International taxation - Trust the treaty – the meeting between trusts and treaties

The trusts chapter in the Income Tax Ordinance (ITO) came into effect in the 2006 tax year and underwent significant legislative amendment effective from the 2014 tax year. In general terms, the trusts chapter gives a trust a status of a taxpayer for tax purposes and considers the assets and incomes of a trust as being held or generated by an individual. The residency of that virtual individual is determined by the trust classification.
For example, for an Israel Residents Trust (including an Israel Resident Beneficiary Trust that is not a Relatives Trust) that “individual” is considered an Israeli resident and the trustee is taxed accordingly. The question arises, how the provisions of the trusts chapter and the taxation thereby dovetail with the tax laws in overseas countries and with the provisions and effect of the tax treaties. Some foreign laws recognize the existence of certain entities that are intended for keeping and managing assets under trust schemes, such as a foundation. In some cases, those trust entities are considered a resident in the country in which they were incorporated and/or in which they are managed. The Israeli legislator and the Israel Tax Authority (ITA) recognize the existence of such entities as trust schemes. Thus, for example, the Addendum to the ITO, lists such entities and classifies them as a trustee for the trusts chapter’s purposes. In addition, in Taxation Decision 6893/15, a similar entity of “establishment” type was referred to as a trust or as a trustee and the taxation treatment corresponded with that classification. A clash of laws may occur when such a trust entity is considered a resident of a foreign country, but is assessed as an Israeli resident individual in accordance with the provisions of the ITO. This situation forms grounds for double taxation, particularly when incomes are generated in a third country and the taxation rights of one of the countries depend on the identity and residency of the taxpayer. Tax treaties include “tiebreaker” clauses for determining a residency (when double residency occurs), but it is not at all clear whether this must be ruled according to the provisions applying to an individual (inasmuch as according to the provisions of the ITO, a trust is treated as an individual) or according to the provisions applying to a person who is not an individual. Usually, the latter is implemented for determining a residency of a company, but to the extent that the rule also applies to a trust, its residency will usually be determined according to the place of effective management. In such a case, to the extent that the effective management is situated in the foreign country, it may be argued that the incomes of the trust are not taxable in Israel pursuant to the provisions of the treaty. An interesting question would be concerning the tax liability of distributions from that trust entity, because these are not classified as a dividend according to the provisions of the ITO and on the other hand distributions from a trust are not taxable by the beneficiaries (except for a “Relatives Trust” in certain cases). In the recently signed treaties, Israel has been trying to relate explicitly to the determination of trust’s residency in the residency clause, such as the new treaty with Malta, thus giving more relevant tools for determining residency of entities or arrangements of this type. A clash between the provisions of the ITO and foreign tax laws may also arise in the context of a trust’s “Underlying Company” (a company that its sole purpose is to hold the trust’s assets on behalf of the trustee). Such a company is not considered as a resident of Israel for tax purposes and effectively it is disregarded for tax purposes, and therefore the residency clause in the treaties is not relevant to it. However, it is possible for such a company to be considered a resident of a foreign country, meaning that problems may arise primarily in all matters relating to the possibility of receiving a foreign tax credit on tax paid in the foreign country, including by way of tax withholding from profits distributed by it to the trust.