Your Taxes: Relatives’ trusts and their limits

money (photo credit: REUTERS)
(photo credit: REUTERS)
Legend has it that the first trusts were administered by priests 1,000 years ago for English and French nobles who took part in the crusades in these parts.
A trust is basically an arrangement in which a settlor (or grantor) transfers assets to a trustee to administer, often for many years, for the benefit of other people – the beneficiaries.
In 2006, Israel introduced a new tax regime for trusts. Most trusts settled by Israeli residents became taxable on their worldwide income, while most trusts settled by a foreign resident were exempt from Israeli tax on foreign income.
This left a big loophole that attracted widespread publicity in one particular case. An Israeli resident allegedly handed his fortune to the unrelated officers of an offshore trust company to contribute to a foundation for the benefit of the Israeli resident and his family. The foundation was established in a country (not the US) that makes it taxable like a trust according to Israeli tax law.

Trusts and foundations with foreign settlor 2014 onward
: To plug the loophole, the Knesset passed a law, commencing January 1, 2014, which introduced the Foreign Residents’ Trust (FRT) for trusts with a foreign resident settlor.
However, if there was ever an Israeli resident beneficiary, the trust will not be an FRT. Instead, a trust with even one Israeli resident beneficiary will be deemed to an Israeli Resident Beneficiary Trust.
This subdivides into either: (1) A taxable Relatives’ Trust if the settlor or the settlor’s spouse are still alive and related to the beneficiary; tax rates of 25 percent to 30% are specified (see below); or (2) A fully taxable Israeli Residents’ Trust (IRT) if the settlor and the settlor’s spouse are deceased and/or are unrelated to the beneficiary; tax rates typically range from 25%-50%.

Who is a relative?
In a Relatives Trust, the settlor(s) or their spouse are alive and are related to all the Israeli resident beneficiaries in one of the following ways: • First-degree relatives: parent, grandparent, spouse, child or grandchild; OR • Second-degree relative of beneficiary (sibling, spouse’s children, spouse of each of the aforementioned, child of sibling, parent’s sibling); AND the assessing officer is satisfied that the formation of the trust and contributions to it were in good faith; AND the beneficiary did not give consideration for his or her “right” to trust assets.

Relatives’ trust taxation:
In general, a Relatives’ Trust must be notified by the trustee to the Israel Tax Authority within 60 days after it was formed or became such a trust on Tax Forms 147 and 154. A pre-2014 Relatives’ Trust should have been notified to the ITA by December 31, 2015.
The taxpayer is the trustee, regardless of foreign law, unless the settlor or beneficiaries agree to report instead to the ITA. Beneficiaries must still report distributions received from a trust since August 1, 2013.
Form 154 requires an irrevocable choice to be made between: (1) The distributions track: Israeli tax of 30% on foreign- source income and gains only if it is distributed; or (2) The allocated income track: Israeli tax of 25% on income derived abroad and attributed to Israeli resident beneficiary in the year the trust first derives the income.
If no choice is made, the distributions track will apply.
Israeli source income, if any, is taxed at regular Israeli rates.
What is not a Relatives’ Trust? The ITA has published two rulings in anonymous redacted form, dated November 26, 2014. In the first ruling, the settlor was a foreign resident and the brother of a second wife of an Israeli resident.
Children of the first wife were among the beneficiaries. The ruling stated the trust was not a Relatives’ Trust because the beneficiaries (children of the first wife) were unrelated to the settlor (their “step-uncle”).
In the second ruling, the settlor was a foreign resident and the brother-in-law of the settlor. Again this meant the beneficiaries were not closely enough related to the settlor, so the trust was not a Relatives’ Trust; it was a fully taxable Israeli Residents’ Trust.

These rulings seem harsh. The ITA accepts these trusts were made in good faith, but nevertheless it applies the strict letter of the law to impose full tax on trusts set up by settlors that are related to the beneficiaries but not closely enough. Is this what the Knesset really intended? Even the crusaders’ trusts would fail the Relatives’ Trust rules.
Note that these rulings relate to the tax law post-2013. In prior years up to and including 2013, no Israeli tax would generally apply to foreign income of such trusts, unless the beneficiaries were able to exercise control or influence over the trust.
What about olim? An ITA circular, dated March 10, 2015, distinguishes between two main situations: First, in the case of an Israeli Residents Trust formed before August 1, 2013, by a nonresident settlor or a settlor in his tax holiday, there is no Israeli tax or tax reporting so long as the settlor is alive and in his tax holiday.
Second, for other Israeli Residents’ Trusts, there is no Israeli tax or tax reporting so long as the settlor and all the beneficiaries are in their tax holiday or are foreign residents.
Beneficiaries of an Israeli Residents’ Trust or a Relatives’ Trust need not report distributions or allocations of overseas income so long as they are in their tax holiday or are foreign residents or Israeli charities.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
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Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.