Israel's 2025 Trapped Profits Law: Mandatory Dividend Distribution & Marginal Tax Above 25% Profitability

Category: Tax Planning | Reading time: approx. 8 minutes

In December 2024, the Knesset passed — as part of the Economic Efficiency Law for 2025 (better known as the "Arrangements Law") — Amendment 277 to the Income Tax Ordinance. The amendment, effective January 1, 2025, targets the phenomenon of "trapped profits": vast sums accumulated over the years in private companies and never distributed to shareholders, in order to defer dividend tax. For tens of thousands of Israeli company owners, this is the most significant change in the tax rules in years.

The amendment stands on two main legs: a new annual tax on undistributed profits (which in practice creates an economic "distribution obligation"), and a dramatic expansion of the wallet-company rules — chief among them a new mechanism that taxes profits above 25% profitability at marginal rates. We explain both, with numeric examples.

Who Does It Apply To? Closely-Held Companies

Both mechanisms apply to a "closely-held company" (חברת מעטים) as defined in Section 76 of the Ordinance — a company controlled by up to five persons, which is not a public company or its subsidiary. In practice, the definition captures the vast majority of private companies in Israel: professional-services companies, family holding companies, and companies of consultants and service providers.

Mechanism One: An Annual Tax on Undistributed Profits — or a Dividend

The heart of the amendment is a choice every closely-held company with accumulated profits must make, each year, between two alternatives:

• The distribution alternative — distributing a dividend of at least 6% of the company's accumulated profits. Shareholders pay the ordinary dividend tax (25%–30%, plus surtax where applicable) — but the company is exempt from the new tax for that year. For 2025, a one-time relief applied: a reduced distribution rate of 5% sufficed.
• The tax alternative — paying an annual tax of 2% of the company's "excess profits". Important: this is not an advance against future dividend tax — it is an additional tax, non-deductible, that is not credited against the tax eventually paid when the dividend is distributed. A tax that repeats itself year after year, as long as the profits remain in the company.

What Are "Excess Profits"? The Safety Cushion

The 2% tax does not apply to all accumulated profits, but only to "excess profits" — accumulated profits minus a "safety cushion" designed to protect companies that use their profits in the business. The cushion is the highest of three amounts:

• NIS 750,000 (shared between all closely-held companies of the same controlling shareholder);
• the company's total annual deductible expenses;
• the cost of the company's assets minus "special assets" (mainly passive financial assets).

The practical meaning: a genuine operating company — with employees, equipment, inventory and running expenses — enjoys a wide cushion and may not be exposed to the tax at all. A holding company that accumulated profits and invested them in securities and deposits — is fully exposed.

When Is the Tax Not Paid? Key Exemptions

• When there are no excess profits (the cushion covers the accumulated profits);
• When the company has current losses (business or capital) exceeding 10% of accumulated profits;
• When a dividend exceeding 50% of excess profits was distributed;
• And of course — when the distribution alternative (6% of accumulated profits) was chosen.

An important carve-out — companies under the Encouragement Law: profits deriving from preferred or benefited income under the Capital Investment Encouragement Law are not included in the profit base for the new tax. The meaning: a preferred enterprise — an industrial or hi-tech company entitled to the law's benefits — can continue accumulating its preferred profits without exposure to the undistributed-profits tax. This is one more reason, sometimes a decisive one, to examine whether your company qualifies for preferred-enterprise status.

Read our full article: The Capital Investment Encouragement Law — who qualifies and what the benefits are →

A Numeric Example

A consulting company has accumulated profits of NIS 5 million, mostly invested in a securities portfolio. Its safety cushion — NIS 750,000 (the highest of the three). Excess profits: NIS 4.25 million. Its annual choice:

• Not to distribute — and pay 2% × 4.25 million = NIS 85,000 a year, every year anew, with nothing credited in the future;
• To distribute 6% of accumulated profits = a NIS 300,000 dividend, on which shareholders pay dividend tax — tax that would have been paid anyway on the day the money was eventually withdrawn.

In most cases, an orderly, planned distribution is economically preferable to an annual non-creditable "fine" — which is why the amendment is described in practice as a de-facto mandatory dividend distribution. But this is not a blanket answer: each company has its own asset structure, financing needs and tax picture, and the right choice requires a specific calculation every year.

Mechanism Two: Expanded Wallet-Company Rules — Marginal Tax Above 25% Profitability

The second leg of the amendment is a significant expansion of Section 62A of the Ordinance — the section created in 2017 to deal with "wallet companies": companies through which senior employees or service providers effectively operate, in order to enjoy low corporate tax instead of marginal personal tax.

The Key Innovation: Taxing "Excess Profitability"

New Section 62A(a1) establishes a mechanism that did not previously exist: a closely-held company whose income derives from personal-effort-intensive activity — activity based primarily on the personal work of its controlling shareholders, such as consulting, professional services and similar vocations — and whose turnover from that activity does not exceed NIS 30 million (per controlling shareholder), will be subject to "mixed" taxation when its profitability exceeds 25% of turnover:

• Profit up to 25% profitability — continues to be subject to ordinary corporate tax (23%);
• Profit above the 25% profitability threshold — is attributed directly to the controlling shareholders, in proportion to their profit rights, and taxed in their hands at marginal rates as personal-effort income — up to 47%, and up to 50% including surtax.

The amount attributed to the shareholder is deducted from the company's income (so no double tax is paid on it), and when eventually distributed — it will not be taxed again as a dividend. An exemption exists for small companies whose excess profits at the start of the year do not exceed NIS 750,000, subject to the conditions set in the law.

A Numeric Example

A consulting company owned by an individual, with an annual turnover of NIS 3 million and a profit of NIS 1.2 million — 40% profitability:

• Profit up to the 25%-of-turnover ceiling = NIS 750,000 → corporate tax at 23%;
• The excess profit = NIS 450,000 → attributed to the controlling shareholder and taxed at marginal rates, as if it were salary.

For profitable service providers — consultants, experts, professionals — this is a material change: the key advantage of operating through a company (deferring tax by retaining profits at low corporate rates) is significantly eroded for everything beyond 25% profitability.

Further Expansions of Section 62A

• A shorter testing period — in the classic wallet-company test (70% or more of income from a single source), the examined period was shortened from 30 months out of four years to 22 months out of three years — bringing more companies into scope, faster;
• Partnerships — new attribution rules also apply to controlling shareholders operating through a closely-held company that is a partner in a partnership (a common structure in large professional firms), so that part of the income is attributed directly to the individual and taxed at marginal rates.

In Parallel: A Higher Surtax on Capital Income

Alongside the two mechanisms, the Arrangements Law added, from 2025, an additional 2% surtax on high capital income — including dividends, capital gains and land appreciation — on top of the existing 3% surtax. The meaning: a high-income individual may pay total tax of up to about 35% on a dividend (30% for a material shareholder + up to 5% surtax). This consideration must enter the distribution plan: on one hand the law pushes companies to distribute, and on the other the cost of distributing has itself risen — making the timing of distributions, spreading them over years, and planning the shareholder's overall income more important than ever.

Is Operating Through a Company Still Worthwhile?

A question we hear a lot since the amendment. The answer: in most cases yes — but the math has changed. A company still offers substantial advantages: limited liability, business flexibility, the ability to bring in partners and investors, and low corporate tax on profits reinvested in the business. What has eroded is the use of a company as a "savings box" for deferring tax on passive profits, and the advantage of exceptionally profitable service companies. For some businesses — mainly individual service providers with high profitability and no need to accumulate capital in the company — the self-employed route may, at certain numbers, be relevant again. This is a case-by-case review worth doing with your CPA, based on your real numbers.

So What Should You Do? Five Preparation Steps

1. Map accumulated profits and the safety cushion — the first step is knowing where you stand: what the accumulated profits are, how large your cushion is (it can sometimes be influenced — for example through asset composition), and the actual exposure.
2. Set an annual dividend policy — instead of ad-hoc decisions, a multi-year distribution plan is now required, balancing the new tax, dividend tax and surtax, and the company's financing needs.
3. Examine your profitability rate — service companies with high profitability should assess their exposure to the excess-profitability mechanism, and its implications for the controlling shareholders' salary–dividend mix.
4. Re-examine the structure of the activity — for some companies, especially clear wallet companies, the current structure may no longer be optimal. See also: Limited Company or Self-Employed.
5. Time it right before year end — the choice between the alternatives is made for each tax year. Consulting before the year ends — not after — is the difference between planning and retrospective reporting. See also: Year-End Tax Preparation.

The above article is provided for general information only and does not constitute professional advice or a substitute for specific consultation. The provisions of the law are complex and include conditions, qualifications and transitional rules not fully detailed here. For any question, you are welcome to contact us — we will be happy to advise, accompany and represent you before the tax authorities in Israel.

Sincerely,
Hager-Alperowitz & Co. — Certified Public Accountants