27.01.2013

Do your tax-planning homework in advance, not when it’s too late. With an LLC you must work out what is best for you in good time.
The Israel Tax Authority (ITA) has published an anonymous tax ruling in which an Israeli investor apparently got it all wrong regarding a US LLC and tragically paid unnecessary Israeli tax.

For US tax purposes, an LLC (limited liability company) is usually a transparent  flow through  entity, meaning the members (shareholders) are taxed, not the LLC itself.

The facts of the ruling

The ruling (2536/12 of June 24, 2012) describes a case in which an Israeli parent company held apparently 100 percent of a private US subsidiary company ( daughter company ).

The daughter company had no business activity but reported its income to the US Internal Revenue Service (IRS), making it a  C-Corporation  for US tax purposes.

The daughter company held a 49% interest in a US LLC ( granddaughter company ).

So the structure was: Israeli parent company > US C-Corporation Daughter Co. (100% owned) > US LLC granddaughter Co. (49% owned).

According to the ruling, the Israeli parent company asked the ITA for a foreign tax credit for tax paid by the LLC: (1) pursuant to domestic Israeli tax law; or (2) under the US-Israel tax treaty; or (3) by treating the LLC as a transparent flow-through entity for Israeli tax purposes and attributing its income to the subsidiary.

In general, Israeli tax law allows an Israeli resident company to credit the foreign corporate income tax of 25%- or-more affiliated (daughter) companies and their 50%-ormore subsidiary (granddaughter) companies. This is known as an underlying, or indirect, tax credit.

Israeli tax law also generally allows a direct credit for foreign withholding taxes on dividends and other payments to the Israeli resident company.

All this applies to foreign federal and state taxes on income and gains, but not city taxes.

The ruling result

According to the ruling, the ITA turned down flat the Israeli company’s request for a foreign tax credit.

The ruling states:  It is not possible to treat the granddaughter company as a  partnership  (i.e., transparent) as it is incorporated as an LLC and is considered as a  company  according to the Israeli tax laws. Therefore the granddaughter s income is considered its own, even though the income is attributed to the daughter company according to the US tax laws.

Consequently, as the LLC was not transparent for Israeli tax purposes and was not 50% owned by the daughter company (only 49%), the Israeli company got no underlying tax credit for US taxes on the LLC ‘s income.

The result was apparently double taxation in the two countries.

What can we learn from all this?

First, an LLC is generally not transparent in Israel, even if it is transparent in the US (but see below).

Second, the US-Israel treaty made no difference. In fact, the treaty does not deal with granddaughter companies.

Third, the taxpayer apparently forgot to do advance tax planning; the double-tax result in this case was avoidable.

The ruling reads like a last vain attempt to pull chestnuts out the fire.

What else could the Israeli taxpayer have done?

The ITA has published a circular (5/2004 dated April 19, 2004, allowing Israeli taxpayers to elect flow-through treatment for an LLC in the first relevant tax return. It appears this is also possible for LLC granddaughter companies.

This means reporting the LLC income that year and every year and crediting applicable US federal and state tax thereon.

As for S-Corporations, the circular allows an Israeli taxpayer to apply to the ITA for relief, but it is unclear what will be granted. The circular aims to avoid double tax but does not allow foreign losses to be offset against Israelisource income.

Other possibilities involving  family company   rules in the Israeli tax law may also have been possible, depending on the facts. A family company is fiscally transparent in Israel, if so elected, and is owned by a company owned entirely by people from one family. Detailed rules apply to   family companies,  which need to be checked out in each case. A family company does not have to be an Israeli company.

To elect or not to elect

Before electing LLC transparency for Israeli tax purposes, prepare alternative calculations of the taxes in the two countries. Sometimes, if an Israeli investor has low US income, transparency may arithmetically be a bad option.

Not electing LLC transparency may also postpone Israeli taxation until the Israeli taxpayer actually receives income; i.e., why pay tax on undistributed LLC income?

To sum up

Do your tax-planning homework in advance, not when it’s too late. With an LLC you must work out what is best for you in good time.

As always, consult experienced tax advisers in each country at an early stage in specific cases.
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Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.