The Israel Tax Authority (ITA) on March 9 announced optional transitional arrangements for Israeli resident beneficiary trusts. This follows Amendment 197 of the Income Tax Ordinance which took effect on January 1.
From that date, Israel imposes tax on the worldwide income and gains of any trust that has an Israeli resident beneficiary, or had one in the past, if the settlor is a foreign resident or was upon his demise.
Israeli tax rates on trust investment income and gains currently range from 25 percent to 50%.
What is a trust?
A trust is an arrangement in which a trustee holds assets for other people (beneficiaries).
Previously, in the years 2006-2013, Israel generally did not tax foreign-source income and gains of trusts with a foreign resident settlor, provided a number of conditions were met. In particular, no beneficiary should be able to exercise “control or influence,” directly or indirectly, over the conduct of the trust, the trust assets, the trustee, the determination of the beneficiaries, the appointment or replacement of trustees, or the distribution of trust assets or income. If a beneficiary exercises control or influence, that person is deemed to be a settlor, making the trust fully taxable in Israel from 2006.
Likewise, if the settlor has passed away and the trustee or beneficiaries are changed without provision for this in the trust documents, this will generally make the trust taxable in Israel. In practice, most trust deeds do make such provision.
Rationale for transitional arrangements
Until now, the term “control or influence” was never defined, despite numerous requests.
Also, the new 2014 rules tax the entire capital gain on assets sold, even if the gain accumulated before 2014.
The ITA’s optional transitional arrangements are intended to offer a partial solution to these issues. Interested parties have until December 31 to apply for the transitional arrangements.
Overview of what’s on offer
The special transitional arrangement offers trustees an option to pay limited tax to resolve the Israeli tax position of a trust that meets the relevant conditions regarding the tax years 2006-2013.
There are three possible approaches: (1) No-tax route – if there is no beneficiary control or influence; (2) Income-tax route – Israeli tax on onethird to two-thirds of trust income derived in the years 2006-2013; (3) Capital-tax route – Israeli tax at 3%-6% of the value of trust capital as of December 31, 2013, plus distributions in 2006-2013; These are discussed further below.
Assuming the no-tax route is not granted (see below), the amounts taxed under the transitional arrangement are intended to match the potential degree of beneficiary influence. The amounts taxed under the transitional arrangements should therefore be as follows: (A) One-third of trust income derived in the years 2006-2013 OR 3% of trust capital, if the settlor was alive on January 1, 2013, and is related to the Israeli resident beneficiaries.
Taxed income and capital may be distributed free of further tax, but post- 2013 profits are deemed to be distributed first.
(B) One-half of trust income derived in the years 2006-2013 OR 4% of trust capital, if the settlor died before January 1, 2013, but was related to the Israeli resident beneficiaries, and the assessing officer is satisfied that the formation of the trust and contributions to it were in good faith. The ITA will assume that the longer the settlor is dead, the greater the beneficiary’s influence.
It is not clear why.
(C ) Two-thirds of trust income derived in the years 2006-2013 OR 6% of trust capital, if in cases (A) or (B) there are clear signs of beneficiary influence over the trustee or trust assets.
Are the settlor and beneficiaries related?
To be related and potentially eligible for a transitional arrangement, the trust must meet the relationship criteria of an Israeli Resident Beneficiary Trust as defined in the tax law for 201 onward. This means the settlor(s) and all the Israeli resident beneficiaries are related in one of the following ways: (A) If the settlor is a first-degree relative of the beneficiary; namely, parent, grandparent, spouse, child or grandchild; OR (B) If the settlor is a second-degree relative of 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.
When are there clear signs of beneficiary influence?
After seven years, the ITA has finally seen fit to define signs of beneficiary influence as any one of the following: if the beneficiary has authority to determine the beneficiaries, trustee or trust assets; if the beneficiary is a member of the investment committee or another management body; if the beneficiary supplied services such as management or consulting services; if the beneficiary transferred assets to the trust for less than full consideration; if the beneficiary has a managerial role in an underlying company or enterprise of the trust; if the trust assets serve as collateral for a loan to the beneficiary not in accordance with the trust deed; if a loan was granted to the beneficiary for X years not on an arm’s-length basis and not in accordance with the trust deed.
According to the ITA announcement, there may be exceptional instances in which assets may be stepped up to their market value with no Israeli tax due. The assessing officer would need to be satisfied beyond all doubt that: (1) there was no influence; (2) no possibility of influence by the beneficiary; (3) no connection of any sort regarding trust matters between the beneficiary and the settlor; (4) there are no signs of abuse or lack of good faith regarding the formation of the trust or contributions to it. The ITA international department and the legal bureau would also need to give their approval.
Such instances would be limited primarily to trusts in which the settlor was alive and resident abroad throughout the period 2006- 2013 and the beneficiaries are (1) minors residing in Israel or (2) have an interest of under 10%. It is not clear what this means.
Trust income is translated to shekels at the US dollar exchange rate at the end of the year the income was derived, or at December 31, 2013, whichever is lower (i.e., better).
Losses can be used within the period 2006- 2013, but they cannot be carried forward to 2014.
Foreign taxes paid are creditable against income to the extent income is taxable.
Tax on income bears interest and inflation adjustment but not penalties.
If part of trust income is taxed, the trustee can also elect to pay tax on a notional sale of the same part of unrealized capital gains as of December 31, 2013, and get a “step-up” of the cost to the market value at that date for future Israeli tax purposes.
Capital-tax route According to the ITA announcement, the capital route may be elected “in appropriate cases in which the return on capital is not exceptional.” It is not clear what this means.
Trust capital is based on a valuation of assets as of December 31, 2013, but liabilities generally may not be deducted. The ITA claims that liabilities usually reflect the cost of assets contributed to the trust, which will themselves be tax deductible.
The cost of trust assets will be “stepped up” to the valuation amount for future Israeli tax purposes.
A foreign tax credit is available for foreign tax on subsequent capital gains over and above the valuation.
If a settlor contributes assets to the trust and the capital route is not applied, those assets will be attributed the cost incurred by the settlor.
The ITA announcement indicates that discretion will be applied to a number of factors, including the following: foreign resident beneficiaries; foreign tax paid by the trust, the settlor or a beneficiary; trusts resident and subject to tax in a country that has a tax treaty with Israel; a trust that already has an Israeli tax ruling; a beneficiary who is an immigrant to Israel (new resident, returning resident in their benefit period); formation date of a trust; date a settlor passed away; other relevant circumstances.
When are the special transitional arrangements NOT available?
The transitional arrangements are NOT available in the following cases: if the settlor and beneficiary are unrelated; if an asset contributed to the trust originates from an Israeli resident; if the beneficiary is directly or indirectly also the settlor; or if the trust capital originates from income that should have been taxed in Israel but wasn’t.
In such cases, the special transitional arrangements are not on offer, but the ITA would be prepared to discuss how the regular rules should be applied.
Procedure and deadline
Interested parties have until December 31 to apply for the transitional arrangements.
Beneficiaries must file an affidavit that they have never contributed any asset to the trust.
Comments and tips
The transitional arrangement offers a useful facility for sorting out the past Israeli taxes of trusts with foreign settlors and related Israeli resident beneficiaries.
Before deciding whether to approach the ITA, consider the following: First, review the trust deed. Second, review income and capital gains realized. Third, review unrealized capital gains. Fourth, review the state of the trust accounts, if any; they will need to be up to date under the new regime. Fifth, consider whether to request a transitional arrangement and, if so, which route.
Sixth, if you select the income route, do you want to pay tax now on unrealized capital gains to get a cost step-up? How will the negotiations go? Slowly but surely, it seems. The ITA will be applying discretionary procedures, and different tax departments will be involved. But the ITA has indicated it hopes to collect substantial tax revenues.
A major issue not adequately addressed is whether Israel will tax the share of beneficiaries living outside Israel. The issue can be raised when negotiating an arrangement with the ITA. Other planning possibilities may also be worth exploring.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.