Closing chapter

Historically, trusts are not commonplace in Israel. Although the Israeli Trust Law 5739‑1979 (the Trust Law) was enacted in 1979, it broadly applies to all fiduciary relationships and not necessarily to a trust in the classic sense of the term. In his book, Shlomo Kerem writes:

‘The Trust Law is intended to serve as a framework legislation for any legal framework whose content is a trust. It makes no difference what legal form the framework takes – whether it is a voluntary trust or a trust regulated by law. Therefore, the Trust Law is a kind of normative standard for any trust. It is consistent with the requirements of such a standard, because it provides instructions for the Trustee’s modi operandi, both appropriate and permitted. It also formalizes a system of remedies and other means of protection for the trust assets.’^[2]

In an article, Professor Adam Hofri‑Winogradow describes how, at the time it was enacted, the Trust Law was exceptional among the trust regimes around the world:

‘In contrast to the overwhelming majority of these regimes, the Law permits the creation of a trust without the ownership of the assets subject to the trust being transferred to the trustee; it did not limit the period of the trust; it created two different trust regimes, the application of one of which is dependent on the manner of the creation of the trust; and it determined an omission norm whereby the beneficiary’s right pursuant to one of these regimes is non‑assignable, non‑pledgeable and non‑attachable.’^[3]

In the relatively young Israel of those days, there was no long‑standing tradition of using trusts. In the late 1990s, as a result of the cancellation of the Currency Control Law 5738‑1978 and the granting of permission to Israeli residents to hold funds outside of Israel (according to the Currency Control Permit 5758‑1998), wealthy families began to set up foreign trusts that were mainly used to hold funds outside of Israel. At that time, it was not clear:

• how trusts and foreign trusts (a fortiori) should be taxed, either as a corporation or as an individual;
• whether a trust’s assets and income should be attributed to the settlor or beneficiaries, or whether the trustee should be taxed; and
• whether there is significance to the place of the effective management of the trust, and so on.

Many people took advantage of the lack of clarity and adopted the position that those trusts that held assets outside of Israel and were managed by foreign‑resident trustees were not liable to tax in Israel. Consequently, a considerable amount of wealth was channelled overseas.

The Israel Tax Authority (the ITA) took its time in responding and, due to the complexity of the matter, the entire issue of the taxation of trusts was not handled in the framework of the comprehensive reform in international taxation that was implemented in 2003 (amendment 132 of the Income Tax Ordinance (the ITO), 2002). It was determined that a special, separate committee be set up, which would examine and settle the taxation treatment of trusts only.

A report by the Yisraeli Committee for the Taxation of Trusts (the Committee), published in July 2003, stated that the institution of trust was not commonplace in Israel for reasons such as differences in cultural background, partial legislative regulation with respect to the establishment of foreign trusts and a lack of regulation of the taxation of trusts. Nevertheless, the report did state that the need had arisen for a comprehensive arrangement for the taxation of trusts, following the accumulation of wealth of families in Israel, the lifting of the control on foreign currency and exposure to the vehicle of trusts abroad. The Committee published its recommendations in 2003 but these were not adopted verbatim and an additional committee was set up in 2005: the joint committee of the State Income Administration and the ITA. Consequently, amendment 147 to the ITO was finally enacted, effective from 1 January 2006, which added a special chapter (the Chapter) dedicated to regulating the taxation of trusts in Israeli law.^[4] The Chapter is comprehensive and determines, as a rule, that the trust/trustee is a taxpayer in and of itself/themselves, who is taxed as an individual. Further, the residence of the trust and its tax implications are derived from the fiscal residence of the settlor and of the beneficiaries.

In passing the comprehensive Chapter, the tax advantages of using foreign trusts came to an end and, since then, trusts have been used as a legitimate and acceptable instrument in all matters pertaining to intergenerational transfers and succession planning. Yet, notwithstanding the passage of the Chapter, there is one key subject that has not been regulated: the issues of the taxation of the contribution to and distribution from a trust of Israeli real estate.

For our purposes, the Chapter (4B of the ITO) forms part of Part E of the ITO, which discusses the taxation of capital assets. Further, in chapter 4B, s.75C of the ITO, an ‘asset’ is defined, for the purposes of the Chapter, as ‘any property, whether real estate or chattels, and any right or benefit, vested or contingent, and all whether in Israel or abroad’.

In other words, the definition of an asset in the Chapter is extremely broad and includes any property whatsoever, including real estate in Israel or abroad.

That said, as distinct from the Chapter, the ITO does not, in principle, apply to the taxation of the purchase and sale of real estate in Israel. For historical reasons, there is another, separate law: the Land Taxation (Appreciation and Purchase) Law, 5723‑1963 (the 1963 Law), which applies to any sale and purchase of real estate in Israel. Accordingly, s.88 of the ITO, which regulates the taxation of capital gains, determines that Part E does not apply to the sale of real estate in Israel (as opposed to real estate abroad, in which case, Part E applies). Therefore, with respect to the taxation of Israeli real estate, although the taxation of current income is regulated under the ITO, purchases and sales are regulated under the 1963 Law.

Therefore, it transpires that there is, apparently, a contradiction between the two provisions. Although Part E excludes from its application real estate in Israel, the section covering definitions in the Chapter (which is, as previously mentioned, part of Part E) also pertains to real estate in Israel. The lack of clarity is even further exacerbated as there are provisions in the Chapter that determine that upon the existence of certain circumstances, a contribution to a trust will not be deemed to be a sale for the purposes of Part E of the ITO. It should also be noted that the provision pertains solely to Part E and it does not specifically pertain to the 1963 Law. Practitioners, therefore, find themselves contending with an unclear law that is the subject of controversy between taxpayers and the ITA. Although taxpayers have claimed that the contribution to a trust of real estate in Israel does not constitute a ‘sale’ (upon the satisfaction of the conditions set forth in the Chapter), the ITA has clung to the position that such a contribution does indeed constitute a sale for all intents and purposes, especially for the purposes of the 1963 Law, and such a transaction is therefore subject to real estate taxation.

This dispute has remained unresolved ever since the passage of the Chapter in 2006, and even in the subsequent legislative amendments^[5] the legislature has not taken the trouble to resolve the lack of clarity. Consequently, throughout this period, the prevalent fact in practice was that, in the absence of well‑regulated provisions in the law, the contribution of Israeli real estate to a trust or the distribution thereof from a trust is exposed to betterment tax and purchase tax. Further, the ITA published a tax ruling in 2012 in which it was determined that the contribution of Israeli real estate to an Israeli trust in which the settlor is also the beneficiary during their lifetime and, ^[6] thereafter, their heirs became the beneficiaries does not constitute the sale of a right in real estate. Nevertheless, in 2016, the ITA published a circular regarding the taxation of trusts,^[7] in which it was determined that the contribution of an asset to a trust constitutes a tax event pursuant to the 1963 Law.

In 2019, this principled dispute finally made its way to the courts in Galis.

Samuel Galis v Director of Land Appreciation Tax Tel‑Aviv

In the Supreme Court of Israel (the Supreme Court) case of Samuel Galis v Director of Land Appreciation Tax Tel‑Aviv,^[8] a Canadian‑resident couple contributed Israeli residential apartments to an Israeli trust (or, to be more precise, to an Israeli trust holding company). The beneficiary of the trust was the Israeli‑resident granddaughter of the settlors; however, at the settlors’ request, she was not aware that she was a beneficiary of the trust and, pursuant to the trust deed, she could have been removed from the trust or other beneficiaries could have been added with her. The trust was a classic irrevocable trust pursuant to common law, where the trustee and the protector (both of whom were Israeli residents) were given extremely broad powers and the settlors’ wishes were set forth, inter alia, in a non‑binding letter of wishes.

The settlors of the trust divested their assets and agreed that they would not retain control of the assets after the transfer thereof to the trustee, provided that they would have the right to contact the trustee and present their wishes with respect to the management of the trust.

The trustee was entitled, at his discretion and subject to approval from the protector, to distribute the trust assets to the beneficiary at any time.

Although the trustee should have considered the settlors’ wishes, they were not required to do so. The trustee would then be subject to certain approvals from the protector, appointed by the settlors of the trust. Numerous powers were conferred on the protector, including appointing or removing the trustee, giving the trustee instructions and the ability to add or remove beneficiaries, according to the settlors’ wishes.

The couple and the trustee claimed that the contribution of the Israeli real estate to the trust was not subject to real estate taxes in Israel, whereas the ITA rejected this position. In the Tel Aviv District Court (the Court) Appeal Committee’s judgment of July 2019,^[9] the taxpayers’ position was accepted and it was ruled that the contribution in this case was not subject to real estate taxes in Israel. Although the decision was unanimous, the panel had differences of opinions in the reasons it provided for the decision.

In a well‑reasoned judgment by one of the members of the Appeal Committee, the relationship between the Chapter and the 1963 Law was comprehensively discussed. The Court reviewed the legislative proceedings in the Israeli parliament (Knesset). It ruled that the fact that the law does not contain a specific reference to the question of the contribution of Israeli real estate to a trust does not constitute a negative arrangement.

The Court decided that, in view of the aspiration to create legislative harmony, the lacuna must be filled in accordance with the purposes of the legislation and the Chapter. The Court concluded that the contribution should not be deemed a sale for the purposes of the provisions of the 1963 Law. One of the panel members ruled that in the present case there had been no ‘sale’ because, effectively, the control over the rights in the asset remained held by the settlors and only the return on the real estate had been assigned to the granddaughter (the beneficiary).

The ITA appealed to the Supreme Court, which allowed the appeal.

In the judgment, the Supreme Court analysed the relationship between the Chapter of the ITO, which formalises the tax treatment that applies to trusts throughout their stages of life, commencing from the establishment of the trust and ending with the distribution of the trust assets and the dissolution of the trust; and the 1963 Law, which governs the taxation of real estate situated in Israel. The Supreme Court concluded that Part E of the ITO formalises the taxation of capital gains that are subject to tax under the ITO but it does not apply to the sale of real estate in Israel, the taxation of which is formalised in the 1963 Law and in the regulations enacted thereunder.

According to the Supreme Court’s approach, this is not a gap or lacuna but rather an informed and clear choice by the legislator to leave unchanged the historical division between the taxation of the appreciation arising from the sale of Israeli real estate under the 1963 Law and the taxation of capital gains under the ITO (including the taxation of appreciation arising from the sale of real estate outside of Israel).

Therefore, the contribution of Israeli real estate to a trust will be subject to the provisions of the 1963 Law only. The provision of the Chapter that determines that a contribution (without consideration) to an Israeli‑resident trust is not a taxable event does not apply to the contribution of Israeli real estate. This does not nullify the application of the Chapter to the ordinary income from the real estate generated by the trust (for example, rental income from the real estate).

Once the Supreme Court had decided that the contribution of Israeli real estate (without consideration) to a trust must be examined through the prism of the 1963 Law, it was required to examine the contribution in the present case from the perspective of the 1963 Law. Given that the matter concerns a contribution to an irrevocable trust, the Supreme Court ruled that this case involves a ‘sale’ pursuant to the 1963 Law and that this sale is not exempt from betterment tax for the transferors (the settlors) or from purchase tax for the purchaser (the trust).

At the same time, the Supreme Court noted that had there been a specific, final and informed beneficiary of the trust on the date of the contribution of the real estate to the trustee and if the trust had reported as required by the 1963 Law, then there would have been no impediment to applying the provisions of s.69 of the 1963 Law. This provision determines the treatment of a ‘nominee’ that holds Israeli real estate, whereby a tax event occurs at the time of the contribution to the nominee (called ‘trustee’ in the 1963 Law) in accordance with the identity of the settlor and the beneficiary, but no additional tax occurs at the time of the distribution to the beneficiary.

However, in Galis, the granddaughter was not the final beneficiary and she had not even been aware that she was a beneficiary of the trust from the outset and, therefore, the provisions of this section did not apply. The Supreme Court further emphasised that this unique arrangement in the 1963 Law may apply not only with respect to a nominee relationship but also with respect to a trusteeship relationship, as occurred in Galis. Nevertheless, the Supreme Court did not expressly address the tax implications at the time of the distribution of the real estate to the beneficiaries in cases in which the provisions of s.69 had not been satisfied; nor did it address the potential for double taxation, which could be entailed therein.

Further, the Supreme Court stated in an obiter dictum that if the contribution had been to a revocable trust, if the settlor had kept the control for themselves (including through the protector), or if the beneficiary had been the settlor himself only, then it is possible that this would not even have been viewed as a ‘sale’, which creates a taxable event.

The Supreme Court’s decision, therefore, clarifies that a contribution to a trust of Israeli real estate will be subject to the provisions of the 1963 Law (and not the ITO). However, perhaps it is possible under certain circumstances to create a revocable trust in which the settlor is the sole beneficiary during their lifetime, and only after their death do the descendants become beneficiaries and the trust become irrevocable. It is possible to argue that under these circumstances, there is no ‘sale’ at the time of the contribution to the trust and, at the time of death, the inheritance provisions in the 1963 Law would be applied. However, as aforementioned, none of these subjects or implications were explicitly discussed in the Supreme Court’s judgment and, therefore, this should be further clarified.

As can be seen, there remain open questions in this regard. At any rate, the Supreme Court actually does leave an opening for making use of trusts with respect to real estate in Israel in the context of succession planning and an intergenerational transfer, naturally, in the appropriate circumstances, and in accordance with the procedural provisions as set forth in the law.^[10]