TAXATION OF FOREIGN INCOME ISRAELI RESIDENTS

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1 TAXATION FOREIGN INCOME FELDMAN BRODY & Associates January 2010 No part of this publication may be reproduced without permission Website: While every effort has been made to ensure the accuracy of the text and information in this booklet, it is intended only as a general guide. Changes in law, regulations or procedures may have occurred since the date of publication and in some cases specific circumstances are not covered by the general information herein. We shall be happy to clarify matters in a meeting with you. Feldman Brody & Associates do not accept any responsibility for actions or decisions taken on the basis of information in this booklet. 1

2 TAXATION FOREIGN INCOME Section Contents Page 1. Basis of Taxation of Israeli Residents 1 2. Tax Residence 2 3. Passive (Unearned) Income Pensions Relief for Business Income 5 6. Capital Gains Tax 6 7. Controlled Foreign Companies (CFC) Trusts 8 9. Tips Comprehensive List of all our Pamphlets 10 Feldman Brody & Associates, January

3 TAXATION FOREIGN INCOME This pamphlet has been prepared to give a brief outline of the taxation aspects of foreign income of Israeli residents. Because of lack of space, we have concentrated on matters that affect new immigrants and returning former residents to Israel, principally from the UK, although many of the matters raised in this pamphlet will be of concern to Israeli residents and immigrants from other countries. In September 2008, the Knesset approved a new law to improve the tax benefits available to new immigrants and many returning residents (see Section 2 below) who arrived in Israel after January 1, This pamphlet incorporates the changes under the new law. It should be noted that the Israeli fiscal year runs from January through December. 1. BASIS TAXATION 1.1 The basis of taxation of individuals living in Israel is very similar to the UK and the U.S.A. That is to say, if a person is resident in Israel, then he/she is taxable on all income arising worldwide. In an attempt to clarify the position, the Israeli tax law includes a guide to the definition of residence. 1.2 While in most cases the date of making Aliya (new immigrant status) is concurrent with the date of taking up residence in Israel, it must be stressed that the Israeli tax law rules refer to new/returning "residents". This means that a new immigrant can acquire this status without becoming an Israeli tax resident. On the other hand, a tourist living more or less permanently in Israel, could be considered an Israeli tax resident with the consequences outlined in this pamphlet. See also Section 2 below. 1.3 It is important to note that in Israel the tax file relates to the family, as a unit, and there is no separate tax file for each spouse. This means that all income of both spouses is entered on one tax form each year. Despite this, some income is calculated based on separate tax rates for each spouse (see 1.4 below). 1.4 Passive (unearned) income, such as bank interest, dividends, etc., is normally assessed as belonging to the spouse with the highest income and apart from certain exceptional circumstances, there is no separate assessment of such income for the other spouse. Earned income (including pensions) is, in most cases assessed separately, so that both spouses can benefit from the lower tax brackets and personal tax credits. 1.5 There is no inheritance tax in Israel. UK expatriates need to take specific advice concerning acquiring exemption from UK inheritance tax. Feldman Brody & Associates, January

4 2. TAX RESIDENCE TAXATION FOREIGN INCOME This subject can be complex in certain cases but as a start: 2.1 The tax law includes various definitions to determine when a person is resident in Israel. The first is where is one s " Centre of Life" where the family lives, where the main home is, where are the main financial and cultural activities, etc. Also, according to the number of days spent in Israel, there is a presumption of tax residence unless it can be shown otherwise. 2.2 The 2008 law defines how (in effect retrospectively) an Israeli tax resident can become a non-resident. Basically, the determination runs over 4 Israeli tax years. 2.3 The new law enables a new arrival / returning resident to opt for the first year to be treated as an 'acclimatisation' period, subject to notifying the tax authority within 90 days of arrival. If the person leaves Israel within the year, then he/she is treated as never having taken up tax residence. Otherwise, the year is treated as part of the first 10 year's income/capital gains exemption period, in accordance with the rules described in the following sections. 3. PASSIVE (UNEARNED) INCOME 3.1 Any interest (except interest paid to controlling shareholders, which is taxable at regular tax rates up to 47% ) is taxable at the rate of 20% on the actual interest. Exchange differences/foreign currency fluctuations are not taxable. As against this, local shekel deposits will be taxed at a lower rate of 15% on the full amount of the interest earned. This lower rate is meant to allow for inflation, but it should be noted that in times of high inflation, the tax will actually eat into the inflationary element of the earnings on shekel bank deposits. 3.2 Income from securities is taxed in Israel at the rate of 20% (except for controlling shareholders where the tax is at 25%). It should be noted that the overseas tax paid (UK dividends receive a tax credit of 10%), can be used as a credit against Israeli tax. 3.3 Overseas rental income if all expenses incurred in receiving the income are claimed, then the net income after expenses will be taxed at regular rates in Israel, in this case no less than 30% and up-to 47% (2008). If foreign tax has been paid on the rental income, then this will be allowed as a credit against the final tax payable in Israel. There is an alternative of paying tax of only 15%, but in this case the calculation is based on the gross rent received, less depreciation only. Under this option however, credit will not be allowed for foreign tax paid. Feldman Brody & Associates, January

5 TAXATION FOREIGN INCOME 3. PASSIVE (UNEARNED) INCOME (Cont.) 3.4 Interest income on Israeli foreign currency/ deposits even though worldwide interest is taxable, as explained above, interest income on special bank (Patach) accounts, in respect of foreign currency deposits held by new immigrants, remain free of tax for the first 20 years after Aliyah. It must be noted, that the deposit must be for at least three months. In addition, the funds must be deposited in the bank within 90 days from when the funds are received in Israel, and there is a special declaration that must be completed for the tax authorities, within 14 days of the first opening of the Patach Account. The rules for returning residents are similar but must be clarified with one s bank. 3.5 Special benefits for new immigrants/returning residents in general, there is a 10-year exemption for passive income, running from the date of becoming resident, in respect of new immigrants and also veteran returning residents (who have been out of the country and were non-israeli residents from more than 10 consecutive years or only 5 years for those returning during inclusive). Passive income includes interest, dividends, royalties, rental income and pensions see Section 4. The exemption applies to income from any assets held and accumulated outside Israel. 3.6 As to the 10-year period of exemption referred to above, this period of time does not relate to the Israeli tax year but rather to the actual count of years from the day of arrival in Israel. For example, a person arriving in Israel on March 31, 2007 will be exempt from tax on passive income, as defined above, until March 30, The income received in the year in which the 10 years come to an end, will be entitled to exemption on a proportional time basis. 3.7 In certain circumstances, Israeli National Insurance (Bituach Leumi) contributions of 12% may be payable on overseas rental income and interest received on private loans, as well as on pensions paid to those beneath Israeli retirement age. Feldman Brody & Associates, January

6 TAXATION FOREIGN INCOME 4. PENSIONS 4.1 Before considering the taxation of pensions, one must look at the definition of a pension. In a publication issued by the Israeli Revenue in December 2002, the main conditions to determine whether income is a pension or not, are the following: The pension is receivable at regular intervals The pension arises from deposits into a pension fund which were made while working overseas as an employee or self-employed person out of that income source, on a regular basis If deposits were made by the pensioner as an employee, any sums deposited by the employer are included as well. To the best of our knowledge, the Israeli authorities have yet to issue a more formal definition, and therefore at the moment we must rely on the above guidelines. 4.2 The above definition only covers a pension received in respect of work performed in a foreign country. This means that there is a question as to whether a private pension arranged off-shore by private investment will fall into this category. It is assumed that pensions transferred to a surviving spouse, will also be included in the above definition, even though not specifically mentioned. 4.3 It must be noted that the 10-year exemption on passive income referred to in Section 3, also applies to pensions. 4.4 During the 10-year period, there is an option to voluntarily pay Israeli tax (in which case, UK tax exemption will apply), on some of the foreign pensions. As part of this voluntary payment arrangement, it maybe possible for the Israeli taxpayer to reduce his worldwide taxation for the 10-year period, and we shall be pleased to give specific advice about this. 4.5 Following the 10-year transition period, the pension itself is fully taxable in Israel. This means that under the Double Tax Treaty with the UK (and also the U.S.A), no tax will be paid in the source country. The liability to Israeli tax covers not only private pensions but also the UK State pension received by all UK citizens (the U.S Social Security Pension remains exempt from Israeli Income Tax under the Double Tax Treaty). Feldman Brody & Associates, January

7 4. PENSIONS (Cont.) TAXATION FOREIGN INCOME 4.6 It should be noted that the Israeli Bituach Leumi (State) pension is exempt from Israeli Income tax. On the other hand, the UK State Pensions are, in principle, taxable in the UK or Israel. 4.7 Pensions are subject to regular Israeli tax rates and for persons over statutory retirement age (men 67, women 64, but possibly earlier, depending on the date of birth) on only 65% of the gross receipts, after allowing for the standard 35% exemption. It is important to note that the law states that the tax to be paid to the Israeli authorities on pensions only will be no more than the tax which would have been paid in the country of origin. If this limitation applies, the Israeli tax authorities will require documentation to prove the matter. This section applies not only to someone who has been an Oleh (new immigrant) as well as Israeli-born returning juveniles, but also to veteran returning residents (see Section 3.5 above). 5. RELIEF FOR BUSINESS INCOME 5.1 In line with the exemption on passive income, there is a 10-year exemption on all business income produced or arising outside Israel. 5.2 An additional gesture has been given for new immigrants and veteran returning residents (see 3.5 above), relating to a company which they own overseas so that for 10 years from the individual becoming resident in Israel, such companies will continue to be treated as not resident in Israel during that period. This is despite the fact that under normal circumstances, a company is deemed to be tax-resident in the place from which it is managed and controlled. The rule in this section also applies to companies established after arrival in Israel. 5.3 It must be made clear that if an overseas business/company is operated from Israel, without any overseas management, it is possible that the Israeli Tax authorities will not accept that this income falls within the exemptions outlined above. Therefore, if the whole base of operations moves with the family to Israel, one should take expert advice to see whether or not the above exemptions will apply. 5.4 The 10-year exemption will be counted on a similar proportional time basis, from the date of arrival and not the Israeli fiscal (calendar) year, as explained in Section 3.6. Feldman Brody & Associates, January

8 6. CAPITAL GAINS TAX TAXATION FOREIGN INCOME 6.1 For many years, Israeli residents have been liable for capital gains tax on a worldwide basis. 6.2 Capital gains tax rate - the general rate of capital gains tax applicable to worldwide assets acquired from January (including those in Israel) where no other specific rate applies, is limited to a maximum of 20%. Gains accruing over a period of ownership starting prior to 2003 (when the basis of taxation changed) and ending beyond that date, will be time-apportioned, and the tax liability calculated according to the appropriate rates. 6.3 Exemptions for new immigrants and "veteran returning residents" (see 3.5 above) - the relief from Israeli capital gains tax applies to the disposal of overseas assets sold within the first 10 years after arrival. Disposals after the 10-year period will be liable to Israeli tax for the period beyond that time (on a proportional time basis). 6.4 The following is an example to demonstrate the above exemption: If an asset was bought overseas on January 1, 1994, the taxpayer became resident in Israel on January 1, 2004, and sold the asset on January 1, 2019, then the exempt period, running from the date of acquisition, until the end of the 10 year period comes to 20 years, and the total period of ownership comes to 25 years. Therefore, 80% (20/25) of the capital gain arising on disposal would be exempt from Israeli capital gains tax. 6.5 This exemption may well be very important to people arriving before they have sold their house or other property overseas, and then selling them after a few years, when they are sure that they have decided to settle permanently in Israel. The house or other property, may be sold without any Israeli capital gains tax liability, and indeed without any UK capital gains tax liability either, because non-uk residents are exempt from UK capital gains tax (as long as the disposal took place beyond 5 April following emigration from the UK). 6.6 Stock Exchange profits are liable to capital gains tax at the rate of 20% on the real profit arising upon sale. For deals through an Israeli financial institution, this tax will be deducted at source. If the taxpayer has losses, he may, if he wishes, file a tax return to set-off the losses against the gains, and obtain a tax refund. Of course, this tax return will include all income and gains arising during the tax year. 6.7 Stock exchange losses may be set-off against all other capital gains, as well as against interest and dividends from financial investments. 6.8 Another innovation of the Israeli tax reform of 2003 is the exit tax which involves taxation of assets held when one leaves Israel permanently. This is beyond the scope of this pamphlet. In any event, it remains to be seen how this tax can be enforced. Feldman Brody & Associates, January

9 TAXATION FOREIGN INCOME 7. CONTROLLED FOREIGN COMPANIES (CFC) 7.1 The Israeli authorities have felt it necessary to try to prevent the avoidance of Israeli taxes by way of setting-up companies overseas. The legislation outlined in this section will however only apply following the end of the 10- year exemption period described in Section 3.5 above. 7.2 A CFC is defined as: The company is not a publicly quoted company, or if partly quoted, the amount available to the public is less than 30% of the company s capital The majority of the income of the CFC is passive income, or most of its profits accrue from passive income (this definition also attacks the setting-up of a string of companies) Tax is paid on the income of the CFC in a foreign country at an overall rate of less than 20% More than 50% of the control of the company is in the hands of Israeli residents. 7.3 Passive income in this respect is defined as: Interest or linkage differences Dividends Royalties Rent income The proceeds of an asset, which was not used by the CFC for business or professional purposes Any other income, which is sourced in any of the previous items, even if it may be considered as business or professional income. Passive income does not include (earned) income from business or professional services, which in Israel would be considered as such, under Israeli tax law. 7.4 The above paragraphs are only a general outline of the situation, which, as has been mentioned above, are designed to prevent the avoidance of tax on income which would generally be taxable in Israel. The way the tax is collected is that the income of a CFC will be treated as a dividend paid to the Israeli shareholder (taxable at 25% rather than the general 20% rate applicable to the income/gains outlined elsewhere in this pamphlet), prorata to his interest in the CFC, even if the dividend is not actually paid to him. Feldman Brody & Associates, January

10 TAXATION FOREIGN INCOME 7. CONTROLLED FOREIGN COMPANIES (CFC) (Cont.) 7.5 In certain circumstances, a CFC will be a useful tool to mitigate UK inheritance tax on UK assets. We shall be pleased to assist as necessary. 7.6 Under certain circumstances, foreign trading companies can also be taxed in Israel (via the shareholders), as well as overseas companies which are managed and controlled from Israel. If our assistance is required we shall need full details of the specific circumstances. 8. TRUSTS It is impossible to complete this general review concerning the Israeli tax system, without at least a brief reference to the situation regarding trusts, both in Israel and overseas. Legislation dealing with taxation of trusts came into effect in The purpose of the legislation is to try, as far as possible, to neutralize the effect of trusts, as regards taxation. In general, the trust income will be attributed at least formally, to the Trustees. Upon certain elections and conditions, in some cases the settlor and in others either the settlor or the beneficiaries can assume the tax burden. There are certain exemptions regarding trusts settled by foreign residents, and those settled by settlors who subsequently become new residents or veteran returning residents (see 3.5 above) when the trust becomes subject to the same tax breaks as those to which the settlor becomes entitled, as outlined in this booklet. Suffice to say that anyone who is the beneficiary or settlor of an existing trust or anyone who wishes to create a new trust, must take professional advice before proceeding. 9. TIPS As a final comment of important points to take into account, we would mention the following: 9.1 Even though overseas income (dividends, property income, pension, etc.) is exempt from tax for up to ten years, it may not be in your best interest to maintain such a situation. There are definite tax advantages, in specific circumstances, to not claiming the exemption. It should not therefore be assumed that the best action and most tax efficient situation is to leave things as they are, and we strongly recommend that you take specific advice to clarify whether or not there are any tax advantages available in your specific circumstances. 9.2 There is substantial tax relief in respect of donations made to Israeli recognised charities. The tax relief is only granted against original copies of the receipts. It is therefore very important to retain these documents; otherwise no tax relief will be available. Feldman Brody & Associates, January

11 TAXATION FOREIGN INCOME 9. TIPS (Cont.) 9.3 Bituach Leumi (National Insurance) if you are not working in Israel, after the short exemption period for new immigrants, presently six months, you must register and pay the health tax ( mas briut ). This payment is in addition to the money payable to Kupat Cholim (health fund) which entitles you to extra benefits over and above those covered by the health tax payments due to Bituach Leumi. Don t wait until you get a bill for thousands of shekels! 9.4 As part of the benefits granted to mark the 60 th anniversary of the establishment of the State of Israel, returning residents who are required to pay the fine in order to get back into the Israeli health system can have this refunded by the Absorption Ministry. 9.5 IHT Planning - even if one dies in Israel having become non-uk resident and non-uk domiciled, IHT continues to apply to most UK assets. This matter requires special consideration and planning to minimise such exposure. 9.6 No annual tax returns will be required during the first 10 years, as long as there is no local Israeli income which requires reporting. Michael Brody, CPA (Isr.), FCA (UK) Feldman Brody & Associates Jerusalem Thanks to Adv. Jeremy Cohn for assistance with the preparation of this pamphlet Feldman Brody & Associates, January

12 TAXATION FOREIGN INCOME 10. COMPREHENSIVE LIST ALL OUR PAMPHLETS We list below all the pamphlets issued by our office. Should you require a copy of any of these, please do not hesitate to contact us accordingly: 1. Business Activities in Israel Individual / Partnership or Corporation? 2. Start Up Kit for Israeli Corporations. 3. Start Up Kit for Amutot. 4. Capital Statements. 5. Start Up Kit for Individuals and Partnerships in Israel. 6. Instructions for Use of (Simple) receipts and Payments Book. 7. Taxation of Foreign Income of Israeli Residents and Its Effect on Western Immigrants (English only). Forinc-1-10/pamphlet Feldman Brody & Associates, January