How Trusts will be Taxed in Israel

Until the recent changes to Israeli tax law, there was no better financial friend to someone moving to Israel than a trust.  Not just any trust – a trust that was deemed a “foreign settler trust” for Israeli tax purposes. 

The objective of a foreign settler trust for olim was to situate the trust in a non-taxed jurisdiction where, with the proper planning, the income earned inside the trust would not be taxed. That meant that the assets of the trust could be invested, earn passive income, and not pay any taxes anywhere – even when the Oleh received a distribution from the trust.

For olim who were beneficiaries of such trusts, it was like having an unlimited tax-free savings account that would last for generations.

The New Law

On  July 30, 2013, the Knesset (i.e., the Israeli parliament), approved a new bill which is referred to as the Law for the Change of National Priorities ("the New Law").  The Bill includes, inter alia, radical amendments in the taxation of trusts in Israel. The effective date of all of the provisions of the New Law listed above is January 1, 2014 (the "Commencement Day").  Beginning from the Commencement Day, the following provisions will apply both to new trust and to trusts there were existed prior to the Commencement Day.

The following describes the main changes that are included in the New Law regarding the taxation of trust in Israel:

Israeli Beneficiary Trust – the New Law defines a new category of trust which is referred to as an “Israeli Beneficiary Trust". An Israeli Beneficiary Trust is defined as follows:

• Beginning from the date in which the trust was settled and until the tax year, all the settlors of the trust are foreign resident and;
• The trust has at least one Israeli resident beneficiary in the tax year.

An Israeli Beneficiary Trust may be classified as a "Relatives Trust" or as a "Non-Relatives Trust".   An Israeli Beneficiary Trust is classified as a Relative Trust if:

1. the settlor is the parent, grandparent, spouse, child or grandchild of the beneficiary; or
2. the settlor is a second degree relative of the beneficiary (e.g., a sibling) providing that the Assessing Officer is convinced that the trust was formed in good faith and that the beneficiary did not make a contribution related to his entitlement to the trust assets.[1]

A trustee in a Relatives Trust is required to notify the Israeli income tax assessor that the trust is classified as a Relative Trust within 60 days upon the establishment of the trust or the day in which the trust became a Relatives Trust for the first time or within 180 days, if the trust existed prior to the date in which the New Law comes into force.

The New Law establishes two alternative tax regimes for the taxation of Relative Trusts:

1. i. The Deferred Tax Regime – under the Deferred Tax Regime, the yearly income of the trust will not be subject to tax in Israel. However, a distribution to an Israeli resident beneficiary will be taxed in Israel at a rate of 30%, unless the trustee proves that the source of the distribution is the funds that were granted to the trust by the settlor.

1. ii. The Alternative Regime -- A trustee in a Relatives Trust may elect to be taxed at a rate of 25% on a yearly basis, with respect to the portion of the trust's income which is allocated to an Israeli beneficiary. If such an election is made, any distributions will be exempt from tax in Israel.

Upon the death of the settler of a Relatives Trust, the trust becomes an Israeli resident trust, and is subject to tax in Israeli on its world-wide income.[2]

From January 1, 2014, the new law ceases to provide for the future possibility of a Foreign Settled Trust and converts existing Foreign Settled Trusts into Relatives Trusts or Non-Relative Trusts.

The New Law introduces other areas of change, namely:

1. i. Reporting requirements of distributions from trusts.  According to the present tax law, an Israeli beneficiary in a Foreign Settlor Trust who receives a distribution of cash from the trust is not required to report this distribution to the Israeli Tax Authorities.   According to the New Law, an Israeli resident who receives distribution from a trust, whether in kind or in cash, is required to submit an income tax return in Israel.

1. ii. Taxation of Trusts settled by New Immigrants- under the current tax legislation, a trust that was settled by a new immigrant is entitled to the same tax benefits to which the new immigrant is entitled (generally, ten year exemption on foreign source income), whether or not the beneficiaries of the trust are also new immigrants. According to the New Law, trusts that were settled by new immigrants who arrive to Israel after August 1, 2013[3], will be entitled to the benefits of new immigrants only if all beneficiaries of the trust are new immigrants or foreign residents, and as long as the settlors are still alive.[4] 

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Prior to January 1, 2014, there are still possibilities to make adjustments to existing trusts and maintain a tax favorable outcome.

[1] All trusts settled by individuals (or entities) with a relation to beneficiaries other than described as a Relatives Trust (either classification) will be deemed an a non-relatives trust (“Non-Relative Trust”) – which is subject to Israel taxes on its worldwide income.

[2] If the deceased settlor’s spouse is alive and that spouse was the spouse of the Settlor when he/she granted any funds to the trust, the trustees have the option to keep the trust a Relatives Trust during the lifetime of the surviving spouse.

[3] There is some debate whether the date is January 1, 2014.  We are currently awaiting a response to this question from the Israeli tax authority.

[4] If the settlor made Aliyah before August 1, 2013, the trust will remain tax exempt for as long as the settlor is alive up to the 10 year Israeli Tax Holiday expiration, even if there are Israeli resident beneficiaries who do not qualify for the 10 year Israeli Tax Holiday.