For the first time, U.S. (and other) foreign trusts with Israeli beneficiaries will be liable for a substantial income tax. Trust settlors face an array of decisions, some with deadlines as early as year-end.
Until 2014, Israel generally exempted from its income tax any trust that had been created by a foreign person, even if there were Israeli resident beneficiaries and, similarly, didn’t seek to tax such Israeli resident beneficiaries on any distributions. But, under a new tax law that took effect on Jan. 1, 2014, many of these previously tax-exempt trusts and/or their Israeli resident beneficiaries have become subject to significant Israeli income-tax liabilities and reporting obligations. U.S. clients who’ve established trusts for Israeli-resident descendants need to be aware of these new reporting requirements and tax liabilities.
Because the law imposes imminent reporting deadlines, it’s essential for all trustees and trusts subject to its provisions to develop an appropriate plan of action in the coming weeks. Unfortunately, the Israel Tax Authority (ITA) is issuing needed guidance on the law slowly, and sometimes informally, which means that advisors must cope with considerable uncertainty in trying to give timely advice. A case study prepared by Bernstein Global Wealth Management, gives some guidance on obtaining a favorable tax result within the confines of the new law, as currently understood.
Relatives vs. Non-Relatives Trusts
According to the new law, an Israeli beneficiary trust is a trust under which all settlors are foreign residents and there’s at least one Israeli resident beneficiary. An Israeli beneficiary trust can be either a:
- Relatives trust, which refers to a trust under which the settlor is still alive and is closely related to the beneficiary as detailed in the law; or
- Non-Relatives trust.
The new law subjects the portion of a non-relatives trust allocable to Israeli beneficiaries to income tax in Israel on all of its worldwide income, at the regular rates of 25 percent to 52 percent. The law doesn’t clarify how to determine the taxable portion.
A relatives trust is treated differently. So long as the trustee notifies the Israeli tax assessor of the trust’s existence by Dec. 31, 2014 (or within 60 days of creation), the trustee may make an irrevocable election between the following two tax regimes:
- Annual tax regime: An annual 25 percent tax is imposed at the trust level on the portion of the income allocated to Israeli beneficiaries. Subsequent distributions aren’t taxed. This is the default regime if no election is made by year-end 2014.
- Deferred tax regime: There’s no yearly tax at the trust level, but the Israeli resident beneficiary is subject to a 30 percent tax upon distribution of trust income. There’s a presumption that income is distributed before principal.
Note that a relatives trust ceases to be designated as such upon the settlor’s death. The trustee, though, has the option of maintaining the relatives trust status—and thus preserving the option of the deferred tax regime— until the death of a surviving spouse, provided that such spouse was married to the settlor at the time that the settlor made any contribution to the trust.
Arrangements with the ITA
In conjunction with the new law, the ITA is offering to negotiate and settle the tax liabilities of trusts. The ITA is offering two inducements to promote the voluntary negotiations:
- Attaining certainty and closure on the possibility of past tax liabilities, because the ITA now asserts that many trusts previously believed by taxpayers to be exempt from Israeli tax under the pre-2014 law actually should have been taxable, and
- Awarding the trust in certain circumstances, and at the discretion of the ITA, a step-up in the cost basis of trust assets to their fair market value at the time the trust became subject to Israeli taxation. The law as written doesn’t provide any step-up, and such a step-up is valuable to reduce future taxable gains when trust assets are sold.
Trustees can choose from two types of settlement routes:
- Income: This is most relevant for trusts that may not be fully compliant with tax law prior to 2014. The trust chooses to pay a portion (one-third to two thirds) of the regular tax liability, depending on the extent to which Israeli beneficiaries influenced the trust, at the passive income rate (generally 25 percent) on 2006–2013 trust income. There’s no step-up in cost basis of trust assets in most cases.
- Asset: The trust chooses to pay a tax based on trust asset value as of Dec. 31, 2013, which includes any distributions to Israeli resident beneficiaries during 2006–2013, at a rate of 3 percent to 6 percent (again, depending on the degree of beneficiary influence). This route is available only when the yield on the trust’s assets isn’t high (as determined by the ITA).
To qualify for a settlement, the Israeli beneficiary must not have transferred any asset to the trust, the settlor can’t be a beneficiary and the trust assets can’t be derived from taxable income in Israel on which taxes weren’t paid. The ITA officer has considerable discretion in making any settlement.
Credit for U.S. Taxes
Recently, the ITA has indicated verbally that any U.S. tax paid on trust income will be applied as a tax credit against Israeli tax, regardless of whether the U.S. tax was paid by the settlor, the trust or the beneficiary. The availability of this tax credit is particularly important for U.S. grantor trusts, in which the grantor pays the trust’s U.S. income tax. Matching U.S. tax payments to trust income for purposes of the Israeli credit will be easier under the annual regime than under the deferred regime because both countries will be imposing their tax on a current basis in the same year.
The authors wish to thank Gidon Broide, Partner, at Broide & Co., an Israeli accounting firm, for his invaluable insights and comments.