On February 15, 2015, the Israeli Tax Authority (hereinafter: “ITA”) published a taxation decision on the subject of taxation of trusts (Taxation Decision No. 6893/15) (hereinafter: “the Decision“). Before we discuss the issues that arise from the decision, we must point out that in view of the Decision, incomes that have arisen from outside of Israel, whose beneficial owners are foreign residents – are taxed in Israel too.
The main facts concerning the Decision were as follows:
A. A trust body of “Establishment Trust” type was established by the head of the family (who passed away a few years ago), who was an Israeli resident.
B. The trust rights holders (beneficiaries) are the three sons of the late father, 1/3 each, two of whom are foreign residents.
C. The Trust’s income, the object of the Decision, derived from dividends received from a U.S. company.
D. In his reports to the ITA, the Israeli beneficiary reported his share (1/3) in the dividend income and paid the due taxes (after receiving foreign tax credit, as permitted by law).
The ITA has determined that the “establishment” under discussion, is an “Israeli Residents Trust” (there was also a dispute regarding the classification of that “establishment” as a trust), which is taxed as an Israeli resident. Therefore, since 2006 the whole dividend income derived from outside of Israel will be taxed by that trust, even though 2/3 of the said income is eventually intended for the two brothers who are foreign residents.
We must point out that according to the wording of the law, in the case of a trust, this is an Israeli Residents Trust that is taxable according to the provisions of the Israeli Tax Ordinance (hereinafter: the “ITO“) as an Israeli virtual taxpayer, including with respect to its foreign beneficiaries. However, it is clear that the fiscal outcome that is caused by the Decision is the taxation of a foreign resident for income derived outside of Israel, and in our position this taxation is unjust, despite being legal.
In our opinion, the trusts chapter in the ITO is intended primarily to prevent tax distortions (usually lack of taxation) that are caused by the existence of a trust and to lead to tax neutrality compared to the situation in which there is no trust involved, and is not intended to expand the tax network concerning the income of foreigners too. A more just result would have been achievable using possible interpretation of the term “resident” in the tax treaty with the USA, whereby only the proportion of Israeli beneficiaries in the trust are to be considered as “a resident of Israel” for the purpose of the treaty, and applying this insight to the right of taxation in Israel, in which case only 1/3 of the dividend income would be taxable in Israel.
On the other hand, it may be argued that the attribution of an Israeli residency only to a 1/3 of the trust’s income is intended only for limiting the commitment of the USA to grant treaty benefits only to “the Israeli part” of the trust. Incidentally, were the shares of the American company held by a LLC, for example, which is not classified as a trust, the Israeli member might still be taxed as an Israeli individual and be entitle to the limited tax rate according to the treaty, and in Israel be taxed only for his share in the income from dividends (including receiving the foreign tax credit). Other solutions in this context may be achieved by “splitting” the trust, whether in practice or through the ITO relevant regulations, or through the implementation of sections from the trust chapter that allow for the attribution of income to beneficiaries, although these solutions are not without flaws and are not free from possible faults.
A major question that is arisen in the context of the taxation result is whether the foreign residents will receive the Israeli tax as credit (for their part) on income that was originally derived in the USA. This is not at all certain and it is certainly possible that those foreign residents would be subject to double taxation. In this context, one may possibly examine the taxation reduction in Israel under Section 16A of the ITO, whose purpose is to prevent these situations, by means of a tax refund, in part or in full, to a foreign resident in certain cases. It is also interesting whether the Decision and the spirit behind it will adversely affect the taxation settlements that have recently been announced concerning foreign trusts that have become an Israeli trusts following the recent amendment to the ITO.
As a rule, many Israeli companies are financed by shareholder loans. Interest that is paid to a shareholder, who is an individual, from a company that he owns (or that is held at a rate of at least 10%), is taxable at the marginal tax rate, according to the tax brackets of the shareholder (there is also the duty on the company to withhold the tax that applies in accordance with the maximum marginal tax rate, 48% today).
In view of this, the common choice in this type of financing is usually a linked shareholder loan (linked to the consumer price index or to any currency exchange rate) that does not bear interest (the linkage differentials or exchange rate differentials by an individual are usually tax exempt).
Recently, our office has encountered cases in which this manner of financing of an Israeli company is done, probably out of habit, even in cases where the shareholder granting the loan is a foreign resident (i.e. cases in which a foreign shareholder grants a loan to an Israeli company).
To the extent that this is not a treaty country, the choice above is correct because the tax liability applying to the shareholder and the duty to withhold the said taxes by the company, due to the interest, is the maximum tax rate, even in the case of a foreign resident.
However, to the extent that the state of residency of the shareholder is a treaty country, the limited withholding tax rate of the relevant tax treaty must be considered. For example, interest that is paid to a shareholder who is a French resident will be subject in Israel to a withholding tax at a rate of just 10% (out of the gross amount) and on the other hand will be deducted as an expense from the company’s income (subject to the rules applying to deduction of financing expenses).
Interest paid to a U.S. resident, for example, will be subject to a withholding tax at the rate of 17.5% of the gross amount or marginal tax on the profit from the interest (if the loan granter has expenses that may be deducted against the interest income), all according to the Israeli-U.S tax treaty.
Taxation at the rate of the marginal tax on net incomes (profits) is possible, in our position, even when it is not explicitly stated in the tax treaty.
It must be taken into consideration that in general the provisions of Section 85A of the ITO applies to such a loan received from a foreign resident (Section 85A of the ITO prescribes provisions regarding transfer pricing in international transactions) and market interest must be quoted. Usually, the ITA will not argue against a situation where the loan does not bear any interest, in the circumstances as described (particularly in the case of a profitable company or a shareholder from a treaty country), but it is certainly possible that in the residency country of a shareholder granting the loan, the local tax authority might exercise parallel provisions concerning transfer pricing rules and will charge the shareholder with tax on deemed interest income.
It would seem, against charging the shareholder for deemed interest income (in his country of residence), that it may be argued that a deemed interest expense at the company’s books should be permitted (despite these being two different countries and the tax charged on the interest income not being in Israel), inter alia in view of the approach that was taken in the Elisha court ruling (Civil Appeal 8131/06) in which it was ruled that the deposit that was made and held by the company generates deemed interest to the loan giver and grants deemed interest expense to the loan recipient at the same time. However, even under this analysis of deemed expense, without withholding tax at source for the foreign resident, this expense will not be permitted in view of the ITO’s provisions.
It is therefore advisable in these cases to specify market interest in shareholder loans that are made to the Israeli company by its foreign resident shareholder, particularly in the case of a treaty country residency.
A foreign resident company (hereinafter: the “Foreign Company“), which is interested in operating in Israel may operate by setting up an Israeli company or through a branch that will be classified as a permanent establishment (hereinafter: a “PE“).
If the Foreign Company were to operate in Israel through an Israeli company, the Israeli company would be liable to tax on its income generated or derived, irrespective of the place it was generated or derived (taxation on a worldwide basis), whereas the PE in Israel will be taxed only on income and profits that are attributed to it (usually incomes that were generated in Israel that are related to that PE).
An example of this is a case in which the Foreign Company establishes a R&D center in Israel, which is operated through a PE.
What would be the case for a R&D center being transferred outside of Israel to another country, including key personnel, assets (including intangible assets) and know-how? Will taxes be imposed in Israel at the time of transfer of the said R&D center?
As a rule, the sale of activity and assets owned by the PE to a third party is a tax event that is taxable in Israel, and usually also in view of the provisions of the standard tax treaties.
In contrast, at the time of relocating the PE outside of Israel, the activity and assets continue to be owned by the Foreign Company, for these did not leave its possession but only relocated, and therefore there is no “sale” event.
It would seem that since no event has occurred at the geographic relocation of the PE, not even an deemed one, the sale of the activity and assets by the Foreign Company in the future would not be taxable in Israel because at the time of sale, these do not constitute the assets of a PE in Israel.
May it be argued that the PE should be considered an independent financial entity and be treated as a company for tax purposes?
One option under this interpretation would hold that a change in geographic location constitutes a change of residency of the virtual company (if for this purpose the PE will be classified as a “virtual company”), in which case Section 100A of the ITO, which prescribes provisions concerning exit tax will apply. Thus later, at the time of sale of the assets of that company, the linear mechanism prescribed in Section 100A will apply and part of the capital gains will be taxed in Israel. We shall state that in general, Section 100A of the ITO prescribes provisions concerning deemed sale of the assets of a person – a natural person or a company – on the day on which he ceases to be an Israeli resident. The section prescribes two alternatives for taxation- taxation on the date on which the person ceases to be an Israeli resident in accordance with the market value of the assets, or deferral of payment of the tax to the date on which the assets will actually be sold, with linear taxation of the part of the capital gains taxable in Israel, and all subject to conditions prescribed in the section.
Another option under this interpretation would hold that the transfer of the R&D center constitutes an event of sale from that virtual company (the PE) in Israel to another virtual company- residing outside of Israel (another PE of the same Foreign Company), and maybe also an deemed dividend distribution to the virtual shareholder (the Foreign Company) of that virtual company, all in view of the position of the ITA that was published on the subject of a change of business model in companies operating in the technology field and the applicable tax consequences.
In our opinion, there is no room for interpretations of this kind and a PE is not to be considered a separate legal entity and therefore in our opinion, the transfer of a PE from Israel will not be considered a tax event that is taxable in Israel.
In addition, even if it were argued that such a transfer of assets and activity from Israel constituted a capital event, such argument that the deemed capital gain was distributed as a dividend in kind would mean imposition of branch tax in Israel, and the ITO does not impose such taxes in Israel on current taxable income or at the time of transfer of profits from a local branch to outside of Israel.
