Claire Shelemay and Lilach Asherov discuss the latest developments for new Israeli residents.Posted on 21 March 2019
The business and trading relationship between Israel and the UK is ever growing. There are more than 300 Israeli companies which together employ thousands of individuals operating in the UK representing sectors including high tech, pharmaceutical and finance. For more than ten years, increasing numbers of people have moved to Israel – in 2018 more than 29,000 new immigrants arrived there.
There are extensive tax exemptions for new residents in relation to overseas income for a period of ten years. Israel and the UK also agreed a protocol to the their double taxation treaty on 17 January 2019 to provide more favourable tax treatments for Israeli investors into the UK and UK investors into Israel. This article looks at the tax exemptions for new Israeli residents and a summary of the recent protocol to the Israel-UK double taxation treaty.
The effect is that new residents are exempt from paying taxes on income earned abroad and do not even have to report it.
Tax exemptions for new residents
The benefits are available to:
- a person who became an Israeli resident for the first time as of 1 January 2007;
- a ‘returning resident’ who was a foreign resident for at least ten consecutive years after their departure from Israel and then became an Israeli resident post-1 January 2007; and
- a person who returned to Israel between 2007 and 2009 after being resident elsewhere for five consecutive years.
The concept of a ‘first-time resident’ for tax purposes applies to any person who was not previously an Israeli resident, not only to those who are eligible to move there according to the Israeli ‘law of return’. In this article, we refer with the cap of ten years for the tax benefits for new Israeli residents.
- Ten-year tax exemption for new Israeli residents.
- Clarification re ‘mixed’ income for Israeli residents working in the UK and Israel
- Update to the double tax agreement between UK and Israel
There is often confusion as to how and when the Israeli tax benefits can be used for employees, self-employed people and those providing services through companies incorporated outside Israel. For example, the concept of income generated from a ‘foreign source’ may be mistaken to include income received offshore. However, according to the country’s ‘source rules’, income generated from services provided while in Israel is ‘Israeli source income’ and not exempted from Israeli income tax despite payments being received offshore. So to determine whether the income is ‘foreign source’, where the taxpayer is physically present when providing the services is relevant.
The situation becomes more complicated when services are provided partly in and partly outside Israel. Nowadays, people work in a way whereby travelling and having clients in different countries is the norm. A laptop and a phone are often the key ingredients for work as opposed to a fixed office. A taxpayer with ‘mixed’ income is required to file an annual tax return in Israel reflecting the ‘Israeli part’ of the income and pay Israeli income tax on this part.
The ITA published Tax Circular No 1/2011 clarifying that such allocation should be based on the number of business days the taxpayer was physically absent from Israel. This position was applied by a ruling published by ITA in 2015.
Another tax ruling published by the ITA in 2018 seeks to re-clarify the application of this methodology by stating that taxpayers must calculate their ‘Israeli income’ by pro-rating their annual income based on the number of ‘business days’ spent in Israel compared with the entire ‘business days’ in that year. The circular further states that ‘a part of a day’ spent in Israel is counted as a full day. The ruling and methodology for allocating the income increases the taxable Israeli element.
‘Business days’ within a period are comprised of the entire days in that period, less Saturdays, Sundays, holidays and private vacations. The taxpayer may opt to subtract Fridays instead of Sundays, provided this choice is consistent. The balance – the entire business days minus business days spent in Israel – reflects that portion of the income which is not taxable in Israel.
For some taxpayers this methodology of counting business days may not truly reflect their working position. A taxpayer may therefore choose to allocate his income based on a different method, in which case he is required to substantiate such allocation and provide any relevant data and documents the ITA may ask for.
De minimis rule
The recent ruling further clarifies a de minimis rule under which, if taxpayers spend less than 60 business days outside Israel during a tax year their entire income is taxed as Israeli sourced income. It was introduced by the tax circular published in 2011 stating that a taxpayer’s entire income will be taxed as Israeli sourced income for scenarios where the time spent outside Israel during a year was short enough to be deemed minor or unimportant. The current ruling clarifies that a period of less than 60 days is ‘unimportant’ and internationally mobile between the grant and exercise of an option. The share option gain is treated as accruing evenly day-by-day across the relevant period and subject to:
- full UK tax if relating to a period of residence in the UK;
- no UK tax liability if relating to a period of residence outside the UK; and
- taxable to the extent it is remitted to the UK if a UK resident is taxable on the remittance basis and performed duties abroad.
Under the new rules, only the time-apportioned part of the overall award value will be subject to UK tax. Companies should consider the UK’s statutory residence test and whether the rules for split-year treatment apply. If an individual is deemed both Israeli and UK tax resident, residence is determined by ‘tie-breaking rules’ set by the treaty, that is location of permanent home, centre of vital interests, habitual abode, nationality, or – as a last resort – by mutual agreement between the competent authorities of both states.
"Companies should consider the UK’s statutory residence test and whether the rules for split year treatment apply.”
Update to the Israel-UK double tax agreement
The agreed protocol to the Israel-UK double taxation treaty signed on 17 January 2019 is a welcome update to the original treaty which was signed in 1962 and last amended in 1970. The protocol follows the recent approach taken by OECD member states in relation to the base erosion and profit shifting project by stating in its preamble that the contracting parties intend to prevent double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including treaty-shopping arrangements.
A key update set out at article VI is that the maximum rate of withholding tax on dividends will be reduced from 15% to 5% of the gross dividend paid to a shareholder in the other country. This is subject to the shareholder directly owning at least 10% of the share capital and the beneficial owner of the dividend being a company – as opposed to a partnership or a real estate investment trust (REIT). Both these conditions must be met for at least one year at the date the dividend is to all these categories as ‘new Israeli residents’, despite the fact that they may be treated differently for specific issues. These tax benefits are available to new residents from the time their centre of life is based in Israel which is not necessarily the date of arrival in the country.
New Israeli residents benefit from a ten-year tax exemption but care must be taken if they work outside the country.
What is the tax benefit?
Israeli tax residents are liable to tax in Israel on their worldwide income, subject to tax treaties. New residents are eligible for a ten-year tax exemption for all foreign sourced income such as investments, pensions, rents and the sale of foreign assets. The effect is that new residents are exempt from paying taxes on income earned abroad and they do not even have to report it. Remember, though, that all relevant UK sourced income must be declared and taxed in the UK.
The Organisation for Economic Co-operation and Development (OECD) and other international bodies have criticised and often put pressure on the Israeli Tax Authority (ITA) to revoke the exemption from reporting income earned abroad. The ITA submitted drafts on two occasions for revoking this exemption but both were rejected. The director of the ITA recently clarified his commitment to pursue this goal hence we cautiously predict that the draft will be submitted for vote again. It is not clear how a revocation of the exemption would affect those who became resident in Israel before such a change.
The tax benefits for new residents are unique, but other jurisdictions have similar ones for various categories of residents. For example, the UK offers a preferential tax regime for those who are UK resident but non-UK domiciled. This is a complex area of the UK tax law but it makes it an attractive place of residence for non-UK domiciled individuals from a tax perspective.
The UK’s most recent update to its non-domicile rules is in F(No 2)A 2017 and had retroactive effect from 6 April 2017. Of particular note was that the UK considers those who have been UK resident for at least 15 of the past 20 tax years to be UK domiciled. This capped the number of years UK residents can enjoy the non-UK domicile benefits and is comparable therefore the entire income is taxable in Israel. We note that this rule is not part of the legislation itself.
Other implications of ‘mixed income’
The ruling further restricts the amount of expenses deductible for Israeli tax purposes. The element of the ‘mixed income’ of a new resident employee which is not taxable in Israel based on the methodology above, may not be deducted for Israeli income tax purposes by the employer – either an Israeli employer or a non-Israeli employer operating in the country through a branch or any other form of a permanent establishment.
The ITA’s positions on mixed-income allocation, the de minimis rule or expenses deduction restrictions have not yet been challenged before Israeli courts.
The situation becomes more complicated when services are provided partly in and partly outside Israel.”
Stock option remuneration
Allocation issues may also arise on other forms of employee remuneration such as stock options. For example, a new Israeli resident employee whose UK employer granted them stock options which were not fully vested before they relocated to Israel, must consider Israeli tax aspects on exercising them.
An Israeli tax ruling from 2013 addresses the case of a new Israeli resident who relocated to Israel (with his family) to be employed by an Israeli subsidiary of his former employer (who granted him options prior to relocation) and clarifies the method for allocating the income gained from exercising options that were not fully vested. The portion of income equal to the number of working days outside of Israel (before relocation) compared to the total ‘working period’ (number of days from the date the options were granted to the date the options are vested) will not be taxed in Israel. The residue of income is regarded as employment income generated within Israel and subject to Israeli taxation. The ruling further states that foreign income tax paid with respect to the latter portion of the income will not be credited against the Israeli tax. We note that the ruling did not address a situation in which the new Israeli resident actually worked outside of Israel, during the vesting period, after becoming an Israeli resident.
The ITA’s position expressed in this ruling seems in line with the position taken by the OECD, as expressed in the commentaries (Model Tax Convention on Income and on Capital, condensed version, 21 November 2017, page 327). These clarify that employee stock options are generally provided as an incentive for future services . If these are performed in more than one state, the allocation of income should be based on the proportion of employment days in each of the states compared with the total number of employment days during which the employment services from which the stock-option is derived have been exercised.
The measures in the UK Finance Bill 2014 which came into force on 6 April 2015 also consider when an employee was paid. If not, the original provisions of the withholding tax not exceeding 15% apply. The UK does not currently withhold taxes on dividends paid by UK companies so the treaty makes no difference to Israeli residents receiving dividends from UK companies. But it does benefit UK residents receiving dividends from Israeli companies because the treaty gives a lower rate of withholding than under Israeli domestic law.
There are specific rules for REITs. Broadly, the UK tax on distributions from a UK REIT to an Israeli individual will not exceed 15% of the gross distribution. Similarly, if the beneficial owner of the distribution is UK resident and holds less than 10% of the REIT capital, the maximum tax will also be 15%.
Article VII provides that the maximum rate of withholding tax on interest on bank loans will be 5% of the gross amount of interest paid and 10% of the gross amount of interest paid for other types of interest. Article VIII sets out that royalties will be taxable only in the recipient’s country of residence unless the payment is made in connection with a permanent establishment.
The protocol will enter into force after it is ratified into domestic law by both Israel and the UK.
Both the ten-year tax exemptions for new Israeli residents and the agreed protocol to the Israel-UK double tax agreement have significant benefits and opportunities including increased tax-efficient investments between Israel and the UK.
Claire Shelemay ACA is the founder and CEO of CrownStone Consulting Ltd – a UK tax boutique in Tel Aviv. Her expertise relates to solving UK tax issues, UK tax dispute resolution and UK/Israel consultancy services. She can be contacted on tel: +972 58 7953599 or +44 07854 904554 and email: claire.shelemay@ crownstone.co.uk
Lilach Asherov Adv TEP is the owner of an Israeli legal firm specialising in Israeli and international tax issues. Previously she was a senior officer at the international tax department of Israel Tax Authority. She can be contacted on tel: +972 3 5235060 or +972 50 4488407 and email: Lilach@asherov-taxlaw.co.il.