About a year ago, an amendment was made to the Tax Ordinance, stating that an individual claiming he is not an Israeli resident, even though the ‘substantial presence test’ applies to him, will be obligated to submit a detailed report indicating the facts on which his claim to non-Israeli residency is based, and with the documents supporting his claim attached. The amendment applies to the tax years 2016 and on.
The amendment thus applies to individuals who have spent 183 days or more in Israel during the tax year, or 30 days or more when in the same year, together with the two previous years, has spent 425 days or more in Israel, and claim to have severed their residency for tax purposes (and as such, not obligated to file tax returns in Israel).
In practice, the amendment may also apply to Israeli residents who have left Israel and moved to another country even before 2016; we shall illustrate this with the following numerical example:
Nir left Israel and moved to the United States in April 2015. The number of days Nir spent in Israel were: 2014 – 300; 2015 – 100; 2016 – 40; 2017 – 185.
The amendment came into effect, as stated above, on January 1, 2016; hence, we shall check the data from this year. In 2016, Nir will have passed the quota of 425 days in Israel; hence, the amendment will apply to him, and obligate him to file a detailed return for 2016. In 2017, Nir spent over 183 days in Israel; hence, he will be required to the submit a detailed report for this year too.
It should be noted that the definition of an Israeli resident denotes “days”, including part of a day; i.e. part of a day is counted as a full day in Israel. The Supreme Court has recently adopted this rule, stating that counting part of a day as a “day” with respect to the Tax Ordinance is a legal fiction aimed at achieving a desired legal result and, among other things, avoiding disputes.
It is not clear if and when the Tax Authority will publish a special application form for submitting a detailed report that includes, as stated, as the section is worded: “a report detailing the facts on which his claim only is based, and with documents supporting his claim attached, if such exist…” It should be noted that submitting a detailed report does not exempt the individual from submitting annual tax returns as a foreign resident, if he had taxable income during the tax year produced or accrued in Israel, from which full tax had not been deducted.
We should note that prior to the amendment, individuals who left Israel and were not obligated to submit annual tax returns could, in effect, avoid reporting the very fact of having emigrated from Israel and postpone the whole matter of their absence until returning to Israel, if at all. Submitting a detailed report, in wake of the amendment, will raise the question of residence during the years after departure too, and provide the tax authorities with important information including the matter of “exit tax”. Thus, if the “quota of days” shall apply and the individual makes a claim of severed residence, then the individual’s main affinities should be examined, and a report compiled in an appropriate and professional manner. A correct submission of the detailed report may establish the claim of severed residence, and even give the authorities a “declaration” of the day of severance. Failure to submit a report at all may leave the individual’s status as an Israeli resident, i.e., will in certain cases incur income tax, national insurance and health tax liability on income from outside of Israel as an Israeli resident, and could even give rise to criminal liability for failure to report.
To conclude, until the amendment, individuals who relocated remained in certain cases ‘under the radar’ of the Israeli tax authorities. In wake of the amendment, a declaration to the authorities in the form of a detailed report is required.
A new section of the Tax Ordinance was recently legislated, imposing a surtax on high incomes. At present, the stated surtax stands at 3% on an individual’s taxable income (from all sources) in excess of NIS 640,000, subject to the provisions of the section. The surtax applies to the individual’s taxable income (from all sources) in excess of NIS 640,000, subject to the provisions of the provisions of the section. The surtax applies to the individual’s taxable income; thus, with respect to an individual foreign resident, the surtax applies to income produced or accrued in Israel. However, pursuant to Ordinance provisions and the regulations deriving from it, foreign resident individuals, from whom full tax was deducted at the source, will be exempt from submitting returns in Israel, even with surtax liability for high income produced; thus, for all practical purposes no surtax will be charged that foreign resident individual.
To the extent that a foreign resident individual is required to file returns in Israel according to the tax assessor’s requirement, by power of his general authority to require anyone to file returns, he will be required to pay the said surtax.
An issue that arises in connection with tax treaties is whether the surtax shall apply in addition to a limited tax rate (or exemption) determined in the tax treaty: The ‘surtax section’ in the Ordinance determines that “the provisions of this section shall apply despite that stated in any legislation”. Whereas elsewhere in the Ordinance it is determined that “since the Minister of Finance has notified in an order that an explicit agreement has been made with a certain country to give exemption from double taxes… The agreement on the matter of… income tax shall be valid despite that stated in any legislation”.
We have thus noted two provisions of the law that supersede “that stated in any legislation” in coexistence, despite the fact that they may contradict each other. In such cases, it is commonly accepted to see later and/or specific legislation as overriding general or earlier legislation; in the above case, the new legislation is both later and specific with respect to the surtax. Nevertheless, the purpose of the section was not to undermine the principles of international taxation in Israel, according to which the provisions of the treaty supersede those of domestic law, including with respect to the limited tax rates or exemptions included in it.
In addition, the treaty usually includes provisions on the taxes discussed in the treaty and, in general, the surtax is included as income tax sheltered under the wings of the treaty. Thus, for example, in the treaty with the United States, it is determined that it shall apply among other things to taxes imposed pursuant to the Israeli Income Tax Ordinance [section 1(1)(b) of the treaty]; the surtax is indeed imposed pursuant to Ordinance provisions. Thus, for a dividend distributed by an Israeli company to an American individual, even in the case of a substantial shareholder (who is usually subject to tax at the rate of 30% plus surtax), according to the treaty only 25% tax will be deducted, and shall be the final tax imposed on that individual. It is understood that to the extent that the treaty gives Israel unlimited first taxation rights, she may also impose a surtax on that income.
The issue is even more complex when treaty country residents produce income from different sources, part of which Israel has limited taxation rights for, and full taxation rights for the rest.
Can it be determined then that income for which the tax rate is limited will come at the last stage of the taxable income ladder and thus not be charged surtax?
The Israel Tax Authority has recently published a tax ruling on taxation of options and participating units of shares for relocated employees.
In the tax ruling, a case was examined in which an employee in an international company allocating him options or Restricted Stock Units – RSU’s (hereinafter: “options”) in an approved track (according to which the employee is liable to 25% tax on the options as capital income and not as ordinary income at a marginal rate of income tax as high as 48%) leaves Israel during the vesting period and realizes the options after ceasing to be an Israeli resident (and probably after the vesting period).
In this tax ruling, the approach taken in previous taxation decisions has been adopted, according to which tax liability in Israel is determined according to the vesting period of options occurring in Israel. Another approach included here is that of Israeli tax authorities, according to which residence is not severed on the day of departure, at least not already at the stage of deduction at source by the Israeli employer or trustee:
“Exit tax” provisions applying to an Israeli leaving Israel enable postponement to the day of realization with respect to the part of the period from the day the option is granted until the day of departure (“Israeli profit”), Israel is the source country and the employer must deduct tax on this part, with no relief given, including relief usually given to new immigrants, and including credit for foreign tax paid.
With respect to the part of the period from the day of departure until the end of the vesting period (“remaining profit”), Israel constitutes the country of residence;
hence, tax will be deducted by the employer/trustee but foreign tax credit will be permitted already at the deduction at source stage. In the decision it was determined that the carry of credit surpluses for next years will not be permitted with respect to this part, and it is not clear why, since the credits section of the Tax Ordinance allows the transfer of surplus credits as stated from the same “basket” (i.e., same source) over the next five years.
It is not clear what the period is for which the Tax Authority wishes to keep taxation rights, as country of residence with regard to relocated employees. We should note that there is no specific requirement for employees to file returns; however, to the extent an employee claims severed residence from day of departure (or a later stage but before the vesting period is over) he will be able to file returns and require a tax refund for tax deducted from him at source in Israel.
We should note that the later the realization day after the end of the vesting period, a claim could be made that in light of the “exit tax” provisions (which apply to options too), the linear division must be based on the period in which the rights are held until realization, and not until the end of the vesting period; thus, the profit balance (non-Israeli profit) will be given more weight in the linear calculation.
With regard to employees returning to Israel it was determined that realization will be on the date the option is converted into a share and on this day the employee will be charged with the marginal tax, as salary\business income. In this case, the “Israeli profit” (part of profit from day of return until end of vesting period) will be taxed as stated above; in other words, with no reliefs including foreign tax credits.
It looks as though the “remaining profit” in this case of employees returning to Israel (part of profit from day of grant to day of return) will be taxed in Israel according to the aforementioned while crediting for foreign taxes. The question here is, does this also apply to those who were foreign residents on the day the options were granted? If so, this means that there has been a change in the policy of the Tax Authority with regard to taxing profit from options produced abroad by a resident returning abroad by a resident returning to Israel, if realization was made when he was an Israeli resident. This position is in line with the tax ruling recently published on the matter of returning residents receiving salary differentials and bonuses, and classifying them as taxable income since they are taxed on a cash basis. Nevertheless, this position of the tax ruling is not clear and, in any case, it was explicitly clarified within the tax ruling that this relates to liability for deduction at source applying to the trustee, assuming that the relocated employee is an Israeli residents; however, this does not relate to determining an employee’s final tax liability, who can as stated make other claims as part of returns filed by him.
A tax ruling has been published recently on transfer of shares of an Israeli company as a gift to a relative, before being sold by that relative. The tax ruling raises several interesting issues in connection with determining the original price and the date of purchase, eligibility of new immigrants for exemption and a step-up arrangement for receipt of a gift from a foreign resident.
A brief summary of the case: A foreign resident (“the foreign father”) holding shares of an Israeli company (purchased by him in 2012) wishes to transfer them as a gift to his son, an Israeli resident (“the Israeli son”) with “new immigrant” status (as of 2014); the Israeli son will subsequently sell the shares. According to tax law in Israel, as a rule, gifts to family members are not taxable (the recipient enters the shoes of the bequeather); furthermore, foreign residents are exempt from capital gains tax when selling shares of an Israeli company; in addition, new immigrants are exempt from capital gains tax when selling shares of an Israeli company if purchased before immigration to Israel, for the duration of the benefits period (10 years). In the facts of the case it is indeed noted that were the foreign father to sell the shares to the Israeli son, he would be exempt from capital gains tax; however, he would be liable to tax in his country of residence.
Tax Authority’s decision: The Tax Authority analyzes the case and makes its decision as follows:
First, the transfer of shares as a gift is indeed exempt from tax. According to day of purchase and original price as defined in the Ordinance, the Israeli son “enters the shoes” of the foreign father; thus, the date of purchase of the shares by him is 2012, and the original price is what they cost the Israeli father.
In this case, since the Israeli son has entered the shoes of the foreign father, he is the one who “purchased” the shares in 2012 (determining the day of purchase in his matter) when he was a foreign resident;
thus, supposedly, he is entitled exemption when selling the shares. However, the law denies exemption when the sold asset is given to the immigrant as an exempt gift; thus, exemption is denied when the shares are sold by the Israeli son. We shall now clarify that the stated qualification is intended to deal with situations in which an Israeli resident (not a new immigrant) owning a foreign asset transfers the asset as an exempt gift to a relative who is a new immigrant, and the latter sells the asset with exemption; the taxable profit is thus “laundered” and classified as exempt profit in the hands of the seller. The case under discussion is different from this aspect, since the profit accumulated by the original owner (the foreign father) would have been tax exempt in any case, had the shares been sold by him.
To summarize, after rejecting the request for exemption (when sold by the Israeli son), it is decided that the original price will still by calculated according to the “entered his shoes” principle; thus, when in the hands of the Israeli son, the entire accumulated profit (which would have been exempt if sold directly by the foreign father) will be taxable.
Associated issues: On the face of things, it appears that the request itself and the way it is presented are somewhat disturbing; hence, the final conclusion may have been inevitable. Nevertheless, there are substantial issues which need to be addressed, and which could (under certain conditions) have even changed the final position determined:
Denial of exemption is based on the gift being a tax-exempt gift among family members. In our opinion, the shares could have been transferred to the Israeli son free of charge (an event still considered a sale with respect to the Tax Ordinance) without asking to apply the exemption to the foreign father rather the fixed exemption on capital gains for foreign residents.
Later on, the original price and date of purchase by the Israeli son should be clarified. In principle, the accepted general assumption is that anyone receiving an asset, the transfer of which was tax-exempt is entering the shoes of the giver with regard to the original price and day of purchase, according to the ‘principle of continuity’, and vice versa. In addition, it is common practice that the day of purchase and original price are interconnected; thus, if a historic day of purchase is determined then the original price will be historic too; and if a new date of purchase is determined then the original price will be the value on that date. In the case at hand, according to the definitions in the Ordinance, these things are not clear and one may even arrive at different conclusions.
If so, the result will be that if a historic date of purchase and original price have been determined, then sale of the shares by the Israeli son will be tax exempt, since he was a foreign resident when “purchasing” the shares, and the qualification of an asset received as a gift among relatives does not apply anyway. If a new date of purchase and an original price have been determined, according to value on date of transfer to son, then no exemption from capital gains tax will apply; however, capital gains will be smaller and constitute only the increase in value from the day the shares are received until their sale.
Another issue that arises is connected with step-up arrangements provided by the Tax Authority, with regard to gifts from a foreign resident. If applied in this case too, the increase in value until the date of the gift would have been exempt from tax in Israel.
However, the Tax Authority does not grant such arrangement with respect to assets in Israel. The question is, why not? The aim of a set-up arrangement is to prevent taxation of an asset’s increase in value during the period in which it was not taxable in Israel; this is true in the case of an Israeli asset whose owner, had he sold it, would have been exempt from tax. However, there is a difference between the two types of assets, since an increase in value of a foreign asset owned by a foreign resident is not at all taxable in Israel, whereas an increase in value of an Israeli asset (under the circumstances described) is subject to tax in Israel but exempt according to a specific clause.
Nevertheless, the difference between them is not substantial rather semantic only.
It may be that the final decision was based on the assumption (or knowledge) that the move the parties wished to make was designed to avoid being taxed in a foreign country, while exploiting the provisions of Israeli law; however, such a move can also be made in the case of an asset outside of Israel. In such as case, the Tax Authority allows an unconditional step-up arrangement with regard to taxing the gift giver abroad. Subsequently, should the very mention of the giver being liable for tax in his country of residence, had he sold the asset, have implications for the final conclusion? In other words, if capital gains tax did not apply to the foreign father in his country of residence at the time he sold the asset, would the decision have been different?
To conclude, before making such moves or other similar ones, it is advisable to consult and examine all applicable aspects of tax, in Israel and abroad; it may be that different results can be achieved, as a result of changing the moves themselves or changing the claims raised.