Global Tax Alert | 18 June 2013

Israeli budget proposal contains significant changes to taxation of trusts

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Executive summary

The budget proposal for 2013-14 introduces significant changes to the Israeli taxation of trusts.

The current trust tax regime provides a wide exemption from Israeli taxation on non-Israeli sourced income derived by a Foreign Resident Settlor Trust (FRST). The proposed legislation would significantly narrow the circumstances under which an exemption from Israeli tax can be sought by the beneficiaries of those trusts. It should be noted that the amendments to the current trust tax regime may affect the tax status of a large number of non-Israeli beneficiaries, who are currently not subject to Israeli taxation.

In addition, the budget proposal sets certain deadlines for Israeli and non-Israeli trustees, who are generally assessable and chargeable for Israeli tax purposes, regardless of their tax residency or the foreign law applicable to the trusts. The trustees will have to comply with various new reporting and compliance requirements that can affect the tax status of the trust and its beneficiaries.

Background

The Israeli trust tax regime currently divides the various trust arrangements into four types of trusts. The Israeli tax consequences depend on the classification of the trust for tax purposes, regardless of the foreign law applicable to the trust.

In general, a trust whose settlors are all non-Israeli residents, both in the year of its creation and in the current tax year, is classified under the current regime as an FRST. An FRST is not subject to Israeli taxation on income it generates from foreign sources, even if some or all of its beneficiaries are Israeli tax residents. In accordance with the current regime, an FRST does not lose its classification after the foreign settlor passes away.

Main amendments under the budget proposal

According to the budget proposal, the aforementioned exemption from Israeli taxation on foreign source income would be significantly narrowed. It is proposed that the exemption would continue to apply only to FRSTs in which all of its beneficiaries during the current tax year are nonresidents. FRSTs which in the current tax year have at least one Israeli beneficiary, will be classified for tax purposes as a new, different type of trust: Israeli Resident Beneficiary Trust (IRBT).

A trust will be classified as an IRBT if, from the day it was formed up to the current tax year, all of its settlors are living non-Israeli residents, and at least one of its beneficiaries in the current tax year is an Israeli tax resident. In fact, the budget proposal proposes two new types of trusts (for tax purposes) since the new IRBT type is divided into two sub-categories: Relatives IRBT, where all of the settlors and all of the Israeli beneficiaries are (first degree) family relatives, and Non-Relatives IRBT.

If the Israeli parliament passes the budget proposal as is, then the exemption from Israeli taxation on foreign source income will be completely denied to all of the beneficiaries (including nonresidents) in a Non-Relatives IRBT. We note that the proposed definition of the term “relative” is quite narrow. For example, an Israeli beneficiary and his father-in-law are not considered relatives under this definition.

With respect to a Relatives IRBT, the new law narrows the exemption only to non-Israeli beneficiaries. An irreversible election can be made by the trustee as to the timing of the taxation of the income attributed to the non-exempt Israeli beneficiaries: either on an accrual basis (subject to tax at a rate of 25%) or upon actual distribution (tax at a rate of 30%).

It should be stressed that under the proposed wording of the proposal, if one of the original IRBT’s settlors passes away, then the IRBT will be reclassified as an Israeli Resident Trust (IRT) from the day of the settlor’s death onwards. The consequences of this event may be drastic from the tax point of view – the change from IRBT to IRT would lead to an overall denial of the tax exemption to all of the beneficiaries of the trust (i.e., not only the Israeli beneficiaries). An IRT is taxable in Israel at rates ranging from 25% to slightly over 50%.

Similar adverse tax consequences are anticipated in case an existing Relatives IRBT does not report its compliance with the new requirements within 60 days from the day on which the new law enters into force.

Final remarks

The changes to the trust tax regime proposed by the bill are controversial in many aspects (e.g., the right of Israel to tax foreign source income attributed partly to non-Israeli beneficiaries, relief from double taxation, etc). One of the controversial aspects is the compliance obligations that the Israeli trust tax regime introduced for (Israeli and foreign) trustees, who are generally assessable and chargeable for Israeli tax purposes, regardless of their tax residency. These compliance and reporting obligations are extended in accordance with the new bill.

Accordingly, trustees who may be affected by the proposed amendments should assess the potential impact of the budget proposal. It is recommended for such trustees to consult Israeli tax advisors as early as possible, in order to fulfill their fiduciary duties.

For additional information with respect to this Alert, please contact the following:

Kost Forer Gabbay & Kasierer, Tel Aviv
  • Sharon Shulman
    +972 3 5687485
    sharon.shulman@il.ey.com
Ernst & Young LLP, Israeli Tax Desk, New York
  • Ram Gargir
    +1 212 773 1984
    ram.gargir@ey.com

EYG no. CM3540