Tax Alert No. 24 - 29.9.2016

On April 7, 2016, an amendment to the Income Tax Ordinance (“ITO”) (hereinafter: “the Amendment“) was published, dealing with expanding the population who has to submit annual tax returns in Israel. The provisions of the Amendment will apply to an annual tax return that must be submitted for the 2016 tax year and onward. Following the Amendment, the list of those required to submit annual tax return has been expanded, as follows:

1. An Israeli resident beneficiary (aged 25 or older) in a trust whose assets are worth not less than NIS 500,000 at the end of the tax year, unless he did not know that he is a beneficiary.

2. An individual to whom the numerical presumption in the definition of an “Israeli resident” in Section 1 of the ITO applies (staying in Israel for 183 days or more, or 425 days or more for a three-year calculation), and who argues that he is not an Israeli resident in the tax year. In the tax return, the individual will state the relevant facts and will attach supporting documentation.

3. An Israeli resident individual who transferred over the period of 12 months NIS 500,000 or more outside of Israel. The duty of an individual to submit an annual tax return as set forth is for the tax year in which the money was transferred and for the following tax year (if a sum has been transferred as set forth within 12 months in two parts, in two consecutive tax years, it would seem that the liability to submit a statement applies to the second and third year). We wish to draw your attention to a number of important points that arise from the said Amendment: firstly, in our opinion, the provisions of the new Amendment do not change the prevailing legal situation, inasmuch as every Israeli resident who is 18 years old or older must submit an annual tax return according to the provisions of the primary legislation of the ITO in any case. The regulations pursuant to the primary legislation that provide an exemption from reporting (“the Exemption Regulations“) are those that actually prescribe the reporting duties in Israel, pursuant to which, for example, employees up to a certain income limit do not have to submit annual tax return in Israel. Thus, as long as the exemption regulations are not modified or adjusted, the new Amendment may not have a valid effectiveness. A number of emphases follow:

   1. An Israeli resident individual (above the age of 18) who has transferred NIS 500 thousand abroad must submit a tax return. In the context of these circumstances, there is an interesting question concerning a person who is a new immigrant or a long-term returning resident (a qualified individual). Because those individuals are exempt from reporting their foreign assets and incomes in Israel, the requirement to submit an annual tax return from them is pointless, as foreign assets and the income thereof will not be reported (as the purpose of the demand for “ordinary” Israeli residents is to tighten the control of their investments abroad and to make sure that they will report their incomes). Moreover, such an amendment will encourage the population of qualified individuals not to import their private capital and money into Israel but to leave it abroad. By the way, for the exact same reason, the ITA itself explained in a professional circular that it published concerning new immigrants that the fact that a qualified individual is a controlling shareholder of a foreign company will not require him to submit an annual tax return despite the qualification prescribed in the Exemption Regulations.

   2. An Israeli resident beneficiary, who knows that he is a beneficiary in the trust, must submit an annual tax return, according to the Amendment. In this context too, an exclusion should be published concerning a qualified individual who is a beneficiary in a trust whose assets are all abroad.

   3. Concerning a person claiming to be a foreign resident and who spends more than 183 days in Israel, we should emphasize that this is also the population of individuals relocating in the second half of the year and claiming that they have severed their residency from the time of their departure abroad.

   In conclusion, the aim of the ITA is to identify individuals who have potential tax liability and the corresponding expansion of the reporting duty is a justified mean. However, the ultimate fulfillment of this goal will be by an amendment and adjustment of the Exemption Regulations (and for the sake of argument, it would be enough to amend those Exemption Regulations only, without any need for primary legislation amendment).

On August 21, 2014, a new tax treaty was signed with Germany, replacing the previous tax treaty that was signed in the 1960s. On May 8, 2016, an order giving the treaty effect from January 1, 2017 was signed.

In preparation for the effect of the treaty and in view of the many investments that Israelis make in Germany, we summarize the implications of the new treaty and special issues related to it, as follows:

Taxes in Germany that are discussed in the treaty
The new tax treaty applies to the German income tax applying to individuals, corporate tax, capital gain tax, trade tax (also referred to as business tax) and the surcharges imposed on them (referring primarily to solidarity tax, at a rate of 5.5% of the tax). Whereas the old tax treaty also included the tax types above, solidarity tax was not explicitly stated in the old tax treaty, although according to the provisions of the ITO, to this day it may be claimed as a credit, inasmuch as it falls under the definition of “foreign taxes” in the ITO.

Rates of withholding tax from dividends, interest and royalties
Dividends: the withholding tax rate for dividends has been decreased from 25% to 10%, and in the case of an Israeli company holding at least 10% or more of the company paying the dividends, the withholding tax has been decreased to 5%.

Interest: the withholding tax rate for interest has been reduced from 15% to 5%. We should point out that by domestic law in Germany, there is no withholding tax on interest payments, with some exceptions (such as profit participating loans). According to the protocol of the new treaty, profit participating loans and similar instruments (set forth in the protocol) that may be deducted as an expense for tax purposes in the German company paying the interest, will not be subject to the reduced tax rate, but German law will apply, meaning a withholding tax at the rate of 26.375%. We should state that even after the new tax treaty takes effect, in appropriate cases and subject to the transfer pricing rules, withdrawal of profits by way of interest should be considered, despite the withholding tax, instead of holding of shares and drawing of profits as dividends, or in addition to the said holding/drawing.

Royalties: according to the new tax treaty, royalties will be taxed only in the payee’s country of residence, i.e. exemption from withholding tax in the payer’s country of residence, compared to 5% withholding tax under the old tax treaty.

Distribution from a real estate investment company:
Like most new tax treaties that Israel has signed in recent years, the provisions of the treaty mentions explicitly distribution of profits from a REIT fund, to the effect that 15% tax will be withheld from distributions received from a real estate investment fund within the meaning of Section 64A2 of the ITO and from a real estate investment company within the meaning of German law, on the condition that the investor has less than 10% of the fund.
According to German law, a German REIT fund is exempt from corporate tax and capital gain tax, while distribution from it is subject to a 26.375% withholding tax.
The combination of the provisions of the tax treaty and the law in Germany leads to a total tax (in Israel and Germany) of just 25% on profits from investment in a German REIT fund.

Indirect credit
The old treaty contains a unique provision providing indirect tax credit also for an individual (without being qualified for companies only, as is the case under Israeli law and some of Israel’s tax treaties) and without a requirement for a minimum holding rate. In the new tax treaty, the said provision has been cancelled, hence with respect to an Israeli individual who directly holds 10% or more of a German company and who has the ability to control the dividend distribution timing, it is advisable to distribute dividends early, in 2016, resulting in paying just 25% for the dividends (the withholding tax rate for dividends under the old treaty), without a need for paying additional tax in Israel due to receiving the indirect credit, instead of 30% (as a significant shareholder) effective from 2017 (in the absence of indirect credit).

In the case of an Israeli company, in contrast, it is advisable to consider delaying a dividend distribution, because the indirect tax credit is available under domestic law in any case, meaning that the relevant consideration is the decrease in the withholding tax rate (for companies only, holding 10% or more of the distributing company), from 25% to 5%. This will mean that in total (including the German corporate tax applying to the distributing company) it will pay just 25% tax for passive activity (instead of 37%, corporate tax and withholding tax for dividends in Germany according to the current treaty) and approximately 34% for business activity (instead of approximately 48% today, as above).

Timing of payments
As set forth, under the effective date clause of the new tax treaty, the reduced tax rates for interest, dividends and royalties as set forth above will apply to payments that will be made from January 1, 2017, irrespective of the date the income was generated. Thus, for example, interest accrued in 2016 but paid to a resident of Germany only in 2017 will be subject to just 5% withholding tax in Israel (and not 15% as prescribed in the old tax treaty). Therefore, in the appropriate cases, deferral of such payments until the effective date of the new provisions should be considered.

Applicability of the tax treaty to trusts
A trust falls under the definition of the term “person” without further details in the tax treaty and the protocol, and may enjoy the treaty’s benefits (like in a number of new tax treaties of Israel). In current tax treaty, there is a doubt concerning the eligibility of the trust to the tax treaty’s benefits, and in many cases there may be double taxation because the taxpayer in one contracting state is not the taxpayer in the other contracting state (for example, in one country the settlor is assessed at the time when the income is generated by the trust and in the other country, the beneficiary is assessed at the time of distribution of the income).