The Economic Arrangements Law

Proposed rules regarding the taxation of trusts may create credibility crisis for Diaspora Jewry

On July 21, the Knesset approved the Economic Arrangements Bill in its first reading. The bill, which incorporates some material statutory amendments that adversely affect Israeli beneficiaries of foreign settlor trusts, is set to take effect from January 1, 2014.

Israel might earn a few points with the international community, but its overall credibility will be scarred. The cancellation of certain benefits coupled, in particular, with the introduction of reporting obligations as well as the taxation of non-resident settlor trusts, including in some instances, on new immigrants and veteran returning residents as of 2014, could cause critical erosion to the confidence of Diaspora Jewry and their professional advisors in the Israeli fiscal system.

The current legal position has been that where a nonresident has vested assets and funds in a trust in favor of an Israeli resident, then as long as the latter has no control over the management of the trust fund, the trust (including distributions) is exempt from tax and reporting in Israel.

The Israel Tax Authority claims that this tax concession has been abused in certain cases where, by example, Israelis have channeled undeclared capital through the medium of non-residents through trusts in favor of themselves, thereby becoming entitled to an absolute tax and reporting exemption on such funds and the income thereon.

We expect the legislative changes to affect to the tax treatment of foreign settlor Israeli beneficiary trusts to be as follows: Distributions from an FSIBT to Israeli beneficiaries will no longer be exempt from tax and reporting in Israel (including foreign settlors who are deemed new immigrants). Tax will either be applied to distributions at a rate of 30% or to all annual trust income allocated to Israeli beneficiaries at a rate of 25% (at the election of the trustees). Israeli beneficiaries will also be required to report their trust income.

To be classified as an FSIBT, the settlor must be alive and all beneficiaries must be first degree relatives of the settlor (spouse, parent, grandparent, child or grandchild). If the settlor is deceased (as well as the settlor’s spouse) or at least one of the beneficiaries is not a close relative, the trust will be classified as an Israeli resident trust and will be taxed on worldwide income.

A foreign settlor trust will only be free of tax and reporting in Israel if all beneficiaries are foreign residents and/or new immigrants benefiting from a 10-year tax holiday. The above constitutes a drastic variation to the current law. I am of the view that the new legislation has evolved as a result of the abuse of the existing law by a few cases of aggressive tax planning. The new legislation will seriously deplete the confidence of multinational Jewish families and their professional advisors in the Israeli tax system.

The fundamental change in the original legislation embodied Amendment 147 of the Israel Income Tax Ordinance, which imposes taxation in accordance with the residence of the settlor and not that of the beneficiaries, as now envisaged by the Arrangements Law, is a full reversal of the original intention of the legislator. The latter model was initially concerned at addressing the taxation of trusts rather than dealing with loopholes pertaining to undeclared capital.

The desire of the Israel Tax Authority to expose trusts in order to verify that tax is being paid as required has brought about absurd situations such as the taxation of awards from non-resident settlor trusts, when in fact the beneficiaries could have received the same awards as an outright gift, fully tax-free.

Moreover, the new legislation also creates serious discrimination between a trust in which the settlor is a new immigrant or veteran returning resident and the beneficiaries are Israeli residents, where awards are now liable for tax even during the 10-year tax holiday period, and trusts where the beneficiary is a new immigrant/veteran returning resident, where the awards are still tax-exempt.

I agree with the need to combat undeclared capital, it being clear to anybody who practices in this sector that the current domestic and international trend is for complete tax compliance at all levels. Thus, for example, what was unthinkable until quite recently is now becoming a norm, namely that many banks in Switzerland and elsewhere will not agree to open a new account in the absence of evidence that the beneficial owner of the account is fully tax-compliant in his country of residence or domicile.

Indeed, the overall position of the tax authority undoubtedly merits positive acceptance. But the authority has acted with shortsightedness and the subject legislation and the course pursued by the tax authority should not have been adopted without more in-depth consideration and debate in appropriate committees.

Undeclared capital is a malaise that must be addressed but legislation should be tailor-made to address the various, specific situations of non-reporting, rather than jumbling everyone into one arena.

Attorney Shira Shine specializes in international tax planning and the formation and management of trusts.