Those affected by the new Israeli income tax law, which became effective on January 1, 2014 and subjected many previously tax-exempt trusts to significant Israeli income tax liability ( See our previous blog post), now have until June 30, 2015 to make many crucial and irrevocable decisions. Trustees of such trusts now have until this date (just recently extended from December 31, 2014) to notify the Israel Tax Authority (ITA) of the existence of a "Relatives Trust" and to make elections concerning the taxation regime to which such trusts will be subjected.
Although the ITA continues to issue guidelines slowly and many questions remain, there have been some notable developments since the law became effective one year ago. The first of these developments is that the ITA is now offering to negotiate and settle tax liabilities of trusts. The ITA intends these negotiations as a way to increase compliance with the new law, but also hopes to capture past tax liabilities of some trusts that the ITA believes should have been paying taxes under the pre-2014 regime due to the influence held by Israeli beneficiaries, among other factors. The appeal of such a negotiation is the possibility that the ITA may offer a step-up in cost basis of the trust assets where a current tax would result. The law itself makes no mention of a step-up, which would reduce future taxable gains when trust assets are sold. The ITA is offering trustees two negotiation routes:
(1) Income Route. This is most relevant for trusts that may have a pre-2014 tax liability. The trust will pay 1/3 to 2/3 of the tax liability – the exact number determined by the level of influence held by the Israeli beneficiaries – at the passive income rate (generally 25%) on 2006-2013 trust income. A basis step-up, if offered, is available here only if the trustee agrees to pay tax as if all trust assets were deemed sold as of December 31, 2013.
(2) Asset Route. Available only when the yield on the trust's assets is not high (as determined by the ITA), a trust choosing this route will pay a tax based on the asset value as of December 31, 2013 at a rate of 3% – 6%, the exact rate to be determined based on the level of beneficiary influence. The assets comprise the actual market value of the trust assets on December 31, 2013, plus any distributions to Israeli resident beneficiaries during 2006-2013.
The ITA officers have wide discretion in these negotiations and may consider such factors as the existence of non-Israeli beneficiaries and any foreign tax liability paid by the trust or anyone associated with the trust. Different negotiation routes may be applied to different assets within the same trust. However, to qualify for these settlements, the Israeli beneficiary may not have transferred any asset to the trust, the settlor cannot be a beneficiary, and the trust assets cannot be derived from taxable income in Israel on which taxes were not paid.
Another development of interest is the guidance concerning the issue of double taxation. The ITA has recently indicated verbally – but not yet in writing – that any U.S. tax paid on trust income by the trust, the settlor or a beneficiary will be applied as a tax credit against the Israeli tax. In the case of a negotiated settlement with the ITA, this tax credit is available for both the income and asset routes, although tax liability from prior years must be paid with interest (but no penalties). Thus, in some cases, in which the U.S. taxes paid equal or exceed the amount of the Israeli tax that would otherwise be payable, there will effectively be no additional Israeli tax. This is particularly important for grantor trusts under U.S. law, where the grantor pays the trust's U.S. income tax. Note, however, that even in cases in which no Israeli tax will be due for these reasons, a trustee is still required to register the trust with the ITA by the June 30, 2015 deadline.
More detailed information can be found in an e-book, accessible here, recently co-authored by Debra Hirsch and Sara Weinberg of Fox Rothschild and John McLaughlin of Bernstein Global Wealth Management. To accompany the discussion of the law by Fox Rothschild, Bernstein Global Wealth Management prepared a case study that highlights some of the issues now faced by U.S. settlors of grantor trusts for relatives who are Israeli beneficiaries.
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.
