On April 24, 2013, a proposed draft (the "Draft") for the amendment of the Economic Arrangements Law was published. The Draft is referred to as a set of "draft decisions" and at this stage it only includes a description of the proposed changes, without specifying the detailed changes in the wording of the law. The Draft, which has been submitted to the Government, includes amendments to a number of Israeli laws, including amendments to the Income Tax Ordinance [New Version] 1961 (the "Ordinance"). One of the amendments which is included in the Draft suggests a radical change of the taxation of trusts in general and the taxation of Foreign Settlor Trusts in particular.
We have summarized below the main proposed amendments with respect to the taxation of trusts, as well as the main implications arising from the proposed amendment.
Proposed changes to the Foreign Settlor Trust Regime
According to the current legislation, as a general rule, a Foreign Settlor Trust is a trust that was settled by a foreign resident who is also a foreign resident during the relevant tax year. Such a trust is subject to tax in Israel, as a foreign resident only on its Israeli source income. In addition, distributions from a Foreign Settlor Trust to Israeli beneficiaries are not subject to tax in Israel. For this purpose, the residence of a deceased settlor is determined according to his residence at the date of his death.
Consequently, if a foreign resident creates a trust for the benefit of Israeli residents and afterwards dies, the trust remains a Foreign Settlor Trust in perpetuity.
The Draft significantly narrows the Foreign Settlor Trust Regime in the following aspects -
The settlor and the beneficiaries should be relatives. The Draft determines that a trust can be classified as a Foreign Settlor Trust only to the extent that the settlor and the beneficiaries are relatives. For this purpose, the Draft determines that -
- Where the settlor and the beneficiaries are first degree family relatives (i.e. parents, children, or grandchildren), the trust can be classified as a Foreign Settlor Trust, without any conditions.
- Where the settlor and the beneficiaries are related in the second degree (this is a broader definition which includes, inter alia, siblings, siblings' children and the parents' siblings), the trust will be presumed to be a Foreign Settlor Trust but the tax authorities will be able to rebut this presumption.
- Where there is no family relationship between the settlor and the beneficiaries, the Trust will not be classified as a Foreign Settlor Trust but rather as an Israeli Resident Trust.
The Draft includes extensive reporting obligations in order to enable the Israeli Tax Authority to enforce the above rules. Accordingly, a new trust will be required to submit a notice to the Israeli Tax Authority with respect to the existing family relations of the settlor and the beneficiaries within 30 days as of the date on which the Trust is established. Existing Trusts will be required to submit such a notice within 60 days from the day on which the new law will become effective.
- A Trust will cease being a Foreign Settlor Trust after the death of the Settlor. The Draft determines that in the case where one of the settlors of a Foreign Settlor Trust has died, the trust will cease to be a Foreign Settlor Trust and the trustees’ income and assets will be considered as the beneficiaries' income and assets. The Draft goes on to determine that even if only one of the beneficiaries is an Israeli resident, the trust will be classified as an Israeli Resident Trust.
In order to enable a "smooth" entrance into the Israeli Tax Regime, the Draft provides a "step-up" in the tax basis of the trust assets for the date of the settlor's death (i.e., the purchase date and the purchase price of the assets of the trust, which are located outside of Israel will be determined as their value upon the death of the settlor). In addition, the Draft determines that where the beneficiaries of the trust are foreign residents, the trust assets and income can be allocated to the foreign beneficiaries.
Election between Taxation of Distributions and the trust income. Even if a Foreign Settlor Trust that has one Israeli beneficiary complies with the above conditions (i.e. the beneficiaries are relatives of the settler, and the settlor is still alive), the Draft determines that either (i) distributions from the trust or (ii) the trust income will be subject to tax. For this purpose, the trustee will be able to elect between the following two alternatives:
- Taxation of the current income of the trust which is allocated to the Israeli beneficiaries at the rate of 25%; or
- Taxation of the actual distributions from the trust. In this case, the entire distribution will be subject to tax at the rate of 30%, unless the beneficiary or the trustee has proved that the source of any part of the distribution is the funds of the settler (in which case that part will not be taxed). In the case in which the distribution includes both a capital component, and an income component the distribution will first be classified as a distribution of income and afterwards as a distribution of the capital.
If the trustees fail to make the above election, they will be deemed to elect to be subject to tax on the actual distributions.
Other Proposed Changes regarding the Taxation of Trusts
Correlative change of the Israeli Resident Trust regime. In the same way in which the Draft determines that after the death of the settlor of a Foreign Settlor Trust, that trust will be subject to tax according to the residency of the beneficiaries, the Draft 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. If all the beneficiaries are foreign residents, the trust will not be subject to tax in Israel. However, in such a case, the assets of the trust will be subject to the Israeli "exit tax" regime.
Death of a settlor who is a new immigrant. According to current legislation, a trust which was settled by a new immigrant is entitled to the same tax benefits to which the new immigrant is entitled (i.e., a 10 year exemption on the foreign source income of the trust). The Draft recommends that upon the death of the settlor, the trust will become subject to tax in Israel.
Beneficiaries' reporting obligations. Under current legislation, an Israeli beneficiary who receives a distribution of cash from a trust (even from a Foreign Settlor Trust), is not required to report this distribution to the Israeli Tax Authority. 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 Draft, an Israeli beneficiary who receives any distribution (i.e. in kind or cash) will be required, as of 2013, to submit a notice to the tax authorities with respect to such distribution, even if the distribution was received from a Foreign Settlor Trust.
Underlying companies. An “underlying company” is a company (regardless of its residency), which holds trust assets on behalf of the trustee. According to 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 Israeli Tax Authorities.
The conditions for a company to be considered as an “underlying company” are not entirely clear under current law. The Draft suggests a new and detailed definition. According to this definition, in order for a company to be classified as an “underlying company”, the following conditions must be met: (i) the company is a new company, which has been established for the sole purpose of holding the trust assets, (ii) the trust has notified the tax authorities on the status of the company as an underlying company within 30 days as of the incorporation date; (iii) the company is registered in the trustee's name only, and the trustee holds 100% of the company directly or indirectly; and (iv) the company will not be considered as an Israeli company for the purpose of Israel's double tax treaties.