The difference between local and international tax counselling
Tax advice given to a client in a certain country, while the client is a resident of another country, or where the relevant income is taxable in another country, must take into account the tax implications in both countries (i.e., the client’s country of residence and the taxing country). Incorrect advice is sometimes a result of overlooking the implications of a double taxation treaty (DTT) or local tax laws in another country. In many cases, only cooperation between tax consultants from both countries can prevent dramatic tax mistakes.
Mistakes can be made in almost any field of taxation. Below are a few examples in which tax planning in one country did not take into account the tax laws in the other:
- Interest income: Although the client was exempt from taxes in the US on interest income from municipal bonds, said exemption was not valid in Israel and the income was subject to taxes; a fact that completely altered the revenue calculations.
- Real estate sale: Upon the sale by an Israeli resident, who was also a US citizen, of a residential apartment in Israel, certain tax exemptions may have been relevant, but said exemptions were not valid in the US and the sale was subject to capital gains taxes (CGTs).
- Trust taxation: A trust not subject to taxes in South Africa was subject to tax in Israel, since trusts with Israeli resident beneficiaries were liable to tax in Israel, in accordance with the provision of the Income Tax Ordinance (New Version), 5721–1961, even if all other beneficiaries were foreign residents.
- Permanent establishment: A company incorporated in Germany created a permanent establishment (PE) in Israel, since it failed to understand how the Israeli tax authority interpreted the legal requirement for PE in Israel. This case needed better practical knowledge of the Israeli tax authority’s position rather than the DTT.
- Questionable residency: A South African citizen assumed in his planning that he was considered a resident of Israel; however, the Israeli authorities did not consider him as such and refused to grant him a certificate of fiscal residence.
German operates in Israel: an example
Herein is a numerical example that demonstrates how planning in one country turns into a tax fiasco in the final calculation. This example includes a common situation where the client, an individual resident of Germany where inheritance and gift taxes are imposed (they could be a resident of the UK, US or any other country where these taxes exist), operates in Israel where these taxes do not exist. The client is the shareholder of an Israeli real estate company that, in the past, purchased land in Israel. The client wants to gift the proceeds from the sale of this land to their children.
The client has several options. Below are two that represent the best and worst options, from a tax perspective:
- selling the land by the company, distributing a dividend to the foreign shareholder and gifting cash to their children; or
- liquidating the company and gifting the land to their children who then sell the land.
The difference between the two options above, when taking into consideration the tax in both countries, can reach more than 200 per cent after tax. However, when the calculation includes Israel only, the worst option would actually be the best choice.
The cost of failing to choose the right tax option in real estate transactions, where the gains are high, can result in high taxes and it is not a coincidence that most malpractice lawsuits against lawyers in Israel are in this field.
For the purpose of this example, Israel’s tax rates will be used, but since the law is very complex, the explanations will be limited. In addition, liabilities that should apply to both options (such as surtax) will not be discussed, and neither will complex liabilities that do not affect this discussion substantially (such as purchase tax on real estate gifts and company liquidation), and other municipal levies.
A significant fact relevant to this example is that an individual selling land in Israel, acquired on 1 April 1961, is liable for the highest CGT rate (39.2 per cent), while a person selling land acquired on 7 November 2001, is liable for the lowest CGT (22.3 per cent). Due to historical changes in the tax rates, any other acquisition date will result in liabilities that fall somewhere between these two extremes.
Another important fact is that the transfer of land from a real estate company to its shareholder when liquidating the company is exempt from CGT and dividend tax in Israel (exceptions are irrelevant for this example). Also exempt from CGT is a gift of real estate given by parents to their children. However, neither case provides a new purchase cost nor an acquisition date, so the original date and cost of the land will be taken into account when the land is eventually sold by the children.
The value of the land in this example is EUR1 million, and it had no significant value when it was acquired.
Below are the relevant Israeli taxes, assuming the land was acquired in April 1961:
| Option 1 | Option 2 | |
| Corporate tax (23%) | 230,000 | n/a |
| Dividend (30%) | 231,000 | n/a |
| Individual CGT | n/a | 392,000 |
| Total tax | 461,000 | 392,000 |
| % | 46.1 | 39.2[1] |
The conclusion is very clear. Whether the land was acquired in 1961, or any other date, the second option is the preferred choice, correct? Absolutely not.
An examination of these facts taking into account the German tax law reveals a different conclusion. The maximum tax Israel can levy on dividend, according to the DTT, is 10 per cent. For the purpose of this example, this article assumes the tax on dividends in Germany is 26 per cent and the gift tax is 15 per cent.
| Option 1 | Option 2 | |
| Israel | ||
| Corporate tax (23%) | 230,000 | |
| Dividend (10%) | 77,000 | |
| Individual CGT | 392,000 | |
| Germany | ||
| Dividend (26%) | 123,000[2] | 260,000 |
| Gift Tax (15%) | 85,470[3] | 150,000 |
| Total Tax | 515,670 | 802,000[4] |
| (%) | 51.5 | 80.2[5] |
As evidenced, in the second option there is no change in the tax liability in Israel. However, liquidating the company and transferring the land to the individual is not exempt in Germany, therefore we need to add 26 per cent as a dividend. On top of that, a gift of land to children is exempt in Israel but not in Germany, therefore we need to add 15 per cent gift tax on the gift of the land to the children.
Conclusion
The liabilities in Israel under the first option amount to taxes of 46.1 per cent, while the second option will not be higher than 39.2 per cent. The choice is seemingly simple, but when we bring this case to the international arena, the client’s liabilities under the first option will be 51.5 per cent, while the second option will result in a minimum of 65.5 per cent tax, and can reach as high as 80.2 per cent. It should be emphasised that this is the tax to be paid, leaving the client with a net of 19.8 per cent.
As shown in the above example, which is not at all theoretical, the differences between domestic and international tax rates can be highly significant, and different options can take on entirely different outcomes. As was said in the beginning of this article, if a client operates or lives in another country, it will always be beneficial to examine the tax liabilities in cooperation.
This article was published with the name ‘Practice makes perfect’ in STEP Journal (Vol28 Iss6), pp.39-41
[1] 39.2 per cent is the highest possible tax rate. Any other acquisition date would yield a better result, down to a minimum tax rate of 22.3 per cent if the land was acquired in November 2001.
[2] After tax credit for the tax paid in Israel.
[3] Gift tax on the remaining cash 569,800, after all other taxes have been paid.
[4] If the land was acquired in 2001, meaning in the best-case scenario for this option, the tax is 65.5 per cent. Still much higher than the alternative option.
[5] See note 4