Tax Alert No. 40 - 28.12.2021

The Income Tax Ordinance includes a special purpose chapter on the taxation of trusts, which imposes tax and reporting duties on trusts, settlors and beneficiaries, and it includes beneficiaries and income into the Israeli tax net, which would be normally exempt from tax in Israel, were it not for the trust arrangement.

A tax ruling has been handed down recently, which determines that the trusts chapter will not apply to shares in a foreign company in the hands of an individual, which are held by him on behalf of an Israeli company. The following are the relevant facts regarding this tax ruling:

A.An Israeli company was engaged in systems development in the financial field.

B.The Israeli company established company Y in country Y, with which Israel has signed on a tax treaty (we would mention that company Y is an active company, which employs employees).

C.The Israeli company sought to provide services to local customers in country Z, however it requested that the shares in company Z, which will be established in country Z, will not be held by it directly but rather indirectly through Company Y.

D.The Israeli company is not interested in the customers in companies Z or Y knowing about its holdings in them, and therefore it transferred its holdings in shares in company Y to a resident of Israel, who has a foreign citizenship, who will hold the shares on their behalf, as a trustee.

E.The trustee has been registered as the holder of all the shares in Company Y and he will act in accordance with the Israeli company’s instructions. He is not entitled to exercise independent judgment. He does not benefit from the fruits of the holding in company Y (for example: dividends and interest or capital gain) and all the income from company Y will be transferred to the Israeli company and will be reported by it.

F.The Israeli company reports on the holding as the shareholder in company Y in its reports to the Tax Authority and in its financial statements.

The Israeli company requested that the trusts chapter, including the reporting duties for the trustee, to submit annual tax reports in Israel would not apply.

It is determined in the tax ruling that the trustee will be viewed as an agent and that the trusts chapter, including the reporting duties that apply to a trustee will not apply to the relationship between the Israeli company and the trustee (so long as the trustee is a resident of Israel), and that the Israeli company will be viewed as the owner of the shares in company Y, including the implications of the provisions of the Ordinance, insofar as they may apply, for example on the matter of a CFC (Controlled Foreign Corporation), and control and management rules.

Furthermore, the tax ruling restricts the credit for foreign tax, which the Israeli company can demand in Israel, as a result of the holding of shares in Company Y in the hands of the trustee to the tax rates that are determined in the tax treaty between the state of Israel and country Y. The significance of this provisions is, for example, that income from a dividend or interest from company Y in the trustee’s hands, or a capital gain (insofar as there is a right to tax in respect of this income in country Y) shall be subject to the taxes that apply pursuant to the provisions of the tax treaty with country Y, and if tax has been paid that is higher than such restriction as a result of the holding by the trustee (for example higher tax rates that apply to income of an individual as compared with a company), there is no credit available for this difference in Israel.

This decision joins a tax ruling that was handed down in 2016 in the Lerner ruling, in which the Court recognized a trust arrangement (although the intention was to an agency arrangement) for the purpose of the holding of the target company.

From our perspective, the recognition of an agency mechanism instead of a trust mechanism in the circumstances of the tax ruling will enable the Israeli company to report on dividend income from company Y or indirectly in concatenation from company Z, on a grossed-up dividend track (subject to compliance with the rest of the conditions that are determined in the Law), subject to the foreign tax credit restriction, which was determined in the tax ruling.

There may be cases in which the trust mechanism is preferable to the agency mechanism, in accordance with the circumstances of the case, which will enable the utilization of the full amount of the foreign tax (subject to the provisions of the ordinance) – for example, where it is not possible to implement the grossed-up dividend path as a result of the holding rate condition that has been set therein not being met.

The agency mechanism enables Israelis who operate outside of Israel to hold foreign assets by means of an agent, whilst being able to enjoy the fruits of the holding in the assets, and our perspective is that this will be in accordance with the circumstances and the nature of the agency.

In our opinion, it would also be appropriate to enable activity by means of an agency in the hands of companies that have an interest not to hold directly or to be identified as the owners of other assets (and not specifically a holding in shares in any foreign company), such as a real estate property or a bank account. This tax ruling is important, in our opinion and it gives additional expression to the Tax Authority’s position, pursuant to which the agency mechanism is possible and is recognized by the Tax Authority.

The air-condition in the car belonging to Mr. Naiveman, who is a veteran tax consultant, was indicating 16 degrees when he travelled to visit the assessing officer, and yet sweat was still dripping from his forehead. Going for meetings with Mr. Foxy, who was a mythological and cunning tax official, always made him feel pressurized. And you cannot blame him, Foxy always succeeded in raising an issue that Naiveman has not even thought of.

This time, however, Naiveman was slightly surer of himself. He went over the case one last time in his head, with considerable concentration (which almost cost an unlucky pedestrian his life): The trust was settled more than a decade beforehand by Yovav, Shimshon’s foreign resident father. Shimshon was both his client and a good friend who was the sole Israeli beneficiary from among five brothers, the rest of whom are foreign residents. The trust is a “relatives trust”, to the best of his understanding, which enables Shimshon to pay restricted tax at a rate of just 30% and only where he receives an actual distribution, however up to that time, he had not received anything. The only time that he had received money from the trust was about two and a half years ago. He had asked his father (who is one of the beneficiaries of the trust) for a loan of NIS 100,000 for the purpose of refurnishing his home, which he would repay when his Study Fund would be redeemed. This really was a clean story, Naiveman thought to himself, after all even Foxy’s ability is not unlimited.

The discussion was held in a good spirit, however, Foxy’s mischievous smile contributed nothing to Naiveman’s level of confidence. “What interest has Shimshon paid on the loan?” Foxy asked Naiveman, and he perceived that Naiveman had not prepared himself for this moment. “Interest? On what? All that happened was that the father gave his son a loan for a short period of time.”

“It’s written in the law”, Foxy replied nonchalantly, which shook Naiveman up slightly, however he made a quick recover: “I searched the entire Income Tax Ordinance, and I did not find any section that mandates interest on a loan within a family. And if you are talking about transfer pricing between a foreign resident and a resident of Israel, and I checked this myself and a trust of relatives is not deemed to be a foreign resident”.

“You’re a funny one”, replied Foxy, “Who is talking about the Ordinance? I am referring to the Income Tax Circular, on the subject of the Tax Authority’s interpretation of the trusts chapter, and this is what guides us. Regarding a loan, it is determined that the provisions of a loanto a beneficiary at a price that is lower than market price may be deemed to be a distribution at the level of the difference between the market price and the consideration that has been paid for it.

“So what’s the story?” replied Naiveman, who was quite calm, “how much can annual interest on an amount of NIS 100,000 be? Let’s assume its NIS 8,000? So come on let’s determine that it’s a distribution, we’ll pay tax and close the story out”.

“Just a moment, hold on”, replied Foxy, “I have not finished reading to you from the circular. So this is how it goes – A loan from the trust to a beneficiary… which has not been returned within 24 months may also be deemed to be a distribution at the level of the principle of the loan…”.

Naiveman had lost any appetite for fighting him: “Fine, I will speak with Shimshon and Yovev and tell them that you are insisting on taxing a distribution of NIS 100 thousand, it does not appear to me that they are going to argue about that”.

“Too late” replied Foxy, “The taxation of a distribution is not what I am interested in. After all, he has repaid the loan. So after we have agreed that the loan is essentially a distribution, so the repayment of the loan has to be a settlement!”

“Where are you going with this Foxy? The last time that I checked, a settlement in a trust is not a tax event” asked Naiveman, feeling (justifiably) worried about what the reply would be.

“That is indeed true” Foxy continued, “but whoever settles an amount in a trust is considered to be a settler, true? And if the settler is a resident of Israel, the trust cannot be a trust of relatives, you agree? And if it is not a trust of relatives, then it is chargeable with taxation on its income, isn’t that the case?”

“Oops, he did it again” Naiveman thought to himself, and admitted his defeat. At the end of the discussion and negotiations, it was agreed that the trustee would return the amount that had been repaid to Shimshon (“at least I achieved something for him” Naiveman thought), and in consideration, Foxy agreed to make do with taxing the amount of the distribution at a rate of 30% and not to claim that there was a change in the classification of the trust.

Naiveman checked the understanding that had been achieved with the trustee. “It’s strange” replied the trustee, “generally the risk when providing a loan is that it will not be returned. This is the first time that I encounter a situation in which the risk relates specifically to it being returned”, however in the end the trustee was convinced and agreed to return the money to Shimshon.

After a few days, Naiveman went back to Foxy’s office in order to sign on the agreement and to arrange the payment. Before leaving his room, he told him how he had got back to Shimshon, feeling bruised and battered (emotionally, of course) and how he had agreed to collect only half of his fee in order to pacify him, after all, they had been friends for many years.

“Only half?” said Foxy, “Are you aware that in that same circular it is determined regarding a settlement that the provision of a service to a trust at a price that is lower than market price, may also be deemed to be a settlement of “an asset” the value of which is the level of the difference between the market price of  the service that has been provided to the trustee and the consideration that has been paid for it”.

The above case is one of many examples of transactions that are connected to trusts and which may give rise to unnecessary tax implications, it is desirable and advisable to receive current advice before they are executed.

In this newsletter, we would like to discuss the appeal by discussing the appeal by “Sephira Veofek Ltd. (“Sephira Israel” or “The Company“) in respect of the tax assessments that had been issued to it for the years 2011 to 2013.

The main facts relating to the case

• Sephira Israel is engaged primarily in the provision of software development and maintenance and the operation of a call center for related companies overseas. Since 2011, it has claimed a reduced tax rate of 7.5%, which is provided to a preferential enterprise (the granting of development services to a foreign resident) and the balance of its revenues have been classified as regular income (which is chargeable at the corporate income tax rate of 23%).

• Pursuant to a transfer pricing study dated April 2011, the appropriate method for Sephira Israel is the retainer method (the payment of a fixed amount, which is not conditional upon the volume of activity). Pursuant to this method, the operating income rate from the supply of services lies between 12.36% and 23.26%, with a median rate of 18.67% (in a review that was conducted for the year 2013, it was determined that the range was between 18% and 30%). It should be mentioned that in a review of similar transactions between unrelated parties, a transaction was also found with an operating income of 39.92%.

• Despite the aforesaid, in the above captioned company’s tax reports, the Company reported on operating profit rates from the provision of research and development expenses of 50.15%, 63.25% and 64% in the 2011, 2012 and 2013 tax years, respectively.

The assessing officer’s main claims

• The assessing officer claims that Sephira Israel’s reported income from the provision of R&D services in the tax years in question are not at arm’s length, and accordingly the income in excess of the median range in the transfer pricing work is chargeable at the regular corporate income tax rate (in accordance with the indications as income from management or marketing services).

• The assessment was not prepared under the provisions of the Ordinance, i.e. the contradictory transfer pricing study that was prepared by the assessing officer, but rather it places reliance on the transfer pricing study that was prepared by the Company, where the profitability rate that it reported in its tax reports is much higher than what arises from that work, and hence the assessment is a reclassification of part of the R&D income such that they will be determined to be other income, which are not entitled to benefits as a preferential enterprise.

Sephira Israel’s main claims

• The provision of the Ordinance on the subject of transfer pricing applies to a transaction in which less profit has been produced and not to a transaction which is higher than is customary, since the substance of the legislation is to prevent erosion of the tax base in Israel and the shifting of the profit outside of Israel.

• If and insofar as there is room for reclassification, then this should not be done from the median rate, but rather from the high rate, which is to be found in the transfer pricing review, which it had performed (i.e. above 39.82%).

The Court’s ruling:

• The provision of the Ordinance on the matter of transfer pricing applies where the international transaction has generated less profits from a comparative perspective and it cannot bear an interpretation pursuant to which the provision of the section applies also where the Israeli side to an international transaction produces more profits from a comparative perspective.

• The assessing officer is entitled to make use (of his authority) for the reclassification of Sephira Israel’s income from R&D services to related companies.

• Since the assessing officer’s claim related to the reclassification of the income and not to the implementation of the provision of the Ordinance, the Court has adopted the maximal profit rate that is to be found in transaction between unrelated parties (more than approximately 40%) as one of the objective criteria and to view income that exceeds this as income that is not entitled to the tax benefits that are provided to a preferential enterprise, and the assessing officer is entitled to classify the income as income from management services (i.e. a transfer pricing review does not apply and the maximal rate therein has been taken).

It arises from the ruling that there was an incentive to shift profits from France, where the corporate income tax rate stood at 33.33% in the tax years in question whereas it stood at 24% to 25%, and the tax rates that apply to income from a preferential enterprise reduce it even more.

The provision of the Ordinance do not determine what the law is regarding income that exceeds what is determined in the transfer pricing study, accordingly it is apparent that the assessing officer’s path to taxing the surplus income (even if there was no income from the preferential enterprise) is trough reclassification. It should be mentioned that if we were talking about an Israeli parent company and a foreign subsidiary, and the collection of income from the subsidiary by the parent company, at a rate exceeding the rate that has been determined to be appropriate in the transfer pricing, so the parent company can to request that this surplus income should be viewed as dividend income and to apply the indirect credit path, that applies to income from a dividend from abroad.