Foreign settlor trusts: regime change

On 1 January 2014, the taxation of trusts in Israel was dramatically changed. Amendment 197 of Israel’s Income Tax Ordinance (the amendment) caused many trusts that were previously exempt from tax (mainly trusts that were settled by foreign residents) to become subject to tax in Israel for the first time. Since the amendment does not include transitional provisions, the Israel Tax Authority (the ITA) has published a circular, allowing for transitional settlement arrangements (tax settlements) for these trusts. Applications for such settlements should be submitted by 31 December 2014. Since certain foundations are also considered as trusts in Israel, this arrangement is generally open to foundations as well.

Cancellation of the foreign settlor trust regime

One significant change included in the amendment is the cancellation of the foreign settlor trust regime. Under this regime, a trust settled by a foreign resident was exempt from tax and reporting in Israel on non-Israeli-source income. Entitlement to this exemption was contingent upon certain conditions, mainly that Israeli beneficiaries could not influence or control the trust or its assets.

Following the cancellation of the foreign settlor trust regime, the amendment provides that a trust will be subject to tax in Israel even if there is only a single Israeli-resident beneficiary. If the foreign settlor is alive and is a relative of any Israeli-resident beneficiary, then, as a general rule, only distributions to Israeli beneficiaries will be subject to tax in Israel, at a rate of 30 per cent. If the settlor has died, or if they are not related to the beneficiary, the trust will be subject to tax in Israel on its worldwide income.

The amendment does not include transitional provisions. Previously exempt trusts therefore became subject to tax without receiving any step-up in the value of their assets. Furthermore, senior officers at the ITA have argued that most foreign settlor trusts were subject to tax in Israel even before 1 January 2014, due to the influence of Israeli beneficiaries over the trusts.

ITA’s proposed tax settlements

In the absence of transitional provisions, the ITA has decided to offer tax settlements for trusts that have become subject to tax in Israel pursuant to the amendment. The purpose of the settlements is twofold:

• settling claims regarding past tax exposure, and 
• providing a step-up in the value of the assets of the trust.

A trustee who chooses not to apply for the tax settlement will be subject to the rules specified in the amendment as written, without transitional relief.

In general, the ITA will allow the trustees to pay a settlement tax in order to settle any past liability. The settlement tax is determined, inter alia, by reference to the extent of the potential influence of the Israeli beneficiaries on the trust, as reflected by different factors such as whether the settlor is alive and whether the Israeli beneficiaries had any means of influence over the trust.

The tax settlements provide two routes for taxation of the trust: the taxable income route and the tax on capital route.

Taxable income route

A trust may elect to pay a portion (usually 33–66 per cent) of the regular tax liability on its taxable income derived during the period 1 January 2006 to 1 January 2014 (the determining period). The taxes will be paid with interest and linkage from the end of each year; penalties will not be imposed.

Losses incurred by the trust during the determining period will be deducted from the income derived during the determining period only. Losses incurred until 2014 may not be carried forward. A foreign tax credit will be granted only in respect of foreign taxes that have actually been paid and only in proportion to the settlement ratio.

This route does not provide for a step-up in the value of the trust’s assets, unless the trustee pays tax on a ‘deemed sale’, as if the assets were sold for their fair market value on 31 December 2013, subject to the settlement ratio.

Tax on capital route

If the yield on the trust’s assets is not extraordinarily high, a trust may elect to pay a percentage (usually 3–6 per cent) of the value of its capital (assets) as of 31 December 2013. This route, generally, provides for a step-up in value of the trust’s assets.

The capital of a trust includes the value of the trust’s assets as of 31 December 2013, plus distributions to Israeli-resident beneficiaries during the determining period. The capital includes all the trust assets, including cash and cash equivalents. The liabilities of the trust will not be deducted; if this causes double taxation, the local tax offices are permitted to seek a solution on a case-by-case basis.

The value of non-traded assets will be determined based on a valuation. In the absence of a valuation, the assessing officer can rely, for example, on the value determined for estate tax purposes in a foreign country. The applicable tax rates are specified in the table below.

The circular allows the assessing officer to consider additional factors in determining the applicable tax liability of the trust, such as: whether the trust or its beneficiaries are residents of other jurisdictions, the date of the trust’s creation or the settlor’s demise, whether the Israeli-resident beneficiaries qualify as new immigrants, whether the trust has settled its Israeli tax liability in the past, and so on.

The conversion of foreign currency into Israeli currency will be made: (1) under the taxable income route, at the lower between (a) the exchange rate on 31 December of the tax year in which the income was realised or (b) the exchange rate at 31 December 2013; and (2) under the tax on capital route at the exchange rate on 31 December 2013, and the tax liability will bear interest as of this date.

With respect to the procedural aspects of the tax settlements, the circular states that a trustee may apply for a tax settlement by 31 December 2014. Israeli beneficiaries are required to submit an affidavit indicating they did not transfer any assets to the trust.

Trusts not entitled to the settlement arrangement

It is worth noting the ITA specifies three scenarios in which a trust will not be entitled to the settlement arrangement. The first is where the trust could have been classified as an Israeli-resident trust before 1 January 2014, because the assets of the trustee originated from an asset transferred from an Israeli resident – when that resident or their Israeli-resident relative are beneficiaries of the trust. The second is where the settlor is a beneficiary directly or indirectly. The third is where any part of the trust fund is derived from under-reported taxable income in Israel. Before entering into a tax settlement, the Israeli beneficiary and the trustee will be required to declare the above conditions are not applicable to the relevant trust.

The ITA’s proposed settlement arrangement creates a unique opportunity for foreign trusts and trustees to settle their affairs in Israel. Since this arrangement is available only during 2014, it is recommended that relevant trusts examine their entitlement and the benefits they can obtain from this arrangement.