guarantee income for the public purse. This basically covers the immediate purpose, but it is not the only purpose. Behind the immediate purpose may lie other purposes that are societal in character. Taxation is a social instrument. Through it, society combats phenomena that it perceives as negative. It encourages those activities that it wishes to encourage and acts as a deterrent against those activities that it wishes to prevent…. It is assumed that the purpose of the law is to aspire to normative harmony. A tax law does not exist in a vacuum. It is interlinked with other laws that impose similar taxation and with the entire body of taxation legislation in Israel. It should be interpreted with a view to creating internal harmony within tax legislation. This harmony is not limited to ‘internal-taxation’ harmony only. The interpreter must aspire to an overall normative harmony. Therefore it is assumed that taxation laws are interlinked with the law in general' (emphasis added). 

  (4) Finally I repeat that in our case I have not addressed the question of the deductibility of expenses in the case of payments that are proven to have been made lawfully in the foreign state. As stated, the laws of various countries distinguish these kinds of cases from other cases of illegal expenses incurred on foreign soil; US law also distinguishes cases in which it was proven that the bribes were paid in order to expedite or facilitate routine governmental procedures not involving discretion (in this context see also the discussion in Uretzky, at p. 144; and by analogy see also Scheinfeld,  at p. 339). In my opinion the cases are different, and the latter case, for example, justifies an interpretation that disqualifies it outright. At any rate, no claim of this kind has been made in this case (all that was claimed by the appellant was that corruption was a very widespread phenomenon in Russia in the years following the collapse of the Soviet Union, and that many believe that corruption helped Russia to survive the transition between regimes; however, the prevalence of this phenomenon does not attest to its legality (see also State of Israel v. Shefer [35], at pp. 470-471; Ben-Tal v. Ben-Tal [16], at p. 61; CrimA 256/97 Lachman v. State of Israel [43]). 

The alternative reason – the evidentiary aspect and the question of proving the expenses

23.  As will be recalled, the major reason given by the lower court for the conclusion it reached was the evidentiary aspect, i.e. the extent to which the appellant proved the expenses it claimed. Based on this aspect, and in light of the testimony of the agents, the Court decided to allow the appeal in a partial manner, in relation to those parts of the commissions paid to the agents as their salaries only, and not in relation to the full expenses that the appellant claimed. The appellant directed its arguments against this decision too, as stated; however I am of the opinion that the appeal should not be allowed on this aspect either.

24. (1) No one disputes that it was incumbent on the appellant to prove the expenses claimed. In an income tax appeal, the burden of proof is squarely on the assessee’s shoulders when addressing a non-accounting dispute, even if – as the appellant claims in this case – it kept its books properly (see Arad [21], at pp. 107-111; CA 486/01 Hoter-Yishai v. Tax Assessor Tel Aviv 4 [44], at p. 326; CA 1124/03 Ganei Ofer Construction and Investment Ltd. v. Tax Assessor Tel Aviv 1 [45], at pp. 313, 323-324; see also Dan Bein, “The Burden of Persuasion and Obligation of Evidence in Taxation Laws,” Mishpat U’Mimshal 3, at p. 277 (1995)).  This is certainly the case when the assessee seeks to prove expenses incurred in generating income. In such a case the Talmudic maxim holds especially true: “He who wishes to extract [money] from his fellow is the one who must bring evidence” (Babylonian Talmud Bava Kama, [83] 35A; see also Beit Zakai Ltd. v. Tax Assessor [13], at p. 522; CA 435/65 Nagid, Trustee Businesses Ltd. v. Commissioner for Income Tax  [46], at p. 287; Namdar, at pp. 226-227). 

(2) The appellant argues that the lower Court erred when it imposed the regular burden of proof on it, and did not consider the difficulties it encountered in producing evidence for payments made in Russia during the period in question, especially in light of the particular circumstances. This argument should be rejected. Basically the appellant is attacking the factual findings of the lower court. In this regard it should be recalled, first, that “the question of the credibility of the evidence and how much weight should be attributed to it is given over to the court of first instance, and it is not the place of the appellate court to interfere with this, except in rare cases” (CA 647/79 Ivun v. Tax Assessor for Special Collections [47], at p. 648, per Justice Bejski; see also CA 274/84 Shapiro and Schweitzer v. Income Tax Assessor Tel Aviv 2 [48] at p. 53; CA 734/89 Pikanti Food Industries Ltd. v. Tax Assessor Gush Dan [49] at pp. 83-84, and the sources ibid). Secondly, I believe that on the merits of the case, there is no reason to interfere with the decision of the lower Court, which weighed the burden of proof borne by the appellant against the evidentiary difficulties that it faced (on this issue see and compare D. and D.  Zra’im Ltd. v. Tax Assessor Haifa [59], at pp. 142-144). The commercial and political circumstances prevailing in Russia at that time did indeed cause evidentiary difficulties; however, at least a few of the appellant’s agents visited Israel, as will be recalled, and yet insufficient documentation was presented regarding the expenses that the appellant paid to them too. Note that the Court did not disqualify all the appellant’s expenses due to lack of documentation; rather, it considered the testimony of the agents who appeared before it, and on that basis it recognized the expenses in a partial manner. In the words of the Court: “If not for the existence of an abnormal situation in the locations where the appellant was operating at that time, which all agree existed, it would have had nothing to say when confronted with the respondent’s claims in regard to the verification of its expenses” (p. 27 of the judgment). Therefore it cannot be said that the Court did not take the evidentiary difficulties encountered by the appellant into consideration. For this reason, too, I cannot accept the appellant’s argument. 

 (3) In this context, I am also unable to accept the appellant’s argument that the Court should have admitted the depositions of the three remaining agents, who did not testify, based on the provisions of reg. 10(b) of the Regulations. Indeed, in hearing an income tax appeal, the Court is not bound by the regular rules of evidence, and it may accept any evidence on which the respondent based its assessment (see also CA 21/60 Levtov v. Tax Assessor Haifa [50], at p. 1606; CA 506/71 Hafetz v. Tax Assessor Haifa [51], at pp. 212, 217; CA 5709/95 Ben-Shlomo v. Director of VAT Jerusalem [52], at pp. 241, 252-254; and also Amnon Rafael, Income Tax – Vol. VI (Osnat Frank, ed.) at pp. 264-268 (2005)) but in our case the respondent did not base its assessment on these depositions. These depositions were submitted in February 1999, during a hearing held by the respondent at the appellant’s instigation, and they are formulated in the most general of terms and in the same format, in a manner that led the respondent to assume that they had been prepared especially for the hearing (see the testimony of Income Tax Coordinator Tzipi Yosef of April 29, 2004, p. 84 of the protocol; I will add that this was also my impression from looking at the depositions – the submission of which was approved by a decision of the District Court of April 29, 2004, see p. 87 of the protocol). At any rate, even if the court had accepted the depositions as evidence, this would have been of no help to the appellant – since the court’s recognition of the appellant’s expenses was ultimately granted only in accordance with the testimony of the agents that held up in the face of cross-examination, and in any case the amounts that were recognized were not consistent with the amounts reported in their depositions. 

25.          The appellant’s other argument relates to the fact that the respondent authorized an exemption from deduction of tax at source from the payments transferred to its agents. I cannot accept this argument, irrespective of whether it was raised in an attempt to reinforce the evidence that the payments were incurred in generating the appellant’s income, or whether it was raised on the normative level. According to counsel for the appellant, authorization of the exemption constitutes a “governmental promise” to recognize the payments as expenses, and non-recognition is therefore a violation of a property right. Deduction at source is a method of tax collection for which the recipient of a payment may, in certain circumstances, be liable, and it is unrelated to the question of proving an expense in the generation of income by the payer: “Deduction at source does not, in essence, relate to the substance of the tax liability or the generation of tax liabilities – when is a person liable for tax and when is that person not liable for tax; rather it relates to the method of tax collection and the administration of taxation” (Tax Assessor Haifa v. Hed HaKrayot Ltd. [4], at p. 683 (regarding deduction at source by an employer), per Vice-President Cheshin; see also ITA 140/89 Dar v. Tax Assessor Haifa [60], at p. 116), and it would not be superfluous to mention s. 1.4 of Directive No. 34/93 on the issue of deduction of tax at source from payments to foreign residents, according to which: “It is hereby emphasized that an exemption from deduction of tax at the stage of deduction at source in no way determines the final status regarding the non-liability of the payment as taxable income for the payee”; a fortiori, in no way does it determine the status of the payment as an expense for the payer. 

The cross appeal 

26.  The respondent cross-appealed the decision of the District Court to partially recognize payments made by the appellant – those that were destined for the agents’ pockets – as expenses. At any rate, I find it difficult to accept the respondent’s assertion that these payments have not been proven. As noted, this is a question of credibility and factual determinations of the District Court, and I have found no grounds to interfere with its decision, which was based on the testimony it heard. Nonetheless, I admit that I had my doubts regarding the question of legality: perhaps the full amount transferred to the agents was “tainted” and “stained” by illegality stemming from the bribery as described above. Ultimately I decided, following careful consideration of the testimony, that the payments transferred to the agents themselves, as payment for their work, should not be viewed as illegal payments. The agents, who were retired or former Russian public servants, performed many tasks for the appellant, foremost of which was the brokerage and contacts between the appellant and the organizations that constituted potential buyers –– activities that are not illegitimate per se, especially under the particular conditions that prevailed in Russia at that time. In the words of the lower court, the agents “led him [the appellant’s director – E.R.] through the commercial and fiscal maze created by Perestroika” (p. 17 of the judgment). They received their fees for this agency, which entailed costs. From the testimony it is also evident that the role of the agents did not end with brokering the transactions, but apparently also involved the installation, adaptation and maintenance of the medical equipment. See, for example, the testimony of the agent Garbuz:

'I knew that the clinic of the Foreign Ministry needed a particular piece of equipment, I approached the clinic and said that I know a body that can supply a suitable piece of equipment... (p. 58 of the protocol) 

I would monitor all the activities, I would release goods at customs, when they got held up. When they installed the equipment and there were problems in the beginning, I would help with the installation' (p. 66, see also p. 63).

A similar story emerged from the testimonies of the agent Lutzky (“What did I physically do – I had meetings in different cities… I met with the workers of the factories…” (p. 21 of the protocol)), and the agent Koznitzova (“I dealt with supply but I looked for customers. I had connections throughout the Soviet Union” (p. 74 of the protocol)); the agent Friedman testified about training and studies (pp. 30, 32)). From here we see that even though promoting the transactions through bribes was a part of the agents’ role – and perhaps even a central part – it was not the only part, and it cannot be said that their fees, which were paid by the appellant, were tainted by illegality such as to disqualify them from being recognized as expenses.

Epilogue

27.          (1)          The completion of the writing of this judgment coincided with the publication of the judgment of the Tel Aviv-Jaffa District Court (Judge M. Eltuvia) in ITA 1015/03 Company Ltd. v. Tax Assessor Netanya [61]; that case, too, addressed the question of the deduction of expenses paid as bribes outside Israel, under rather similar circumstances, and its conclusion is consistent with the aforesaid. In that case the bribe was paid directly by the company being assessed, as part of a single transaction that was larger in scope than the transactions in our case. I will not address the circumstances of that case here, but I will briefly address several of the principle-based reasons for the decision. The judgment addresses, inter alia, the claim of a governmental promise and damage to property due to its violation, and the use of monies by the controlling shareholder in order to give a bribe – but these questions are not relevant to our case.

 (2) According to the judgment, recognition of bribes given outside Israel as an expense undermines the fundamental principles of the State of Israel and is incompatible with its obligations under the UN Charter, as well as with public policy, which is not confined to the borders of the State (citing a case of an arbitration award being revoked due to bribe payments that were made outside Israel and that constituted the factual basis for the arbitration award – OM (Jer) 2212/03 Gad v. Siman-Tov [62], per Judge Okon; LCA 3476/04 Siman-Tov v. Gad [53], per Justice Joubran). It was ruled that recognizing a bribe payment as an expense would make the Israeli public an accomplice to the crime, and that when accurate assessment and public policy clash, the latter must prevail. It was also determined that the prohibition on deducting bribe payments is designed to act as a disincentive to engaging in activities that involve giving bribes, and that it is doubtful whether bribe payments, which are antithetical to public policy, can be  considered a necessary and essential expense for generating income. 

                 (3) I humbly agree with the message of these words, as I explained above. As stated, in my opinion the recognition of expenses that were incurred to pay bribes is in general incompatible with public policy. Our case, as stated above, falls into the category of illegal expenses – the payment of which constituted an actual crime – and these should not be recognized for tax purposes for reasons of public policy. I have expressed my position that a person who chooses to spend money on bribes should know that the legal authorities will not support these activities, even indirectly, by recognizing them as an expense. 

                 (4) After these lines were written, the respondent requested that this judgment be appended as a reference.

28.            In conclusion, I recommend that my colleagues not allow the appeal or the cross-appeal.

 Justice E. Hayut

I agree with my colleague Justice E. Rubinstein that the appeal and cross-appeal should be denied, but in my opinion the fundamental question regarding the deductibility of illegal expenses (which the lower court said it addressed most perfunctorily, and even then, more than was necessary) may be left for a more opportune moment, since the appeals can be denied by simply adopting the lower court’s finding and conclusions on the factual plane.

 In its judgment the lower court ruled that the income tax appeal filed by the appellant should be partially allowed and that the fees the appellant paid to the four agents who worked on its behalf in Russia during the 1992-1996 fiscal years should be recognized as deductible expenses. The Court emphasized at the start of its judgment that the appeal before it “turns primarily on questions of fact and credibility,” and the deliberations on these questions are indeed the main focus of the judgment. The court noted that the point of departure in this context is the well-established rule that in cases involving recognition of expenses as deductible, the burden of proof is borne by the assessee, who must present material evidence and appropriate documentation to establish his claims regarding the expenses incurred.  Nevertheless, the lower court held that under special circumstances the assessee may be allowed to provide a basis for recognizing the expenses it claims “even in the absence of formal documentation… providing that in place of the documentation required to support the claims, other credible evidence is submitted, such as oral testimony from credible witnesses.” In this case, the appellant claims that its activities in the states of the Soviet Union were mainly carried out via seven agents, but it did not possess formal documentation to show that these expenses were incurred as claimed, in the relevant fiscal years, as fees to the agents and as additional payments for “marketing facilitation” and “brokerage.” Ultimately the appellant managed, following a not inconsiderable effort, to obtain testimony from four of the agents who worked for it during those years, and the court was prepared to recognize that these were special circumstances due to the unique situation that prevailed in the Soviet states with the advent of Perestroika. It was therefore willing to examine and rely on the testimonies of those agents who testified before it (Koznitzova, Garbuz, Lutzky, and Friedman, as well as the testimony of Koznitzova’s daughter Mrs. Dvinsky) regarding the question of the expenses, even in the absence of formal documentation for the relevant transactions. The court examined and analyzed these testimonies thoroughly and found them credible and convincing. It therefore used them as the basis for its decision to allow partial deduction of the expenses that the appellant claimed, in the amount of the fees that it paid to those agents according to their testimony (Koznitzova – $48,000; Garbuz – $10,000; Friedman – $30,000; and Lutzky – $135,000). Regarding the remainder of the expenses claimed by the appellant, including the payments which it termed “under the table” payments, the court thought that these had not been proven through any material evidence and that this was sufficient to deny the appellant’s claims in their regard. In the words of the court:

'In our case, since there is no real proof regarding a significant portion of the expenses claimed by the appellant, there is no room to recognize these as deductible. Regarding the other portion of the expenses, those accounted for in the testimony of the agents summoned before me – i.e. Mr. Garbuz, Mr. Lutzky, Mr. Friedman, and Ms. Koznitzova – I have reached the conclusion that what I heard from them was enough to create an evidentiary basis for proving that these payments were made to them, even in the material absence of documents that should have substantiated the transactions that generated those expenses.'  

These findings and conclusions of the lower Court are based, as stated, on a thorough and exhaustive evaluation of the testimonies before it and, like my colleague Justice Rubinstein, I too see no reason to interfere with them. This is also the case regarding the ruling of the lower court that in light of the special situation that prevailed in the Soviet states during the years in question, the credible testimony of the agents is sufficient in terms of evidence, insofar as it relates to the fees paid to them by the appellant for their services. 

For these reasons, I concur with the position of my colleague Justice Rubinstein that both the appeal and the cross-appeal should be denied.

Justice Y. Elon

I concur with position of my colleagues Justice E. Rubinstein and Justice E. Hayut that the appeal and cross-appeal should be denied.

 Like my colleague Justice Hayut, I too am of the opinion that in the matter of these appeals, the concrete factual findings of the lower court and the judicial outcome that they entail are sufficient basis for this conclusion. 

 The fundamental question raised by my colleague Justice Rubinstein regarding the general approach that should be adopted in relation to the deductibility of expenses that are allegedly illegal, and which were incurred by an Israeli tax-payer outside Israel, need not be decided in the context of the appeals before us. This is a complex and multi-faceted issue, which has manifold implications on many and various planes. It is possible that many aspects of this issue are a matter for statutory regulation.

In any case, I concur with the words of my colleague Justice Hayut, that a systematic investigation of this issue should be left for a more opportune occasion, when a decision on the matter is actually required.

Decided as per the judgment of Justice E. Rubinstein.

2 Sivan 5768

June 5, 2008

  

 

1

15 U.S.C §§ 78m, 78dd-1 (1988)       1, 39

1Court Regulations (Appeals Regarding Income Tax) 5739-1978               11

3

3Textile Mills Corp.‎ v.‎ Commissioner               5

A

Anon case             21, 26

Arad case              43

B

Babylonian Talmud Bava Kama          6, 43

Babylonian Talmud Ketubot               5

Babylonian Talmud Ketubot, 105B    6

Babylonian Talmud Sanhedrin           6, 41

Babylonian Talmud Sotah 47B           6

Bank of Israel Law, 5714-1954          1, 18

Beit Zakai case      23, 24

Ben-Tal case          32

Bob Jones University v.‎ United States, Goldsboro Christian Schools, Inc.‎ v.‎ United States     5, 25

Book of Kings II     6, 35

Bundesgesetz über die direkte Bundessteuer (DBG), (Law on Direct Federal Tax), 642.11 RS, Dec. 14 1990, Abs. 27, 59 (1990)                2, 40

Bundesgesetz über die Harmonisierung der direkten Steuern der Kantone und Gemeinden (StHG), (Law on the Harmonization of Direct Tax), Dec. 14 1990, Abs. 10, 25 (1990)            2, 40

C

CA 101/74 Hiram Landau Road Construction and Development Works Ltd. v. Water Sources Development (Foreign Countries) Ltd        4, 35

CA 1124/03 Ganei Ofer Construction and Investment Ltd. v. Tax Assessor Tel Aviv 1           4, 43

CA 1527/97 Interbuilding Construction Company Ltd. v. Tax Assessor Tel Aviv 1   4, 41

CA 21/60 Levtov v. Tax Assessor Haifa            4, 44

CA 274/84 Shapiro and Shweitzer v. Tax Assessor Tel Aviv 2      4, 44

CA 294/94 Jewish Burial Society v. Kestenbaum           2, 21

CA 3498/94 A. v. B.             3, 23

CA 380/75 Pardes Cooperative Association of Citrus Growers Ltd. v. Tax Assessor for Big Enterprises             2, 19

CA 435/65 Nagid, Trustee Businesses Ltd. v. Income Tax Commissioner  4, 43

CA 438/90 Haifa Tax Assessor v. Hed HaKrayot Ltd       2, 19

CA 486/01 Hoter-Yishai v. Tax Assessor Tel Aviv 4        4, 43

CA 506/71 Hafetz v. Tax Assessor Haifa           4, 44

CA 507-508/59 Credit Fund v. Loan Fund       2, 19

CA 522/63 Beit Zakai Ltd. v. Tax Assessor       3

CA 5258/98 A. v. B.             2, 21

CA 5709/95 Ben-Shlomo v. Director of VAT Jerusalem                4, 44

CA 578/75 Ben-Tal v. Ben-Tal            3, 25

CA 6416/01 Benvenisti v. Official Receiver    3, 22

CA 647/79 Ivun v. Tax Assessor for Special Collections                4, 44

CA 6585/95 M.G.U.R.  v. Municipality of Nesher           3

CA 661/88 Haimov v. Hamid et al.    2, 21

CA 734/89 Pikanti Food Industries Ltd. v. Tax Assessor Gush Dan              4, 44

CA 900/01 Keles v. Tax Assessor Tel Aviv 4    4, 42

CA Granot Enterprises – Central Agricultural Cooperative Ltd. v. Tax Assessor for Large Enterprises                4, 41

Camarano v.‎ United States 5, 25

Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (Nov. 21 1997, 37 I. L. M 1 (1997)    2, 40

Court Regulations (Appeals Regarding Income Tax) 5739-1978 1

CrimA 126/76 State of Israel v. Shefer            4, 34

CrimA 163/82 Moshe David v. State of Israel 3

CrimA 2521/03 Sirkis v. State of Israel             2, 21

CrimA 256/97 Lachman v. State of Israel        4, 43

CrimA 2597/04 Roitman v. State of Israel       3, 29

CrimA 341/73 State of Israel v. Vita  4, 34

CrimA 355/88 Levi v. State of Israel 4, 34

CrimA 389/72 Zokaim v. State of Israel            4, 34

CrimA 4596/05 Rosenstein v. State of Israel  4, 37

CrimA 4722/92 Markowitz v. State of Israel   4, 41

CrimA 5046/93 State of Israel v. Hochman     3, 31

CrimA 7068/06 State of Israel v. Ariel Electrical Engineering Traffic Lights and Maintenance Ltd.      3, 32

CrimA 71/83 Flatto-Sharon v. State of Israel   3, 34

CrimA 733/07 Cohen v. State of Israel             3, 30

CrimA 7646/07 Cohen v. State of Israel          2, 22

CrimA 8573/96 Mercado v. State of Israel      3, 30

CSA 1/77 Klein v. State of Israel        3, 31

Currency Supervision and Trade with Enemy States Law             1, 19

D

Deuteronomy       5, 33

E

Efrat case               26

El-Arbiya case       19

El-Arbiya Hotels case           18, 24

Evico case              27

Exodus   5, 33

Ezekiel    6, 34

F

FCrimH 2980/04 Evico v. State of Israel           3, 26

FH 22/61 HaOleh Loan Fund, Mutual Society Ltd. and HaPoel HaMizrahi Credit Fund, Mutual Society Ltd. v. Tax Assessor for Large Enterprises, Tel Aviv            2, 18

FH 22/82 Beit Jules Ltd. v. Raviv Moshe and Assoc. Ltd                3

Foreign Corrupt Practices Act (FCPA), 15 U.S.C §§ 78m, 78dd-1, 78dd-2, 78ff (1977)          1, 38

H

HaOleh Loan Fund v. Tax Assessor for Large Enterprises case    18, 20

HCJ 368/76 Gozlan v. Beit Shemesh Local Council        3, 32

HCJ 4562/94 Abu Daka v. Lod Military Court  3, 29

HCJ 5413/07 A. v. State of Israel       3, 22

HCJ 693/91 Efrat v. Population RegistryCommissioner at the Ministry of the Interior            2, 21

Hed HaKrayot case              22, 23

I

Income Tax Ordinance  s.17              1, 8, 17, 41

Internal Revenue Code, 26 U.S.C § 162(c)(1) (1958)    1, 38

Isaiah      6, 34

ITA (Haifa) 13/82 Frumkin v. Tax Assessor      5, 24

ITA (Haifa) 40/95 Vered Recycling v. Tax Assessor Haifa              5, 24

ITA (Jer) 54/84 El-Arbiya Hotels Ltd. v. Tax Assessor Jerusalem  5, 18

ITA (TA) 1143/01 Miller v. Tax Assessor Tel Aviv 3        5, 24

ITA (TA) 98/84 Frankel v. Tax Assessor Tel Aviv 1          5, 24

ITA 1015/03 Company Ltd. v. Tax Assessor Netanya     5, 47

ITA 140/89 Dar v. Tax Assessor Haifa               5, 45

ITA 5019/97 D.  and D.  Zra'im Ltd. v. Tax Assessor Haifa             5, 30

L

LCA 10231/04 Traum v. Gaidamak   4, 38

LCA 1436/90 Giora Arad, Company for Investment Management and Services Ltd. v. Value Added Tax Administration                3

LCA 3476/04 Siman-Tov v. Gad         5, 47

LCA 8253/99 A. v. B.           3, 22

LCrimA 5905/98 Ronen v. State of Israel        3, 30

Lilly v.‎ Commissioner           5, 25

Loi de Finances Rectificative Pour 1997 (Amending Law on Finances for 1997), Law No. 97-1239 of Dec. 29, 1997, J. O no. 302 Dec. 30, 1997       2, 40

M

Mercado case       35

Midrash Tanhuma                6, 35

Mishnah Hallah     5

N

National Insurance Law [Consolidated Version], 5728-1968       1, 20

O

OM (Jer) 2212/03 Gad v. Siman-Tov                5, 47

P

Pardes v. Tax Assessor case               19, 24

Penal Law, 5737-1977        1, 26

R

Rabbi Chaim Yosef David Azulai, Birkei Yosef (Hoshen Mishpat, s. 9, ss. 10)             6

Rabbi Yechiel Michel HaLevi Epstein, Aruch Hashulhan, (Hoshen Mishpat, s. 9, ss. 1             6

Rabbi Zvi Hirsch Eisenstadt, Pithei Tshuva, (Hoshen Mishpat, 34, 27)        6

Ronen case           31

S

S.E.C. v. Lockheed Aircraft Corp.       5

Shefer case           43

Shulhan Arukh, Hoshen Mishpat       5, 33

Song of Songs Rabba           5, 23

T

Textile Mills Corp.‎ v.‎ Commissioner  25

U

United Nations Convention Against Corruption, Articles 12(4), 15 and 16               2

W

Wireless Telegraph Ordinance [New Version] 5732-1972          1, 20