It is a truism that the U.S. tax code affects almost every facet of American life, but the Treasury Department recently discovered that it also shapes the borrowing patterns of the state of Israel.
Thousands of American Jews buy Israel Bonds, although some yield only 4 percent interest, less than half the market rate. The buyers accept the lower rate "because they have a feeling for the state of Israel" and want to help finance the country's roads, harbors and other public works, according to Don Bezahler, attorney for Israel Bonds in New York.
Now the Treasury Department has ruled that under the Deficit Reduction Act of 1984, those bondholders face a penalty. The law imposed new taxes on people who make loans at artificially low interest rates as a way to reduce their tax bills.
Among the abuses the law was designed to rectify were cases in which wealthy people made interest-free loans to their children, invested the money in the child's name and then earned taxable interest at the child's lower tax rate.
In a recent letter to House Ways and Means Committee Chairman Dan Rostenkowski (D-Ill.), Assistant Treasury Secretary Ronald A. Pearlman said that unless the law is amended, it "clearly requires" penalties against holders of 4 percent Israel Bonds issued since the act took effect.
Treasury's finding has set off a determined campaign by supporters of Israel to restore the old status of the bonds. Sen. Pete Wilson (R-Calif.) and Rep. Charles B. Rangel (D-N.Y.) announced this week that they are sponsoring legislation to exempt the bonds from tax penalties, and Pearlman has offered Treasury's help if Congress wants to draft a change.
"Under [the new] rules, no one will be able to afford the tax consequences of buying Israel Bonds," Wilson said yesterday.
Under the 1984 act, people making loans below the market interest rate are taxed as if the loans were made at the going federal rate. That is, the government will treat the lender as if he earned a market rate of interest. In the case of Israel Bonds, the act characterizes the 4 percent notes as a form of contribution, in the guise of foregone interest, to the state of Israel. Since gifts to foreign governments are not tax deductible, this would raise a buyer's tax bill, making the bonds less attractive to investors.
The current adjusted federal interest rate for long-term bonds is 10.69 percent, according to the Treasury Department. At that rate, someone buying a 4 percent bond worth $10,000 would receive roughly $400 in interest but would be taxed on about $1,069 in interest. The $669 difference would mean a tax increase of $334.50 for someone in the 50 percent tax bracket.
Bezahler took issue with the characterization of Israel Bonds as a camouflaged, deductible contribution to Israel.
"Nobody buys Israel Bonds for tax avoidance," said Bezahler, adding that he holds some Israel Bonds himself. "They do it because they want a tie with the state of Israel and they want Israel to continue to have low-cost bonds . . . . If I want to contribute to Israel, I give to the United Jewish Appeal. For that I get a tax deduction. When I buy an Israel Bond, I want a tie with Israel."
The penalty would affect taxpayers who bought bonds after the act took effect in June 1984. A spokesman for Israel Bonds said the agency sold $102 million in 4 percent bonds in 1984, and $62 million so far this year.
The issue came to light in Pearlman's letter to Rostenkowski in August. Overall, the 1984 Deficit Reduction Act was expected to raise $48 billion by closing a variety of tax loopholes. Penalties on low-interest loans, including Israel Bonds, were expected to raise $136 million of the total.
"People buying these bonds, to whom tax consequences are important, are waiting until this can be clarified," said Rangel, who learned of the issue from former New York governor Hugh Carey, whose law firm represents Israel Bonds. "It was clearly not the intent of Congress to impair the marketability of Israel Bonds."