How To Get A Double Tax Credit From The U.S. To A Tax Credit In An International Treaty

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1 Volume 71, Number 6 August 5, 2013 Israeli Tax Reform and U.S. Trusts: Effective Treaty Relief From Double Taxation? by Elizabeth Kessenides Reprinted from Tax Notes Int l, August 5, 2013, p. 561

2 Israeli Tax Reform and U.S. Trusts: Effective Treaty Relief From Double Taxation? by Elizabeth Kessenides Elizabeth Kessenides is a tax attorney with Berdon LLP in New York. The author would like to thank Marc Ausfresser, Robert Cassanos, and Stephen Land for their thoughtful comments and exchanges on the topic of double tax and treaty rules. Most tax practitioners generally believe that when it comes to double taxation risk, tax treaties get you to the right result; that is, either the foreign taxing jurisdiction has to desist, or the United States will grant its citizens/resident taxpayers a credit for the taxes it allows a foreign government to impose under the treaty. This belief is not necessarily well founded, because many treaties currently in force fall short of offering relief from double taxation in all cases. This issue is of the moment, as Israel s government has adopted major reforms to the tax treatment of foreign (that is, non-israeli) trusts. 1 (Related coverage: p. 514.) Until now, Israel did not tax trusts whose settlors were all nonresidents of Israel on foreign-source income. Under the recently passed Israeli legislation (Israeli tax reform), for any trust with beneficiaries that are Israeli residents, either: 1 This article is in response to the summary of the legislative proposals as set forth in Guy Katz, Government Considering Wide-Ranging Tax Reform, Tax Notes Int l, July 1, 2013, p. 40; and Leon Harris, Your Taxes: Trust Proposals Too Bad to Be True, The Jerusalem Post, June 11, The provisions were passed into law in Israel on July 30, the trust itself will be required to pay Israeli income tax; or the beneficiaries who reside in Israel will be subjected to Israeli income tax on distributions. These taxes will apply to Israeli- and foreign-source income. 2 This means that a U.S. trust with beneficiaries who are dual Israel-U.S. residents (including U.S. citizens who are residents of Israel) could face Israeli income tax at a rate of at least 25 percent, or else the Israeli resident beneficiaries will incur Israeli tax on distributions at a rate of 30 percent. Also, there will be U.S. tax imposed on either the trust, the beneficiaries, or (in the case of an entity classified as a grantor trust 3 ) the 2 Id. The bill has been described as setting forth different regimes for cases in which the settlor of the trust is still living, as opposed to trusts that exist after the death of the settlor; there are also distinctions made for trusts with a defined class of relatives as the only beneficiaries. In some cases, the trust will be liable to tax in Israel, and in other cases distributions to beneficiaries will be taxed, with a possible irrevocable election available to the trust (to incur tax at the trust level). 3 Under the grantor trust provisions of the Internal Revenue Code of 1986 as amended, the grantor is treated as the owner of the trust s assets and is taxed directly on its income. See sections of the code. All section references herein are to the code, unless otherwise indicated. TAX NOTES INTERNATIONAL AUGUST 5,

3 FEATURED PERSPECTIVES grantor. 4 Large numbers of trusts exist that have been established by U.S. citizen grantors, with beneficiaries who are both U.S. citizens and residents of Israel. How will the Israeli tax reform affect such trusts? The potential for double taxation and the application of the Israel-U.S. tax treaty 5 to avoid this result raises interesting questions of treaty interpretation. It appears that in cases where the trust itself is the relevant taxpayer in both countries, the treaty should offer some relief by requiring Israel to offer a tax credit for certain U.S. taxes incurred by the U.S. trust, 6 and the United States to offer a credit for certain taxes imposed by Israel. But where the trust is the relevant taxpayer in one jurisdiction, and either the beneficiaries or the grantor are the relevant taxpayers in the other jurisdiction, the answers are unsettled. The discussion below reviews the application of U.S. domestic law to a U.S. trust that is potentially subject to Israeli tax under the bill, the relevant provisions of the treaty, and the unanswered questions that remain. For this discussion, it has been assumed that the assets of the trust consist solely of stock and securities, and that any such stock does not represent an interest in a United States real property holding corporation. 7 Background 4 The proposals in Israel apply to trusts regardless of whether they are classified from a U.S. tax standpoint as grantor trusts, testamentary trusts, or simple or complex trusts. 5 See Convention Between the Government of the United States of America and the Government of the State of Israel With Respect to Taxes on Income, signed Nov. 20, 1975; Protocol Amending the Convention Between the Government of the United States of America and the Government of the State of Israel With Respect to Taxes on Income, signed May 30, 1980; and Second Protocol Amending the Convention Between the Government of the United States of America and the Government of the State of Israel With Respect to Taxes, signed Jan. 26, For purposes of this article, the term U.S. trust refers to a trust that is a U.S. resident under the provisions of section 7701(a)(30). 7 The term United States real property holding corporation is defined in section 897(c)(2). 8 Section 904(a) and 904(b). In the absence of a treaty granting appropriate relief from double taxation, a U.S. taxpayer can seek some relief by virtue of claiming, to the extent allowable under the Internal Revenue Code, a foreign tax credit. U.S. statutory law imposes limitations on a taxpayer s opportunity to claim a foreign tax credit, however. The provisions of section 904 limit the foreign credit that can be claimed to the U.S. tax on income from foreign sources. 8 Thus, if the income on which the foreign tax is paid is treated as U.S.-source income under the code, without a relevant treaty that would re-source the income to make it foreign-source income, it is possible that no relief will be available in the United States for foreign taxes paid. It may be the rare case in which a foreign country imposes tax on income treated as U.S. source under U.S. statutory rules, but the situation can (and does) arise from time to time, particularly with intangible assets. For example, many foreign countries tax sales of stock by nonresidents where the stock represents an interest in an entity whose value is derived principally from real estate located in that foreign country. Gain on such a sale would, in the hands of a U.S. resident, be treated as U.S.-source income under section 865, which sets forth statutory source rules for income relating to sales of non-inventory personal property. The section 865 source rules were dramatically altered by Congress in Until that time, gain on personal property sales was sourced by reference to the location of the sale, generally understood to be a title passage rule. 9 This approach was susceptible to manipulation, and when tax rates were reduced in 1986, Congress decided to change the determination to a residence-based standard. 10 Thus, in the case of a U.S. resident, income or gain from the sale of personal property is generally U.S. source; in the case of a nonresident, the income or gain is generally non-u.s. source. 11 (There are some exceptions to this basic residence rule, including one that requires in the case of a U.S. citizen residing abroad that a foreign tax of 10 percent or more be incurred on the income, otherwise the income is treated as U.S. source.) 12 In terms of double tax conventions, because the United States taxes its citizens as well as its residents on their worldwide income, the U.S. generally insists on the inclusion of a savings clause the effect of which is to preserve the right of the U.S. to tax citizens and residents on the basis of the provisions contained in the code. The Israel-U.S. treaty s savings clause (article 6(3)) reads as follows: Notwithstanding any provisions of this Convention except paragraph (4), a Contracting State may tax its residents and its citizens as if this Convention had not come into effect. Article 6(4) provides, in relevant part, that the provisions of article 6(3) shall not affect the benefits conferred under article 26. Thus, the savings clause of the treaty does not override article See Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, pp Id. 11 Section 865(a). Before section 865(a) was adopted in 1986, the source of income from gains of sales of personal property depended on the place of sale. See Boris Bittker and Lawrence Lokken, Federal Taxation of Income, Estates & Gifts, para The place of sale rule, however, was acknowledged as being susceptible to manipulation. 12 Section 865(g). 562 AUGUST 5, 2013 TAX NOTES INTERNATIONAL

4 Article 26 is titled Relief from Double Taxation ; it thus conveys the general goal of the treaty, even though it may not always assure this result. Article 26(1) of the Israel-U.S. treaty provides: In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow a citizen or resident of the United States as a credit against the United States tax the appropriate amount of taxes paid or accrued to Israel. The lead-in language to the provision quoted above is very meaningful it reinforces the concept that while a credit may be allowed, it is subject to the limitations of the law of the United States. These limitations include, under current law, the limitation imposed by section 904 referred to above. Israel similarly has agreed in article 26(3) of the treaty to allow to a resident of Israel a credit for U.S. taxes paid in accordance with and subject to the limitations of Israeli law. 13 The subject to modifier was added in 1993 by the second protocol. The U.S. Treasury Department explanation of the second protocol, in addressing this new modifier, stated as follows: However, the law as it is applied [by Israel] at any time must be consistent with the general provisions of the paragraph, i.e., it must continue to provide for a full foreign tax credit for U.S. income tax. 14 The treaty also contains source rules. Article 4 (source of income) addresses the sale of tangible or intangible personal property. When the treaty was first adopted, article 4 required that such income shall be treated as income from sources within a Contracting State only if such sale, exchange or other disposition is within that Contracting State. 15 Thus, the Israel-U.S. treaty adopted a situs test, presumably a title passage rule, for determining source. 16 When the treaty was adopted in 1975, the source rules under section The subject to concept, in terms of Israel s tax credit being subject to the provisions of law in Israel, was inserted into the treaty by the second protocol in See U.S. Treasury Department, Technical Explanation of the Second Protocol. 15 Article 4(6) also includes a special source rule for sales of stock in some Israeli corporations, but that rule is not the focus of this article, which instead focuses on sales of publicly traded securities or stock of U.S. domestic corporations. 16 The Treasury Department technical explanation of the treaty, as amended by the first protocol, acknowledged that the source rules of article 4 may differ from those provided in the code, and went on to state that a taxpayer may not make inconsistent choices between Code and Convention rules. See Technical Explanation of the Convention Between the Government of the United States of America and the Government of the State of Israel, May 30, FEATURED PERSPECTIVES also applied a title passage rule for sourcing income from sales of personal property. Congress amended the law in 1986 because it considered the test too easily susceptible to manipulation. 17 Under a title passage rule, title generally passes, in the case of exchangelisted securities, under the rules of the relevant clearing system. The question thus becomes, What is the relationship between the code provisions and the treaty? Which rule is given preference? While Congress can override the provisions of a double tax convention, particularly if Congress makes clear its intent to do so, in the case of Israel, the second protocol was agreed to by the U.S. and Israeli governments in 1993; thus, it was accepted by the United States a number of years after the revisions to section 865. In the second protocol, specific reference was made to the source rules of article 4 and their application to sales of some intangible assets in computing the foreign tax credit. Article 26(4) now provides: Notwithstanding any other provision of this Convention, the source rule for income derived from the sale, exchange or other disposition of stock or of interests in an intangible set forth in Article 4 shall apply for purposes of this Article. The other source rules set forth in Article 4 shall also apply for purposes of this Article, to the extent not prohibited by the domestic law of the Contracting State that is providing relief from double taxation. Further, the U.S. Treasury Department explanation of the 1993 second protocol specifically states that it is intended that this rule apply notwithstanding the savings clause of Art. 6. This appears to make clear the decision of the competent authorities at that time regarding the manner in which source would be determined, and it should prove helpful when dealing with sales of personal property and the potential for double taxation. If a person is entitled to claim treaty benefits, that person should be entitled to claim a tax credit, in Israel, for U.S. tax paid on U.S.-source income (as determined under the treaty). What About Dual Residents? Article 3 of the Israel-U.S. treaty defines fiscal residence. Under article 3 of the treaty, a trust with a grantor who is a U.S. person and dual-resident beneficiaries could be classified as both a U.S. resident and an Israeli resident trust. While there are tie-breaker rules in the treaty for natural persons, the treaty does not currently provide a tie-breaker rule for entities. Article 3(3), added in 1993 by the second protocol, reads: 17 The rule clearly allowed for selectivity on the part of taxpayers. See Rev. Rul , C.B. 287, in which an exchange of debentures for stock was sourced based on where the exchange agent to whom the debenture-holder surrendered its certificates was located (and the holder could freely choose). TAX NOTES INTERNATIONAL AUGUST 5,

5 FEATURED PERSPECTIVES where a person other than an individual is a resident of both Contracting States, the competent authorities of the Contracting States shall endeavor to settle the question by mutual agreement and determine the mode of application of the Convention to such person. Until the competent authorities make such a determination, the person shall not be treated as a resident of either Contracting State except for purposes of Article 26 (Relief from Double Taxation), Article 27 (Nondiscrimination) and Article 31 (Entry into Force). Thus, a dual-resident trust is not able to assert the benefits of the treaty generally until the competent authorities act (for example, for purposes of reduced rates of withholding on dividends, or interest). But the dual resident trust should be able to assert treaty benefits for purposes of the relief from double tax section provided for by article 26 even absent action by the competent authorities, and the source rules of article 4 are specifically referenced in article 26. Who Will Offer the Credit? Where does this leave a trust treated as a U.S. person under the code, if one or more of its beneficiaries are dual residents? Would the provisions of article 26 compel Israel to issue a credit for U.S. taxes paid by a U.S. trust? What if the tax in the United States is paid not by the trust but by the grantor? What if the tax in Israel is paid by the resident beneficiaries? The most straightforward situation is one in which the tax is paid, in both countries, at the trust level. Let s assume for this purpose that all income earned by the trust would be sourced to the United States under the treaty source rules, either because of the situs of sale test or because the payer of the relevant income (dividends or interest) is in the United States. 18 If Israeli income tax is imposed on income sourced to the United States, Israel should allow the trust to claim a tax credit for U.S. taxes paid by the trust. The United States would not, in such instance, allow a tax credit (assuming the trust did not have other nontaxed sources of foreign income), because all the trust s income would be U.S. source (implicating the foreign tax credit limitation rules of section 904, which are emphasized by the lead-in language in accordance with and subject to the limitations of U.S. law ). Matters become uncertain, however, for trusts taxed as grantor trusts under the provisions of the code. In those cases, the relevant taxpayer in the United States 18 Article 4 of the treaty provides that dividend income shall be sourced as income from within a contracting state only if paid by a corporation of that state. Interest income is treated as income from within a contracting state if paid by the relevant country, a political subdivision thereof, or a resident of the contracting state. is the individual grantor whereas the relevant taxpayer in Israel will be either the trust itself or the beneficiaries. In fact, because the Israeli tax reform appears to impose tax in situations in which a trust has beneficiaries who are Israeli residents as well as other beneficiaries who are not, the more likely outcome is that the beneficiaries will incur tax in Israel on the distributions. 19 If so, a proper offset would not appear to be possible, unless the competent authorities reach some sort of agreement allowing for a credit to be claimed even if the tax was imposed, in the other country, on a different taxpayer. 20 To illustrate the point, consider the situation in which a U.S. citizen and resident is the grantor of a grantor trust, established for the benefit of his grandchildren. Some of the grandchildren are residents of Israel. Assume the trust s income, both under the treaty s sourcing rules (as well as U.S. statutory rules), is all U.S. source. In the United States, the relevant taxpayer is the grantor, who is required to include the income earned by the trust on her return. In Israel, the relevant taxpayer is the trust. Under article 26(3) of the treaty, Israel is only required to offer a foreign tax credit to a resident of Israel for the amount of taxes that resident paid: Israel shall allow to a resident of Israel as a credit against Israeli tax the appropriate amount of income taxes paid or accrued to the United States...Such appropriate amount shall be based upon the amount of tax paid or accrued to the United States but shall not exceed that portion of Israeli tax which such resident s net income from sources within the United States bears to his entire net income for the same taxable year. There is nothing in the treaty requiring Israel to recognize taxes paid by the grantor as taxes paid by the trust, though that would seem to be the proper result. Thus, it is not clear at this time that any offset would be available. 19 In the case of a trust with both Israeli resident and U.S. resident beneficiaries, the trustee may decide that it is not appropriate for the trust to pay tax on its income, which may or may not ultimately be distributed to the Israeli resident beneficiaries. Thus, while the tax rate imposed at the beneficiary level in Israel is proposed to be higher (30 percent as opposed to 25 percent), there may be other considerations that result in tax being paid at the beneficiary level. 20 It is worth observing that in a mirror image situation, if the United States were to impose tax on beneficiaries who received distributions from a trust treated as a grantor trust under Israeli tax law, the code offers some relief section 667(d)(1) appears to offer a foreign tax credit and the provisions of section 665 would allow relief even if it was the settlor who paid the tax in Israel. This example lends further support to the view that Israel should take into account taxes paid by U.S. grantors and offer appropriate relief where the grantor is paying tax to the United States. 564 AUGUST 5, 2013 TAX NOTES INTERNATIONAL

6 Given this dilemma, the U.S. grantor might decide to take steps to source the income earned by the trust to Israel (while this would not be within her control in the case of interest and dividend income, it could work for some personal property sales). Such measures might allow some foreign tax credit to be claimed in the United States. But even this approach is likely to mean a real tax increase. Israel s tax rate is higher than the maximum U.S. tax rate applicable to long-term capital gains. Furthermore, beginning this year, in the U.S. there is a 3.8 percent additional tax that would apply under section 1411, a tax that may not necessarily be offset by foreign tax credits. 21 To take the hypothetical further, when a grantor of a U.S. grantor trust is a U.S. citizen but is an Israeli 21 As section 1411 is drafted, foreign taxes would not appear to be creditable in computing net investment income. See New York State Bar Association Report on the Proposed Regulations Under Section 1411 (May 15, 2013). This NYSBA report discusses the possible implications when a taxpayer incurs foreign tax on net investment income, including arguments in favor of treating the section 1411 tax as a tax for foreign tax credit limitation purposes under section 905. The report also raises the question whether Congress intended to override treaty provisions when adopting this provision. FEATURED PERSPECTIVES resident with a tax home in Israel, under the source rules of section 865, gain on the sale of stock should be treated as foreign-source income. This may make it easier for a grantor to claim a tax credit (in the case of an entity taxed as a grantor trust) for the Israeli tax paid, if the tax is paid by the trust itself. The treaty rules for determining the source of income suggest that sales of stock might be structured to best suit the needs of a taxpayer. This is precisely the sort of thing Congress sought to avoid when it adopted the changes to section 865. A great deal remains to be seen about how Israel will implement the provisions of the recently enacted law particularly as it relates to trusts that are also residents of other countries. Trustees would be well advised to seek guidance on this topic, and tax advisers will have to parse through the treaty with different factual variations in mind. The latest reports indicate that the provisions of the Israeli tax reform affecting trusts will become effective on January 1, It is possible that until the competent authorities act, double taxation cannot be ruled out in all instances. TAX NOTES INTERNATIONAL AUGUST 5,