Knesset passes law including reform to the taxation of trusts
05 August 2013
Posted by: Author: Meir Linzen and Guy Katz
Author: Meir Linzen and Guy Katz
On July 30, 2013, the Knesset (Israel's Parliament) enacted the proposed reform to the taxation of trusts in Israel, referred to as the Law for the Change of National Priorities (Legislation Amendments for Achieving the Budget Purposes for the Years 2013 and 2014) (the "Law").
The Law is effective as of August 1, 2013. However, the effective date with respect to the amendments to the chapter dealing with the taxation of trusts is January 1, 2014 except for changes regarding the reporting obligations of beneficiaries, which will become effective immediately.
There were no material changes in the final version of the Law, over and above the changes which were described in our circular dated 17th July, 2013. For your convenience, below is a summary of the central provisions of the Law in their final form, as they pertain to the taxation of trusts. Most of these provisions were already described in our prior circulars.
- Cancelation of the Foreign Settlor Trust Regime
The Law effectively cancels the Foreign Settlor Trust regime in Israel. Under current legislation, trusts that were settled by foreign residents were generally tax exempt in Israel, even after the settlor's death. Furthermore, distributions to Israeli resident beneficiaries were exempt from tax. According to the Law, such trusts will continue to be tax exempt in Israel only to the extent that all their beneficiaries are foreign residents (in which case they will be defined a Foreign Resident Trusts). In the event that a trust that was settled by a foreign resident has Israeli beneficiaries, such trust will become subject to tax in Israel.
For this purpose, the Law defines a new type of trust which is referred to as an "Israeli Beneficiary Trust". An Israeli Beneficiary Trust is a trust which: (i) was settled by a foreign resident who continued to be a foreign resident from the day on which the trust was established until the relevant tax year; and (ii) has at least one Israeli beneficiary. A trust will be classified as an Israeli Beneficiary Trust regardless of its revocability. In order to qualify as an Israeli Beneficiary Trust, the trust must comply with two additional conditions –
i. The Settlor and the beneficiaries should be relatives (this situation is referred to in the Law as a "Family Trust"). The settlor is considered as a relative of the beneficiary if the beneficiary is his spouse, parent, grandparent, child or grandchild. If the Settlor and the beneficiaries are relatives of a "second degree" (a broader definition which includes inter alia, siblings, siblings' children and the parents' siblings), then they will be considered as relatives for the purpose of this definition only to the extent that the assessing officer is convinced that the trust was settled in good faith and the beneficiary has not paid any consideration for his right in the trust assets.
A trust must report its qualification as a Family Trust to the ITA within 60 days of its formation or its attaining Family Trust Status (or in the case of existing trusts, 180 days from the day the Law becomes effective – namely January 28, 2014). This is a general reporting obligation and will not affect the trust's entitlement to such status.
ii. The Settlor is still alive. For this purpose, a settlor will be deemed alive as long as the settlor's spouse is alive, provided the couple was married at the time at least one transfer was made to the trust. If the Trust does not comply with the above conditions (i.e., the settlor and the beneficiaries are not relatives or the settlor has died), it will be considered as an Israeli Resident Trust and will be subject to tax on its world-wide income according to the identity of the beneficiaries.
If the trust complies with the above conditions, it will be subject to tax as follows -
a) A distribution to the beneficiaries will be taxed at a rate of 30%. If the trustee proves that it distributes assets that were settled into the trust by the settlor (distribution of the principal as opposed to distribution of income), such a distribution will not be subject to tax. For this purpose, the income of the trust will be considered to be distributed before the principal of the trust, and whenever a distribution is made to more than one beneficiary, the principal distribution to the Israeli beneficiary will be equal to his share in the distribution; or
b) Instead of being taxed on distributions, the trustee can elect, subject to certain specific conditions, for the trust income which is allocated to the Israeli beneficiary to be subject to tax at a lower rate of 25% in the year it has accrued. If such an election is made, the distributions will be tax exempt. Such an election is irrevocable.
2. New Immigrant Trusts
According to the Law, a trust which was settled by a New Immigrant will be entitled to the benefits of New Immigrants (i.e. 10 year exemption on foreign source income), only to the extent that all the beneficiaries of the trust are New Immigrants.
The Law does include a transition clause, in this regard, which provides that the taxation of New Immigrant Trusts will only apply with respect to trusts that were settled by new immigrants who arrive in Israel after the date on which the Law becomes effective, and as long as such new immigrants are alive.
In addition, there are a number of important clarifications that were included in the final version of the law, as follows:
i. A New Immigrant Trust will also be entitled to the benefits provided to New Immigrants if some of the beneficiaries are foreign residents or New Immigrants.
ii. The ITA will have the authority to enact regulations, subject to the confirmation of the Finance Committee, which will enable the allocation of the income of the trust to New Immigrant beneficiaries.
iii. To the extent that the New Immigrant benefits do apply as described above, they will continue even if the trust is set up after the settlor immigrates to Israel.
3. Foreign Settlors of Trusts with New Immigrant Beneficiaries
Similarly, if a trust was settled by foreign residents and the trust has an Israeli beneficiary, such that it is an Israeli Beneficiary Trust, the portion of the trust income attributable to New Immigrant beneficiaries will be entitled to receive the New Immigrant Benefits.
4. Charitable Trusts
The Law provides that trusts settled by foreign residents in which the only Israeli beneficiaries are "public institutions" will maintain the status of Foreign Resident Trusts.
The Law further clarifies that such "public institutions" will not be considered beneficiaries for the purposes of qualifying as an Israeli Beneficiary Trust.
The effect of this revision is that a trust settled by a foreign resident (including a deceased foreign resident) will not be subject to tax in Israel simply due to the existence of charitable organizations which receive grants or distributions. The definition of a "public institution" for this purpose will automatically include organizations to which a tax free gift can be made in Israel (the government, municipal authorities, KKL, Keren HaYesod – Joint Jewish Appeal for Israel and bodies that are tax exempt in Israel under section 9(2) of the Income Tax Ordinance [New Version] 1961) and other similar bodies that are tax exempt in Israel, under applicable law. In addition, the Law states that the Director General of the ITA, with the approval of the Finance Committee, is authorized to expand the list of "public institutions" specifically for this purpose.
5. Underlying companies (Trust Holding Companies)
Under the current legislation, an "underlying company” is a company (regardless of its residency), which holds trust assets on behalf of the trustee. Under Israeli law, such a company is "disregarded”. Consequently, its assets are considered as the trustee’s assets and its income is considered as the trustee’s income. An underlying company is not required to submit annual tax returns and to open a tax file with the ITA. The conditions for a company to be considered as an "underlying company” are not entirely clear under the current law.
The Law proposes a new and detailed definition of an "underlying company". According to this definition, in order for a company to be classified as an "underlying company” it must hold trust assets for the trustee, and in addition the following conditions must be met: (i) the company has been established for the sole purpose of holding the trust assets, (ii) in the case of an Israeli Resident Trust and Israeli Beneficiary Trust, and Israeli Testamentary Trust and a trust that holds assets in Israel, the trust has notified the tax authorities on the status of the company as an "underlying company” within 90 days of the incorporation date (or together with the first annual tax return submitted following the passing of the Law); and (iii) the trustee directly or through a single subsidiary (only one additional corporate tier is allowed) holds 100% of the company's shares;
6. Beneficiaries Reporting Obligations
Under current legislation, an Israeli beneficiary who receives a distribution of cash from a trust is not required to report this distribution to the ITA. Only a beneficiary who receives a distribution in kind (i.e. an asset which is not cash) is required to report the distribution. Under the Law, an Israeli beneficiary who receives any distribution (i.e. in kind or cash) will be required to submit a tax return in Israel on its world-wide income. The Law does not clarify that this reporting obligation will not apply to New Immigrants. However, the ITA has promised to clarify this issue in a circular.
This provision will become effective immediately.
7. Taxation of an Israeli Resident Trust after the death of the settlor
In the same way in which the Law determines that after the death of the settlor of an Israeli Beneficiary Trust the trust will be subject to tax according to the residency of the beneficiaries, the Law determines that when the settlor of an Israeli Resident Trust dies, the trust will be subject to tax according to the identity of the beneficiaries as a Testamentary Trust. For this purpose, even if the trust has only one Israeli beneficiary, the entire trust will be considered as an Israeli Resident Trust.
8. Open Issues
There are three important matters that were not dealt with in the Law itself and which the ITA has indicated will be addressed separately in the near future. The three issues are as follows:
i. Dual Residency and Double Taxation. In scenarios where the Law now taxes a trust on a residency basis, while such trust is a resident of a different jurisdiction, a double taxation exposure could arise. For example, an Israeli Beneficiary Trust with a US settlor and mostly US beneficiaries will be subject to tax in Israel on all its worldwide income, following the death of the settlor. This trust however is also taxed as a resident in the US. The Law does not provide a solution to this problem. The Double Tax Treaty between the US and Israel also does not settle the tax residency of the trust, but instead requires the "competent authorities" of the US and Israel to settle the issue on a case by case basis. The ITA has stated that it will form a committee together with the Israeli Bar Association to address this matter.
ii. Hybrid Trusts. In the case of a trust involving both Israeli and non-Israeli beneficiaries (so-called "hybrid trusts"), the Law does not provide any guidance as to how such income will be allocated between the various beneficiaries. This could be relevant in a variety of scenarios under the new Law. For example in the event that income allocable to a new immigrant beneficiary is entitled to the benefits, while the rest of the income is not. The ITA has indicated that separate regulations will be issued providing guidelines for the allocation of income in hybrid trusts.
iii. Step Up Basis in Appreciated Assets. The Law does not provide any step up basis to the value of a trust's assets as of the Effective Date. This would potentially mean that a trust which has suddenly become subject to Israeli taxation under the Law and which sells foreign assets following the Effective Date would be subject to tax on the entire historic appreciation of such assets since the time they were purchased. The ITA has indicated that it will publish proposed settlement arrangements to mitigate this problem. The provisions of such settlement arrangements are not yet clear. However, it is expected that a trust will be able to pay a tax on part of the current value of the assets and receive a step-up in the basis of its assets.