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Tax Problems of American Investments in Israel, Part II*
Published online by Cambridge University Press: 12 February 2016
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With citizenship and residence sufficient to sustain United States taxation of worldwide income, a United States citizen, resident or corporation, is liable for United States taxes on all income derived from Israeli sources. Such income, being Israeli-linked by virtue of the source rules described in the first part of this article, will normally be subject to Israeli taxation. In these circumstances the United States taxpayer would be in principle subject to both Israeli and United States taxes.
In reality, however, double taxation is the exception to the rule. The United States has adopted unilateral relief measures in the form of the exemption from its taxes of certain income derived from sources outside the United States, the deductibility of foreign taxes, and a foreign tax credit. Israel, for her part, grants numerous exemptions from Israeli taxes to receipts which would be otherwise taxable, and greatly reduces its taxes on certain income. We turn first to those measures of relief afforded by the United States Internal Revenue Code.
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98 Double taxation of income occurs where a specific receipt is considered by the laws of both taxing countries to be “income” in accordance with their respective laws. Where the concept of income is different there may be avoidance of double taxation, albeit inadvertent. Moreover, even if the two taxing countries adhere to a similar concept of income but characterize income by means of different criteria, double taxation may be avoided. Thus, were one country to regard the receipt as “income” while the other country regarded it as a “return of capital” due to the application of different standards, the problem of double taxation would not arise.
In the case of Israel and the United States, the concept of income of both countries is very similar. A comparative detailed analysis of the relevant provisions of the United States Internal Revenue Code and the Israeli Income Tax Ordinance is beyond the scope of this article. Suffice it to note that both enactments refrain from specifically defining the concept of income. The broad sweep provided to the concept of income by the United States Supreme Court in Eisner v. Macomber, 252 U.S. 189 (1920) (cited with approval by the Tel Aviv District Court in Mifelei Shlomo Ltd. v. Commissioner of Income Tax (1966) 54 P.M. 194, appropriately describes the concept of income common to both Israel and the United States.
99 See Newman, , “Tax Administration in Striped Trousers: The International Operations Program of the Internal Revenue Service” (1957) 12 Tax L. Rev. 171, 179–99Google Scholar; Wilkins, , “A Note on the ‘Gore Amendment’” (1965) 18 Nat'l. Tax J. 321.Google Scholar
100 See Frank, , “Income Earned Abroad: What Constitutes Foreign Residence” (1963) 21 N.Y.U. Inst. on Fed. Taxation, 217.Google Scholar
101 Treas. Reg. 1.871–2(b) (1957).
102 See for example: Ingram, Adm. v. Bowers 47 F.2d 925 (N. Y. Dist. Ct. 1931), aff'd 57 F.2d 65 (2nd Cir. 1938); Christina de Bourbon Patino 13 T.C. 816 (1949), aff'd 186 F.2d 962 (4th Cir. 1950); Carl H. Thorsell 13 T.C. 909 (1949); Rudolf Jetiinek 36 T.C. 826 (1961), acquiesced in 1964–2 Cum Bull. 6; Ferenc F. Molnar 14 P-H Tax Ct. Mem. 1057 (1945), aff'd 156 F.2d 924 (2nd Cir. 1946); Jones v. Kyle 190 F.2d 353 cert, denied, 342 U.S. 886 (1951); Evans v. U.S. 101 F. Supp. 564 (Calif. Dist. Ct. 1951); D.L. Philippe 26 T.C. 984 (1956).
103 See for example: Downs v. Comm. 166 F.2d 504 (9th Cir. 1948), cert, denied, 334 U.S. 832 (1948); Fred H. Pierce 22 T.C. 493 (1954); Burlin B. Hamer 22 T.C. 343 (1954), acquiesced in 1954–2 Cum. Bull. 4; Torpel Nesland 15 P-H Tax Ct. Mem. 869 (1946); Supino v. U.S. 192 F. Supp. 389 (Ky. Dist. Ct. 1961); David E. Rose 16 T.C. 232 (1951), acquiesced in 1951–1 Cum. Bull. 3.
104 For example, the joining of a church in Herman F. Baehre 15 T.C. 236 (1950), acquiesced in 1951–2 Cum. Bull. 1; Mary K. Sanford 37 P-H Tax Ct. Mem. 301 (1968); Lois K. Stierhout 24 T.C. 483 (1955), acquiesced in 1955–2 Cum. Bull. 9; membership in certain societies and clubs, William E. Adams 46 T.C. 352 (1966); learning the native language, Joe May 39 B.T.A. 946 (1939), acquiesced in 1939–2 Cum. Bull. 23.
105 See for example: Charles F. Boudlin 8 T.C. 959 (1947), acquiesced in 1967–2 Cum. Bull. 1; Louis C. Beauchamp 16 P-H Tax Ct. Mem. 328 (1947); Elliot D. Sass 23 P-H Tax Ct. Mem. 999 (1954); Sochurek v. Comm. 300 F. 2d 34 (7th Cir. 1962); John J. Scheuren Jr. 30 P-H Tax Ct. Mem. 311 (1961).
106 See for example: Comm. v. Estate of Fiske 128 F. 2d 487 (7th Cir. 1942); Francis C. Weeks 16 T.C. 248 (1951), acquiesced in, 1951–2 Cum. Bull. 4; L. E. C. Thomas 33 B.T.A. 725 (1935); Ralph Love 8 T.C. 400 (1947). In William B. Cruise. 12 T.C. 1059, 1062 (1949) the Court said: “Something more is required than a mere statement that a taxpayer intended to remain in a foreign country and therefore became a resident of that country”.
107 See for example: David O. Tilburn 24 P-H Tax Ct. Mem. 784 (1955); Mary K. Sanford 37 P-H Tax Ct. Mem. 301 (1968); Ceska Cooper 15 T.C. 757 (1950), acquiesced in, 1951–1 Cum Bull. 2; Florica Constantinescu 11 T.C. 37 (1948), acquiesced in, 1948–2 Cum. Bull 1; An application for a permanent visa has been held to manifest the intention required for the status of a resident: Hans F. Wriedt, 15 P-H Tax Ct. Mem. 130 (1947); Joe May, 39 B.T.A. 946 (1939), acquiesced in 1939–2 Cum. Bull 23; see Mimm. 5883, 1945 Cum. Bull. 244.
108 See for example; Moore v. U.S. 289 F. 2d 926 (5th Cir. 1961); Herman F. Baehre 15 T.C. 236 (1950), acquiesced in, 1951–1 Cum. Bull. 1; Grant Foster 34 P-H Tax Ct. Mem. 1389 (1965), aff'd, 391 F. 2d 727 (4th Cir. 1968); George A. Page 24 T.C. 52 (1955); Wood v. Glenn 92 F. Supp. 389 (Ky. Dist. Ct. 1961); Hernisgsen v. Comm. 243 F. 2d 954 (4th Cir. 1957).
109 See for example: Josette J.F. Verrier Friedman 37 T.C. 539 (1961); Audio G. Harvey 10 T.C. 183 (1948), acquiesced in, 1948–1 Cum. Bull. 2.
110 For some examples involving the computation of the 510 days of required presence see: Ladd v. Riddell 309 F. 2d 51 (9th Cir. 1962); Bennett v. Riddell 48 A.F.T.R. 1293 (Calif. Dist. Ct. 1954); Renoir v. Comm. 321 F. 2d 605 (9th Cir. 1963); Rev. Rul. 590, 1957–2 Cum. Bull. 458; Rev. Rul. 72, 1954–1 Cum. Bull 117; Rev. Rul. 487, 1956–2 Cum. Bull. 504; Rev. Rul. 171, 1955–1 Cum. Bull. 80.
111 For some interpretations of “earned income” see; Rev. Rul. 326, 1962–2 Cum. Bull. 281; Frank L. Kluckholm 18 T.C. 892 (1952), acquiesced in, 1953–1 Cum. Bull. 5.
112 The definition of earned income raises a number of interesting questions. Can, for example, writers or composers derive earned income by providing their literary or musical services rather than their finished artistic creations? Can self-employed taxpayers engaged in purchasing and selling goods outside the United States allocate part of the sales price to earned income? Can the 30 per cent rule be circumvented simply by incorporation and drawing a reasonable salary from the incorporated business? These and other questions, while beyond the scope of our discussion, amply demonstrate the flexibility of the term “earned income” as defined in section 911(b).
113 United States Internal Revenue Code, sections 911(a)(1) and 911(a)(2).
114 See Louis H. Mooneyhan 47 T.C. 693 (1967); Lawrence P. Dowd 37 T.C. 399 (1961); Rev. Rul. 36, 1960–1 Cum. Bull. 279; Rev. Rul. 612, 1954–2 Cum. Bull. 189; Rev. Rul. 87, 1967–1 Cum. Bull. 186.
115 United States Internal Revenue Code, section 911(c)(5).
116 United States Internal Revenue Code, Section 911(c)(1)(B). Both the $20,000 and $25,000 limitation apply to compensation received for services performed during the period of residence or presence outside the United States. Amounts received as earned income shall be deemed received in the taxable year during which the services to which the amounts are attributable are performed (section 911(c)(2). Moreover, remuneration for such services must be received not later “than the close of the taxable year in which the services to which the amounts are attributable are performed” (911(c)(4)). Thus, the limitations of section 911(c) cannot be overcome by deferring to receipt of remuneration over a period of two taxable years and may be partially lost if spread over three such years.
117 United States Internal Revenue Code, section 911(a)(1).
118 See, E. Owens, The Foreign Tax Credit, Int'l Program in Taxation, School of Law, Harvard University, 1961; Surrey, “Current Issues in the Taxation of Corporate Foreign Investment” (1956) 56 Colum. L.Rev. 815; Slowinski, and Haderlein, , “United States Taxation of Foreign Income: The Increasing Role of the Foreign Tax Credit” (1965) Ill. L. Forum 471Google Scholar; Slowinski, , (1966) 10 Tax Counsellor's Q. 129Google Scholar; Kalish, , “Tax Considerations in Organizing for Business Abroad” (1966) 44 Taxes 71.Google Scholar
119 United States Internal Revenue Code, section 901(b)(1).
120 See for example: New York I. Honduras Rosario Mining Co. v. Comm. 168 F. 2d 745 (2nd Cir. 1948); Comm. v. American Metal Co. 221 F. 2nd 134 (2nd Cir. 1955); Keasberg I. Mattison Co. v. Rothensies 133 F. 2nd 894 (3rd Cir. 1943); Prudential Ins. Co. of America v. U.S. 319 F. 2nd 161 (et. cl. 1963).
121 In Rev. Rul. 254, 1964–2 Cum. Bull 186, tax under section 6 of the Land Appreciation Tax Law applying to gains from the sale of real property was recognized as a foreign tax for the purposes of the foreign tax credit.
122 United States Internal Revenue Code, section 904(b)(3).
123 See Creed and Miles, Foreign Tax Credits of Domestic Corporations, secs. 902, 906, 963, (1963) 24 N.Y.U. Inst. on Fed. Taxation 1353; De Kosmian, and Chapman, , “The Derivative Foreign Tax Credit; the Complex Problems and Planning Possibilities” (1965) 23 J. Tax 46Google Scholar; Schoenfeld, , “Some Definitional Problems in the Deemed Paid Foreign Tax Credit of Section 902: ‘Dividends’ and ‘Accumulated Profits’” (1963) 18 Tax L. Rev. 401Google Scholar; Weiss, , “Earnings and Profits and the Determination of the Foreign Tax Credit” (1965) 43 Taxes 849Google Scholar; Hartley, , “Accumulated Profits/Earnings and Profits Re: The Deemed Paid Foreign Tax Credit” (1966) 19 Tax Executive 44.Google Scholar
124 See Nicholson, , “Gross-Up and the Tax Credit” (1963) 16 Tax Executive 31.Google Scholar
125 1963–1 Cum. Bull. 137.
126 United States Internal Revenue Code, section 902(a)(1).
127 Ibid., section 902(c)(1)(A).
128 Ibid., section 902(a)(2).
129 Ibid., section 902(c)(1)(B).
130 For some examples of such deductions see, Rev. Rul. 213, 1966–2 Cum. Bull. 51; Rev. Rul. 191, 1955–2 Cum. Bull. 51; Rev. Rul. 191, 1955–1 Cum. Bull. 366; Rev. Rul. 507, 1956–2 Cum. Bull. 120; Amtorg Trading Corp. v. Comm. 65. F. 2d 583 (2nd Cir. 1923).
131 United States Internal Revenue Code, section 275(a)(4).
132 Thus, if the taxpayer has no itemized deductions (and cannot deduct his foreign taxes as a business expense) and incurs a foreign tax of $30, a $1,000 standard deduction will prove more beneficial as an instrument of tax savings.
133 By virtue of a 1968 amendment, applicable retroactively to 1961, (Sefer HaHukim No. 524 p. 46) a resident individual's income will always be deemed to include a cost-of-living allowance. The amended section 10 was considered by the Tel-Aviv District Court in Assort v. Assessing Officer of the Dan Region (1969) 2 P.D.A. 116, which dealt with nonresident taxpayers who sought the cost-of-living exemption with respect to their rental income. No evidence had been adduced by the nonresident taxpayers to show that the rental income included a cost-of-living allowance. The Court found the amended section to specifically require the discrimination between resident and nonresident taxpayers, and therefore sustained the Assessing Officer's denial of the exemption to the nonresident taxpayers. See, also, Assessing Officer v. Manopla (1966) (II) 20 P.D. 695; Income Tax Order (relief from tax of part of the cost-of-living allowance), 1967, K.T. No. 2050, p. 2506, amended in 1968 in K.T. No. 2243 p. 1760; in 1969 in K.T. No. 2405 p. 1610.
134 Income Tax Regulations (exemptions and relief for income of Eilat residents), 1956; Income Tax Regulations (tax exemptions and relief in certain settlements and para-military settlements of Nahal), 1957; Income Tax Regulations (tax exemptions and relief for income derived in newly settled areas and development areas), 1961. These regulations have been amended quite often. Their full version is found in Kovetz Dinei Missin, 11.4 p. 19–36.
135 Income Tax Regulations (exemption from tax on other income), 1969, K.T. No. 2405, p. 1606.
136 Income Tax Regulations (partial exemption of dividends from tax), 1966, K.T. No. 1847, p. 1014 and amended in K.T. No. 1890 p. 2154; Income Tax Regulations (exemption from tax on dividends), 1966, K.T. No. 1890, p. 2154; Income Tax Order (dividends as preferred income), 1963, K.T. No. 1520, p. 358.
137 Income Tax Order (relief from tax on foreign income of residents), 1963, K.T. No. 1504, p. 151.
138 Income Tax Order (exemption from tax of debenture interest) 1963, K.T. No. 1490, p. 2115; Income Tax Order (exemption from tax on deposits of non-residents), 1961, K.T. No. 1181, p. 2495; See also, Income Tax Order (exemption from tax of interest on foreign currency deposit), 1970, K.T. 2513, p. 954, with respect to exemption for immigrants.
139 Section 23 of the Law applies (with minor exceptions) the provisions applicable to approved enterprises to approved property. Section 23 of the Law also applies (with minor exceptions) the provisions applicable to approved enterprises to recognized enterprises. Section 24 of the Law applies (with minor exceptions) the provisions applicable to approved investments to approved loans.
140 Law for the Encouragement of Capital Investments, section 17.
141 Ibid., chapter six.
142 These loans are not directly granted in accordance with the provisions of the Law for the Encouragement of Capital Investments. The government assists approved enterprises in obtaining medium and long term loans through banking institutions. Such loans depend on the location of the enterprise, the value of the enterprise's fixed assets, and the total percentage of the grant and loan of the enterprise's fixed assets. The interest rate on such loans varies between 6½% to 9%.
143 Law for the Encouragement of Capital Investments, chapter four.
144 Ibid., chapter eight.
145 Ibid., chapter five.
146 Ibid., chapter nine.
147 Ibid., sections 41–43A.
148 Ibid., chapter seven.
149 Thus, if an approved enterprise first derived taxable income in 1963, the five year period will end in 1967 whether or not taxable income was derived during 1964 and 1965. If in those two years no taxable income was derived the enterprise would forever lose two of the five beneficial years.
It is worthwhile noting that a delay in the operation of an approved enterprise coupled with first and second year operational losses may deprive it of the entire tax relief otherwise accorded to it. Thus, an enterprise approved in 1962, starting operations in 1972 and first deriving income in 1974 will not be eligible for any relief from income and company taxes because, by the end of 1973 the twelve year period will have elapsed. In such circumstances the enterprise would be well advised to seek cancellation of its first plan and to submit a second one in 1972 prior to the start of operations.
150 The exemption granted to nonresident companies is not limited to a certain period as in the case of individuals. On the other hand, the granting of the relief to nonresident companies has been left to the discretion of the Minister of Finance. In the case of individuals there is no room for the exercise of administrative discretion; the statutory language compels the automatic granting of the relief upon such taxpayer's request.
151 See, Bachrachj, , “Israel as a Tax Haven” (1970) 4 International Lawyer 853.Google Scholar
152 By virtue of section 20 the provisions of section 19 are made inapplicable to sums distributed or credited to controlling shareholders unless such sums constitute: sums allowed as a deduction from income, dividends, the repayment of loans made by a controlling shareholder for a period not in excess of one year, or sums loaned to such a shareholder for less than three months during one taxable year.
153 Petroleum Pipeline Concession Law, (1959) 13 L.S.I. 277.
154 Encouragement of Savings (Guarantee of Loans; Income-Tax Reductions), (1956) 10 L.S.I. 49Google Scholar amended in (1957) 11 L.S.I. 168.
155 See, for example, State of Israel Bonds (Second Independence Issue) Law, (1967) 21 L.S.I. 69, amended 21 L.S.I. 78.
156 Israel Company Ltd. Law, 1969, Sefer HaHukim No. 561 p. 149.Google Scholar
157 O.E.C.D. Model Convention, article 12. Of course, the Proposed Treaty adopts in all its provisions an “all or nothing” approach towards the existence of the permanent establishment while the O.E.C.D. Model Convention denies its reduced rates only where the income in question is effectively connected with the permanent establishment. This rule is true with respect to royalties, interest and dividends.
158 The prerequisite of article 18 of the Proposed Treaty seems to take an “all or nothing” approach. Thus, if the income of the commercial traveller is $5,500, apparently the entire exemption from Israeli taxation is lost and the entire sum may be taxed by Israel. And if only part of the income of an employee of a United States resident or corporation is deducted for purposes of computing the profits of a permanent establishment the entire income, whether or not so deducted, may be taxed by Israel.
159 Article 18(3) seems to imply that where the $ 250 limit is surpassed the entire income, and not only that portion in excess of $ 250 per day, will be subject to Israeli taxation. Presumably the $ 250 limit is to be determined on an average basis. There seems to be no violation of the Proposed Treaty if an entertainer derives $ 5,000 during his first 10 days in Israel, and subsequently prolongs his stay so to average $ 250 per day instead of $ 500 attained during the first ten days.
160 The favourable reduced rates may also be denied in the case of investment or holding companies. Article 17 of the Proposed Treaty provides: A corporation of one of the Contracting States deriving dividends, interest or royalties from sources within the other Contracting State shall not be entitled to the benefits of article 13, article 14, or article 15 if (a) by reason of special measures granting tax benefits to investment or holding companies the tax imposed on such corporation by the former Contracting State with respect to such dividends, interest or royalties is substantially less than the tax generally imposed by such Contracting State on corporate profits, and (b) 25 percent or more of the capital of such corporation is held of record or is otherwise determined … to be owned, directly or indirectly, by one or more persons who are not individual residents of the former Contracting State (or, if residents of Israel, are citizens of the United States).”
161 Proposed Treaty, article 8(1).
162 This rule is similar to the more general provision of section 18 (c) of the Israeli Income Tax Ordinance.
163 Section 1235 provides in general that a transfer (other than of gift, inheritance or decease) of property consisting of all substantial rights to a patent, or on individual interest therein which includes a part of all such rights, by an individual who created such property or any other individual who is not “related” to the inventor or his employer who has acquired such property for money or money's worth prior to the actual reduction to practice of the potential invention, should give rise to a long term capital gain. See, Peritt, , “Patents under Code Section 1235” (1955) 33 Taxes 265.Google Scholar
164 Ben Arieh v. Assessing Officer of Kfar Saba (1967) (I) 21 P.D. 174.
165 A group of residents and/or corporations of the United States owning at least 25 percent of the voting power of an “eligible corporation” may elect to qualify as a single investor for purposes of the investment credit.
166 See Hellawell, , “United States Income Taxation and Less Developed Countries: A Critical Appraisal” (1966) 66 Colum. L. Rev. 1393, 1414.CrossRefGoogle Scholar
167 Section 873 of the United States Internal Revenue Code provides for the allowance of deductions only and to the extent that they are connected with income which is effectively connected with the conduct of a trade or business in the United States. Exceptions from this general rule are losses arising from certain casualties and theft, charitable contributions and the allowance of one personal exemption under section 151 of the United States Internal Revenue Code.
168 For a detailed analysis of tax relations between developed and developing countries see Tax Treaties between Developed and Developing Countries. United Nations publications E/4614, ST/ECA/110, Sales No. E.69.XVI.2 (1969).