Your Taxes: Transitional option for trusts formed pre-2006

The optional arrangement involves paying a low rate of Israeli tax soon, usually on "trust capital" with no foreign tax credit.

taxes good 88 (photo credit:)
taxes good 88
(photo credit: )
In last week's article, we reviewed the amendment enacted May 2008 regarding a reduction in the obligation of trustees, settlors and beneficiaries to file annual tax returns - in many cases a one-time notice may be sufficient (Income Tax Ordinance Amendment 165). This follows a new trust tax regime introduced in 2006, whose aim is to impose Israeli tax each year on the worldwide income of trusts settled by Israeli resident settlors ("Israeli Residents' Trust"). Foreign source income will be exempt in the case of a qualifying trust formed by a non-Israeli resident settlor ("Foreign Resident Settlor Trust") or formed exclusively for the benefit of non-Israeli resident beneficiaries ("Foreign Resident Beneficiary Trust"). A trust formed under a person's will ("Testamentary Trust") will be taxed or exempt according to fairly similar rules. What happens to trusts formed before 2006? On June 23, 2008, the Israeli Tax Authority published an optional Israeli tax agreement arrangement (also referred to as "an arrangement") regarding certain pre-2006 trusts. Summary of the Optional Arrangement: The optional arrangement involves paying a low rate of Israeli tax soon, usually on "trust capital" with no foreign tax credit. Trust capital means the market value of non-Israeli trust assets on December 31, 2005 plus distributions in the years 2003-5. The tax rate is 6% or 10% if the settlor and beneficiaries are both Israelis. The rate is 4% in most other cases. In certain cases, the rise in value is taxed instead of "trust capital." In return, the trustees will receive greater certainty and a "step-up" of the cost of the trust assets for future Israeli tax purposes, when calculating capital gains and depreciation. Prior to 2006, irrevocable trusts with assets outside Israel were generally considered to be outside the Israeli tax net. This was based on Sections 82-84 of the Income Tax Ordinance. The optional arrangement is based on the premise that there may be doubt regarding the irrevocability of a trust. If a trustee doesn't agree, he doesn't have to opt for the arrangement and can pay capital gains tax at regular rates when trust assets are eventually sold (unless an exemption applies). Which trusts qualify? A trust which meets ALL the irrevocability criteria listed below will be regarded as a "Qualifying Trust" where some doubt exists about the revocability of the trust, but this doubt is low; therefore it may be included in the arrangement on offer. The irrevocability criteria are as follows: 1. None of the settlors, nor their spouses, are beneficiaries of the trust, directly or indirectly; 2. None of the beneficiaries, directly or indirectly, were children of the settlor aged under 20 any time in the 2003 tax year or if they were, they were married by the 2003 tax year; 3. The settlor and/or beneficiary cannot revoke the trust; 4. The settlor cannot take back an asset contributed to the trust. The terms "settlor" and "beneficiary" are as defined in the provisions of the trust regime. Procedure for electing the optional arrangement Applications for the above trust taxation arrangement should be submitted to the International Tax Section of the Technical Department, by October 31, 2008. Documents to be submitted with the application include: trust deed; letter of wishes, if any; correspondence between the settlor and the trustee; valuation of the assets included in trust capital; confirmation of the trustee regarding the trust classification and other facts; financial statements of the trust for the years 2003-2005, audited or reviewed by an accountant; report detailing the trust capital as defined in paragraph 1.4 herein; additional reports and documents upon request by the International Tax Division. Assets in Israel are not eligible and must be excluded in the calculation of trust capital. In the event that a trust is taxed and resident in another country under a tax treaty with Israel, the applicable tax rate in Israel will be checked on a case by case basis. For example, this is potentially relevant in reducing Israeli tax on US resident trusts to the extent non-Israeli source income is subject to US tax in the hands of the trust or its US resident beneficiaries. A simplified example: In 1980, Joe Cohen, an Israeli resident, contributed $10 million to an irrevocable trust with an offshore trustee for the benefit of his children after they reach age 21. The trust immediately used the money to buy a building in Manhattan. On December 31, 2005, the building is valued at $50 million. In such a case, it seems the trustee can choose between: 1) Paying now Israeli tax at a rate of 6% of the NIS equivalent of $50 million, with no foreign tax credit, by opting by October 31, 2008 to apply the terms of the Israeli Tax Authority's arrangement, plus regular Israeli taxes on all other trust income and capital gains, commencing 1.1.06; or 2) Paying Israeli tax upon a future sale at various rates ranging up to 47% (in 2008) of the resulting capital gain (currently $40 million), less a credit for US federal and state (not city) taxes. The calculation is done in shekels with adjustment for the high rates of inflation in Israel over the years. The tax under #1 above appears to be the shekel equivalent of $3 million (6% of $50 million). Due to complex Israeli tax rules, benefits for immigrants, Israeli hyperinflation until 1985, exchange rate movements and the need to calculate foreign taxes available for credit, it is not possible to do a back-of-the-envelop tax estimate of the tax due under #2 above. Detailed calculations are necessary. So is the optional arrangement worthwhile? A review of the rules suggests that in many cases, there may be better alternative choices. The optional arrangement has many pros and cons to consider with advisors in each country. The discussion below is not exhaustive. What are the pros? The pros include greater certainty and the possibility of paying less tax on pre-2006 capital gains that are realized by a trust after January 1, 2006. What are the cons? The valuation as of December 31, 2005 will not always be easy to prepare with precision - for example, real estate values have entered a period of uncertainty due to the sub-prime credit crunch. The arrangement process involves negotiation with the Israeli Tax Authority, so the outcome will not be known with certainty before the negotiations are concluded. Also, the due date for paying the optional tax will not be known when electing the arrangement. Bottom line: The optional arrangement offered to trusts by the Israeli Tax Authority may result in Israeli tax savings and less controversy in some cases. But it may not be at all appropriate in other cases, depending on the circumstances. And cases involving new or returning resident settlors or beneficiaries will require complex calculations as part of the decision process. As always, consult experienced advisors in each country at an early stage in specific cases. Leon Harris is an International Tax Partner at Ernst & Young Israel