Israel's international tax system for individuals – new rules?

Back to Private Client Tax Committee publications

Daniel Paserman

Gornitzky & Co, Tel Aviv

Paserman@gornitzky.com

Inbar Barak Bilu

Gornitzky & Co, Tel Aviv

inbarb@gornitzky.com

Tax residency of individuals

Any person who is considered an Israeli tax resident is subject to tax in Israel with respect to their worldwide income. Therefore, any income produced or accrued by an Israeli tax resident from a source within Israel or abroad is subject to tax in Israel.

At the same time, a foreign tax resident (ie, a person who is not an Israeli tax resident) is generally subject to tax in Israel only with respect to income that was derived from a source within Israel.

An individual is considered an Israeli resident for tax purposes if their centre of life is in Israel. The ‘Centre of Life test’ is a ‘facts and circumstances’ test, which examines the individual’s family, economic and social ties (the ‘centre of life’). Two tests are used to determine one’s centre of life: an objective test and a subjective test.

The objective test examines where most of the individual’s connections are ‘physically’ located. In order to determine the location that is the centre of the individual’s life, the test takes into account a holistic view of their family, economic and social ties and factors in certain objective criteria, including:

• the place of the taxpayer’s permanent home;

• the taxpayer’s family’s place of residence;

• their regular place of business/employment;

• the place of the individual’s active and substantive economic interests; and

• the location of the organisations in which the taxpayer is involved.

The subjective test examines where the individual consider their centre of life to be, and whether or not, according to their own subjective feelings and opinions, they considers themselves to be an Israeli resident. The subjective intention of an individual is examined through external-objective characteristics, such as their actions, presentations and so forth.

It should be noted that, while both the criteria of the objective and subjective tests are used in determining the place of the individual’s centre of life, the weight given to the factors of the objective test and the subjective test is not equal. According to case law, the issue of residency will be determined primarily based on the objective test, and the factors contained in the subjective test will be attributed limited weight.

In addition to the abovementioned two-pronged tests that examine the centre of life of the individual in accordance with objective and subjective criteria, Israeli tax law also provides two rebuttable presumptions when measuring the number of days the individual has spent in Israel (the Presumptions). Day includes part of a day. According to these Presumptions, an individual who stays in Israel for more than 183 days of a tax year or more than 425 days over the course of three consecutive tax years (and at least 30 days in the third tax year) is presumed to be an Israeli tax resident.

According to these Presumptions, if an individual stays in Israel for a certain number of days during the tax year, they are presumed to be an Israeli tax resident, unless otherwise proven through certain substantive ties.

However, the Presumptions can be rebutted by both the individual and the Israel Tax Authority, and the party that wishes to rebut them is subject to the burden of proof in showing that the individual’s centre of life is not in Israel. In accordance with the generally accepted approach, the Presumptions are one-directional and only used to determine Israeli tax residence and not to rule it out. In other words, an individual who does not fall under these Presumptions is not necessarily deemed to be a foreign tax resident, and the centre of life criteria must still be examined.

Tax benefits to new Israeli residents and veteran returning residents

An individual who became an Israeli tax resident after 2007, whether for the first time in their life or following the individual having spent a considerable period of time (a period of at least ten consecutive years) outside of Israel as a foreign tax resident (a 'new resident’), may be entitled to various material tax and reporting benefits for the ten year period commencing from the date an individual became an Israeli tax resident (benefits period).

Such a new resident is exempt from Israeli tax and reporting with respect to foreign source income. Capital gains derived from the sale of shares in Israeli companies that were purchased prior to them becoming an Israeli tax resident may, in certain circumstances, be tax exempt for a new resident. However, assets sold following the end of the benefits period will only enjoy a relative exemption according to a partial exemption mechanism (linear).

In addition, some of the anti-avoidance measures relating to foreign entities are not applicable in the case of a new resident during the benefits period. For example, in general, Israeli tax law provides that foreign entities managed and controlled from Israel are considered Israeli tax residents, even if incorporated abroad. However, the legislation qualifies this rule and provides that, during the benefits period, such entities will not be regarded as Israeli tax residents merely because they are managed and controlled by a new resident. Nevertheless, under certain specific circumstances, the activities in Israel of an individual during the benefits period may cause the foreign incorporated entity to be deemed as having a permanent establishment in Israel.

In principle, the tax and reporting benefits provided to new residents also apply, mutatis mutandis, to trusts and foundations, if the settlor and beneficiaries are Israeli tax residents entitled to the new resident regime.

In order to welcome new residents warmly, the Israel Tax Authority allows an individual who moves to Israel to apply that their first year qualify as an ‘acclimation year’. During the first year of stay in Israel, the new resident may be considered as a non-Israeli tax resident, thus allowing the individual to explore the possibility of residing permanently in Israel without immediately being regarded as an Israeli tax resident and being subject to Israeli taxation in full. If one elects to apply this status and thereafter stays in Israel permanently, the acclimation year will be counted as part of the benefits period (ie, only nine years of benefits will remain).

On the other hand, if the individual leaves Israel during the acclimation year, there will be no Israeli tax consequences with respect to their arrival or departure, and the individual will be treated as though they had never been an Israeli tax resident.

Excepting groundbreaking legislation changes

The Israeli residency tests described above, have received a considerable amount of criticism. Many argue that the criteria are not clearand are subject to various interpretations which create uncertainty. Therefore, the Israel Tax Authority recently established a special internal committee which has been charged with, inter alia, changing the residency tests under Israeli tax law (the Committee). The Committee's conclusions have not yet been published, but the general consensus is that the Israel Tax Authority intends to toughen the residency tests.

The prevailing assumption is that the Committee intends to determine that staying in Israel for a certain period of time will create irrebuttable presumptions that the individual is an Israeli resident, and, in the alternative, a stay in Israel of less than a certain period of days will result in the individual being defined as a non-Israeli resident. With respect to stays in Israel which are less than the period which creates the presumptions of tax residency, but more than the period that excludes the determination of tax residency, the Israel Tax Authority will continue to use the centre of life test.

Regarding the current benefits granted to new residents, there is significant criticism with respect to the purpose and value of providing such benefits to new Israeli residents and veteran returning residents. As discussed above, the current legislation only provides tax and reporting exemptions for investments outside of Israel, and it is argued that such exemptions do not encourage new residents to make investments in Israel. The common understanding is that the Committee aims to limit the current new resident tax benefits by shortening the period of the exemption and reducing the scope of the benefits.

There have been similar attempts in recent years to curtail the special tax regime, but these attempts have failed, and until this point there has been no change to the benefits granted since the date of their enactment. Therefore, at this point, it is difficult to assess what effect the Committee’s deliberations and recommendations will actually have.

The Committee's conclusions may also have an impact on the exit tax that is currently imposed at the time of termination of Israeli residency. The assets of an Israeli who seeks to terminate his residency are considered to have been sold on the day prior to the day on which the taxpayer ceased to be an Israeli tax resident. In general, the tax event is deemed to have occurred on the date of the change of residency, but it is currently possible to postpone the date of tax payment to the date of the actual realisation of the assets. In essence, this creates a scenario in which the taxpayer leaves Israel and the Israel Tax Authority has limited recourse to collect the taxes due from the former Israeli resident since they are out of its jurisdiction of enforcement.

This issue is also included in the Committee's recommendations. The Israel Tax Authority proposes to change the provisions of the law so that, in certain circumstances, the taxpayer will be required to report and pay the exit tax at the time of the termination of residency or to deposit some form of collateral to secure the making of such payment while continuing to submit tax filings after their tax residency has terminated.

The Committee's expected recommendations and conclusion may be dramatic. They might have extensive and significant tax implications that will have an effect on the tax status of individuals in Israel, the decision-making process of foreign residents or former Israeli residents as to whether to immigrate or return to Israel, as well as the tax implications for an Israeli resident who leaves Israel.

Back to Private Client Tax Committee publications