As is well known, many individuals made Aliya to Israel or returned to live in Israel after the amendment of the Income Tax Ordinance in 2008. These individuals are considered beneficial individuals for tax purposes and they are about to complete their ten years of tax holiday in Israel in accordance with para 14 of the Income Tax Ordinance.
The tax benefits granted under the Amendment in 2008 apply to a person who has been a resident of Israel for the first time and to a veteran (“long absent”) returning resident who after being at least 10 years a foreign resident, has become an Israeli resident (or as a temporary order in the law states a person who returned to Israel in the years between 2007 and 2009 and who has been outside of Israel at least 5 consecutive years is sufficient for the status as veteran returning resident).
The law grants the beneficial taxpayers an exemption from reporting of the assets and the income from foreign sources for a period of 10 years (called the “benefit period”), an exemption from tax for foreign source current income for 10 years and an exemption of capital gains tax from foreign sourced assets, whether purchased before or after their return. After the end of the benefit period, the current foreign source income will be subject to Israeli tax immediately and in full, whereas the capital gains tax liability is partially still exempt because of the linear approach taken in para.97 b(3) of the Israeli Income Tax Ordinance. This linear approach leads to the result that only that portion of gain which relates to the period of the holding of the assets from the end of the 10 year period is subject to capital gains tax in Israel.
The beneficial taxpayer whose 10 year benefit period is about to end often ask himself/herself how to prepare or to act before the end of the benefit period.
- Make sure when the 10 year period has started
First, the taxpayer should examine carefully at what tax year his/her tax benefit period has started and therefore also in what tax year it will end. The terms “first time Israeli resident” or “veteran (long absent) returning resident” are based on the definition of “Israeli resident” whose implementation is not always so clear. There can be a dispute between the taxpayer and the tax authorities with respect to when the benefit period has started. Often the taxpayer will claim that the benefit period has started later than the tax authority claims, for example due to the fact that the wife and children came to Israeli before the taxpayer himself.
2. Distribution of dividends before the end of the 10 year period?
Upon the expiration of the benefit period any dividend distributions from the holding in a foreign corporation will be subject to Israeli tax (if the beneficial taxpayer remains in Israel). Therefore, there is a clear incentive to distribute any dividends of a foreign corporation before the end of the benefit period and the beneficial taxpayer who has a holding in a foreign corporation with accumulated profits should strive for the distribution of the profits before the end of the benefit period.
3. Sale of foreign assets before the end of the 10 year period?
In some cases the dissolution of the foreign company should be considered before the end of the benefit period, especially if the assets are to be sold afterwards. The capital gain upon dissolution of the company is not subject to Israeli tax if the dissolution is made before the end of the 10 year period. The original purchase price for the individual taxpayer will be the value of the asset at the time of the distribution/dissolution of the foreign company, so that only the gain after the end of the 10 year period will be subject to tax in Israel upon the sale of the asset.
With respect to portfolio assets it is probably preferable to sell the assets before the end of the benefit period if they have been held already for a long time and have increased in value. The profit will be exempt from Israeli tax. In contrast, if the assets in the portfolio bear inherent losses, the assets should probably not be sold before the end of the benefit period. The taxpayer should wait with the sale until the end of the benefit period in order to use the loss upon sale as a set off against future profits.
With respect to bonds which carry interest to be realized after the benefit period, they should be sold before the end of the benefit period or before the receipt of the interest in order to use the benefit that the built in interest as capital gain is fully exempt from capital gains tax.
4. Loans from foreign related parties?
Has the beneficial taxpayer granted loans to foreign related parties then any accrued interest should be paid in advance before the end of the benefit period, if possible. Furthermore, loan agreements between the shareholder and a related foreign company should be changed not to carry any more interest after the benefit period, because the receipt of interest payments are subject to the progressive tax rate in Israel, which can amount to 50 % tax.
5. Sale of assets – not real estate – to a holding company?
Upon the sale of an asset after the benefit period the accumulated gain is taxed on a linear basis. As a consequence, the exemption for the gain is getting proportionally smaller with the passage of time. The sale of the asset to a holding company within the 10 year benefit period would be exempt from capital gain. The subsequent sale of the asset after the benefit period is subject to full capital gains tax in Israel. Therefore, if it is assumed that the holding in the foreign corporation is expected to increase after the end of the benefit period, an asset should not be sold or transferred to another holding corporation before the end of the benefit period in order to use the exemption based on the linear approach for the part of the gain which is expected to be accumulated after the end of the period. In contrast, if the assets are not expected to increase any more substantially after the end of the benefit period then it would be more advisable to transfer the assets to a holding corporation before the end of the benefit period and to use the full exemption for capital gain within the benefit period. Any gain after the benefit period would be subject to the normal capital gains tax in Israel.
These recommendations are only relevant for assets which are not real estate in the foreign jurisdiction. The disposition of real estate is almost always subject to tax in the foreign country, including capital gains tax, whereas the disposition of normal assets, other than real estate, are often exempt in the source country because of the provisions of a treaty for the Avoidance of Double Taxation between Israel and the foreign country.
6. Reporting and comparison of capital declarations during and after the benefit period
Section 134 b and 135 of the Income Tax Ordinance stipulate that during the benefit period, the beneficiary individual is exempt from reporting on their income abroad, on income deriving from assets abroad, whether purchased before the return to Israel or after within the 10 year benefit period and they are exempt from including assets abroad in the capital declaration. After the benefit period, the taxpayer, if he remains in Israel, will be subject to Israeli tax with his worldwide income, will have to file an Israeli tax return and thereby be forced to attach Form 150 regarding all the holdings in foreign entities and to include capital assets in his capital declaration. Even though the taxpayer is protected from the reporting obligation during the benefit period, it is desirable that he retains a record of income and assets abroad during the benefit period.
7. Foreign corporation – control and management by the beneficial taxpayer
Before the end of the 10 year benefit period it might be desirable to implement some structural changes to a foreign corporation. A foreign entity which is solely controlled by a beneficial resident during the 10 year benefit period is not treated as if the management and control is in Israel and is therefore not classified as an Israeli entity. Towards the end of the beneficiary period it should be carefully considered whether the foreign corporation should be still controlled and managed from Israel, because after the benefit period this foreign corporation will be classified as an Israeli entity. If the foreign corporation is not interested to be considered an Israeli corporation, the management structure might have to be changed so that the control and activity of the corporation is outside of Israel.
8. Trusts should be examined at the end of the benefit period
If the settlor of a trust is an Israeli resident the income of the trust is subject to tax in Israel. The Amendment 197 to the Income Tax Ordinance stipulates that in case the settlor of a trust made Aliya or returned to Israel before August 1, 2013 (maybe also required that the trust itself is established before that date), the income of this trust will be exempt from Israeli tax during the 10 year benefit period, even if all or part of the beneficiaries are Israeli residents. After the benefit period the whole income of such a trust, where at least one beneficiary is Israeli resident will be subject to tax in Israel. Therefore, one might consider splitting the trust in two before the end of the benefit period: one trust with the Israeli beneficiary and another trust with the foreign beneficiaries.
Summary
For many beneficial taxpayers the benefit period of 10 years based on the Amendment made to the Israeli Income Tax Ordinance in 2008 will soon expire. The expiration has immediate tax consequences. The beneficial taxpayer should carefully consider and analyze how he might structure and eventually change certain investment strategies before the expiration of the benefit period.