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Critical Information for New Immigrants and Returning Residents Regarding Tax Benefits

June 2013 - Tax & Private Client. Legal Developments by Herzog Fox & Neeman .

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A New Governmental Proposal to Significantly Narrow the Tax Benefits for New Immigrants and Returning Residents in Israel

On April 25, 2013, a proposed amendment to the Economic Arrangements Law (the "Draft") was published. The Draft is referred to as a "decision draft", and at this stage in time only includes a description of the proposed changes without providing detailed language for proposed changes in the law. The Draft, which has been submitted to the Government, includes various amendments to Israeli laws, including amendments to the Israeli Income Tax Ordinance [New Version] 1961 (the "Ordinance"). One of these amendments proposes a radical change to the tax relief for New Immigrants and Long Absent Returning Residents (former Israeli residents who return to Israel after being foreign residents for a period of at least 10 years) (collectively referred to in this Note  as "New Immigrants").

 

We summarize below the main changes proposed with respect to the taxation of New Immigrants, as well as the main implications arising from the proposed amendments.

 

1.    Cancelation of the exemption from reporting obligations.

Under the current legislation, New Immigrants are not subject to Israeli reporting obligations with respect to their foreign source income and assets, for a period of ten years. The Draft proposes to abolish this relief and to require New Immigrants to report their foreign source income or assets regardless of any tax exemption to which they are entitled.

 

This change is very significant and is expected to impact many New Immigrants who are currently living in Israel and are not subject to any reporting obligations. The two main reasons noted in the Draft for abolishing the reporting exemption are that (i) due to the reporting exemption, the tax authorities cannot evaluate if a particular income item is entitled to exemption from tax; and (ii) the reporting exemption contradicts international standards of transparency and information exchange; Israel is currently subject to review by a committee of the OECD, which has informed the Israeli tax authorities that the reporting exemption must be noted in their report as reflecting a policy which is contrary to international standards.

 

2.    Death of a settlor of a trust who is a new immigrant.

Under current legislation, a trust which was settled by a new immigrant is entitled to the same tax benefit to which the New Immigrant is entitled (namely a 10-year exemption on foreign source income).

These benefits continue after the death of the settler of the trust, until the end of the 10-year term. The Draft proposes that upon the death of the settlor, the trust will not be entitled to the benefits which are provided to New Immigrants, and will become subject to tax in Israel on its world-wide income.

 

3.    Taxation of Dividends received by new immigrants.

 As mentioned above, New Immigrants are entitled to a 10-year exemption on their foreign source income, including foreign source dividends. According to the current law, if the dividend is distributed by a foreign company, the dividend will be classified as foreign source income, and will be tax exempt in Israel. The new Draft proposes that if the dividend has been distributed by a foreign company, but it was distributed from income which was derived in Israel, then such dividend will not be classified as foreign source income, and accordingly, the exemption will not apply. For example, in a case where a foreign company has a business in Israel and distributes its profits from the business in Israel as a dividend to a New Immigrant - the current legislation exempts such a dividend from tax (1), but the proposal in the Draft seeks to tax such a dividend in Israel.

 

4. Exemptions Provided to Companies Held by New Immigrants.

The Israeli tax laws include two main anti-deferral regimes -

 

(i) Controlled Foreign Companies Regime (CFC).  According to the Israeli CFC legislation, the passive income of a foreign company is, in certain circumstances, to be allocated to its Israeli shareholders as if this passive income had been distributed as a dividend to them.

 

(ii) Foreign Occupation Companies (FOC). As a general rule, a foreign company that is used by Israeli residents in order to provide services outside of Israel is considered, under certain circumstances, to be an FOC. Part of the income of an FOC which is derived from services that are provided by Israeli residents is subject to tax in Israel. New Immigrants are not subject to the CFC and FOC regimes and the Draft does not propose to change this. However, the Draft makes a significant change regarding the way in which the New Immigrant affects his Israeli partners in the CFC and the FOC.

 

As a general rule, one condition that must be satisfied for a foreign company to be a CFC or FOC is that more than 50% or 75% (respectively) of the means of control of the company (2) are held by Israeli residents. According to current legislation, New Immigrants are considered as foreign residents and therefore their immigration to Israel does not affect the taxation of their Israeli partners in the foreign company.

 

The Draft proposes to ignore New Immigrants when calculating the percentage of Israeli means of control, and not to treat them as foreign residents. The effect of the proposal in the Draft can be illustrated in the following example. Suppose that the New Immigrant holds 65% of a foreign company and an Israeli resident holds 35%. According to current legislation, the interests of the New Immigrant are taken into account and regarded as those of a foreign resident. The foreign company is therefore not considered as a CFC, since Israeli residents hold less than 50% of the means of control, and both the Israeli resident and the New Immigrant are not subject to tax on deemed dividends from the foreign company.   According to the proposal in the Draft, however, the interest of the New Immigrant is disregarded, and the foreign company is deemed to be entirely held by the Israeli minority shareholder (Israeli residents will hold 35%/35%=100% of the means of control). Such a company will become a CFC upon the immigration of the New Immigrant to Israel and the Israeli resident may be regarded as having received its share of the foreign company's income as a deemed dividend (the New Immigrant will remain tax exempt).

 

This change is very important, as there are many cases in which new Immigrants hold foreign companies together with their Israeli relatives. According to the proposed change, these Israeli  relatives may become subject to tax on their share in the profits of the foreign company, even if they do not receive any actual distribution from the foreign company.

 

Proposed changes in taxation of foreign Trusts

 

Another extremely important set of proposals is intended to bring about dramatic changes to the taxation of foreign trusts, and in particular the taxation of "a Foreign Settlor Trust", namely a trust established by a non-Israeli resident for the benefit of, among others, Israeli resident beneficiaries.  For more details on the proposed changes to the taxation of Trusts, open the attached link.

 

For more information about the latest developments in Tax, please contact Meir Linzen, Head of HFN's Tax Department

linzen@hfn.co.il or on +972-3-692-5520

 

1 Note that the Israeli Tax Authority has published a circular in which it argues that even under current legislation these

dividends are subject to tax.

 

2 In this context, "means of control" includes: (i) the right to participate in the profits of the foreign resident company;

(ii) the right to appoint a director to the foreign resident company; (iii) voting rights; (iv) the right to receive a portion

of the balance of assets of the foreign resident company upon winding-up; and (v) the right to direct a person vested

with one of the rights referred to in (i)-(iv) above as to how such right may be exercised;