By Anthony Diosdi
The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify U.S. and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The U.S. currently has income tax treaties with approximately 58 countries. This article discusses the implications of the United States- Israel Income Tax Treaty.
There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the United States is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States- Israel Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- Israel Income Tax Treaty and the implications to individuals attempting to make use of the treaty.
Definition of Resident
The tax exemption and reduction that treaties provide are available only to a resident of one of the treaty countries. Thus, the determination of an individual’s country of residence is important because the United States- Israel Income Tax Treaty only applies to residents of the United States and Israel.
The term “resident of the United States” means: 1) a business entity formed in the United States, or 2) any other person (except a corporation or any entity treated under United States law as a corporation) resident in the United States for purposes of United States tax, but in the case of an estate or trust only to the extent that the income derived by such person is subject to United States tax as the income of a resident. Section 7701(b) of the Internal Revenue Code treats an alien individual as a U.S. resident where such an individual is 1) lawfully admitted for permanent residence, (26 C.F.R. Section 301.7701(b)-1(b)(1)) “Green card test:” An alien is a resident alien with respect to a calendar year if the individual is a lawful permanent resident at any time during the calendar year. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned.”) (2) meets the substantial presence test, (An individual meets the substantial presence test with respect to any calendar year if i) such individual was present in the United States at least thirty-one days during the calendar year, and ii) the sum of the number of days on which such individual was present in the United States during the current year and the two preceding calendar year (when multiplied by the applicable multiplier: current year – 1, first preceding year – ⅓, second preceding year – ⅙) equals or exceeds 183 days) or iii) makes a first year election.
The term U.S. resident may also include a U.S. corporation, partnership, or trust if these entities were established in the United States.
In contrast to the U.S. law, the Israel Income Tax Ordinance defines a “resident” as follows: “an individual who resides in Israel except for such temporary absences which to the assessing officer may seem reasonable and not inconsistent with the claim of such individual to be resident in Israel.” The courts in Israel have stated that the entire picture relating to the question of residence of the taxpayer should be examined, including such factors as birthplace, ownership of property in Israel, close family residing in Israel, the type of visa used for entry into Israel, the taxpayer’s own representations, military service, the nature of the taxpayer’s living quarters in Israel, and, above all, the length of time spent in Israel. If these and any other relevant factors show that a home has been established in Israel. If these and any other relevant factors show that a home has been established in Israel, then the taxpayer will be considered a resident for tax purposes.
The Israel Income Tax Ordinance defines a nonresident taxpayer as being anyone other than a person resident in Israel. It elaborates on this definition by including, inter alia, any person who is in Israel for some temporary purpose only, as described above.
The term Israel resident may also include a corporation or business entity established in Israel.
Because the United States and Israel have their own unique definition of residency, a person may qualify as a resident in more than one country. For example, an alien who qualifies as a U.S. resident under the substantial presence test pursuant to U.S. tax law may simultaneously qualify as a resident of Israel under its definition of residency. To resolve this issue, the United States- Israel Income Tax Treaty has included a tie-breaker provision in the treaty. The tie-breaker rules are hierarchical in nature, such that a subordinate rule is considered only if the superordinate rule fails to resolve the issue. Article 3 of the United States- Israel Income Tax Treaty provides the following rule for individuals in determining residency:
1) the individual will be a resident in the country in which he maintains his home;
2) if the provisions of (1) do not apply, the individual will be a resident in the State in which he has an habitual abode if he has his permanent home in both Contracting States or in neither of the Contracting States;
3) if the provisions of provisions (1) and (2) do not apply, the individual will be a resident of the State with which his personal and economic relations are closer if he has an habitual abode in both Contracting States or in neither of the Contracting States.
4) if he is a national of both States or neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement;
For purposes of determining tax residence, in determining an individual’s permanent home, regard shall be given to the place where the individual dwells with his family, and in determining the Contracting State with which an individual’s personal and economic relations are closer, regard shall be given to his citizenship (if he is a citizen of one of the Contracting States). The treaty does not provide a tie-breaker provision for corporations. Thus, a dual resident corporation can be taxed by both the United States and Israel.
We will now discuss the operative articles of the United States- Israel Income Tax Treaty.
Permanent Establishment
A central tax issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all of the income derived from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Such an extreme approach has its limits, however. For example, if the exporter’s marketing activities within the importing country are de minimis, the administrative costs of collecting the tax on those activities may exceed the related tax revenues. These concerns have led countries to include permanent establishment provisions in their income tax treaties.
Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. Article 7 of the United States- Israel Income Tax Treaty states that profits are taxable only in the Contracting State where the enterprise is situated “unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein,” in which case the other Contracting State may tax the business profits “but only so much of them as [are] attributable to the permanent establishment.” The concept of permanent establishment is a key term to this and any bilateral tax treaty. Article 5 of the United States- Israel Income Tax treaty defines permanent establishment as a “fixed place of business” – including a place of management; a branch, an office, a warehouse; a workshop, a farm or plantation, a store or other sales outlet, a mine, quarry, or other place of extraction of natural resources, a building site, or construction project, or the maintenance of substantial equipment or machinery within a Contracting State for more than six months.
The term “permanent establishment” does not include: 1) the use of facilities solely for the purpose of storage, display, or delivery of goods or merchandise belonging to the enterprise; 2) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display, or delivery; 3) the maintenance of a stock or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; 4) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or for collecting information, for the enterprise; 5) the maintenance of a fixed place of business for the purpose of purchasing goods or merchandise, or for collecting information for resident; 6) the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research; and 6) the maintenance of a building site or construction, assembly or installation project which does not exist for more than 6 months.
If a resident of one treaty country has a permanent establishment in the other treaty country, the importing country may tax the taxpayer’s business profits, but only to the extent those business profits are attributable to the permanent establishment.
Associated Enterprise/Related Persons Provision
Under Article 11 of the United States- Israel Income Tax Treaty, the U.S. and Israel are permitted to allocate profits between two related businesses, as if their financial relations were those of unrelated businesses. Treating related businesses as independent businesses resembles the arm’s-length standard used to allocate income pursuant to Internal Revenue Code Section 482.
Income from Real Property
The United States- Israel Income Tax Treaty does not provide tax exemptions or reduction for income from real property. Therefore, both the home and the host country maintain the right to tax real property income, which includes income from natural resources. This rule applies to rental income, as well as gains from the sale of real property.
Grants
Article 10 of the treaty permits an Israeli political subdivision to make a qualified cash grant to a resident of the United States. The qualified cash grant is excluded from the gross income of the U.S. resident or U.S. corporation. The term “qualified cash grant” is one approved by Israel for investment promotion in Israel, but shall not include any amount which in whole or part, directly or indirectly: 1) is in consideration for services rendered or to be rendered, or for the sale of goods; 2) is measured in any manner by the amount of profits or tax liability; or 3) is taxed by Israel.
Independent Personal Services
Treaty provisions covering personal services compensation are similar to the permanent establishment clauses covering business profits in that they create a higher threshold of activity for host country taxation. Generally, when an employee who is a resident of one treaty country derives income from services performed in the other treaty country, that income is usually taxable by the host country. However, in certain cases, this income may be exempt from taxation by the host country. Under Article 16 of the United States- Israel- Income Tax Treaty, a contracting State may tax the income from personal services of a nonresident individual if the individual is present in that State for a period or periods aggregating more than 183 days in the taxable year of income of that other State.
Dependent Personal Services
Under Article 17 of the treaty, a Contracting State may not tax employment income derived by a nonresident to the extent the employee services are performed in the Contracting State: 1) the employee is present in the Contracting State less than 183 days during a taxable year; 2) the remuneration is paid by, or on behalf of, an employer or company who is not a resident of the other State; and 3) the remuneration is not deductible in determining taxable profits of a permanent establishment, a fixed base or a trade or business which the employer or company has in the other State.
Dividends
Under Article 12 of the United States- Israel Income Tax Treaty, the Source State can impose a gross withholding tax of 25 percent of the gross amount of the dividend; or when the recipient is a corporation, 12.5 percent of the gross amount of the dividend paid, but only if: 1) during the part of the paying corporation’s taxable year which precedes the date of payment of the dividend and during the whole of its prior taxable year (if any), at least 10 percent of the outstanding shares of the voting stock of the paying corporation was owned by the recipient corporation; and 2) not more than 25 percent of the gross income of the paying corporation for such prior taxable year (if any) consists of interest or dividends (other than interest derived from the conduct of a banking, insurance, or financing business and dividends or interest received from subsidiary corporations, 50 percent or more of the outstanding shares of the voting stock of which is owned by the paying corporation at the time such dividends or interest is received).
Dividends paid by a corporation of one of the Contracting States to a person other than a resident of the other Contracting State (and in the case of dividends paid by an Israeli corporation, to a person other than a citizen of the United States) shall be exempt by the other Contracting State.
Branch Profits Tax
The U.S. imposes a 30 percent branch profits tax on the “dividends equivalent amount” of a foreign corporation engaged in a trade or business in the U.S., where the “dividend equivalent amount” is roughly equal to the taxable income of the branch, less income of the branch, less income tax paid by the branch and less amounts retained in U.S. operations. There are no provisions in the United States- Israel Income Tax Treaty that will reduce or avoid the branch profits tax.
Interest
Article 13 of the United States- Israel Income Tax Treaty permits a withholding rate of 17.5 percent of the gross amount of such interest. However, the withholding rate is reduced to 10 percent when interest is paid by banks, savings institutions, or insurance companies. The term “interest” as used in this treaty means income from money lent and other income which under the taxation law of the Contracting State according to its own law, including the provisions of this treaty where applicable.
Royalties
Article 14 of the United States- Israel Income Tax Treaty reduces source-state withholding tax royalties paid to 15 percent. The term “royalties” in Article 14 means a payment or credits of any kind to the extent to which they are in consideration for the use of: 1) copyright, patent, design or model, plan, secret formula or process, trademark, radio or television broadcasting; 2) industrial royalties and industrial include gains derived from the sale, exchange, or other disposition of any property or rights to the extent that the amounts realized on such sale, exchange, or other disposition for consideration are contingent on the productively, use, or disposition of property or rights.
Gains from the Alienation of Property
Under Article 15 of the treaty, a resident of one of the Contracting States shall be exempt from tax by the other Contracting State on gains from the sale, exchange, or other disposition of capital assets unless: 1) the gain is from the sale or exchange of real property; 2) the gain is treated as industrial establishment which the resident has in such other Contracting State; 3) the resident is present in the other Contracting State for a period or periods aggregating 183 days or more; or 4) a resident of the United States owns either actually or constructively within a 12 month period 50 percent of the voting power of an Israeli corporation or more than 50 percent of the value of an Isreali corporation on the last day of the 3 taxable years preceding the sale or exchange or disposition of the corporation.
Capital Gains
Under Article 15 of the treaty, a resident of one of the Contracting States shall be exempt from tax by the other Contracting State on gains from the sale, exchange, or other disposition of capital assets unless: 1) the gain is from the sale, exchange or other disposition of real property; 2) the gain is from royalties; 3) the gain is an asset attributable to a permanent establishment which the resident has in such other Contracting State subject to a number of limitations.
Cross-Border Pensions and Annuities
Article 20 of the United States- Israel Income Tax Treaty addresses the taxation of cross-border pensions and annuities. Subject to the provisions of Article 20, pensions and other similar remuneration paid to an individual who is a resident of one Contracting State in connection of past employment shall be taxable only in that State. The term “pensions and other similar remuneration,” as used in this Article means periodic payment made by reason of retirement, in consideration of services rendered, or by way of compensation paid after retirement for injuries received in connection for past employment. Annuities paid to an individual who is a resident of one of the Contracting States shall be taxable only in that State. The term “annuities,” as used in Article 20, means stated sums paid periodically at stated times during the life, or during a specific ascertainable number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered or to be rendered).
The way the United States- Israel Income Tax Treaty is drafted provides Australian nonresidents that work in the United States planning opportunities to reduce U.S. income tax consequences or eliminate U.S. federal tax associated with IRA, 403(b) or 401(k) contributions after they depart the United States. For example, let’s assume that Tom is an Israel national that came to the U.S. on an E-3 Visa for a short-term assignment. While working in the U.S., Tom contributed money to an IRA. Tom has returned to Israel and would like to withdraw money from his U.S. based IRA. However, Tom is concerned about the U.S. 20 percent withholding tax and the 10 percent early withdrawal penalty.
Since Tom is a citizen of Israel, he may utilize the United States- Israel Income Tax Treaty to avoid the 20 percent withholding tax and the early withdrawal penalty. This is because under Article 20, of the United States- Israel Income Tax Treaty, “pensions and other similar remuneration” paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explain that “paragraph 1 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment….shall be taxable only in the State [of residency].” This means that under the applicable provisions of the United States- Israel Income Tax Treaty, the country of residence has the sole taxing rights over pension distributions.
The terms “pensions and other remuneration” is not defined in the United States- Israel Income Tax Treaty. However, the OECD defines the word “pension” under the ordinary meaning of the word which covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Article 18. See OECD 2014 Commentary, Art 18. Thus, although Article 20 of the United States- Israel Income Tax Treaty makes a reference to “periodic payments,” the word “periodic” does not preclude Tom from excluding a lump sum IRA distribution from U.S. federal income tax. Even though the OECD or Article 18 of the United States- Israel Income Tax Treaty does not mention the term IRA, the Internal Revenue Service (“IRS”) has clarified that IRAs can be defined as pensions for articles in U.S. income tax treaties. See PLR 200209026. Since Tom is a resident of Israel, he can utilize the United States- Israel Income Tax Treaty to avoid U.S. federal tax on the distribution from his IRA.
Social Security Payments
Article 21 of the treaty states that social security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State shall be exempt from tax in both Contracting States.
Limitation on Benefits
Because tax treaties provide lower tax rates on dividends, interest, royalty income, and retirement accounts, individuals and multinational corporations may attempt to utilize treaties even though they are not residents of either country of the treaty at issue. This practice is known as “treaty shopping.” The United States- Israel Income Tax Treaty does not contain a Limitation on Benefits (“LOB”) provision.
Relief From Double Taxation Provision
Article 26 of the United States- Israel Income Tax Treaty prohibits double taxation of income in the following manner:
1. In accordance with the provisions of U.S. tax law, the United States shall allow a citizen or resident of the United States shall allow a citizen or resident of the United States as a credit against the United States tax the appropriate amount of taxes paid or accrued to Israel and, in the case a United States corporation owning at least 10 percent of the voting stock of an Israeli corporation from which it receives dividends in any taxable year, shall also allow credit for the appropriate amount of taxes paid or accrued to Israel by the Israeli corporation paying such dividends with respect to the profits out of which such dividends are paid.
2. If any taxable year a citizen or resident of the United States takes a credit against tax with respect to a compulsory loan to Israel, then: 1) any interest received on such loan shall not be included in taxable income for purposes of United States income tax and no deduction shall be allowed for any interest assessed or collected; 2) Upon repayment or recoupment of the principal of the loan, the amount of the value in United States dollars received shall be treated as a refund for the year the loan was made of taxes paid to Israel for such year equal to the basis of such loan; 3) Any amount in excess of such basis shall be included in taxable income for purposes of United States tax for the year the repayment or recoupment is made; 4) No interest shall be assessed or collected by the United States on any amount of tax due for the loan.
3. Israel shall allow to a resident of Israel as a credit against Israeli tax the appropriate amount of income taxes paid or accrued to the United States and, in the case of an Israeli corporation owning at least 10 percent of the voting stock of a United States corporation from which it receives dividends in any taxable year, shall also allow credit for the appropriate amount of taxes paid or accrued to the United States by the United States corporation paying such dividends with respect to profits out of which such dividends are paid. Such an appropriate amount shall be based upon the amount of tax paid or accrued to the United States but shall not exceed that portion of Isaeli tax which such resident’s net income from sources within the United States bears to his entire net income for the same taxable year.
Non-Discrimination Provision
The United States- Israel Income Tax Treaty contains a non-discrimination provision. The non-discrimination provision is designed to prevent the U.S. or Israel from taxing a resident from the other state at a greater rate than a resident taxpayer.
Mutual Agreement Procedure and Exchange of Information
The United States- Israel Income Tax Treaty provides a mutual agreement procedure by which a resident of either the United States or Israel can request assistance from the competent authority in obtaining relief from actions of one or both treaty countries that the taxpayer believes are inconsistent with the treaty. Assuming the taxpayer’s objections are justified, the competent authority is empowered to resolve the case by mutual agreement with the competent authority of the other treaty country.
In addition to the mutual agreement procedures discussed above, the United States- Israel Income Tax Treaty provides for exchanges of information regarding taxpayers as a mechanism for enhanced compliance with respect to international transactions. Under the United States- Israel Income Tax Treaty, the competent authorities of the United States and Israel shall exchange such information as is necessary for enforcing provisions of the tax treaty, as well as the internal laws of the two countries concerning taxes covered by the treaty. For example, the United States and Israel might share information regarding a taxpayer that both countries are auditing.
Disclosure of Treaty-Based Return Positions
Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.