Dear Clients, Friends and Colleagues,

We are writing to update you on two recent significant developments regarding the taxation of Trusts that hold Israeli real estate. These developments may significantly affect many trust structures that own Israeli real estate directly or indirectly, and therefore necessitate a careful review of these structures.

A. In a Nutshell

The taxation of Israeli real estate is governed by a separate law known as the Law for the Taxation of Real Estate (the “RE Law“).  As opposed to the law dealing with taxation of income and capital gains generally, the RE Law does not include detailed provisions regarding the taxation of Trusts.  The one specific reference in the RE Law to Trusts is a provision that when real estate is purchased in trust on behalf of a Beneficiary, notification of the Trust arrangement should be provided to the Israeli Tax Authority (“ITA“) within 30 days.  In such a case, if notification has been filed with the ITA, the Beneficiary of the Trust will be considered as the purchaser of the real estate, and therefore the transfer of the real estate from the Trustee to the Beneficiary will  not be deemed a tax event and subject to tax.  By the same logic, when an individual transfers real estate to a Trust for his or her own benefit, the transfer is exempt (since the transfer is effectively to himself or herself).

The precise application of the above provisions is unclear, and leads to many areas of uncertainty.  In light of this uncertainty, two recent attempts have been made to clarify the law, but in practice, seem to have increased the uncertainty:

(i) New Decision of Israel’s Supreme Court.  Israel’s Supreme Court recently handed down a ruling, in the “Geliss” matter,  (CA 7610/19), which makes it clear that the transfer of Israeli real estate assets to a Trust is considered as a tax event, which will be subject to both Purchase Tax and Capital Gains Tax  unless the Settlor is the only Beneficiary, and a notification of the Trust is submitted in timely fashion to the ITA.

The Supreme Court thereby reversed a previous decision of the lower court in which it was decided that the provisions of the Income Tax Ordinance (the “Ordinance“) which relate to the taxation of Trusts, also apply to the contribution of Israeli real estate to a Trust.

(ii) Ruling published by the ITA. Further to this decision of the Supreme Court,  the ITA published a private ruling according to which a Trust which allows for the change of beneficiaries is not considered a “trust” under the RE  Law, and therefore, a transfer of real estate to such a Trust will be subject to tax.

The decision of the Supreme Court confirms the position previously held by the ITA, as published in the Income Tax Circular 3/2016, that only the provisions of the RE Law and the Regulations promulgated under that Law determine the tax regime that applies to the transfer of Israeli real estate from a Settlor to a Trustee. The current position of the ITA narrows the definition of Trusts for the purpose of the RE Law only to trusts in which it is impossible to change the beneficiaries.  This decision of the Supreme Court, and the subsequent statement of the ITA position, mean that great care must be taken and advanced planning is necessary before any Israeli real estate asset is transferred to a Trust.

Our firm has extensive experience in the field of the taxation of Trusts in general and the taxation of real estate assets held in Trust in particular.  We therefore recommend anyone for whom this Client Update may be relevant to contact us as soon as possible.  We will be happy to advise on all of the possible implications of the Supreme Court decision and the Ruling of the ITA.

B. In More Detail

1. The Geliss Case.

Factual Background

In 2016, the Settlors of an Israeli Trust, residents of Canada, contributed their rights in four real estate properties in Israel to a Trust.  The establishment of the Trust was reported to the Assessing Officer in accordance with the provisions of the Ordinance, and the Trust was classified as an “Israeli Residents Trust”. The Settlors and Trustee declared that the Trust is irrevocable.  In other words, once the assets had been transferred from the Settlors to the Trustee, the Settlors had “disconnected themselves” from the assets, and no longer had any right to control the assets.  In accordance with the terms of the Trust, the Trustee has undertaken to hold the Trust assets (namely the real estate properties in Israel) in order to advance the interests of the Beneficiaries of the Trust, at the Trustee’s discretion.

After transferring the rights in the real estate properties to the Trust, the Settlors reported the transfer to the Real Estate Tax Office, “as a precautionary measure”, claiming that the transfer is exempt from Capital Gains Tax and Purchase Tax under the provisions of the Ordinance.  The Director of Real Estate Taxation rejected the claim of the Settlors, and required the Settlors to pay Capital Gains Tax and Purchase Tax with respect to the transfer of the real estate assets.

The Appeals Committee ruled unanimously that the position of the Settlors should be accepted, and that the decision of the Real Estate Tax Office should be canceled.  The majority of the Appeals Committee argued that there is a lacuna in the law that requires attention.  Similar to the transfer of other assets to a Trust, the transfer of real estate assets to a Trust should likewise not be regarded as a “sale” under the Ordinance, as a result of which the tax event will be deferred to the actual distribution of the assets to the Beneficiaries of the Trust.  The Chairman of the Appeals Committee, Judge Altuvia, agreed with the conclusion of the majority of the Appeals Committee, but based his conclusion on different reasoning.  Judge Altuvia analyzed the facts of the case, and in particular the powers held respectively by the Settlors and the Trustee, and found that most of the rights in the assets remained in the hands of the Settlor.  Accordingly, the transfer of the real estate assets to the Trustee did not constituted a “sale”.

The Real Estate Tax Office filed an appeal to the Supreme Court against this decision of the Appeals Committee of the ITA.

Discussion

The Supreme Court reversed the decision of the Appeals Committee.  In his ruling, Judge Stein ruled that the RE Law provides an exemption from tax to Trusts in two different situations.  The first situation, mentioned in Section 3 of the RE Law, refers to transfers to Trusts created under specific laws, such as a transfer of assets to a liquidator, to a guardian, and so on.  The second situation, mentioned in Section 69 of the RE Law, refers to a transfer from a Trustee to a Beneficiary under a Trust which was reported to the Real Estate Tax Office.  However, the RE Law does not exempt the transfer of real estate from a Settlor to a Trustee, unless the Beneficiary of the Trust is the Settlor himself or herself.  In its decision, the Court specifically confirmed the position of the ITA, as expressed in Income Tax Circular 3/2016, including an exemption from tax for a transfer of real estate property to a Trustee where the Settlor is also the only Beneficiary of the Trust.  Judge Stein noted that the Section in the Income Tax Ordinance which provides that the contribution of an asset to a Trust is not regarded as a “sale” does not apply to Israeli real estate, since the provisions of Part E of the Ordinance exclude real estate assets and specify that such assets will be taxed under the RE Law.  This distinction clarifies the fact that the legislature wanted to maintain two different tax regimes for real estate and other assets respectively.  Judge Stein also noted that there is a material difference between the Ordinance and the RE Law regarding treatment of assets in a Trust.  Under the Ordinance, Trust assets are generally identified with the Settlor of a Trust, whereas under the RE Law, assets are identified with the Beneficiary.

2. ITA Tax Ruling 3399/22

Following the decision in the Geliss matter, the ITA published a Tax Ruling (number 3399/22) in respect of a couple (the “Owners“) who wished to register residential apartments that they own in the name of an Israeli lawyer, who will act as nominee/trustee, and who will hold and manage the apartments for the Owners (the “Trustee“). The Trustee has no discretion with respect to the apartments, and is not authorized to perform any action with respect to the apartments without prior written instructions from the Owners. The Owners, and not the Trustee, have full responsibility with respect to the apartments. The Trustee has no benefit from the apartments other than his fees for management of the apartments. Any of the Owners or the Trustee can terminate the trust agreement on prior notice of 90 days.

The Owners requested the ITA to confirm that the contribution of these apartments to the Trustee will not trigger Real Estate Tax, and that the transfer of the apartments to their heirs, after their death, will not be considered a “sale” for tax purposes.

The ITA accepted the request, and explained that a “Trust” under the RE  Law is a Trust which has a specific and known beneficiary and which complies with two conditions: (i) a procedural condition – notification of the Trust arrangement to the ITA within 30 days of the the transfer of the real estate, and (ii) a substantive condition –whether a trust relationship in fact exists, in light of the relevant statute and case law.

In this case, the ITA noted that the Trustee serves as a proxy/nominee only, without any discretion, and simply carries out the wishes of the Owners. Accordingly, the beneficial owners of the apartments were and remain the Owners, and the transfer of the apartments to the Trustee did not create a tax event. Sale of the apartments by the Trustee during the life of the Owners will be regarded as a sale by the Owners themselves. Transfer of the apartments from the Trustee to the Owners’ heirs after their death will be regarded as a direct inheritance from the Owners to their heirs.

In the Ruling, the ITA clarified its position that a trust agreement which allows any change in or addition of beneficiaries is not a “Trust” under the RE Law, but only a “trust framework”. Transfer of real estate to the Trustee or from the Trustee to a Beneficiary in the case of a “trust framework” will be regarded as a sale and will be subject to tax.

The Tax Department

Herzog Fox & Neeman