By: Yoad Frenkel, Adv. & C.P.A. (Israel)[1] - Ziv Sharon & Co. Law Office

As is well known, in the past two and a half years, taxpayers who have been classified as "first-time Israeli resident" or as "veteran returning residents" (hereinafter: "beneficiary individuals") have completed their ten years of tax holiday in accordance with Section 14 of the Income Tax Ordinance (New Version), 5721-1961 (Hereinafter: "The Ordinance").

Amendment 168 of the Ordinance was passed in second and third readings in the Knesset in September 2008 and applies retroactively to those who immigrated or returned to Israel from 1/1/2007 onwards. The purposes of the amendment, which were mentioned in the bill were: (1) immigrant absorption. (2) The return of quality human capital to the State of Israel. (3) Encouraging investors with high economic ability to become residents of Israel. These purposes are important in the interpretation of the benefits granted to beneficiary individuals.

The definition of a "person who has been a resident of Israel for the first time" places an emphasis on a person who was not an Israeli resident earlier, whereas the definition of "veteran returning resident" emphasizes that prior to his return the person spent ten consecutive years abroad (until December 31, 2009, a temporary order provided that five consecutive years of stay abroad before the return were sufficient). These definitions, based on the definition of "resident of Israel", are not definitions whose implementation is always clear (see the last judgments in the John Doe case, Amishkashili and Bar Refaeli). In other words, there is a risk that with respect to beneficiary individuals, if the Tax Authority examines their compliance with the definition even after the ten years elapse, the ITA will be able to retroactively revoke the benefits. In our opinion, insofar as we are concerned with beneficiary individuals who submitted tax returns due to the existence of business in Israel or other grounds enumerated in the Income Tax Regulations (Exemption from Accountability), 5748-1988, as most of the reports of the benefit period have the ITA cannot tax the foreign sourced income in these years.

As is well known, beneficiary individuals are tax exempted on their foreign sourced income in accordance with section 14 of the Ordinance as well as tax exempt with respect to capital gains from foreign sourced assets, whether purchased before or after (within the ten year tax holiday) their return. While the first benefit expires after the elapse of the tan year tax holiday, the capital gains tax liability is carried out on a linear basis - only the portion of the period of holding the asset from the date of the elapse of the ten years to the date of the sale shall be subject to capital gains tax.

At this point, it is clear that if there is an intention to distribute dividends to the beneficiary individual, it is desirable to make the distribution before the end of the ten year ta holiday so the income would be exempted from tax in accordance with section 14 of the Ordinance.

Sections 134b and 135 of the Income Tax Ordinance stipulate that during the benefit period, the beneficiary individuals are exempt from reporting on their income abroad, on income deriving from assets abroad (purchased before their return / after return during the benefit period), and they are exempt from including assets abroad In the capital declaration. After the ten years have elapsed, if the beneficiary individuals remain in Israel, they will be subject to on their worldwide income, will be forced to attach Form 150 regarding holdings in foreign entities and to include capital assets abroad in their capital declaration. The question arises as to whether, in the framework of an audit, the Tax Authority is authorized to deplete Articles 134b and 135 by comparing capital between a declaration of capital that was prepared during the benefits period and a capital declaration that was prepared after the benefit period. In our view, the answer is negative. In our opinion, sections 134b and 135 of the Ordinance are valid both during the benefits period and after the benefits period passes as far as the reference to those years of the benefit period is protected from the reporting obligation. At the same time, it is good that these taxpayers will act (although as stated, they are not obligated to do so), to retain a record of income and assets abroad during the benefit period.

The end of the benefits period also necessitates the economic possibility of implementing a structural change in the Group, as well as examining the exposure of control and management from Israel regarding foreign entities. As is well known, in order to encourage the migration of multinational companies incorporated abroad to Israel as a "resident" in relation to the "body of persons", the definition determined that if the control and management of the foreign company are carried out solely by the beneficiary individual or anyone on their behalf during the 10-year period of benefits, the ITA cannot argue for an effective management and control from Israel and therefore cannot classify the foreign entities as Israeli residents. Therefore, towards the end of the ten year tax holiday, the circumstances of the operation of the foreign entities from Israel must be carefully examined - if the activity of the beneficiary individual from Israel is critical to the foreign entity's activity then it should be classified as an Israeli entity. However, if it is possible to appoint a mechanism abroad and to manage and control the activity of the entity outside Israel, then it should be further classified as a foreign entity for fiscal matters.

Even with respect to trusts, preparations should be examined at the end of the benefits period. Thus, for example, the provisions of the Amendment 197 to the Income Tax Ordinance stipulate that if the settlor of the trust has returned to Israel prior to 1/8/13 (and the Tax Authority even argues it is required that settlor settled a trust before the said date), the income of the trust abroad will be exempted from tax during the 10 year tax holiday, even if all or part of the beneficiaries are residents of Israel. Now, just before the end of the benefits period, in a situation in which some of the beneficiaries are residents of Israel and some of them are foreign residents, a split of the trust should be examined to two trusts: (1) Israeli trust where all beneficiaries are Israeli residents (2) Foreign beneficiary trust where all beneficiaries are foreign residents (it needs to be irrevocable).

Another ramifications in this regard may be the examination of the distribution of assets "just before" the elapse of the ten years tax holiday to save problems of crediting foreign taxes or to overcome the STEP UP problem, as well as examining trust holding companies a moment before the end of the benefit period - do they meet the definition of "Trust Assets Company" a defined in Amendment 197 to the Ordinance or is it better to liquidate just to avoid a possible two tier taxation.

[1] International Tax Partner, Ziv Sharon & Co. Law Office. Formerly, Mr. Frenkel worked as a tax specialist in the International Tax Division, Israel Tax Authority.

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.