On July 29, the Knesset passed the Law for the Change Of National Priorities (Legislative Amendments For Achieving Budgetary Goals For The Years 2013 and 2014). Generally it takes effect from August 1, 2013, but most of the tax-rate and trust changes apply from January 1, 2014. Below is a non-exhaustive overview of the new trust rules.

Unlike before, the overall aim is to tax any trust anywhere in the world with Israeli beneficiaries.

Foreign-residents trust

Description: In the case of a foreign-residents trust (FRT), no Israeli tax is imposed on income and gains from foreign sources. The new law rules out Israeli-resident beneficiaries and changes the name of a trust (previously it was called a foreign-resident settlor trust).

Definition: An FRT is now defined as one of the following: (1) EITHER a trust in which all the settlors (grantors) and all the beneficiaries are foreign residents in the tax year, OR all the settlors are foreign residents and all the beneficiaries are public-purpose beneficiaries or foreign residents, AND there were no Israeli-resident beneficiaries since its formation; (2) ALTERNATIVELY, an FRT is a trust in which all its settlors are deceased and all the beneficiaries in the tax year are foreign residents, OR all the settlors are deceased and all the beneficiaries are public-purpose beneficiaries or foreign residents, AND there were no Israeli-resident beneficiaries since its formation.

Unfortunately, the above definition is far from clear, and doubts already exist.

For example, if a trust has Israeli-resident beneficiaries 20 years ago, is it always precluded from being an FRT? Charity trusts: A public-purpose beneficiary does not count as an Israeli-resident beneficiary and won’t taint an FRT.

A public-purpose trustee is defined as the State of Israel, a municipality, Keren Kayemeth LeIsrael-Jewish National Fund, Joint Israel Appeal, charitable public institutions per Section 9(2) of the Income Tax Ordinance, or similar bodies exempt from tax in Israel, or a public body so prescribed by the director of the Israel Tax Authority (ITA) with the approval of the Knesset Finance Committee.

Tax treatment: No Israeli tax is imposed on income and gains of an FRT from foreign sources. Since the FRT is classified as a foreign resident, it will be taxable on Israeli-source income and gains, subject to certain exemptions, such as interest on PATACH foreign-currency deposits and capital gains on Israeli securities that are unrelated to Israeli real estate or natural resources.

Conditions:
An FRT may be revocable or irrevocable, discretionary or specific.

Various conditions will continue to apply to an FRT. In particular, no beneficiary may exert “control or influence” over the trust or its assets, and trust assets cannot originate from transfers from an Israeli-resident beneficiary or their relative.

Reporting: Under the new law, all trust distributions received by an Israeli beneficiary from August 1, 2013, onward must now be reported on his or her annual Israeli tax return. Previously, FRT beneficiaries only had to report noncash distributions received.

Israeli-resident beneficiary trust

Definitions: An Israeli-resident beneficiary trust (IRBT) is defined as a trust in which: (1) All the settlors are foreign residents, from formation up to the tax year, and; (2) There is at least one Israeli-resident beneficiary in the tax year.

A public-purpose beneficiary (charity, see above) does not count as a beneficiary.

The type of IRBT that qualifies for better tax breaks is a “relatives trust.” A relatives trust is defined as an IRBT in which all the settlors and all the Israeli-resident beneficiaries are related in one of the following ways: (a) The settlor is a first-degree relative of the beneficiary; namely, a parent, grandparent, spouse, child or grandchild; OR (b) the settlor is a second-degree relative of the beneficiary (sibling, spouse’s children, spouse of each of the aforementioned, child of sibling, parent’s sibling); AND the assessing officer is satisfied that the formation of the trust and contributions to it were in good faith; AND the beneficiary did not give consideration for his or her “right” to trust assets.

In addition, the trustee must report the relatives trust within 60 days of its formation or transformation into one, or within 180 days after August 1, 2013 (i.e., by January 27, 2014, apparently) in the case of pre-2014 trusts.

Israeli tax treatment and timing – relatives trust: Generally, distributions by a trustee to an Israeli-resident beneficiary of foreign-source income will be taxed in Israel at 30 percent.

Distributions of capital are exempt from Israeli tax. For these purposes, capital means an asset contributed to the trust that would have been exempt from Israeli tax had the asset been transferred (i.e., gifted) by the settlor directly to the beneficiary. In a mixed distribution, income is deemed to be distributed before capital. If a distribution is made to several beneficiaries, an Israeli-resident beneficiary is deemed to receive capital pro rata to his share of the distribution.

Alternatively, the trustee may elect within 60 days of its formation or transformation into one (unclear what – a trust?), whichever is later, to allocate foreign-source trust income to an Israeli-resident beneficiary and be taxed thereon at 25%. Such an election cannot be revoked so long as the trust is a relatives trust. Income taxed at 25% will not be taxed later when distributed.

Assets contributed to a relatives trust are treated like a direct transfer from the settlor to the beneficiary; i.e., no Israeli tax if a bona fide gift.

Israeli tax treatment and timing – IRBT but not a relatives trust: The trust will subject to Israeli tax on worldwide income and gains like a regular Israeli-residents trust (IRT). Trust income will be taxed like income of an Israeli-resident individual.

If a relatives trust stops being one, this must be reported within 60 days to the ITA. It seems a 30% deemed distribution tax charge was intended but may not apply in practice, the way the final law was drafted.

Olim beneficiaries portion taxed?
A 10-year Israeli tax holiday will apply to overseas income and gains of the trust if: (1) If a trust becomes a relatives trust following the migration to Israel of a new or senior returning resident (after living abroad five to 10 years) on or after August 1, 2013, on that person’s share of such income; or (2) if a foreign-resident settlor sets up a relatives trust, for the benefit of new or returning residents, for the remainder of their 10-year period of benefits. If the settlor dies, the tax-year holiday is dependent on all the beneficiaries being new or returning residents.

Effect of death of settlor or his spouse: Note that after the death of a settlor, a relatives trust becomes instead an Israeli-residents trust. That means the worldwide income and gains of the trust income will all be fully taxable in Israel.

The taxpayer is the trustee. It seems this provision will affect FRT trusts overnight from January 1, 2014, if any settlor died in the past. Exceptions are: (1) If the settlor’s spouse is still alive and was married to the settlor when any assets were contributed to the trust, the trust remains a relatives trust in the spouse’s lifetime; (2) The 10-year tax holiday will apply to new or senior returning residents’ share of overseas income and gains.

Foreign beneficiaries’ portion taxed? Apparently not in the case of a relatives trust, but Israeli tax will generally apply to all trust income after the death of a settlor. It is unclear if existing regulations will apply regarding the refund of Israeli tax paid on foreign income distributed to foreign-resident beneficiaries, or even exempting foreign income allocated to foreign-resident beneficiaries and distributed to them within a prescribed period (zero to four years) subject to strict conditions.

Are past gains taxed? Apparently yes, if they crystallize on or after January 1, 2014.

Notices: See above regarding notice to the ITA within 60 days after a trust starts or stops being a relatives trust.

Reporting: Trustees and/or beneficiaries must report taxable income on annual tax returns. Clarification will need to be published in this regard.

Commencement

The new trust tax regime applies to all trusts from January 1, 2014.

Comments

Affected families and trustees should consider urgently what action to take before the end of 2013. Is it time to crystallize income? Hive off foreign beneficiaries? In many cases, detailed calculations and up-to-date trust accounts will be helpful.

As always, consult experienced tax advisers in each country at an early stage in specific cases.

leon@hcat.co
Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.

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