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Investing abroad is no easy matter, especially when two or more tax systems are involved.
The Israeli tax reforms of 2003 & 2006 made Israeli residents taxable in Israel on their worldwide income, usually at rates of 20 percent to 49%, and income from a foreign source will be taxed in the foreign "source" country, as well. Therefore, it is vital to avoid double taxation.
In principle, there are two methods: the exemption method and the credit method in the country of residence.
Israel mainly applies the latter method - Israeli residents may credit foreign taxes on foreign source income and capital gains against Israeli tax, if certain requirements are met. In this way, the combined tax liability will be topped up to the higher of the tax rates prevailing in the two countries, but hopefully no more than that.
Israel has double tax treaties with around 40 countries but the foreign tax credit rules in the Income Tax Ordinance (ITO) apply even if the income was derived in a country that has no tax treaty with Israel. Where a treaty does exist, its provisions will supplement the ITO rules and occasionally vary them. The Israeli Tax Authority also has issued a Circular (26/2002, dated December 31, 2002) explaining its views on the ITO rules.
How do you qualify for a foreign tax credit?
The main foreign tax credit rules in the ITO and the above Circular may be summarized as follows:
* Foreign tax must actually be paid within two years after the end of the year in which the income is taxable in Israel. Later payments of foreign tax are creditable when actually paid.
* It must be a "tax," i.e. payment to the tax authorities of a foreign country calculated as a percentage of income accrued or derived in that country, including tax payments to a state in a federal country or region in that country, but not municipal taxes.
* This rules out a credit for city taxes, taxes paid "voluntarily" or to the "wrong" country, social security payments, estate or inheritance taxes, lump sum payments, penalties, interest or government fees.
* The tax must be mandatory, final and not refundable in any way.
* The taxpayer must be an Israeli resident for Israeli tax purposes (basically, center of living in Israel). Non-Israeli residents should claim double tax relief in their country of residence. Citizenship is not normally relevant here.
* The income and tax will be translated to shekels according to detailed rules in the tax regulations - usually according to the Bank of Israel representative exchange rate on each date of payment.
* The above Circular also states (in Para. 2.3.3) that no credit will be given for tax paid abroad contrary to the provisions of a tax treaty. This is especially pertinent to US citizens and green card holders who are resident in Israel - they are governed by special split foreign tax credit rules in Article 26(2) of the US-Israel tax treaty and professional advisors should be consulted in specific cases.
Suppose the foreign tax exceeds Israeli tax? Israel will not refund foreign tax paid. However, any excess foreign tax credit may be offset against Israeli tax on income from the same type (i.e. same "source" or "basket") in the following five tax years - after adjusting the excess foreign tax credit for Israeli inflation between the end of the year it is generated and the end of the year it is used. For example, an excess foreign tax credit on foreign rental income in 2005 may not be set off against Israeli tax on foreign dividends but it may be adjusted for Israeli inflation and offset against Israeli tax on foreign rental income from the same building or a different one in the years 2006-2010. A few minor exceptions to this rule exist. It is not possible to deduct foreign taxes as an "expense" from income.
What additional rules apply to Israeli resident individuals?
If the foreign income is taxed at a special rate in Israel (e.g. 20% for most dividends, interest and capital gains), the foreign tax credit cannot exceed the special tax rate. For other regular income, the foreign tax credit cannot exceed the average Israeli tax rate on all such regular income multiplied by the amount of foreign tax.
What additional rules apply to Israeli resident companies?
With respect to foreign dividend income, an Israeli company may choose between:
* Direct foreign tax credit only: a 25% tax is imposed on foreign dividend income and any dividend withholding tax incurred is creditable in Israel; or
* Direct and "underlying" foreign tax credits: full Israeli company tax is imposed (31% in 2006) on "grossed up" foreign dividend income, and a credit is granted for dividend withholding tax and "underlying" corporate tax paid abroad by 25%-or-greater affiliates and their direct 50%-or-greater subsidiaries. However, any excess foreign tax credit may not be used in the following five years.
What final tips can we offer?
* First, always consult your tax advisor on all these aspects.
* Second, if the amount of foreign tax is adjusted - e.g. due to a foreign tax audit - any adjusted foreign tax may be taken into account in Israel within two years thereafter.
* Third, a "participation exemption" is available in lieu of a foreign tax credit to Israeli holding companies that invest NIS 50 million or more in total in certain active foreign affiliated companies.
* Fourth, there is no credit for estate tax or inheritance taxes on investments in countries like the US, UK, France, Spain, South Africa and elsewhere - these taxes can be very large (up to 46% in the US even if you are not a US citizen). Techniques exist for avoiding these taxes altogether sometimes, so take professional advice in all such cases.
* Finally, if you receive a dividend from a foreign company out of income that was partly taxed in Israel (not company tax), you may claim a pro rata credit for your share of the Israeli taxes. This is pursuant to obscure provisions in Section 163 of the Income Tax Ordinance.
The writer is an International Tax Partner at Ernst & Young Israel