Many good stories begin with an extraordinary idea - usually somebody else's. This one is no different.
Two old friends, partners in a new-age web commerce business, stopped for a coffee at one of their favorite bistro bars in Los Angeles, after another routine meeting with a vendor.
Simon added some sugar to his latte and said, "Israel is about to provide us a once-in-a-lifetime opportunity for its 60th anniversary."
"I prefer not to jump to conclusions before they pass the law in the Knesset," answered Jacob.
"True, but I'm already looking forward to watching as the country with the heaviest tax burden in the world creates a new individual tax haven - all for the sake of its coming birthday."
A recent proposal making its way to the Knesset for legislation offers a ten-year tax exemption on foreign income. If the bill passes into law without any last-minute changes, I believe it will create a unique opportunity for new immigrants and returning expatriates to live in the Holy Land for ten years without paying any taxes to the State of Israel on their income generated abroad.
The new individual tax haven our heroes from LA were talking about could theoretically be structured in the following way.*
Two shareholders, each holding a 50% interest in a US corporate entity, generating income through web commerce in the US, agree that one of them (who may be making Aliyah for personal reasons) will purchase 49% of his partner's stake for $100,000 before leaving the US. From his residence in the Holy Land, our new immigrant continues earning income abroad by providing services to the corporation (which continues to issue him W-2 or 1099 forms). In addition, the US corporation distributes annual dividends to him.
Let's assume the new immigrant receives an annual salary of $80,000 and an annual dividend of $20,000. In such a scenario, the entire $100,000 is tax exempt in Israel for the ten-year incentive period, since this income is generated abroad by assets in the immigrant's possession prior to Aliyah.
On his US tax return, our dual-citizen Israeli exempts his $80,000 of earned income from taxation by using the foreign earned income exclusion. Given that the standard deduction and personal exemptions will usually exceed the $20,000 dividend income amount, the US tax liability on the dividend will be zero.
Fortunately for our heroes, the global e-trade continues to expand and corporate profits grow. After nine years and 11 months, our dual-citizen decides to sell all of his shares to his partner, or to a third party, for the amount of $1 million and to retire. The approximately $900,000 in capital gains is still tax exempt in Israel and is taxed in the US at reduced capital gains rates of 15 percent or less.
Our new Israeli could deposit a portion of the proceeds received from this sale into an American pension plan. According to current Israeli regulations, a retired immigrant pays taxes on his foreign pension income at the same rate he would have paid had he remained abroad. Because the tax brackets in the US "kick in" sooner than in Israel, usually there is no tax due in the US on pension income of approximately $20,000. The possible outcome for our hypothetical dual citizen is: no taxes due in the US or in Israel on his pension income.
Under the proposed tax incentive package, there is a real possibility for people like our hero to make Aliyah and live out their lives in a Holy Land tax haven.
But that tax haven can easily become a "honey trap" for the unprepared immigrant. While such tax exemptions are definitely an effective means of promoting immigration to Israel, they can also lead to very unpleasant surprises down the road. Eventually, the immigrant - perhaps no longer so "new" - will suddenly learn first-hand about the extent of the taxes he's been exempted from for the previous decade. New immigrants benefiting from the proposed tax relief would do well, therefore, to plan for the "day after" in consultation with knowledgeable Israeli financial advisors.
On the national level, too, there are dangers inherent in the proposed tax exemption law. As it now stands, it opens the door to tax evasion, criminal activities and money laundering.
The current proposal includes an Israeli filing exemption for foreign generated income. Coupled with the fact that there is no general filing requirement in Israel, local tax authorities simply won't have any reliable information about new residents utilizing the proposed exemption.
Tax authorities in Israel generally turn the spotlight on someone's activities only if that individual opens a file with the Income Tax Authority. As a result of the proposed filing exemption, however, no files will be opened and the Income Tax Authority won't have a clue as to the scope of income generated abroad and flowing into Israel - whether from legal business activities, in the best case scenario, or from illegal or fictitious activities, in the worst. Amendment of the proposed tax exemption to include a reporting requirement could maintain order and provide essential information to the tax authorities.
Instead of the problematic proposed tax filing relief law, I believe that increased immigration to Israel, and reduced emigration, can be more easily achieved by reducing corporate and individual tax rates for all Israelis. With tax rates and tax brackets for earned and passive income made comparable with those of developed Western countries, the Holy Land will quickly become a desirable place for both global and local business activities.
* The hypothetical case described above should not be considered tax advice and is provided for discussion purposes only. For responsible financial planning, consult with a professional tax advisor.
