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Has the Israeli Tax Authority got it right with trusts? Not yet.
Postponement: In February 2007, the Israeli Tax Authority announced a postponement of trust reporting under the new Israeli trust tax regime (see below) until September 30, 2007. But, on September 18, the Tax Authority announced another extension until the end of the year. This extension applies to the filing of notices, declarations, affidavits and elections required under the new regime, as well as reporting income generated and activities conducted within a trust.
In addition, the due date for filing tax returns for the 2006 tax year is extended for anyone required to file a tax return solely due to the new regime - for example, trustees, persons who settled a trust in the year and persons who received anything from a trust if they are not otherwise required to file a tax return under Israel's detailed tax return rules.
The September 18 announcement explains that the Tax Authority is still engrossed in studying plans to amend Israel's primary legislation, issue regulations and design of forms. These will concern the duty and method of reporting trusts and other material matters. The extension is intended to facilitate completion of the legislation process and give the public and professional advisers time to prepare for the resulting reporting.
The announcement also clarifies that anyone required to file a 2006 tax return for reasons unrelated to a trust must report his other income on the due date prescribed by law. Reports required under the new trust regime will be completed after publication of the relevant forms according to an announcement that will be made in this regard.
So, what is a trust? A trust is an arrangement in which a settlor (or "grantor" - e.g. the father of a family) transfers assets to a trustee (e.g. a lawyer or bank trust department) to hold and invest for the ultimate benefit of beneficiaries (e.g. wife, children, grandchildren). Trusts date back around 1,000 years; they enabled wealthy crusaders to deposit the title to land temporarily with a priest until they returned from battle in our holy land.
Do trusts matter? Trusts are a useful way of preserving wealth in a family. If Mr. Smith earns $100 million, he does not want his children to squander it all at a casino - he wants future generations to share his good fortune. Trusts are also a big source of currency for Israel. It is estimated that family transfers of foreign currency into Israel exceed $2 billion per year, much of this via foreign family trusts.
Israeli taxation of trusts: In 2003, the main Israeli tax reform became effective. It imposed worldwide taxation on Israeli residents, but not always on trusts. So a new tax regime was enacted into the Income Tax Ordinance with effect from January 1, 2006. However, we only have the bare bones and still await more detailed regulations, guidance and forms regarding trust taxation as mentioned above. These items have been reportedly promised many times - to the Knesset Finance Committee, the Supreme Court and at public seminars.
The main types of trust specified in the new Israeli tax regime are briefly as follows:
Israeli Residents Trust - A trust that had an Israeli resident settlor and an Israeli resident beneficiary upon formation and still has an Israeli resident settlor or beneficiary in the tax year concerned. It also includes other trusts not falling into one of the categories below. Commencing in 2006, this type of trust is taxed in Israel on worldwide income at 20%-48% on its entire worldwide income, even if the trust is irrevocable and discretionary, even if some of the beneficiaries reside outside Israel.
Foreign Resident Settlor Trust - A trust formed entirely by non-resident settlors, or a trust that has non-resident settlors and beneficiaries in the tax year concerned. Non-Israeli source income may be exempt from tax and tax reporting in Israel if certain conditions are met. In particular, beneficiaries must not have control or influence over the conduct of the trust.
Foreign Resident Beneficiary Trust - A trust formed by an Israeli settlor exclusively for foreign resident beneficiaries. Non-Israeli source income may be exempt from tax and tax reporting in Israel if certain conditions are met.
Testamentary Trust - A trust created via a will by one or more persons who were Israeli resident upon their death. If any beneficiary is Israeli resident, the Testamentary Trust will be taxed in Israel on worldwide income, otherwise non-Israeli source may be exempt from tax in Israel if certain conditions are met.
What are the main issues arising? The new Israeli trust tax regime presents a number of challenges to both the Tax Authority and the parties to many trusts around the world. Here is a sample of the issues:
Trustees:Trustees are responsible for reporting and paying the Israeli tax on trust income "even if the trustee is a foreign resident or if the trust is governed by the rules of foreign law." If they don't, they are punishable. This provision has stirred controversy and it remains to be seen how much tax Israel collects from foreign trustees administering assets located outside Israel.
Multinational families: If a settlor is Israel resident, worldwide trust income may all be taxed if some beneficiaries or potential beneficiaries reside in Israel and some reside abroad. Draft regulations are apparently being formulated that propose to exempt trust income paid or allocated to foreign resident beneficiaries, if certain conditions are met. But trust income would be taxed if it is not distributed or if the beneficiaries are unknown ( e.g. unborn), according to the proposals. It remains to be seen what whether the proposals will be passed.
Double taxation issues: The tax law allows Israeli residents a credit for foreign taxation on income and capital gains. It is not clear how this will work in the trust context. For example, Joe Cohen of Tel Aviv (or New York ) died, leaving US real estate and securities worth $20 million in trust for his Israeli resident kids. These assets cost him $100,000 in the 1980s. Pursuant to the trust terms, the kids have the trustees sell the assets and distribute the cash.
The US Internal Revenue Service collects federal estate tax at rates ranging up to 45% (in 2007, 55% in 2011) on the full $20m. and the Israeli tax authority may collect capital gains tax at rates of up to 48% on the capital gain of $19.9m. This is known as the "93% tax trap" (more if there are US state estate taxesâ€¦). It remains to be seen if Israel will grant relief for the US estate taxes against Israeli capital gains tax.
Actually, Joe could have avoided this trap for his kids with a little tax planning in his lifetime. If you are like Joe, please consult competent tax advisers in each country immediately.
Re-settlements: In the past, many Israeli residents received overseas assets from a foreign relative or their trust and immediately contributed those assets into a new trust for the benefit of the family. Such a trust may be classified as both an Israeli Residents Trust and a Foreign6
Resident Settlor Trust under the new regime. So the trust income may be both taxable and exempt in Israel. This uncertainty needs to be resolved as it has occurred in many cases.
Records: The new trust regime provides no guidance regarding the keeping of books and records by foreign trustees.
No transitional rules: The new trust regime takes effect for trust income "accrued or derived" on or after January 1, 2006. It is unclear how to tax trust capital gains that may have accumulated over many years. All taxed? Pro rata split? Revaluation ("step-up") as of the end of 2005?
To sum up, the Israeli Tax Authority has a lot to think about. In the longer term, there may be problems for any Israeli beneficiaries with unexplained wealth. Since some types of trusts are more benign than others, readers are advised to consult experienced professional advisers in each country to review the available options.
The writer is an International Tax Partner at Ernst & Young Israel.