This article is intended to update you on some draft regulations recently circulated by the Israel Tax Authority (ITA) for comment. A trust is an arrangement in which a settlor (grantor) transfers assets to a trustee to hold and invest for the ultimate benefit of beneficiaries (e.g. wife, children, grandchildren). On January 1, 2006, Israel introduced a new tax regime for trusts. However, reporting under the new regime has been postponed until September 30, 2007. One of the issues that the ITA is trying to fix by then is the long international reach of a so called "Israeli Residents' Trust" (IRT) and certain testamentary trusts. In general, the annual income and gains of an IRT are taxed in Israel at rates of 20%-48%. The trustee is held responsible for reporting and paying the tax to the ITA, without regard to foreign law. An IRT has a long definition that covers trusts in any country, even if the trust is irrevocable and discretionary. The definition includes, among others, trusts with: * An Israeli resident settlor and an Israeli resident beneficiary upon formation, unless all left Israel before the tax year concerned. * A settlor who moved to Israel after settling the trust, but some or all beneficiaries live abroad. * A trust settled by an Israeli resident with some beneficiaries residing in Israel and others abroad. Also, a testamentary trust (made via a will) of an Israeli resident testator will be taxed like an IRT if any beneficiary is an Israeli resident. These rules will often bring trusts of multinational families fully into the Israeli tax net, so the proposed new regulations aim to provide an exemption for foreign source income distributed by an "irrevocable privileged trust" to foreign beneficiaries if various conditions are met (see below). Income retained by the trust will not qualify. First, according to the proposals, the trust must be an irrevocable trust, as defined in detail. Second, an income test is proposed: the exempt amount must not exceed income derived by the trust in the same and three preceding tax years. Third, a distributable income test is proposed: the exempt amount must not exceed the lesser of (1) the amount distributed by the trust in the year concerned (2) total income minus total distributions of the trust since its formation until the end of the previous year. This will be extremely difficult to calculate if no old records remain of a trust formed decades ago. Fourth, the trustee must elect to apply these proposed regulations when filing the annual tax return of the trust. Fifth, the sting: When the first time the above election is filed, the trust assets must be revalued at market value as of the end of the previous tax year and the resulting paper gain ("step up") will be subject to capital gains tax at rates of 20%-48%, according to the proposals. This could be a disaster for an older trust with large paper gains. However, an exception may apply to a settlor of a former Foreign Resident Settlor Trust if the settlor migrated to Israel. Sixth - another sting: Any assets subsequently contributed to the trust will immediately be taxable as if the settlor had gifted the asset directly to the foreign beneficiary, at rates of 20%-48%. Seventh: The proposed regulations specify in detail who is considered a foreign beneficiary -basically not people who migrate out of Israel. Nevertheless, in the case of an IRT, "foreign beneficiaries" would include persons who have migrated to Israel, if all the Israeli resident settlors are deceased. In the case of a testamentary trust, a "foreign beneficiary" is any individual who is a non-Israeli resident in the tax year concerned. The proposed start date for these regulations is January 1, 2006, and they will apply to trust income "accrued or derived" on or after that date. Unfortunately, it is unclear whether capital gains and paper gains realized after that date will be taxable in full or whether any transitional relief will apply. Comments: The above is only a summary and the proposed regulations do not go far enough for trusts associated with multinational families. The proposed regulations suffer from: complexity, applying only to distributed income; requiring data about all past distributions; taxing paper capital gains; uncertainty about pre-2006 capital gains; and uncertainty whether foreign trustees will comply with Israeli tax law. In practice, trustees and families will probably consider other action - the sooner the better. As always, consult experienced professional advisers in each country. firstname.lastname@example.org The writer is an International Tax Partner at Ernst & Young Israel.