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15 November 2015

Taxation of trusts, part 8 – taxation issues

As we have seen previously in this series, tax is levied in Israel in one way or another wherever there is at least one Israeli resident in the picture of a trust (with the potential exclusion of those within their 10-year exemption for new or returning residents).

The next few posts will look at some of the potential tax traps that can occur as a result of this legislation. Whilst it may not be possible to get around these issues with trusts that are already in existence, for those trusts that are in the process of being settled and worded, it is extremely important to take expert advice BEFORE matters go into practice so as to ensure that the tax consequences do not undo the overall aim of the trust.

Different taxpayers and double taxation
A basic tenet of international tax rules is that tax is not paid twice on the same income. And therefore, if Israel wants to tax an individual on (for example) dividend income earned overseas, a credit for the tax borne in the other country will be given against the tax due on the same income in Israel.

In certain countries (e.g. USA, UK), trust income that is distributed to a beneficiary is taxed in the hands of the beneficiary only, and not in the hands of the trust. As we have seen though, Israel's default position is to tax the income of the trust at the trust level, although in certain circumstances the income can be wholly attributable to either the settlor or the beneficiary. In these cases, there may well be situations whereby the same income is being taxed in the hands of someone different in each country. The tax authorities could therefore turn around and argue that no credit can be given for tax borne in the foreign country since the specific taxpayer in Israel did not bear any tax on this income abroad.

At present, there have been no regulations in Israel published regarding relief from double taxation in such circumstances. Therefore, if a stance is to be taken to claim the tax paid by a different taxpayer on the same income, full disclosure must be made to the tax authority.

The most obvious solution to this issue is to ensure that the incomes are taxable in the hands of the same taxpayer in each country. Practically though, this may not always be possible or even advisable (due to high tax rates)

Revocabilty of a trust

This can be a classic example of where there are issues.  As we have previously seen, a trust cannot be considered irrevocable if there is a family relationship between the settlor and the trustee.

Consider the following (real-life) example:
Non-resident parent passes away. As part of the will, a trust is established for the benefit of the Israeli-resident child, funded by their portion of the inheritance. The reason a trust is established is to ensure that the funds are put to good use (e.g. studies, housing etc.). However, the parent sufficiently trusts their child, and the child is appointed as sole trustee of the trust.

As such, the trust is considered an Israeli resident trust and is also considered recovable under Israeli tax law.

Since the settlor is deceased, the settlor cannot pay the taxes on the income, and so the trust pays the tax itself. Under certain conditions, the beneficiary can elect to tax any distributions of income made to them – but one of the conditions required is that the trust be considered irrevocable!

You might ask why this should make any difference – the trust and the beneficiary pay tax on the income at the same rate? The answer is two-fold. Firstly, the beneficiary may have unused tax credits that can be used to lower the taxes; there are no such credits at the trust level. Secondly, in this particular case at least, any income distributed to the beneficiary is taxed at the beneficiary level in the USA. And as such, we are back to the potential double-tax problem listed above.

My personal take – and I stress that this has not been approved by the tax authorities - on this sort of case is that such a trust is indeed considered irrevocable. Since the concept of revocability surrounds the ability of the settlor to take control of the assets in the trust once settled, I think it's fair to say that a deceased settlor is in no position to take control. Further it could be argued that a deceased person has no relatives – at least as far as tax law is concerned; again the logic being that a deceased person cannot exert any influence.

All said and done though, if this is applicable to you, contact me today in order to review your particular circumstances and how the taxes can best be handled.