Recent conversations suggest there are many misconceptions about trusts and the new Israeli tax rules for them.
What is a trust? A trust is an arrangement in which a settlor (or grantor - e.g. Dad) 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). This may be to prevent the family fortune being wasted or for many other reasons. Israel
has a 1979 Trust Law that broadly follows the common law (Anglo Saxon) model.
The Israeli Tax Authority thinks tax planning is a common reason for the use of trusts, since the repeal of exchange control in 1998. So commencing in 2006, a new Israeli tax regime will apply to both common-law trusts and European civil law foundations, among others.
The aim of the new regime is to prevent tax avoidance by Israeli resident settlors of an Israeli Residents' Trust by attributing annual worldwide trust income and gains to the settlor or the beneficiaries and requiring the trustee to report and pay the Israeli tax on their behalf. This will apply irrespective of where the trustee is located. It remains to be seen whether foreign trustees will fall in line with these new Israeli requirements. One Swiss trustee told me he isn't even allowed under Swiss law to say whether he has any Israeli clients.
In the case of a Foreign Resident Settlor Trust formed entirely by non-resident settlors (or with non resident settlors and beneficiaries in the tax year concerned), an exemption may apply to trust income and gains. Originally this exemption was meant to encourage flows of capital from families abroad to relatives in Israel. However, the exemption is conditional on the Israeli resident beneficiaries having no ability to control or influence the conduct of the trust. In practice, this may be difficult to prove, and various other conditions must also be met.
A separate exemption may also apply to income and gains of a Foreign Resident Beneficiary Trust formed by an Israeli settlor exclusively for foreign resident beneficiaries, provided various conditions are met and compliance declarations are filed annually with the Israeli Tax Authority.
In the case of a Testamentary Trust formed under the will of a person who was Israeli resident upon his death, the Israeli tax outcome will depend on the tax status of each beneficiary.
Detailed rules govern migrations, the contribution of assets to each type of trust, and the distribution of income and assets from them. In addition, reporting and enforcement provisions are prescribed regarding trustees, settlors and beneficiaries, irrespective of their location as well.
In particular, unpaid final (non-appealable) tax debts may be collected from the settlor(s) and/or from the beneficiaries up to the amounts distributed to them (100% taxationâ€¦.). However, it appears tax debts may not be collected from the settlors of irrevocable pre-August 10, 2005 trusts. Other detailed rules exist, and transitional reporting requirements apply in 2005 and 2007.
What does it all mean? At this stage, it appears that Israeli trust taxation has moved into the 21st century and many perceived loopholes have been plugged. Multinational families may face broad tax and disclosure requirements covering the whole family, and double-tax relief regulations have yet to be promulgated.
What tips can we offer? Israeli beneficiaries of a Foreign Resident Settlor Trust may be exempt if they can show they exert no control or influence over the conduct of the trust. Trusts settled by Israeli residents will generally be taxable unless all beneficiaries are foreign residents and annual declarations to this effect are filed.
All trust arrangements potentially involving Israeli residents must be carefully reviewed without delay. Planning opportunities may exist in a number of cases.
The writer is an international tax partner at Ernst & Young Israel