For many years, Israel has not taxed Israeli residents on any distributions they received from trusts created by a U.S. person with a U.S. trustee unrelated to the beneficiaries; beneficiaries were not even required to report such distributions. This all changed when the Israeli Knesset passed its recent tax reform law, effective January 1, 2014, subjecting many previously tax-exempt trusts to significant Israeli income tax liability. The reporting and tax obligations discussed below are imposed even if there are no assets in Israel, no trustee in Israel and the settlor is not an Israeli resident.
According to the new law, an Israeli Beneficiary Trust is a trust under which all settlors are foreign residents, and there is at least one Israeli resident beneficiary. While all trusts in this category will now be taxed, those that can be classified as a Relatives Trust (sometimes referred to as a Family Trust) – when the settlor is the parent, grandparent, spouse, child or grandchild of the beneficiary – have an option that presents the more complicated tax-planning issue.
Trustees of existing Relatives Trusts must notify the Israeli tax assessor of the existence of such trusts by January 28, 2014 (or within 60 days of the creation of a new Relatives Trust). Then, the Trustee must choose between two possible taxation regimes. Under the Deferred Tax Regime, the Israeli resident beneficiary is taxed at a 30% rate upon distributions when received, while there is no yearly tax at the trust level. Note that only income, not principal, is subject to taxation, but there is a presumption that income is distributed before principal.
The Trustee may make an irrevocable election to be taxed instead under the Alternative Regime, which imposes a 25% tax at the trust level on a yearly basis with respect to the portion of the income allocated to Israeli beneficiaries. Under this regime, distributions to beneficiaries are not taxed. Regardless of which regime is chosen, at the death of the settlor, the trust would become an Israeli Resident Trust, subject to Israeli taxes on its worldwide income. However, in many cases, this change in status can be postponed until the death of the surviving spouse of the deceased settlor.
American clients who have established trusts for their children and grandchildren, some or all of whom live in Israel, need to be made aware of the new reporting requirements and income tax liability that the trusts, or their children and grandchildren themselves, will now bear. Many factors must be considered in choosing between the possible taxation regimes. Some issues, such as the possibility of double taxation in Israel and the U.S., are still unclear and further guidance and regulations are still pending. What is clear, however, is that many previously tax-exempt trusts – whether grantor or non-grantor, revocable or irrevocable – now must make some difficult decisions about their new tax liability, and will require consultation with qualified U.S. and Israeli tax counsel.
Please click the following link for a diagram illustrating the effect of the new tax law: Diagram.