US & Israel Income Tax Treaty

United States & Israel Income Tax Treaty

US Israel Tax Treaty: The United States has entered into several tax treaties with different countries across the globe — including Israel. There are many US taxpayers who are originally from Israel and/or still maintain offshore accounts, assets & investments, and/or generate income from Israel. While the United States and Israel have a bilateral tax treaty and FATCA Agreement in place — there is no Totalization Agreement nor Estate Tax Treaty. The purpose of the United States tax treaty is so Taxpayers can determine what their tax liability is for certain sources of taxable income. While the treaty is not the final word in how items of income will be taxed, it does help residents better understand how either the IRS and/or Israel will tax certain sources of income – and whether or not the saving clause will further impact the outcome. Let’s review the basics of the US & Israel Income Tax Treaty – and how the income tax treaty between the US and Israel works.

Israel and US Taxation Basics

In general, the default position is that a Taxpayer who is a US person such as a US Citizen, Legal Permanent Resident, or Foreign National who meets Substantial Presence Test is taxed on their worldwide income. This would also include income that is being generated in Israel and can be tax-free or exempt under the tax rules of Israel — unless an exception, exclusion or limitation applies (such as with pension).

Saving Clause in the Israel Income Tax Treaty

As we work through the United States-Israel Tax Treaty, one important thing to keep in mind is the saving clause. The saving clause is inserted in tax treaties in order to limit the application of the treaty to certain residents/citizens. With the saving clause, each country retains the right to tax certain citizens and residents as they would otherwise tax under general tax principles in their respective countries — absent the tax treaty taking effect.

What does the Saving Clause Say?

• • • Notwithstanding any provisions of this Convention except paragraph (4), a Contracting State may tax its residents (as determined under Article 3 (Fiscal Residence) and its citizens as if this Convention had not come into effect.

Limitations on the Saving Clause

• • • The provisions of paragraph (3) shall not affect:

      • (a) The benefits conferred by a Contracting State under

        • Articles 10 (Grants), 21 (Social Security Payments), 26 (Relief from Double Taxation), 27 (Nondiscrimination) , and 28 (Mutual Agreement Procedure); and

      • (b) The benefits conferred by a Contracting State under

        • Articles 22 (Governmental Functions), 23 (Teachers), 24 (Students and Trainees), and 30 (Diplomatic and Consular Officers) upon individuals who are neither citizens of, nor have immigrant status in, that Contracting State.

What Does This Mean?

The Saving Clause is inserted into a tax treaty in order to allow each country to reserve the right to tax citizens and residents the way that they would otherwise tax them had the treaty not been in effect. Despite the insertion of the saving clause into a tax treaty, there are exceptions to the saving clause as well —

Permanent Establishment in the Israel Income Tax Treaty with the US

• • • 1. For the purpose of this Convention, the term “permanent establishment” means a fixed place of business through which a resident of one of the Contracting States engages in industrial or commercial activity.

    • 2. The term “fixed place of business” includes but is not limited to: (a) A branch; (b) An office; (c) A factory; (d) A warehouse; (e) A workshop; (f) A farm or plantation; (g) A store or other sales outlet; (h) A mine, quarry, or other place of extraction of natural resources; (i) A building site, or construction or assembly project, or supervision activity connected therewith and conducted within the Contracting State where such site or project is located, where such site, project, or activity continues for a period of more than 6 months; and (j) The maintenance of substantial equipment or machinery within a Contracting State for a period of more than 6 months.

What Does This Mean?

If a resident of one country has a Permanent Establishment (PE) in the other country, then that other country has the right to tax income generated from the Permanent Establishment within its borders. But, if there is no permanent establishment in place, then the mere fact that a non-permanent establishment generates income in the other country does not allow that other country to tax the income.

Income From Real Property in Israel/US Income Tax Treaty

• 1. Income from real property, including royalties and other payments in respect of the exploitation of natural resources and gains derived from the sale, exchange, or other disposition of such property or of the right giving rise to such royalties or other payments, may be taxed by the Contracting State in which such real property or natural resources are situated. For purposes of this Convention, interest or indebtedness secured by real property or secured by a right giving rise to royalties or other payments in respect of the exploitation of natural resources shall not be regarded as income from real property.

• 2. Paragraph (1) shall apply to income derived from the usufruct, direct use, letting, or use in any other form of real property.

• 3. Gains from the alienation of shares of a real estate association (as defined in the Israeli Land Appreciation Tax Law) may be taxed by Israel.

What Does This Mean?

This article provides that if income is earned by residents of one country, as a result of real property that is located in the other country — then it may be taxed in that other country. And, since it does not use the word shall, it presumes that either country may be able to tax the income. Still, foreign tax credits from a US perspective should avoid a US person from having to pay tax to both the United States and Israel on the same income (although the foreign tax credit is not always a dollar-for-dollar credit).

Dividends

• • • 1. Dividends derived from sources within one of the Contracting States by a resident of the other Contracting State may be taxed by both Contracting States.

    • 2. The rate of tax imposed by one of the Contracting States on dividends derived from sources within that Contracting State by a resident of the other Contracting State shall not exceed- (a) 25 percent of the gross amount of the dividend paid; or (b) When the recipient is a corporation, 12.5 percent of the gross amount of the dividend paid, but only if- (i) 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 (ii) 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).

    • 3. 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 from tax by the other Contracting State.

    • 4. Paragraphs (2) and (3) shall not apply if such dividends are treated, under paragraph (6) of Article 8 (Business Profits), as industrial or commercial profits attributable to a permanent establishment which the recipient has in the other Contracting State. In such case, the provisions of Article 8 (Business Profits) shall apply.

What Does This Mean?

When dividends are paid by a company of one country to a resident of that other country, then that other country has the opportunity to tax the income. Noting, that the first country (aka country of source) still gets the opportunity to tax the income — but may only tax the dividend income up to a certain percentage.

Interest in Israel/US Income Tax Treaty

• • • 1. Interest derived by a resident of one of the Contracting States from sources within the other Contracting State may be taxed by both Contracting States.

    • 2. Interest derived by a resident of one of the Contracting States from sources within the other Contracting State shall not be taxed by the other Contracting State at a rate in excess of 17.5 percent of the gross amount of such interest, except that, if the interest is derived from a loan of whatever kind granted by a bank, savings institution, or insurance company or the like, the interest shall not be taxed at an amount in excess of 10 percent of the gross amount of such interest.

    • 3. Notwithstanding paragraphs (1) and (2), interest beneficially derived by (a) one of the Contracting States, or by an instrumentality of that Contracting State, not subject to tax by that Contracting State on its income, or (b) a resident of such Contracting State with respect to debt obligations guaranteed or insured by that Contracting State or an instrumentality thereof, shall be exempt from tax by the other Contracting State.

    • 4. Interest paid by a resident of one of the Contracting States to a person other than a resident of the other Contracting State (and in the case of interest paid by a resident of Israel, to a person other than a citizen of the United States) shall be exempt from tax by the other Contracting State unless such interest is treated as income from sources within the other Contracting State under paragraph (2) of Article 4 (Source of Income).

What Does This Mean?

It means that while either state may tax the interest income generated from either state for residents of either state — there are limitations to the amount of tax and the type of interest that may be taxed.

Capital Gains in Israel/US Income Tax 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- (a) The gain is from the sale, exchange or other disposition of property described in Article 7 (Income from Real Property) situated within the other Contracting State, (b) The gain is from the sale, exchange or other disposition of property described in paragraph (2) of Article 14 (Royalties), (c) The gain is treated, under paragraph (6) of Article 8 (Business Profits), as industrial or commercial profits attributable to a permanent establishment which the resident has in such other Contracting State, (d) The resident, being an individual, is present in the other Contracting State for a period or periods aggregating 183 days or more during the taxable year, or (e) The gain is derived by a resident of the United States from the sale, exchange, or other disposition of stock in an Israeli corporation, but only if- (i) The resident of the United States owns either actually or constructively within the 12-month period preceding such sale, exchange, or other disposition, stock possessing more than 50 percent of the voting power of the Israeli corporation, and (ii) More than 50 percent of the fair market value of the Israeli corporation’s gross assets used in its trade or business are physically located in Israel on the last day of each of the 3 taxable years preceding the sale, exchange, or other disposition (or, if the corporation has been in existence for less than 3 years, on the last day of each preceding taxable year of the corporation).

    • In the case of gains described in paragraph (1) (a), the provisions of Article 7 (Income from Real Property) shall apply. In the case of gains described in paragraph (1) (b), the provisions of Article 14 (Royalties) shall apply. In the case of gains described in paragraph (1) (c), the provisions of Article 8 (Business Profits) shall apply.

What Does This Mean?

The capital gains rules provide that when gains are earned by a resident of one country as a result of alienating real property located in the other country — then the other country has the opportunity to tax the income. It is important to evaluate the definition of the term immovable property situated in the other Contracting State to determine whether that particular type of asset qualifies.

Public Entertainers

• • • Notwithstanding Article 16 (Independent Personal Services) and 17 (Dependent Personal Services), the income derived by an individual who is a resident of one Contracting State from his performance of personal services in the other Contracting State as a public entertainer, such as a theater, motion picture, radio or television artist, a musician, or an athlete, may be taxed by the other Contracting State, but only if the gross amount of such income exceeds 400 United States dollars or its equivalent in Israeli pounds for each day such person is present in the other Contracting State for the purpose of performing such services therein.What Does This Mean?

This section provides that, subject to other sections, an artist or entertainer who is a resident of one country and provides entertainment services in the other country may be tax in the other country — although any income that is less than $400 in total is exempt; there are exceptions, exclusions and limitations.

Pensions in the Israel Income Tax Treaty with the US

• • • 1. Except as provided in Article 22 (Governmental Functions), pensions and other similar remuneration paid to an individual shall be taxable only in the Contracting State of which he is a resident.

    • 2. Alimony and annuities paid to an individual who is a resident of one of the Contracting States shall be taxable only in that Contracting State.

    • 3. Child support payments made by an individual who is a resident of one of the Contracting States to an individual who is a resident of the other Contracting State shall be exempt from tax in that other Contracting State.

    • 4. The term “pensions and other similar remuneration”, as used in this Article, means periodic payments other than social security payments covered in Article 21 (Social Security Payments) made (a) by reason of retirement or death and in consideration for services rendered, (b) by way of compensation for injuries or sickness received in connection with past employment, or (c) by reason of payments made under a plan benefiting self-employed individuals all or some of the contributions to which qualify for special tax treatment.

    • 5. The term “annuities”, as used in this Article, means a stated sum paid periodically at stated times during life, or during a specified number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered).

    • 6. The term “alimony”, as used in this Article, means periodic payment made pursuant to a written separation agreement or a decree of divorce, separate maintenance, or compulsory support which payments are taxable to the recipient under the internal laws of the Contracting State of which he is a resident.

What Does This Mean?

Pensions are always an integral part of any tax treaty. Article 20 provides that pension earned by resident of one country is only taxable in that country if that is where the pension was earned in that country. But, when referring to Social Security payments, it is taxed by source, which means the country that is making the payment gets the opportunity to tax the income. A portion of the pension application is exempted from the Saving Clause.

Government Service

• • • Wages, salaries, and similar remuneration, including pensions, annuities, or similar benefits, paid from public funds of one of the Contracting States:

      • (a) To a citizen of that Contracting State, or

      • (b) To a citizen of a State other than a Contracting State who comes to the other Contracting State expressly for the purpose of being employed by the first-mentioned Contracting State, for labor or personal services performed as an employee of the national Government of that Contracting State, or any agency thereof, in the discharge of functions of a governmental nature shall be exempt from tax by the other Contracting State.

What Does This Mean?

When it comes to government service, it is important to note that if a person earns remuneration — including pensions as a result of working for the government — then those public funds are generally only taxable in that country, although exceptions may apply.

Relief from Double Taxation in the Israel Income Tax Treaty with the US

• • • Double taxation of income shall be avoided in the following manner: 1. In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended front time to time without changing the general principle hereof), the United States shall allow to 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 of a United States corporation owing 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. Such appropriate amount shall be based upon the amount of tax paid or accrued to Israel, but the credit shall not exceed the limitations (for the purpose of limiting the credit to the United States tax on income from sources within Israel or on income from sources outside of the United States) provided by United States law for the taxable year. For the purpose of applying the United States credit in relation to taxes paid or accrued to Israel, the rules set forth in Article 4 (Source of Income) shall be applied to determine the source of income. For purposes of applying the United States credit in relation to taxes paid or accrued to Israel, the taxes referred to in paragraphs (1) (b) and (2) of Article 1 (Taxes Covered) shall be considered to be income taxes. 

    • If for any taxable year a citizen or resident of the United States takes as a credit against tax under paragraph (1) an amount with respect to a compulsory loan to Israel (which is included as a tax under paragraph (1) (b) (v) of Article 1 (Taxes Covered)), then- (i) 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 to which clause (iv) applies; (ii) 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 for such loan; (iii) Any such 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; and (iv) No interest shall be assessed or collected by the United States on any amount of tax due for the year the loan was made except to the extent that interest referred to in clause (i) was received. The Secretary of the Treasury or his delegate shall prescribe regulations he deems necessary to carry out the purposes of this paragraph including rules for determining whether all amount included as a tax under paragraph (1) (b) (v) of Article 1 (Taxes Covered) has been taken as a credit against tax.

What Does This Mean?

This is more of a general provision that provides that the purpose of the tax treaty is to avoid certain double taxation — and that subject to certain restrictions in the different articles, double taxation will prevent a person from being taxed twice on the same income.

Exchange of Information

• • • The competent authorities of the Contracting States shall exchange such information as is necessary for the carrying out of this Convention and of the domestic laws of the Contracting States concerning taxes covered by this Convention insofar as the taxation thereunder is in accordance with this Convention. Any information so exchanged shall be treated as secret and shall not be disclosed to any persons or authorities other than those concerned with the assessment, including judicial determination, or collection of the taxes which are the subject of the Convention. 

    • In no case shall the provisions of paragraph (1) be construed so as to impose on one of the Contracting States the obligation- (a) To carry out administrative measures at variance with the laws or the administrative practice of that or of the other Contracting State; (b) To supply particulars which are not obtainable under the laws or in the normal course of the administration of that or of the other Contracting State; (c) To supply information which would disclose any trade, business, industrial, commercial or professional secret or trade process, or information, the disclosure of which would he contrary to public policy.

What Does This Mean?

The exchange of information provision is designed to further enforce the fact that the purpose of the tax treaty is to promote cooperation and to facilitate any exchange of information necessary for each country to obtain the goals and objectives of being in a double taxation agreement with the other country.

Offshore Reporting (FBAR & FATCA) & United States/Israel Tax Treaty

When a US person has various Accounts, Assets or Investments in Israel, they have to reported to the United States each year on various different forms depending on the value of and category of the assets/accounts.

Here are some common forms which may need to be filed:

5 International Tax Forms You May Have Missed

The following is a summary of five (5) common international tax forms.

FBAR (FinCEN 114)

The FBAR is used to report “Foreign Financial Accounts.” This includes investments funds, and certain foreign life insurance policies.  The threshold requirements are relatively simple. On any day of the year, if you aggregated (totaled) the maximum balances of all of your foreign accounts, does the total amount exceed $10,000 (USD)? If it does, then you most likely have to file the form. The most important thing to remember is you do not need to have more than $10,000 in each account; rather, it is an annual aggregate total of the maximum balances of all the accounts.

Form 8938

This form is used to report “Specified Foreign Financial Assets.”

There are four main thresholds for individuals is as follows:

• • • Single or Filing Separate (in the U.S.): $50,000/$75,000

    • Married with a Joint Returns (In the U.S): $100,000/$150,000

    • Single or Filing Separate (Outside the U.S.): $200,000/$300,000

    • Married with a Joint Returns (Outside the U.S.): $400,000/$600,000

Form 3520

Form 3520 is filed when a person receives a Gift, Inheritance or Trust Distribution from a foreign person, business or trust. There are three (3) main different thresholds:

• • • Gift from a Foreign Person: More than $100,000.

    • Gift from a Foreign Business: More than $16,076.

    • Foreign Trust: Various threshold requirements involving foreign Trusts

Form 5471

Form 5471 is filed in any year that you have ownership interest in a foreign corporation, and meet one of the threshold requirements for filling (Categories 1-5). These are general thresholds:

• • • Category 1: U.S. shareholders of specified foreign corporations (SFCs) subject to the provisions of section 965.

    • Category 2: Officer or Director of a foreign corporation, with a U.S. Shareholder of at least 10% ownership.

    • Category 3: A person acquires stock (or additional stock) that bumps them up to 10% Shareholder.

    • Category 4: Control of a foreign corporation for at least 30 days during the accounting period.

    • Category 5: 10% ownership of a Controlled Foreign Corporation (CFC).

Form 8621

Form 8621 requires a complex analysis, beyond the scope of this article. It is required by any person with a PFIC (Passive Foreign Investment Company).

The analysis gets infinitely more complicated if a person has excess distributions. The failure to file the return may result in the statute of limitations remaining open indefinitely.

*There are some exceptions, exclusions, and limitations to filing.

Receiving a Gift or Inheritance from Israel

If you are a U.S. Person and receive a gift from a Foreign Person, Foreign Business or Foreign Trust, you may have to file a Form 3520. The failure to file these forms may lead to IRS Fines and Penalties (see below).

Which Banks in Israel Report U.S. Account Holders?

As of now, there are nearly 2000 Foreign Financial Institutions, within Israel that report US account holder information to the IRS. The FFI list can be found here:

What is important to note, is that the list is not limited to just bank accounts. Rather, when it comes to FATCA or FBAR reporting, it may involve a much broader spectrum of assets and accounts, including:

• • • Bank Accounts

    • Investment Accounts

    • Retirement Accounts

    • Direct Stock Ownership

    • ETF and Mutual Fund Accounts

    • Pension Accounts

    • Life Insurance or Life Assurance Policies

Totalization Agreement for US & Israel

The purpose of a Totalization Agreement is to help individuals avoid double taxation on Social Security (aka U.S. individuals living abroad and who might be subject to both US and foreign Social Security tax [especially self-employed individuals] from having to pay Social Security taxes to both countries).

As provided by the Agreement:

• • • An agreement effective September 1, 1993, between the United States and Israel improves Social Security protection for people who work or have worked in both countries. It helps many people who, without the agreement, would not be eligible for monthly retirement, disability or survivors benefits under the Social Security system of one or both countries. It also helps people who would otherwise have to pay Social Security taxes to both countries on the same earnings.

    • The agreement covers Social Security taxes (including the U.S. Medicare portion) and Social Security retirement, disability and survivors insurance benefits. It does not cover benefits under the U.S. Medicare program or the Supplemental Security Income program.

    • This document covers highlights of the agreement and explains how it may help you while you work and when you apply for benefits.

The United States has entered into 26 Totalization Agreements — but not with Israel.

The Israel Income Tax Treaty with the US is Complex

In conclusion, The US and Israel tax treaty is a great source of information to help better understand how certain income may be taxed by either country depending on the source of income, the type of income and the residence of the taxpayer. The tax outcome may be changed depending on whether or not the savings clause impacts how tax rules will be applied for certain types of income.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.

Contact our firm for assistance.