In September 2020, the Israeli Tax Authority published a tax ruling on the subject of the taxation of the income of Israeli investors in an American REIT fund (“The tax ruling‘).

The tax ruling is not the first ruling that the Tax Authority has issued in relation to an American REIT fund in respect of the taxation of the income of Israeli investors therein, as arises from the document for the listing for trading on the Stock Exchange in Israel for the company CIM Commercial Trust Corporation (“The prospectus” and “The tax ruling for the prospectus“).

As arises from the abovementioned tax rulings and from the prospectus, an American REIT fund is subject to a special tax regime in the United States, pursuant to which, the REIT fund’s income, which is distributed to the investors in it, will not be subject to corporate income tax in the United States, but rather to taxation by way of the deduction of tax at source, which applies to the distribution of the REIT fund’s profits as dividends to the investors in it, and in accordance with the source of the income from which the dividend is distributed, in the following manner:

(A) If the source of the chargeable income is rental income, it will be subject to the withholding tax at source in the United States, at a rate of 30%, where the tax treaty between Israel and the United States restricts the  withholding rate to 25% for an individual who is resident in Israel and who holds less than 10% of the REIT fund.

(B)  If the source of the profit is from the sale of real estate (or a right in entities that hold real estate), it will be subject to the withholding tax in the United States, which applies to the sale of real estate pursuant to the FIRPTA Law, and the taxpayer will be required to submit a tax report in the United Stated and to report on a dividend that is sourced in a capital gain (Capital Gain Dividend) and to pay the federal tax on it, which applies to a foreign resident in respect of the a capital gain that is sourced in the sale of real estate in the United States (at present the rate is up to 20% for an individual and 21% for a company with the addition of branch tax, insofar as it may apply).

(C) If the REIT does not have distributable profits, a distribution from the fund is effectively classified as a return of investment, and it is not subject to tax in the United States.

It should be mentioned that for tax purposes in the United States, the distribution of a dividend that sources in a capital gain from the sale of real estate or from rental income, is deducted from the REIT fund’s chargeable income. Income that has not been distributed to the shareholders in the REIT fund will be chargeable with corporation tax.

Within the framework of the tax ruling for the prospectus, the Tax Authority determined an unprecedented tax ruling, that dividend income that is received from a REIT fund (by an investor who is a resident of Israel) is to be classified and accordingly is to be taxed in accordance with the source of the income from which the dividend is distributed, i.e. the income (from a dividend) that is sourced in the income of the REIT fund (and the intention is primarily for rental income ), is to be classified for tax purposes in Israel as income from capital gain; income that is sourced in the return of an investment is also to be classified as capital gain!

Such classification applies to an investor who is a resident of Israel irrespective to his holding rate in the REIT fund.

In light of the fact that this is a tax ruling that reflects the Tax Authority’s position, the question of what the Tax Authority based itself on, when deciding to ignore the distribution of a dividend from a foreign company, and the reclassification of such dividend to income from a different source for tax purposes in Israel, arises. It is clear to everyone that the distribution of dividends from an Israeli company or from a foreign company, with retained earnings, will be classified as a dividend for tax purposes in Israel, subject to the tax rates that are set in the law in relation to an individual or a company.

To the best of our understanding, a dividend from a REIT fund is taxed in the United States as chargeable income at the regular tax rate in the hands of an individual (tax brackets), and a dividend that is sourced in a capital gain is subject to the tax brackets that apply to a capital gain (a rate of up to 20%). Accordingly, it is possible that the Tax Authority sought to make a parallel between the manner of the taxation that applies in the United States on income from a dividend from a REIT fund and the manner of the taxation in Israel. However, we would mention that the Tax Authority’s position in relation to distributions from an LLC is that this is a dividend for tax purposes in Israel (on the ground that the LLC is deemed to be an “opaque” company), even though for tax purposes in the United States, the taxpayer is taxed on income that is attributed to him from the LLC and in accordance with the classification of the income at the level of the LLC. Accordingly, in our opinion, in relation to a REIT fund as well as any distribution from it as dividend for tax purposes in Israel subject to a restricted tax rate (25%) and moreover, according to the tax treaty with the United States, the distribution from a REIT is classified as dividend for the purposes of the treaty.

We would further mention that a controlled foreign company (CFC), which has passive rental income or capital gains from the sale of real estate that was not subject to tax abroad, the controlling interest’s relative share of the undistributed profits, will be classified as income from dividend. The Israeli legislator has determined explicitly that a distribution of notional profits will be classified as dividend and it has not prerogative to reclassify those items of income in accordance with the source from which they derive.

As an aside, we would mention that the Tax Authority’s position, pursuant to which the return of an investment in a REIT fund (on the assumption that there are no distributable earnings) is classified as capital gain, does not accord with the Tax Authority’s position which was presented in a professional circular on the subject of the classification of income from an unearned distribution (the reduction of capital), pursuant to which the reduction of capital, under certain conditions, is not a taxable event so long as it does not exceed the adjusted original price of the investment of the shares in the company, and is deducted from the adjusted original cost.

The Tax Authority has published a similar tax ruling on the subject of the taxation of the income of Israeli investors in an American REIT fund (“The fund“) that is going to raise equity on the Israeli capital market (the Stock exchange in Israel) (“The additional tax ruling“).

Within the framework of the additional tax ruling, the Tax Authority repeated its position that makes a distinction between an investor who holds less than 10% of the fund and an investor who holds more than 10%.

In relation to an investor who holds less than 10% of a fund, dividend income from the fund will be classified as dividend income, including a distribution that is sourced in a reduction of capital (return of an investment) by the fund.

In the case of a reduction of capital, the Tax Authority decided to ignore the above-mentioned circular that was published on the subject of the classification of income from a distribution other than of profit (a reduction of capital), pursuant to which a reduction of capital, pursuant to which a reduction of capital, under certain conditions, is not a taxable event so long as the distribution does not exceed the adjusted original cost of the investment in the company’s shares, and it will be deducted from the adjusted cost.

Can it be deduced from this, reading between the rows, that the Tax Authority’s position is that the abovementioned circular does not apply to foreign companies, and accordingly the return of an investment from a foreign company will be classified as a dividend for tax purposes in Israel? From our perspective, there is no justification for such a distinction and a reduction of capital from a foreign company must be treated the same as a reduction of capital from an Israeli company and distinguishing between them constitutes discrimination.

Regarding a return of an investment to a shareholder who holds 10% or more of the fund, the Tax Authority has been more severe with the shareholder in that it has determined that the return of an investment is to be classified as income from a business or an occupation (subject to the regular tax rates, up to 50%!).

In relation to such an investor, the Tax Authority has repeated its position, which was published in the prospectus, while in certain cases it has even worsened the taxpayer’s position:

• In relation to a shareholder who has filled an active role in the fund, a distribution of profits that is sourced in a capital gain in the fund will be classified as business income!!! And not as a capital gain; and

• The return of an investment will also be classified as business income. We do not understand how the return of an investment can constitute business income.

The additional tax ruling does not mention what the Tax Authority’s considerations were in these determinations. From our perspective, there are inherent difficulties in reclassifying distributions of dividends as income from a different source for tax purposes in Israel, while it is clear that any distribution of profits from an Israeli company or from a foreign company, with a balance showing retained earnings, is to be classified as a dividend for tax purposes in Israel, which is subject to the fixed lower tax rates.

Apparently, since this is a tax ruling by agreement, which was required by the party making the payments to the investors, for the purpose of the withholding of tax at source, the principles that are presented above were agreed between the Tax Authority and the REIT fund.

As we understand the situation, the principles in relation to the substantive taxation (the classification of income from dividends as rental income or income from a business or as income from capital gain), may apply to the investors without there having been partners in the process of the issuing of the additional tax ruling.