Israel’s taxation system has undergone a major reform since 2003. The Income Tax Ordinance was revised as of 2003 pursuant to which an Israeli resident is taxed on worldwide income rather than the previous territorial tax system. The Taxation of Trusts Law (the "Law"), effective as of January 1, 2006, while imposing taxes on Israeli residents with respect to trusts is advantageous to foreign residents. Israel is a major international business and financial center for non-residents.
The Foreign Settlor Trust and the Taxation Thereof
There are a number of categories of trusts under the Law. This article emphasizes the category relevant to foreign residents, the foreign settlor trust. This trust is designed either for non-resident family members who wish to provide for their family in Israel or for foreign residents who wish to appoint an Israeli trustee to manage family assets and wealth.
The conditions required for a trust to be classified as a foreign settlor trust are: (i) the settlor is a non-resident of Israel at the time of formation of the trust and during the tax year; or (ii) the settlor and the beneficiaries are non residents of Israel during the tax year.
A foreign settlor trust is viewed as a foreign resident personally, with the country in which the settlor resides as its place of residence, regardless of whether the trust is classified as revocable or irrevocable. The assets held by the trustee are viewed as though said assets were held by a foreign resident personally. As a result, the income of the trust is regarded as the income of a foreign resident. Trust profits that are not derived from sources in Israel are not taxable in Israel. Further, there are no reporting obligations in Israel.
This tax and reporting exemption relates to income derived from sources such as rental, interest, dividend, capital gains and business profits outside Israel. The foreign settlor trust, in certain cases, may also be exempt from tax on certain income derived from Israel from interest or capital gains as such income may be viewed as income of a foreign resident.
The Underlying Company
The Law introduced the underlying company in Israel. This Law provides for the establishment of an underlying company of a trust within Israel or abroad for the purpose of the legal separation between the trustee’s personal assets and the trust’s assets. The company is not established for the purpose of managing an active business but for the purpose of holding assets on behalf of s trustee.
An underlying company is a separate legal entity holding a trust’s assets for the trustee, directly or indirectly. Every entity which possesses assets that are not its own, but belong to the trustee by virtue of a trustee's duty, fulfills the definition of an underlying company.
The Law provides that this underlying company is regarded as a ‘flow through entity’. The Israeli Tax Authority is to ‘look through’ the company and treat the assets and the income derived therefrom as though they were held directly by the trustee.
As the trustee of a foreign settlor trust is not subject to tax or reporting requirements, said trustee may utilize an underlying company, whether in Israel or abroad, to hold the trust’s assets. Neither the trustee nor the underlying company is subject to tax or reporting obligations on the income derived from sources outside Israel. Where the underlying company derives income from sources within Israel, such income is considered earned by a foreign resident. Since income from foreign currency deposits in Israeli banks is exempt from taxes if held by a foreign resident, the underlying company (even if established and managed in Israel) may receive the same exemption. The exemption may also be granted if the income is derived from sources such as capital gains from the sale of securities on the stock exchange which is exempt from taxes if owned by a foreign resident.
The concept of an underlying company is simple and advantageous in constructing the most efficient trust arrangement possible. Until now, settlors and practitioners preferred appointing foreign trustees out of concern that having an Israeli trustee could create tax liabilities in Israel. Following the Law, the place of residence of the trustees will not affect the taxation of the trust. It is the tax status of the beneficiary and the settlor that will determine Israeli tax liability.
This is an important development in Israel. It provides opportunities to both Israeli and overseas trust companies and trust and estate practitioners. The appointment of Israeli trustees is encouraged by the Tax Authority. Not only will it advance the use of domestic professional services, but it will also enable the Tax Authority to communicate directly with trustees. Foreign trustees seeking assistance and better communication with the tax authorities may co-operate with Israeli trustees in order to fulfill their duties in Israel.