Until 2014, Israeli residents were not taxed on any distributions they received from trusts created by a foreign person with a foreign trustee unrelated to the beneficiaries, and were not even required to report such distributions. This all changed when the Israeli Knesset passed its recent tax reform law, effective Jan. 1, subjecting many previously tax-exempt trusts to significant Israeli income tax liability.
The reporting and tax obligations discussed below are imposed even if there are no trust assets in Israel, no trustee resident in Israel and the settlor is not an Israeli resident. Since the law imposes a number of deadlines that occur in mid-2014 (the deadlines had originally been at the end of January 2014, but were just extended to June 30, 2014), it is essential to plan and comply soon, but further guidance is needed from the Israel Tax Authority before this can be done properly.
According to the new law, an Israeli Beneficiary Trust is a trust under which all settlors are foreign residents, and there is at least one Israeli resident beneficiary. All such trusts will be taxed under the new law, but the timing and rate of the tax will depend on the exact relationship between the settlor of the trust and the beneficiaries. An Israeli Beneficiary Trust can be either:
- a Relatives Trust (sometimes referred to as a Family Trust), when the settlor is the parent, grandparent, spouse, child or grandchild of the beneficiary; or
- a Non-Relatives Trust, a designation which applies to all other Israeli Beneficiary Trusts.
A Non-Relatives Trust is taxable as an Israeli Resident Trust and subject to income tax in Israel on all of its worldwide income, at the regular rates of 30 percent to 52 percent, even if only one beneficiary is an Israeli resident. There are no choices or elections to be made here—simply a new tax to be paid. The more complicated tax-planning issues arise in the context of the Relatives Trust.
Trustees of existing Relatives Trusts must notify the Israeli tax assessor of the existence of such trusts by June 30, 2014 (or within 60 days of the creation of a new Relatives Trust). Then, the trustee can choose between two possible taxation regimes. The default rule is the Deferred Tax Regime, under which there is no yearly tax at the trust level, but the Israeli resident beneficiary is taxed at a 30 percent rate upon trust distributions when received. Note that only income, not principal, is subject to taxation, but there is a presumption that income is distributed before principal.
The trustees of a Relatives Trust may instead make an irrevocable election to be taxed under the Alternative Regime, which imposes a 25 percent tax at the trust level annually on the portion of the income allocated to Israeli beneficiaries. Under the Alternative Regime, subsequent distributions to beneficiaries are not taxed. This election must be made by June 30, 2014, for existing trusts.
Regardless of which regime is chosen, at the death of the settlor, the trust would become an Israeli Resident Trust, subject to Israeli taxes on its worldwide income. However, the trustees have the option to maintain the status of the trust as a Relatives Trust after the death of the settlor until the subsequent death of the settlor's spouse, if the surviving spouse was married to the settlor at the time that the settlor made any contribution to the trust in question.
There is also an exception for trusts created by, or for the benefit of, new immigrants to Israel, who are not taxed for the first 10 years on foreign-source income.
U.S. clients who have established trusts for their descendants, some or all of whom live in Israel, need to be made aware of the new reporting requirements and income tax liability that the trusts, or their descendants, will now bear. Many factors must be considered in choosing between the possible taxation regimes, and clients with applicable trusts need to consult with qualified U.S. and Israeli tax counsel. Much is still unknown or unclear about the application and implementation of the new law; therefore, tax planning recommendations remain difficult. Further guidelines and regulations are expected, but it is uncertain when these guidelines will be released.
At this point, the only forms released for trustees and beneficiaries to fulfill their reporting and election requirements are in Hebrew. The purpose of the filing extension until June 30, 2014, was presumably to give the government time to release forms and interpretative regulations in English, so that people can make informed decisions about this new law.
To what extent will a U.S. trustee, or an Israeli beneficiary, face penalties in Israel for failing to report the existence of or distributions from a newly taxable trust? The enforcement mechanisms are unknown, especially since many trustees are not in Israel and will fail to report simply because they are unaware of the change in the law and the new requirements.
Yet another open issue is the question of the basis of trust assets. A trust subject to this new tax regime that sells low-basis assets would have a very significant tax liability; had such assets been sold by Dec. 31, 2013, there would have been no taxable gain. The law as it currently stands does not offer any basis step-up on the law's effective date; however, it is anticipated that the regulations will address this point.
Below are some planning suggestions to help navigate this very uncertain period. Note at the outset that every trust and situation is different and will require separate analysis.
Division of Trusts
One suggestion is to divide trusts, where possible and where applicable, such that there are separate trusts for the Israeli beneficiaries and for the non-Israeli beneficiaries. The law will impose a 25 percent tax at the trust level (assuming the Alternative Regime election is made), with respect to the portion of the income allocated to Israeli beneficiaries, but the method of allocation is not yet clear and may not be proportionate to the percentage of Israeli resident beneficiaries.
Distribution of Trust Assets
Some practitioners are terminating trusts with both Israeli and non-Israeli beneficiaries, and distributing as much as possible to non-Israeli beneficiaries. This may be advisable (or even present a planning opportunity) where compatible with the family dynamics or where the original purposes of the trust for the Israeli beneficiaries has changed. However, this also requires careful consideration, because there can be significant disadvantages. First, if the trust was created for a nontax purpose—whether asset protection, the need to professionally manage assets for children or grandchildren not yet ready for such management, or otherwise—this purpose will be defeated by distribution of trust assets. Furthermore, a trust can have the benefit of preventing assets from being subject to estate tax on the death of the settlor and/or the beneficiary, which could be undermined by a termination of the trust.
Change of Timing or Payor of Tax to Avoid Double Tax
Finally, the issue of double taxation has sparked much speculation—will trusts that fall under this new regime be forced to pay taxes in two countries without credit? It would be reasonable to assume that some credit in Israel for taxes paid in the U.S. on U.S.-source income would be offered. However, this conclusion is more likely if the taxpayer and the timing of the tax liability are the same in both jurisdictions. If the trust (or the beneficiary) is the taxpayer in one jurisdiction and the settlor is the taxpayer in the other (e.g., with a grantor trust), this conclusion is much less certain. The first consideration is whether the Deferred Regime or Alternative Regime would offer a better chance at obtaining a credit for taxes paid elsewhere. It has been suggested that, by electing to pay 25 percent per year at the trust level, rather than 30 percent at the beneficiary level upon distributions, Israel is more likely to offer a credit for taxes paid by the trust in the U.S. if they are being paid at the same time as the taxes owed in Israel.
However, the issue of an available credit is more complicated when the relevant taxpayer in each jurisdiction is not the same. For example, this would be the case for grantor trusts—U.S. taxes would be paid by the grantor, while the beneficiary or trust would possess the tax liability in Israel. To deal with this issue, some practitioners are considering terminating grantor-trust status for such trusts, so that the relevant taxpayer is the trust in both countries (assuming the Alternative Regime is chosen). However, those considering such a move must also be aware that there are very significant advantages to grantor-trust status. When the grantor pays U.S. tax, it is equivalent to a tax-free gift to the beneficiaries, reducing the grantor's estate. This is a significant advantage that should not be relinquished without careful analysis. Further, it is not by any means certain that Israel will grant any credit, even if the taxpayers and the timing of the tax payments are the same.
The new Israeli income tax law has created far more questions than answers. It is hoped that further regulations and guidelines over the coming months will address the many open issues. Moreover, it is important to analyze each trust to see whether the family would be better off paying the 25 percent tax annually or delaying payment but paying at the 30 percent rate, even if no credit against U.S. tax is given. Depending on the assumptions made (such as the rate of return earned and number of years until distributions are expected), the answer differs and should be discussed with clients and documented. In the meantime, the suggestions in this article are intended to raise awareness of the issues and give some preliminary guidance to help obtain as favorable a tax result as possible within the confines of the new law, as currently understood.
Originally published in the February 19 issue of the New Jersey Law Journal.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
