A trust is an arrangement in which a settlor (or grantor; e.g., Dad) transfers assets to a trustee (e.g., a lawyer or bank trust department) to hold and invest for the ultimate benefit of beneficiaries (e.g., wife, children). This may be to prevent the family fortune being wasted or for many other reasons.
The Israel Tax Authority thinks tax planning is a common reason for the use of trusts. Since 2006 the Israeli tax regime applies to common-law trusts and European civil-law foundations, among others.
The new regime imposes tax on most trusts that were formed by an Israeli resident.
However, an exemption from Israeli taxes applies to non-Israeli-source income and gains generated by a Foreign Resident Settlor Trust. This is a trust formed entirely by non-resident settlors (or with non-resident settlors and beneficiaries in the tax year concerned).
An exemption generally applies to foreign-source trust income and gains. This exemption is meant to encourage flows of capital from families abroad to relatives in Israel.
However, the exemption is subject to several conditions; in particular, the beneficiaries must have no ability to ‘‘control or influence‘‘ the conduct of the trust.
If an Israeli resident beneficiary does control or influence a trust, he or she is deemed to be an additional settler, making the trust fully taxable in Israel. The trustee is generally responsible for filing the trust tax return, regardless of any foreign laws.
Despite many requests, the Israel Tax Authority has never published guidance on what constitutes ‘‘control or influence‘‘ over trustees by a beneficiary. This can result in considerable uncertainty.
Is a trust formed by a foreign settler taxable or exempt in Israel?
Unofficial discussions with Israeli tax officials indicate that ‘‘control or influence‘‘ is a common sense test.
So it is interesting to note a recent common sense court case in Jersey, Channel Islands, regarding a trust.
In the M Settlement Case, the trust was set up by Mr. M., who was a drunkard. The beneficiaries were Mr. and Mrs. M., their children and other relatives. Mr. M. was also the protector, which meant he could replace the trustees.
Mr. M. had debts of GBP 318,000. He asked the trustees for money, but they refused his request. The trust only had GBP 190,000 in cash, and the trustees were concerned about Mr. M.‘s alcoholism. In addition, there were other beneficiaries to consider: the children. So Mr. M. used his power as protector to dismiss the trustees and appoint Mr. D. as a replacement trustee. Mr. D. was an 81-year-old friend of the family who was in poor health.
Mr. M. asked Mr. D. to transfer the entire trust fund, and Mr. D. duly obliged. But one of the children who was a potential beneficiary objected and sought the assistance of the Jersey court.
The court ruled that Mr. M. had a conflict of interest and his rationality was in doubt, so the court suspended Mr. M.‘s powers as protector of the trust.
As for distributing trust assets, the court ruled that it is necessary to consider whether the position will be better after the payment ‘‘from a realistic and common sense point of view.‘‘ The court concluded that payment of all the trust assets to Mr. M. would still leave him indebted and directed that the assets be divided among Mr. M.‘s children.
Note that Jersey law is not binding in Israel, and this case dealt with control exercised by a settlor rather than a beneficiary. But the case does illustrate common sense. Therefore, if the trustees apply their own common sense regarding distributions of trust assets, it might be argued that there was no beneficiary ‘‘control or influence,‘‘ depending on the circumstances. Evidence of common sense must, of course, be proven. That‘s not always easy, but it was proven in the above case.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
Leon Harris is an international tax specialist at Harris Consulting & Tax Ltd.