On 13th June, 2013 we issued a client circular regarding a proposed reform in the taxation of trusts in Israel which is included in a new bill which is referred to as the Bill for the Change of National Priorities (Legislation Amendments for Achieving the Budget Purposes for the Years 2013 and 2014) (the "Bill").
Following a "first reading" in the Knesset (Israel’s Parliament), the Bill was submitted to the Finance Committee for further review and edits. The Finance Committee held a series of sessions on the provisions relating to taxation of trusts on Thursday, July 4, 2013 and on Sunday, July 14, 2013. Herzog, Fox and Neeman tax partners Meir Linzen and Guy Katz actively participated in both these sessions of the Finance Committee.
At the end of these two sessions, the Finance Committee agreed on the final version of the trust chapter of the law on which it will vote later today and tomorrow (Wednesday and Thursday). This final version includes some very significant changes to the provisions of the Bill that deal with the taxation of trusts.
Following the final confirmation of the Finance Committee, the Bill will be returned to the Knesset for a "second reading" and then a "third reading". Once the Bill passes a "third reading", it is published as an official law. The Bill is part of the government's budget for 2013-2014 and must pass into law by July 31, 2103; otherwise the government will be forced to call for new elections.
Part A of this Circular summarizes the main revisions made to the Bill at the Finance Committee session relating to the taxation of trusts. Part B provides an overall review of the central elements of the reform to date.
Part A – Revisions of the Finance Committee
- The Effective Date
The provisions pertaining to the taxation of trusts shall come into effect as of January 1, 2014 (the "Effective Date") – namely, the 2014 tax year. The original wording of the Bill specified that these provisions should be effective beginning on August 1, 2013. The extra five months until the amendment takes effect should provide existing trusts with more opportunity to plan for the implementation of the new law.
- Trust Holding Companies
The Israeli Tax Authorities (“ITA”) agreed to revise the new definition of a Trust Holding Company such that it will also include companies held indirectly by the trustee. In other words, subsidiaries of Trust Holding Companies can also be classified as Trust Holding Companies, and therefore transparent for tax purposes in Israel. Of course, such subsidiaries must also meet the criteria for a Trust Holding Company, as set out in the Bill.
In addition, the ITA agreed to change the notice obligation regarding the existence of a Trust Holding Company. According to the new legislation, one of the conditions for a company to be considered as a Trust Holding Company is that a notice is provided to the ITA within 90 days of the establishment of the company (or for existing companies in the first tax return which is submitted after the Bill is enacted). The ITA agreed to determine that this demand will apply only with respect to Trust Holding Companies that hold the assets of (i) an Israeli Resident Trust; (ii) an Israeli Beneficiary Trust; (iii) an Israeli Resident Testamentary Trust; or (iv) assets located in Israel. Foreign Trusts which do not hold Israeli assets will not be required to report the existence of their Trusts Holding Companies.
- New Immigrant Trusts
According to the Bill, a trust which was settled by a New Immigrant will be entitled to the benefits of New Immigrants (i.e. 10 year exemption on foreign source income), only to the extent that all the beneficiaries of the trust are New Immigrants. As a result of the discussions held at the Finance Committee, it was agreed that the final version of the Bill will include the following provisions –
- It was agreed that the above provisions regarding the taxation of New Immigrant trusts will only apply with respect to trusts that were settled by new immigrants who arrive in Israel after the date on which the law becomes effective, and as long as such new immigrants are alive.
- A New Immigrant Trust will also be entitled to the benefits provided to New Immigrants if some of the beneficiaries are foreign residents or New Immigrants.
- The Bill was changed to provide the ITA with the authority to enact regulations, subject to the confirmation of the Finance Committee, which will enable the allocation of the income of the trust to New Immigrant beneficiaries.
- The amended Bill clarifies that to the extent that the New Immigrant benefits do apply as described above, they will continue even if the trust is set up after the settlor immigrates to Israel. This result is not clear under the current law, and has been clarified in a circular issued by the ITA's legal department. The ITA has now agreed to take this opportunity to clarify this issue as well.
- Foreign Settlors of Trusts with New Immigrant Beneficiaries
Similarly, if a trust was settled by foreign residents and the trust has an Israeli beneficiary, such that it is an Israeli Beneficiary Trust, the portion of the trust income attributable to New Immigrant beneficiaries shall be entitled to receive the New Immigrant Benefits. This result was not clear from the Bill itself.
- New Immigrants Exemption from Reporting Distributions
The Bill imposes a reporting obligation on Israeli beneficiaries who receive distributions from a trust. The reporting obligation requires the relevant beneficiary to submit a full yearly tax return which includes the distribution. The revision does not clarify that this reporting obligation will not apply to New Immigrants. However, the ITA has promised to clarify this issue in a circular.
- Charitable Trusts
The original Bill did not include any provisions regarding the taxation of charitable trusts which were settled by foreign residents. As part of the discussions in the Finance Committee the Bill was changed to provide that trusts settled by foreign resident in which the only Israeli beneficiaries are "public institutions" will maintain the status of Foreign Resident Trusts.
The amended Bill also clarifies that such "public institutions" will not be considered beneficiaries for the purposes of qualifying as an Israeli Beneficiary Trust. The effect of this revision is that a trust settled by a foreign resident (including a deceased foreign resident) will not be subject to tax in Israel simply due to the existence of charitable organizations which receive grants or distributions. The definition of a "public institution" for this purpose will automatically include organizations to which a tax free gift can be made in Israel (the government, municipal authorities, KKL, Keren HaYesod – Joint Jewish Appeal for Israel and bodies that are tax exempt in Israel, under section 9(2) of the Income Tax Ordinance [New Version] 1961) and other similar bodies that are tax exempt in Israel, under applicable law. In addition, the Bill will state that the Director General of the ITA, with the approval of the Finance Committee, is authorized to expand the list of "public institutions" specifically for this purpose.
- Death of a Settlor in an Israeli Beneficiary Trust
The Bill determines that if even one of the settlors of a trust is deceased and the trust has at least one Israeli beneficiary, the trust will be deemed an Israeli Resident Trust and subject to tax in Israel on its worldwide income. The ITA has agreed to soften this provision slightly such that the trust will not become an Israeli Resident Trust if the spouse of the deceased settlor is still alive, provided the couple was married at the time of at least one of the transfers of assets to the trust was made.
- Death of the Settlor in a Foreign Resident Trust
The original language of the Bill did not clarify that following the death of a settlor, a trust with only foreign settlors and foreign residents would remain a Foreign Resident Trust (i.e. taxed in Israel only with respect to its Israel source income). The ITA has agreed to add an explicit clause to the Bill confirming that the term "Foreign Resident Trust" includes trusts in which the settlor is deceased, provided he or she was a foreign resident at the time of his or her death.
- Reporting a Family Trust
The Bill provides that a trust must report its qualification as a Family Trust within 60 days of attaining such status (or 180 days from the effective date of the Bill). This provision was originally formulated as a material provision, such that a failure to report on time would deny a trust such status indefinitely. The ITA agreed to revise the provision such that it will be a general reporting obligation and not a material component of the definition of a Family Trust.
- Tax Losses following Liquidation
The Bill was amended to determine that following the liquidation of an Israeli Beneficiary Trust and an Israeli Resident Trust in which all the settlors have died, the carry forward losses of the trust will be transferred to the beneficiaries of the trust.
Part B – Overview of Taxation of Trust Reform
Below is a review of the main provisions of the tax reform relating to trusts in Israel, as it stands today. The summary includes many of the provisions described in our earlier Circulars, as well as the revisions agreed at the Finance Committee (all of which are still subject to a final confirmation of the Finance Committee and a vote at the Knesset).
- Cancelation of the Foreign Settlor Trust Regime
The Bill effectively cancels the Foreign Settlor Trust regime in Israel. Under current legislation, trusts that were settled by foreign residents were generally tax exempt in Israel, even after the settlor's death. Furthermore, distributions to Israeli resident beneficiaries are exempt from tax. According to the Bill, such trusts will continue to be tax exempt in Israel only to the extent that all their beneficiaries are foreign residents. In the case of a trust that was settled by a foreign resident has Israeli beneficiaries, such a trust will become subject to tax in Israel.
For this purpose, the Bill defines a new type of trust which is referred to as an "Israeli Beneficiary Trust". An Israeli Beneficiary Trust is a trust which: (i) was settled by a foreign resident who continued to be a foreign resident from the day on which the trust was established until the relevant tax year; and (ii) has at least one Israeli beneficiary. A trust will be classified as an Israeli Beneficiary Trust regardless of its revocability.
In order to be qualified as an Israeli Beneficiary Trust, the trust should comply with two additional conditions –
- The Settlor and the beneficiaries should be relatives (this situation is referred to in the Bill as a "Family Trust"). The settlor is considered as a relative of the beneficiary if the beneficiary is his spouse, parent, grandparent, child or grandchild. If the Settlor and the beneficiaries are relatives of a "second degree" (a broader definition which includes inter alia, siblings, siblings' children and the parents' siblings), then they will be considered as relatives for the purpose of this definition only to the extent that the assessing officer was convinced that the trust was settled in good faith and the beneficiary has not paid any consideration for his right in the trust assets.
A trust must report its qualification as a Family Trust to the ITA, within 60 days of its formation or its attaining Family Trust Status (or in the case of existing trusts, 180 days from the day the Bill becomes effective). This is a general reporting obligation and will not affect the trust's entitlement to such status.
- The Settlor is still alive. For this purpose, a settlor will be deemed alive as long as the settlor's spouse is alive, provided the couple were married at the time at least one transfer was made to the trust.
If the Trust does not comply with the above conditions (i.e., the settlor and the beneficiaries are not relatives or the settlor has died), it will be considered as an Israeli Resident Trust and will be subject to tax on its world-wide income according to the identity of the beneficiaries.
If the trust complies with the above condition, then it will be subject to tax as follows -
- A distribution to the beneficiaries will be taxed at a rate of 30%. If the trustee proves that it distributes assets that were settled into the trust by the settlor (distribution of the principal as opposed to distribution of income), such a distribution will not be subject to tax. For this purpose, the income of the trust will be considered to be distributed before the principal of the trust, and whenever a distribution is made to more than one beneficiary the principal distribution to the Israeli beneficiary will be equal to his share in the distribution; or
- Instead of being taxed on distributions, the trustee can elect, subject to certain specific conditions, for the trust income which is allocated to the Israeli beneficiary to be subject to tax at a lower rate of 25% in the year it has accrued. If such an election is made, the distributions will be tax exempt. Such an election is irrevocable.
- Trusts Involving New Immigrants
Under current legislation, a trust which was settled by a new immigrant is entitled to the same tax benefit to which the New Immigrant is entitled (i.e. 10 year exemption on its foreign source income). These benefits are currently provided even if the beneficiaries are Israeli residents that are not entitled to these benefits.
The Bill significantly narrows this provision such that a trust which was settled by a New Immigrant will be entitled to the 10 year exemption only to the extent that its beneficiaries are also entitled to this exemption or if they are foreign residents. However, this provision will apply only with respect to trusts that were settled by New Immigrants who arrived in Israel after the new law became effective and as long as the settlor is still alive.
The new legislation also clarifies that a trust settled by a New Immigrant after his immigration, in which all the Israeli resident beneficiaries are also New Immigrants will be entitled to the New Immigrant benefits.
In the same way, the proposed legislation determines that if a trust was settled by a foreign resident and the trust has an Israeli beneficiary such that it is an Israeli Beneficiary Trust, the portion of the trust income attributable to New Immigrant beneficiaries will be entitled to the New Immigrant Benefits.
- Underlying companies (Trust Holding Companies)
Under the current legislation, an “underlying company” is a company (regardless of its residency), which holds trust assets on behalf of the trustee. Under Israeli law, such a company is “disregarded”. Consequently, its assets are considered as the trustee’s assets and its income is considered as the trustee’s income. An underlying company is not required to submit annual tax returns and to open a tax file with the ITA. The conditions for a company to be considered as an “underlying company” are not entirely clear under the current law.
The Bill proposes a new and detailed definition of an "underlying company". According to this definition, in order for a company to be classified as an “underlying company” it must hold trust assets for the trustee, and in addition the following conditions must be met: (i) the company has been established for the sole purpose of holding the trust assets, (ii) in the case of an Israeli Resident Trust and Israeli Beneficiary Trust, and Israeli Testamentary Trust and a trust that holds assets in Israel, the trust has notified the tax authorities on the status of the company as an “underlying company” within 90 days of the incorporation date (or together with the first annual tax return submitted following the passing of the Bill); (iii) the trustee directly or indirectly holds 100% of the company's shares;
- Beneficiaries Reporting Obligations
Under current legislation, an Israeli beneficiary who receives a distribution of cash from a trust is not required to report this distribution to the ITA. Only a beneficiary who receives a distribution in kind (i.e. an asset which is not cash) is required to report the distribution. According to the Bill, an Israeli beneficiary who receives any distribution (i.e. in kind or cash) will be required to submit a tax return in Israel on its world-wide income.
- Taxation of an Israeli Resident Trust after the death of the settlor
In the same way in which the Bill determines that after the death of the settlor of an Israeli Beneficiary Trust the trust will be subject to tax according to the residency of the beneficiaries, the Bill determines that when the settlor of an Israeli Resident Trust dies, the trust will be subject to tax according to the identity of the beneficiaries as a Testamentary Trust. For this purpose, even if the trust has only one Israeli beneficiary, the entire trust will be considered as an Israeli Resident Trust.
- The Effective Date
The amendments to the trust tax regime in Israel shall apply beginning on January 1, 2014 (the "Effective Date"). In other words the provisions of the Bill will begin with respect to the 2014 tax year.