What's happening to trusts? Not a whole lot. Every now and then the Israeli Tax Authority (ITA) realizes it is difficult to defy gravity. A few years back the ITA failed to tax venture capital funds differently from the rest of the world - now, the same seems to be happening with trusts. What is a trust? A trust is an arrangement in which a settlor (or grantor - e.g. father) 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). Trusts date back around 1,000 years. They were originally intended to enable wealthy crusaders to deposit title to land and other assets temporarily with a priest until they returned from battle in the Land of Israel! Trusts are a big source of currency for Israel. It is estimated that family transfers of foreign currency into Israel exceed $2 billion per year, much of this via foreign family trusts. In 2003, the main Israeli tax reform became effective - it imposed worldwide taxation on Israeli residents but not always on their trusts. So a new tax regime was enacted into the Income Tax Ordinance with effect from January 1, 2006. However, we only have the bare bones and still await more detailed regulations, guidance and forms regarding trust taxation. These items have been reportedly promised many times - to the Knesset Finance Committee, the Supreme Court and at public seminars. Now, the Israeli Tax Authority has just announced that the due date for filing announcements, declarations, returns and regulations under the new regime has been postponed to September 30, 2007. This is because the Tax Authority is considering amendments to the primary legislation, promulgation of regulations and the design of forms concerning the obligation and mode of reporting trusts and other material issues. However, this will not lead to a delay or waiver of any other return required under any law. Other income is reportable on the due date prescribed by law. Reports required under the new trust regime will be completed after publication of the relevant forms according to an announcement that will be made in this regard. For further details of this admission that all is not right, please see the announcement of February 22, 2007, on the Tax Authority's own Web site: www.mof.gov.il/taxes. Let's first briefly recap the main types of trust specified in the new Israeli tax regime: * Israeli Residents' Trust - Had an Israeli resident settlor and an Israeli resident beneficiary upon formation, and still has an Israeli resident settlor or beneficiary in the tax year concerned. Also includes other trusts not falling into one of the categories below. Commencing in 2006, this type of trust is taxable in Israel at 20%-48% on its entire worldwide income, even if the trust is irrevocable and discretionary, even if some of the beneficiaries reside outside Israel. * Foreign Resident Settlor Trust - Formed entirely by non-resident settlers, or had non-resident settlors and beneficiaries in the tax year concerned. Israeli source income may be taxed and foreign source income is exempt from tax and tax reporting in Israel if certain conditions are met. In particular beneficiaries should not have control or influence over the conduct of the trust. * Foreign Resident Beneficiary Trust - Formed by an Israeli settlor exclusively for foreign resident beneficiaries. Israeli source income may be taxed and foreign source income is exempt from tax and tax reporting in Israel if certain conditions are met. * Testamentary Trust - Created by one or more persons who were Israeli resident upon their death. If any beneficiary is Israeli resident, the Testamentary Trust will be taxable, otherwise, Israeli source income may be taxed and foreign source income is exempt from tax in Israel if certain conditions are met. The new Israeli trust tax regime presents a number of challenges to both the Tax Authority and the parties to many trusts around the world. Here is a sample of the issues: Even foreign trustees are liable. The new law places the primary tax reporting and payment duty on the trustee "even if the trustee is a foreign resident or if the trust is governed by the rules of foreign law (ITO Section 75F(f))." And "the provisions of every law regarding the payment of tax, reporting, collection and punishment will apply to the trusteeâ€¦" (ITO Section 75O(a)). These provisions have stirred intense controversy. Serious doubts have been aired about the ability of Israel to impose its jurisdiction over foreign trustees. Other western countries tax trust income but NOT foreign trustees. Instead those countries generally tax the settlor or the beneficiary and add an interest charge or surtax if the beneficiaries do not receive anything for a few years. Furthermore, some foreign trustees are apparently forbidden from cooperating with the Israeli requirements relating to trust. For example, Article 9 of Trusts (Jersey) Law 1984 was amended in 2006 to clarify that: "No foreign judgement with respect to a trust shall be enforceable to the extent that it is inconsistent with this Article irrespective of any applicable law relating to conflicts of law." Article 271 of the Swiss Criminal Code is even more emphatic: "Any person who, without authorization, has conducted on Swiss territory for a foreign State acts that are a matter for public authorities, any person who has conducted such acts for a foreign party or another foreign organization, anyone who has furthered such acts, will be punished by imprisonment and, in serious cases, by reclusion." In other words, a Swiss trustee risks solitary confinement in Switzerland if he reports to the Israeli Tax Authority! Why? Apparently this provision was originally enacted to prevent Swiss trustees assisting the Nazi German government. Many other onshore and offshore locations have similar confidentiality provisions for their bankers and other professionals that may only be lifted in serious criminal cases - for example narcotic or terrorism-related money laundering cases. The Swiss Federal Department of Finance states on its Web site that Switzerland has "declared its willingness to providing administrative assistance to other countries in cases of tax fraud (but not simple tax evasion)." So it seems Israel will have to consider taxing only the trust settlors and beneficiaries, not trustees located abroad. Double Taxation issues: The tax law allows Israeli residents a credit for foreign taxation on income and capital gains. It is not clear how this will work in the trust context. The Minister of Finance is empowered to issue regulations in this regard, subject to the approval of the Knesset Finance Committee. These regulations have been promised many times and are eagerly awaited. Will it be possible to credit all foreign taxes imposed on settlors, beneficiaries, trusts and trustees? What about foreign taxes on gifts, estates and inheritances? Multinational families: Many Israeli families have relatives living abroad and have established a trust to help preserve family wealth for the long-term. However, the definition of an Israeli Residents Trust means that almost any trust with an Israeli resident settlor and foreign beneficiaries will be taxed in Israel on all its worldwide income and gains. This includes trusts settled by immigrants to Israel after the expiry of their 5-10 year exemptions for income and gains from pre-arrival assets. For example, Joe Cohen immigrated from New York to Israel in 1995. Before he immigrated, he established a trust administered by a Delaware trustee for the benefit of himself and his 10 children who all still live in the US. That trust is fully taxable in Israel. It is unclear whether Israel will credit US taxes on income, capital, gifts and estates (and vice versa whether the US will credit Israeli taxes). This situation was entirely foreseeable and needs to be resolved rapidly. One way may be to tax the Israeli settlor (if still alive) or Israeli resident beneficiaries upon receipt. It seems difficult to tax beneficiaries before receipt - distributions may be at the discretion of the trustee - based on need - and beneficiaries may as yet be unborn. Resettlements: Take the situation of a trust established by a family outside Israel with wealth generated outside Israel. A foreign estate/inheritance tax advantage may be possible if the trust assets are distributed - before they appreciate significantly - to a younger Israeli relative who immediately re-settles the assets in a new trust for the benefit of his wife and kids and the family abroad. Such a trust may be classified as both an Israeli Residents' Trust and a Foreign Resident Settlor Trust under the present trust regime in Israel. So the trust income may be both taxable and exempt in Israel. This uncertainty needs to be resolved as it has arisen in many cases. Records: The new trust regime provides no guidance regarding the keeping of books and records by foreign trustees. Perhaps they should be sufficient to meet the needs of the forms that still have not been published. Transitional provisions: The new trust regime takes affect for trust income "accrued or derived" on or after January 1, 2006. It is unclear how to tax capital gains that may have accumulated over many years. Pro rata split? Revaluation ("step-up") as of the end of 2005? To sum up, the Israeli Tax Authority has a lot to think about. In the longer term, there may be problems for Israeli settlors or beneficiaries with unexplained wealth. Since some types of trust are more benign than others, interested readers are advised to consult experienced professional advisers on a regular basis. Leon.firstname.lastname@example.org The writer is an International Tax Partner at Ernst & Young. The views expressed herein are his own.