Shekel money bills.
(photo credit: REUTERS)
They say you should never ask a kit-bag question, which is a question you may not like the answer to.
It seems that is what happened when someone asked the Israel Tax Authority (ITA) a question about a Liechtenstein establishment and got an unfortunate tax ruling in response.
The father of a family set up an establishment in Liechtenstein in the 1960s, anonymously using a local representative in Vaduz, Liechtenstein. An establishment is a passive investment entity formed under special rules in Liechtenstein.
The father and one son migrated to Israel in the 1970s, leaving two other children living abroad.
By 1980, the three children were each beneficially entitled to a one-third interest in the establishment.
The establishment held a 40-percent interest in a US corporation with real-estate investments in Israel.
The US corporation paid Israeli taxes on income from the Israeli real estate and then distributed the income up to the Liechtenstein establishment, which distributed the income to the three beneficiaries.
For US tax purposes, the establishment was treated as a flowthrough; i.e., the establishment was ignored and its beneficiaries were taxed instead in the US.
Therefore, the distribution to the Israeli resident son qualified in the US for a 25% dividend-withholding tax rate under the US-Israel tax treaty, instead of 30% withholding tax under domestic US tax law.
The question put to the ITA was whether the Liechtenstein establishment was a flow-through for Israeli tax purposes as well, making the US dividend-withholding tax creditable against the Israeli resident son’s tax liability of 25%-30% in Israel.
If so, the son need apparently only pay 0%-5% Israeli tax after crediting the US tax.What the ruling concluded:
The Israeli tax ruling said yes, the Israeli resident son could indeed treat the Liechtenstein establishment as a flow-through for Israeli tax purposes and claim a foreign tax credit for the US dividend-withholding tax.
But there was a sting in the tail. The ruling pointed out that the Liechtenstein establishment was fully taxable like a trust in Israel.
This is because a Liechtenstein establishment is expressly taxed like a trust according to the Israeli tax law as it was settled by the father, an Israeli resident of many years’ standing, up to his death in 2005.
Therefore, the structure landed the two children living abroad in the soup. They also had to pay 25%-30% Israeli tax on the dividends, and as non-Israeli residents it seems they would not be entitled to any foreign tax credit! The ruling goes on to say that the parties involved were not absolved from any responsibility for their alleged “failures” in the matter by requesting the ruling.What should they have done?
A number of possibilities should be checked out in similar cases. For example, could the establishment file Israeli tax returns and claim a full foreign tax credit.
Perhaps the establishment should have been dissolved before the Israeli tax law changed in 2006.
Or perhaps the establishment should have been split in two before 2006, one for the Israeli resident son and one for his overseas siblings. The availability of tax-treaty relief should also be checked.
Others in a similar position should take proper advice soon, if they didn’t already.Recent developments:
The establishment in this case is fully taxable in Israel, like a trust, because the settlor/founder/grantor was an Israeli resident.
Commencing in 2014, trusts and establishments are also fully taxable in Israel if any beneficiary is an Israeli resident.
In each case, the share of income and gains of Israeli and foreign beneficiaries is swept into the Israeli tax net, with minor exceptions. Is this within Israeli jurisdiction? Guidance has been promised by the ITA since the middle of 2013, but it is still awaited.Concluding comments:
If trustees and fiduciaries are expected to comply with the Israeli tax law, they should at least know what it says and what double-tax relief exists, without being penalized for asking a kit-bag question.
The ITA may collect more tax by issuing guidance in this complex area.As always, consult experienced tax advisers in each country at an early stage in specific firstname.lastname@example.org Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.