Tax Alert No. 2 - 25.8.2008

On July 25, 2005, an amendment to the Israeli Income Tax Ordinance (the “ITO“) was enacted, Amendment No. 147. Prior to the Amendment, taxation of trusts in cross-border cases was based on general provisions of the Ordinance, dealing with the endorsement or transfer of rights (e.g., Sections 82 – 84 of the ITO).

The 2005 Amendment was an outcome of a highly debated process and numerous references and reports. It has introduced a new trusts tax chapter into the ITO – Chapter Four 2 – that endeavors to adopt into the ITO the main tax law principles in relation to trusts according to Israeli case law, in an effort to provide high level of clarity and a “new order” in this area. This Chapter introduces four “types” of trusts in addition to certain reporting requirements. On the other hand, this Amendment also has triggered a high level of ambiguity and legal doubts in relation to Israeli trusts and this area is still highly debated by tax law practitioners and scholars. The common view is that the Amendment is extremely complicated and it raises many legal as well as practical questions.

The Amendment includes the following trust types:

• An Israeli Residents Trust (IRT);
• A Foreign Settlor Trust (FST);
• A Foreign Resident Beneficiary Trust (FRBT); and § The Testamentary Trust (TT);

The extensive reporting requirements under the current law and mainly the fact that a ” Foreign Settlor Trust “, in which almost all of the parties (i.e., the settlor, the trustee and most of the beneficiaries) are non-Israeli residents, may still be subject to tax in Israel (if certain conditions are met), was highly criticized.

The complexity of the trust law does not allow us to discuss many of the debated issues in a tax alert. However, the following example may illustrate the argument: under Section 75(g), a non-Israeli resident trust may still be considered as subject to Israeli taxation in relation to the trust income, in case the Settlor and one of the beneficiaries were Israeli residents upon the creation of the trust andif one beneficiary remains an Israeli resident. Correlative reporting requirements are also triggered.

Below we highlight the significant developments (including the enactment of regulations):

Recent amendments seem to alleviate some of the mentioned ambiguities. According to the most recent announcement of the Israeli Income Tax Authority (“ITA“),  a possible settlement regarding the capital/income of “old trusts”, i.e. those created prior to 2006 may be available. The charge to be imposed under such a settlement is between 4% – 10% (the actual percentage depends on the residence status of the settlor, the beneficiary or the trustee, as the case may be) and is based on the capital value of the trust as to 31.12.2005. Such a settlement may resolve tax liabilities for previous tax years and may provide a “step-up basis” with respect to
assets held under the trust. The final date to submit a request for a settlement is set to 31.10.2008. Please be noted that anonymous application may be filed.

Further, reporting requirements have been eased by requiring a notice to the ITA in lieu of an annual tax return in specific cases. Moreover, the Minister of Finance may use his authority to release a trustee of a trust settled by a non-Israeli resident (FST) from the duty to file an annual tax return if its income is an exempt income under the ITA, or that tax was dully withheld (this issue should be regulated in the near future.

In addition, new regulations recently issued allowing the trustee of an Israeli Resident Trust (IRT) to exclude from Israeli tax basis the portion of the trust’s income and capital gains which are attributed to foreign beneficiaries. For this purpose, the trustee may secure a specific portion of the trust’s income to foreign individual beneficiaries, or alternatively, may amend the tax statements that were already filed (up to 4 tax years). In case the trustee chooses to secure a specific portion of income or gains to foreign beneficiaries, he cannot use the other alternative, i.e., to amend previous tax statements. Both alternatives require that the assets held by the trust be deemed as if they were sold by the settlor to the foreign beneficiaries, in the appropriate portion and repurchased by the trustee immediately thereafter. Israeli taxation (if any) should apply as a result of such sale. The trustee must formally request the application of one of these alternatives.

Transfer pricing (“TP“) tax implications should be regarded as a key factor, in relation to any cross border transaction. A re-llocation of income by any tax authority may cause significant tax liabilities and double taxation, in addition to a possible tax inspection by the Israeli ITA.

It should be noted that the Israeli TP rules are under constant changes and developments. Section 85A of the ITO was enacted while introducing the arm’s length principle into the Israeli law. Detailed regulations were introduced on November 29, 2007 (the “Regulations“), These Regulations allow a taxpayer to use alternative TP methods (or another most appropriate method) for Israeli TP purposes, in order to determine the arm’s length price. Additionally, the Regulations impose detailed reporting requirements.

Considering the complexity of this issue and the high level of uncertainty, the ITA have recently published (July 14, 2008) a very detailed TP Circular (the “Circular“).

Due to wide scope of the TP area, we chose to highlight only few selected issues that were discussed in the Circular.

Special relations – the definition of the term “special relations” in Section 85A should be interpreted not only as family relations or control within a group of companies, but also as intending to address “other” relations that may influence pricing policies between the parties.

According to the Circular, this means that special relations may exist also were there are mutual economic interests between the parties, or where the parties are guided by the same interest and therefore choose not to set “market price” (a transaction between a senior employee and his employing entity us provided as an example). We hold the view that the Circular has widened the scope of the legal provisions and that it further contributes to the lack of clarity under the Israeli TP rules.

A one-time transaction between related parties – according to the Regulations, a one-time transaction, if authorized as such by the ITA, should not trigger TP reporting requirements as well as the determination of an arm’s length price between related parties. However, neither the Regulations nor the ITO define the term “one-time transaction” or assist the taxpayer in this respect, and the Circular only provides a general guidance: the very low frequency of transactions and its limited economic scope
(the Circular indicated that where the transaction does not exceed 10% of the annual income amount of the taxpayer in the specific business area and the actual amount is up to 4 million Israeli Shekels, the transaction should be regarded as a “one-time-transaction”. We hold the view that these two parameters are insufficient in order to establish whether a specific transaction between related parties should substantially be subject to TP rules.

Reporting and documentation requirements– the Regulations require to apply reporting and documentation requirement with respect to any cross-border “transaction” between related parties and on a very short time (60 days upon request of the ITA). A taxpayer is required also to indicate “all international transactions” in a special form. The term “transaction subject to report” is not defined and actually, an absurd scenario may be, where transactions performed on a daily basis between related entities should all be reported, while imposing an extensive and un-proportional administrative burden on the taxpayer (in addition to the heavy and unreasonable burden on the  ITA). An Advance Approval may be granted by the ITA upon request, but this process may
also create a heavy administrative burden to the ITA.

Due to the recent developments with respect to Israeli Returning Residents and New Immigrants (or “Olim“) tax reform and the significant potential implications of this reform, we decided to provide a recent update on the draft legislation, in addition to our comments. This is following our detailed reference on our Tax Alert No. 1 and due to the high interest of clients and colleagues on the issue.

The benefits: on August 18, 2008 the Kenesset (the Israeli Parliament) Immigration committee has authorized the final draft of the tax reform of Israeli Returning Residents and New Immigrants. This reform contains considerable tax benefits to eligible individuals. The draft provides for an extensive tax exemption and a waiver of any reporting requirements associated with eligible income and gains of Returning Resident (i.e., former residents who resided out of Israel at least 10 years) and Olim, for a period of 10 yeas. Exempt income includes any income, from passive as well as active sources, including income from occupation and employment income, as long as such income is sourced out of Israel.

Applicability on Israeli Returning Residents: a Returning Residents will enjoy similar benefits as a New Immigrants, provided that he resided out of Israel for a minimum period of 10 years.

According to a transitional provision (proposed to apply until December 31, 2009), a Returning Resident that resided out of Israel only for a period of 5 years may still be eligible for these benefits, provided that he was not an Israeli resident on January 1, 2007. It should be noted that the residency test and the determination of one’s residency is a complicated test that takes into account legal definitions and parameters as well as the specific facts of each case.

However, the requirement for the status of a “regular” returning resident (i.e., former Israeli residents that do not meet the 10 years residency abroad test) have been tightened, to include only returning residents who resided abroad for 6 years and not for 3 years, as under the current law.

A change in the definition of an “Israeli resident”: according to the draft, an Israeli resident who resided out of Israel for a period of 4 continuous years and on the last 2 years his center of life was out of Israel, may be considered as a “foreign resident” for Israeli income tax purposes, but only if he stayed in Israel less than 183 days in each of the first 2 years. According to our view, the above may have positive implications and should not be viewed as carrying adverse implications only.

A one-year “adaptation period”: in order to enjoy this option, one should send an application to the ITA within 90 days from his day of immigration to Israel.

As a final remark we emphasize again that the waiver of any reporting requirements associated with eligible exempt income has extremely significant implications on Returning Residents and Olim. We hold the view that the draft reform requires a close examination by potential immigrants in order to wisely plan their steps. In addition, possible implications in relation to trusts and transparent entities should also be carefully addressed in order to achieve optimal tax results.