Tax Alert No. 38 - 20.6.2021

In September 2020, the Israeli Tax Authority published a tax ruling on the subject of the taxation of the income of Israeli investors in an American REIT fund (“The tax ruling‘).

The tax ruling is not the first ruling that the Tax Authority has issued in relation to an American REIT fund in respect of the taxation of the income of Israeli investors therein, as arises from the document for the listing for trading on the Stock Exchange in Israel for the company CIM Commercial Trust Corporation (“The prospectus” and “The tax ruling for the prospectus“).

As arises from the abovementioned tax rulings and from the prospectus, an American REIT fund is subject to a special tax regime in the United States, pursuant to which, the REIT fund’s income, which is distributed to the investors in it, will not be subject to corporate income tax in the United States, but rather to taxation by way of the deduction of tax at source, which applies to the distribution of the REIT fund’s profits as dividends to the investors in it, and in accordance with the source of the income from which the dividend is distributed, in the following manner:

(A) If the source of the chargeable income is rental income, it will be subject to the withholding tax at source in the United States, at a rate of 30%, where the tax treaty between Israel and the United States restricts the  withholding rate to 25% for an individual who is resident in Israel and who holds less than 10% of the REIT fund.

(B)  If the source of the profit is from the sale of real estate (or a right in entities that hold real estate), it will be subject to the withholding tax in the United States, which applies to the sale of real estate pursuant to the FIRPTA Law, and the taxpayer will be required to submit a tax report in the United Stated and to report on a dividend that is sourced in a capital gain (Capital Gain Dividend) and to pay the federal tax on it, which applies to a foreign resident in respect of the a capital gain that is sourced in the sale of real estate in the United States (at present the rate is up to 20% for an individual and 21% for a company with the addition of branch tax, insofar as it may apply).

(C) If the REIT does not have distributable profits, a distribution from the fund is effectively classified as a return of investment, and it is not subject to tax in the United States.

It should be mentioned that for tax purposes in the United States, the distribution of a dividend that sources in a capital gain from the sale of real estate or from rental income, is deducted from the REIT fund’s chargeable income. Income that has not been distributed to the shareholders in the REIT fund will be chargeable with corporation tax.

Within the framework of the tax ruling for the prospectus, the Tax Authority determined an unprecedented tax ruling, that dividend income that is received from a REIT fund (by an investor who is a resident of Israel) is to be classified and accordingly is to be taxed in accordance with the source of the income from which the dividend is distributed, i.e. the income (from a dividend) that is sourced in the income of the REIT fund (and the intention is primarily for rental income ), is to be classified for tax purposes in Israel as income from capital gain; income that is sourced in the return of an investment is also to be classified as capital gain!

Such classification applies to an investor who is a resident of Israel irrespective to his holding rate in the REIT fund.

In light of the fact that this is a tax ruling that reflects the Tax Authority’s position, the question of what the Tax Authority based itself on, when deciding to ignore the distribution of a dividend from a foreign company, and the reclassification of such dividend to income from a different source for tax purposes in Israel, arises. It is clear to everyone that the distribution of dividends from an Israeli company or from a foreign company, with retained earnings, will be classified as a dividend for tax purposes in Israel, subject to the tax rates that are set in the law in relation to an individual or a company.

To the best of our understanding, a dividend from a REIT fund is taxed in the United States as chargeable income at the regular tax rate in the hands of an individual (tax brackets), and a dividend that is sourced in a capital gain is subject to the tax brackets that apply to a capital gain (a rate of up to 20%). Accordingly, it is possible that the Tax Authority sought to make a parallel between the manner of the taxation that applies in the United States on income from a dividend from a REIT fund and the manner of the taxation in Israel. However, we would mention that the Tax Authority’s position in relation to distributions from an LLC is that this is a dividend for tax purposes in Israel (on the ground that the LLC is deemed to be an “opaque” company), even though for tax purposes in the United States, the taxpayer is taxed on income that is attributed to him from the LLC and in accordance with the classification of the income at the level of the LLC. Accordingly, in our opinion, in relation to a REIT fund as well as any distribution from it as dividend for tax purposes in Israel subject to a restricted tax rate (25%) and moreover, according to the tax treaty with the United States, the distribution from a REIT is classified as dividend for the purposes of the treaty.

We would further mention that a controlled foreign company (CFC), which has passive rental income or capital gains from the sale of real estate that was not subject to tax abroad, the controlling interest’s relative share of the undistributed profits, will be classified as income from dividend. The Israeli legislator has determined explicitly that a distribution of notional profits will be classified as dividend and it has not prerogative to reclassify those items of income in accordance with the source from which they derive.

As an aside, we would mention that the Tax Authority’s position, pursuant to which the return of an investment in a REIT fund (on the assumption that there are no distributable earnings) is classified as capital gain, does not accord with the Tax Authority’s position which was presented in a professional circular on the subject of the classification of income from an unearned distribution (the reduction of capital), pursuant to which the reduction of capital, under certain conditions, is not a taxable event so long as it does not exceed the adjusted original price of the investment of the shares in the company, and is deducted from the adjusted original cost.

The Tax Authority has published a similar tax ruling on the subject of the taxation of the income of Israeli investors in an American REIT fund (“The fund“) that is going to raise equity on the Israeli capital market (the Stock exchange in Israel) (“The additional tax ruling“).

Within the framework of the additional tax ruling, the Tax Authority repeated its position that makes a distinction between an investor who holds less than 10% of the fund and an investor who holds more than 10%.

In relation to an investor who holds less than 10% of a fund, dividend income from the fund will be classified as dividend income, including a distribution that is sourced in a reduction of capital (return of an investment) by the fund.

In the case of a reduction of capital, the Tax Authority decided to ignore the above-mentioned circular that was published on the subject of the classification of income from a distribution other than of profit (a reduction of capital), pursuant to which a reduction of capital, pursuant to which a reduction of capital, under certain conditions, is not a taxable event so long as the distribution does not exceed the adjusted original cost of the investment in the company’s shares, and it will be deducted from the adjusted cost.

Can it be deduced from this, reading between the rows, that the Tax Authority’s position is that the abovementioned circular does not apply to foreign companies, and accordingly the return of an investment from a foreign company will be classified as a dividend for tax purposes in Israel? From our perspective, there is no justification for such a distinction and a reduction of capital from a foreign company must be treated the same as a reduction of capital from an Israeli company and distinguishing between them constitutes discrimination.

Regarding a return of an investment to a shareholder who holds 10% or more of the fund, the Tax Authority has been more severe with the shareholder in that it has determined that the return of an investment is to be classified as income from a business or an occupation (subject to the regular tax rates, up to 50%!).

In relation to such an investor, the Tax Authority has repeated its position, which was published in the prospectus, while in certain cases it has even worsened the taxpayer’s position:

• In relation to a shareholder who has filled an active role in the fund, a distribution of profits that is sourced in a capital gain in the fund will be classified as business income!!! And not as a capital gain; and

• The return of an investment will also be classified as business income. We do not understand how the return of an investment can constitute business income.

The additional tax ruling does not mention what the Tax Authority’s considerations were in these determinations. From our perspective, there are inherent difficulties in reclassifying distributions of dividends as income from a different source for tax purposes in Israel, while it is clear that any distribution of profits from an Israeli company or from a foreign company, with a balance showing retained earnings, is to be classified as a dividend for tax purposes in Israel, which is subject to the fixed lower tax rates.

Apparently, since this is a tax ruling by agreement, which was required by the party making the payments to the investors, for the purpose of the withholding of tax at source, the principles that are presented above were agreed between the Tax Authority and the REIT fund.

As we understand the situation, the principles in relation to the substantive taxation (the classification of income from dividends as rental income or income from a business or as income from capital gain), may apply to the investors without there having been partners in the process of the issuing of the additional tax ruling.

In November 2020, a court ruling was handed down in the Hosen House Ltd. case (hereinafter: “The Hosen ruling“).

General background

The self-purchase of shares (share buyback) is an economic transaction within the framework of which a company purchases shares that it has issued using retained earnings that are available to it, which is a transaction that has been permitted in Israel according to the legislation of the Companies Law.

On the plain of tax laws, the question arises of whether a self-purchase has an identical tax result to the distribution of a dividend or should the sale of shares within the framework of a self-purchase be related to as if it were a taxable event in respect of which only capital gains tax should be imposed?

The Tax Authority’s position and the position adopted in case law up to the Hosen ruling

In the past, the Tax Authority has published an income tax circular (hereinafter: “The circular“), which mentions the two previous court rulings (the Dan Bronavski and Bar Nir Tamar rulings), which determines across the board and without any connection to a claim of artificiality that, in both of the rulings, a self-purchase triggers dividend income for the remaining shareholders and sometimes also for the outgoing shareholders. According to the approach that was delineated in the Bronavski case (which will be discussed in this newsletter), the transaction is to be classified as a transaction comprising two stages:

• In the first stage, the distribution of a (notional) dividend in an overall amount in accordance with the amount of the purchase for each of the shareholders prior to the purchase in accordance with their relative share, including the seller.

• In the second stage, the remaining shareholders purchase the selling shareholders’ shares from him in the gross amount of the notional dividend (which has been “distributed” to the remaining shareholders.

The Hosen court ruling

This ruling deals with a self-purchase that is not pro-rata and determines that in a self-purchase transaction, only the selling shareholder will be taxed on a capital gain. The result is that there is no taxable event for the remaining shareholders, and they should not be seen as having received a (notional) dividend from the company whereas for the selling (outgoing) shareholder there is no reclassification of a self-purchase transaction from a capital gain to a notional dividend.

The implications of the Hosen ruling

We will present the implications of the Hosen ruling (in which, as mentioned above, the situation of a notional dividend for the remaining shareholders is refuted) for the tax aspects that would apply in accordance with the “Bronavski approach”:

• A self-purchase by an Israeli company that is held by individuals who are foreign residents

No tax event will occur for the remaining shareholders involving a notional dividend and therefore they are not to be charged with tax at a rate of 25% or 30% (for a substantive shareholder) or a lower rate where the issue involves individuals who are residents of a treaty country.

For the selling shareholder, the full amount of the income will be classified as capital gain and not as a notional dividend, even though this might, in certain circumstances, increase the tax rate (according to a linear calculation, due to the fact that until 2003 the capital gain tax rate was taxed at the marginal tax rates up to 50%,) however in other circumstances, an exemption from tax may be granted to foreign residents pursuant to the Israeli Tax Ordinance or pursuant to a treaty.

• A self-purchase by an Israeli company that is held by foreign companies

No tax event involving a notional dividend will apply to the remaining shareholders and therefore they will not be charged with any tax. For the selling shareholder, the non-classification of the income as a notional dividend and leaving the full amount as capital gain may even afford a full exemption of the provisions of the Ordinance are met or pursuant to a treaty.

• A self-purchase by a foreign company that is held by Israeli residents

As mentioned above, no taxable event involving a notional dividend will apply to the remaining shareholders and they will not be charged with tax.

In relation to the selling shareholder:

• Where the seller is an individual: as mentioned above, the classification of the income as capital gain and not as a notional dividend, in certain circumstances, may increase the effective tax rate; however, in other circumstances, a full or partial exemption from tax (on a linear basis) may be granted, if the person in question is a new immigrant or a returning veteran resident, in the appropriate circumstances.

• Where the seller is a company: the classification of the income as capital gain and not as a notional dividend will negate the possibility of receiving an indirect (underlying) tax credit (in contrast to the dividend approach).

To summarize, the ruling reawakens the Tax Authority’s position in a self-purchase event. However, we would mention that this is a ruling by the District Court, it is reasonable to assume that the Tax Authority will appeal to the Supreme Court.

Until there is a final ruling, it is expected that this issue will be the subject of uncertainty and we would recommend that each case be examined in depth and in accordance with the circumstances.

Furthermore, we would mention that on all matters relating to a self-purchase by a foreign company, it is also necessary to examine the relevant company laws in that country that may affect the legal conclusion on the tax issue.

This is an allegorical tale (it is based on real events, although the names and the circumstances have been changed for the purposes of the newsletter).

Jacques Cohen is a wealthy individual and a resident of one of the countries in Europe, who has created a trust for the members of his expanded family, who are foreign residents. Jacques, who used to be a doctor and is a well-known philanthropist, wishes to include the Beilinson Hospital as a beneficiary in the trust in order to contribute to its development and thus strengthen the medical services in Israel.

After having consulted with his tax consultant in Israel, Jacques understood that there is no impediment whatsoever to recording a hospital in Israel as beneficiary, since the legislator, who wished to encourage the giving of donations to public institutions of this type determined that “a beneficiary for public purposes”  in a trust of foreign residents or in a trust with a beneficiary who is resident in Israel, will not be harmed by the classification of such a trust as a foreign trust (in our illustration, a trust of foreign residents). Jacques was of course very happy with the news and he even praised his tax consultant for his professional and satisfactory response.

One fine day (which it became apparent afterwards was actually partially cloudy), Jacques decided to immigrate to Israel, inter alia, in order to gain an impression regarding the development of the hospital and to examine whether it was necessary to recommend to the trustee that he increase the amount of the donations from the trust.

When he arrived in Israel, Jacques asked the much-praised tax consultant whether his having immigrated to Israel could create problems for the trust. “Don’t worry” replied the tax consultant, with a haughty expression on his face, “since all of the members of your family are staying abroad, the trust is supposed to be a trust of foreign resident beneficiaries, and will continue to be exempt from taxation”.

However, after a further check that the consultant made, he got back to Jacques with a very sad expression on his face and had to report to him that the trust would not be considered to be a “trust of foreign resident beneficiaries” because in that type of a trust, the hospital is considered to be an Israeli beneficiary for all intents and purposes and therefore the desired classification would be denied to him.

“So what?” asked Jacques angrily, “Does the trust have to pay tax in Israel?”

All of a sudden, the tax consultant remembered the extravagant reliefs that the State of Israel grants to new immigrants, and reacted instinctively with a hesitant smile on his face that to the best of his memory, a trust that has become an Israeli trust following the creator of the trust’s immigration to Israel will continue to be exempt from taxation, at least for a period of 10 years.

Jacques agreed to swallow the bitter pill, however since he was beginning to lose trust in the tax consultant, he asked him to check the situation again. You guessed right, the tax consultant had to get back to Jacques again and looking nauseous and shaking, he had to tell him that the trust had also become Israeli following its creator’s immigration, the exemption would not be received unless all of the beneficiaries are new immigrants or returning veteran residents, and the hospital is neither of those. Once again, even in this case the legislator did not except a public institution.

After discussing matters with his family, Jacques agreed to swallow this pill as well, but he did still want to know what, all the same, it is possible to get if donating money to a hospital in Israel, apart from a feeling of satisfaction.

The tax consultant, who had begun to feel that his job was in danger, gave the only positive response that he could think of – “you can get a tax credit of 35% of the amount of the donation for a donation to a recognized public institution, this is a well-known rule that everyone is sure about, but let me double check”.

As expects, the tax consultant got back to Jacques, head bowed and dispirited and explained to him that a trustee in a trust, to differentiate from every other Israeli taxpayer, is not entitled to receive a tax credit for donations. “It’s the law, that is what appears in the Income Tax Ordinance” said the consultant, “and there is nothing that can be done”.

“Damn it” cried Jacques, “If that is the case then I have no choice other than to remove the hospital from the list of beneficiaries and the sooner the better”. That is what he did, the trustee removed the hospital from the list of beneficiaries, and informed the director general of the hospital whilst apologizing for the deterioration in the state of the patients that could be expected.

The tax consultant is looking for a new job, by the way.

All of the above, needs to be handled by the Tax Authority, which needs to provide the clarification that is required, if it chooses to do so.