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.