Your Taxes: Trust proposals too bad to be true

Following publicized cases of perceived abuse, new draft legislation proposes to tax any trust with an Israeli resident beneficiary.

By LEON HARRIS
June 11, 2013 23:58
An accountant [illustrative photo]

An accountant calculator taxes 370. (photo credit: Ivan Alvarado / Reuters)

 
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In this article we review in detail the latest sweeping Israeli budget proposals for trusts.

Until now, Israel mainly sought to tax trusts with an Israeli resident settlor. Following some well publicized cases of perceived abuse, new draft legislation proposes to tax any trust with an Israeli resident beneficiary, referred to as the Israeli Resident Beneficiary Trust (IRBT).

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Each year around $3 billion flows into the economy from family relatives abroad. A good part flows via mostly exempt foreign resident settlor trusts. By taking away this exemption, Israel risks a deterioration in the balance of payments and a devaluation of the Shekel.

The proposals are included in the budget bill that could be enacted in June/July.

Following is an overview of the proposals.

Definition

An IRBT is defined as a trust in which: (1) every settlor (=grantor) is a foreign resident, at the time of formation and in the tax year; and (2) there is at least one Israeli resident beneficiary in the tax year, and (3) the settlor is a first degree relative of the beneficiary namely: spouse, parent, grandparent, child or grandchild; OR (4) the settlor is a second degree relative of beneficiary (spouse, brother, sister, parent, grandparent, child, spouse’s children, spouse of each of the aforementioned, child of brother or sister, parent’s brother or sister); and the Assessing Officer is satisfied that the trust was formed in good faith; and the beneficiary did not provide services in consideration for his/her “entitlement” to trust assets.



An IRBT may be revocable or irrevocable.

Comment

First degree relatives are also second degree relatives, making it unclear which requirements apply to them. Clearly the proposals were hastily drafted. Let’s hope the Knesset clarify things when enacting the bill.

Israeli tax

As for tax, the trustee will have to choose between: (1) 25 percent tax on trust income when it is derived if it is allocated to a specific relative, or (2) 30% tax on distributions to an Israeli resident beneficiary.

To qualify for the 25% tax rate, the trustee and beneficiary will have to jointly notify the ITA (Israel Tax Authority) of the income allocation within 30 days after formation of the trust or after adding an Israeli resident beneficiary. The notification is irrevocable so long as the IRBT has an Israeli resident beneficiary (not necessarily the same one). This means the trustee exercises his discretion about allocating present and future trust income to a beneficiary, but need not distribute the income.

The 30% tax will not apply if the trustee or beneficiary can prove that part of the distribution is derived from an asset (i.e. capital) contributed to the trustee and that a direct transfer from the settlor to the beneficiary would have been exempt. The remaining part of the distribution will be taxed at 30%. For these purposes, trusts profits are deemed to be distributed first, then capital; and trust capital distributed is deemed to be distributed to beneficiaries pro rata to their share of the distribution of trust assets and income in the period from the formation of the trust to the end of the tax year.

Comments

This is vague. Can retained trust income be rolled into capital in the settlor’s lifetime? And after the settlor’s death? How are expenses allocated? Careful trust accounting will be needed.

Immigrant exemption

If an FRST (Foreign Resident Settlor Trust) becomes an IRBT after a beneficiary became a new resident or a senior returning resident (who lived abroad 10 years), the beneficiary’s income will be eligible for the 10-year tax exemption for foreign source income and gains. Under the present (old) law, an indefinite Israeli tax exemption applied to foreign resident settlor trusts. The exemption decreased to 10 years if the settlor made Aliya to Israel.

Death of a settlor

If one of the settlors dies, the trust will cease to be an IRBT and will instead be a fully taxable Israeli Residents’ Trust, but the 30% tax rate will apply with appropriate adjustments and each distribution shall be deemed to be income generated before the date of death unless something else is proven (e.g. a capital distribution apparently).

The ITA director would be authorized to issue instructions, including calculating the split of distributions, conditions, limitations and forms.

Note that it is unclear whether any relief will be granted for foreign beneficiaries existing currently or designated/born in the future. This is a serious omission.

There are existing regulations for not imposing Israeli tax on income accruing or distributed to non-resident beneficiaries, but they are subject to numerous limitations and a penal 70% tax rate in certain cases.

Comments This would grant extremely broad powers to the ITA to determine conditions and limitations.

And foreign beneficiaries may well fall within the Israeli tax net. Foreign settlors are likely to think twice about transferring wealth to family members in Israel and elsewhere via a trust. In the case of US beneficiaries, the US-Israel tax treaty may counteract Israeli taxation.

Capital gains tax

For Israeli capital gains tax purposes, a contribution to a trust is treated like a transfer from the settlor to the beneficiary.

Comments

Therefore the cost of any asset contributed to a trust is the Settlor’s cost, with no “step-up” to the market value when the settlor contributed the asset to the trust. This means possible double tax in Israel and abroad.

There is also no “step-up” upon the entry into force of the proposed amendment. This means years of gains accruing before the amendment will be swept into the Israeli tax net.

Notice
 

The trust must notify the Israeli Tax Authority within 30 days after formation of a trust that it complies with the above conditions concerning settlor-beneficiary relationship, otherwise the trust will be deemed to be a fully taxable Israeli Residents’ Trust (IRT).

Comments

This is harsh because there will be many cases involving discretionary trusts and/or trustees abroad where it will be difficult to notify the ITA in time, within 30 days. The reporting party would be the trust, so the beneficiary is powerless to help with the reporting.

It is unclear how the Trust can report within 30 days that the Assessing Officer is satisfied with a second degree relationship… Effective date The IRBT rules take effect when the law is enacted and published – this could be in the next month or two. In the case of trusts formed before the law takes effect, the trust has 60 days after the formation of the trust to report compliance with the above IRBT conditions.

Comment

Nearly all existing trusts were formed over 60 days ago – the clause needs to be amended perhaps to 60 days after the law takes effect.

Reporting


All trust distributions, including exempt ones, will be reportable on a tax return according to the proposals.

Closing comments

It remains to be seen what will be enacted and when. The proposals attack Olim and wealthy families mercilessly, including relatives abroad.

They also show shortsightedness on the government’s part after it introduced a comprehensive new tax regime in 2006 and tempered it under international pressure in 2008. Our guess is the same could happen again. Failing that, appropriate tax planning may well mitigate the impact in many cases...

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

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

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