Dan Dobry
Dan Dobry

Challenges of a Duel US-Israel Citizen Residing in Israel

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Background 

Many citizens of foreign countries also happen to hold US citizenship without ever residing in the US. They may have it because they were born in the US or received it from their parents.

Regardless of how the US citizenship was obtained, they are still required to file an annual tax return with the IRS on their worldwide income. Same as all US citizens who live in America.

Case Study Israel 

The State of Israel has a population of approximately 8,712,000 inhabitants as of the end of 2020. In terms of area and population, Israel is quite a small country. Its national territory roughly corresponds in size to that of the US state of New Jersey. 

Regarding the subject of migration, too, Israel is unusual in one very important way: the state is virtually built on immigration. 

The population of Israel has doubled several times over the past 60 years, in particular as a result of immigration. Since 1948 more than three million immigrants have been registered, and in the 1990s Israel was even the country with the highest percentage of immigration worldwide in proportion to the size of its population. 

Since 1948 112,000 US-born citizens have arrived in Israel and it is estimated that 250,000 – 300,000 Israelis are holding dual citizenship with the US living in Israel.

28% of the population of Israel is age 0-14 and only 10.3% are over 65 as opposed to the OECD average of 18.5% and 15%. The average age for males is 28.4 and 30.6 for women. 

Life expectancy for males is 81.7 and women 84.6 higher than the OECD average. 

40% of the population of Israel lives in the Central area and 16.5% in the Tel Aviv region. 17% live in the North, 14% in the South, and 12% both in the Haifa and Jerusalem regions. 

US Expat reporting Requirements 

All US citizens and green card holders are required to file income tax reports the same way as those residing in the US. 

In addition, under FATCA legislation US citizens living abroad are required to report annually their assets held in foreign banks and Financial Accounts. (FBAR)

The penalties are severe and include a penalty of 10,000 USD for failure to file each year and an additional 10,000 USD each month after the taxpayer is aware of the delinquency and 10% of the value of the asset/s. If the reporting error is deemed wilful (that the taxpayer was aware that he had to report and chose not to or reported falsely on purpose) the penalty could be up to 100,000 USD a year and 100% of all the assets.

This can be corrected by a Voluntary disclosure program.  

US Citizens residing in Israel and saving and investing  

US citizens residing in Israel have special investment challenges and tax issues that are still not resolved and expose Israeli US citizens to significant tax exposures. 

The challenge of a PFIC (Passive Foreign Investment Company)

A passive foreign investment company (PFIC) is a foreign-based corporation that exhibits either one of two conditions. The first condition, based on income, is that at least 75% of the corporation’s gross income is “passive,” income that is derived from investments rather than from the company’s regular business operations. The second condition that determines a company as a PFIC, based on assets, is that at least 50% of the company’s assets are investments that produce income in the form of earned interest, dividends, or capital gains.

All foreign investment managers and companies are PFICs and all investment vehicles managed by Israeli or Foreign Companies are PFIC.  

In this capacity, all managed accounts, mutual funds, provident funds, and pension funds are PFIC and subject to severe tax penalties including: 

  1. Tax must be paid on all income derived each year regardless of the asset has been sold or is still being held at the highest level in the US (40%) and regardless of the tax rate or exemptions in the country of the origin of the residing US citizen. 
  2. The taxpayer cannot deduct bad years’ losses from Good year gains. 

The IRS came to a treaty with the UK Government and Malta regarding the accumulation of retirement assets in a pension account that would exempt the pension fund from FATCA and PFIC requirements, based on this precedence accountants worldwide especially in countries with mandatory contribution laws consider a pension fund or mandatory retirement vehicle (not voluntary) to be FATCA and PFIC exempt. This however does mean that contributions by an employer will not be taxed in the US as notional income therefore all withdrawals of notional monies or monies that have received local tax exemptions will be taxed in the US as income when they are withdrawn. 

The challenges for a US citizen residing in Israel 

Retirement Assets 

Employers in Israel have been required to provide their employees with defined contribution pension arrangements since 2008. 

Contribution rates

Mandatory minimum contribution rates to individual retirement savings accounts were introduced in 2008 and were phased in gradually until reaching 6.5% of pay (capped at national average earnings) for employers and 6% of capped pay for employees 

The level of required contributions for severance plans is 8.33%. 

Most employees in Israel also have mandatory savings in education funds 10%

Total mandatory saving for Israelis. 

Employer contributions  Employee contributions  Total
Retirement accounts 6.5% 6% 12.5%
Severance accounts 8.33% 0% 8.33%
Education accounts  7.5% 2.5% 10%
Total 22.33% 8.5% 30.88%

What happens to US citizens who contribute to mandatory pension and retirement plans? 

Most American Citizens living in Israel participate in pension and retirement plans sponsored by employers. These plans have beneficial tax treatment under local laws, but Americans must be aware that these plans may be deemed as PFICs and will not receive favorable tax treatment under US law. Local tax laws are usually nullified by US tax treatment and double tax could occur. Failure to report these assets can result in significant penalties. 

Avenues of Investments for US citizens 

Pension Plans that are paid as an annuity. 

Clients accumulating assets in local pension plans and will start decumulating or annuitize the investments when they arrive at retirement age. 

US Accountants generally deem the value of this plan as a deferred instrument and will only tax the income as income when the client starts taking it in the future. 

Risks: 

The US tax service will deem this as a PFIC and tax the fund’s income each year at the highest level of tax (all pension funds report and compete on gains/losses every year). 

An additional risk is that the ITA will not recognize the tax paid in Israel, and the result will be double taxation. 

An additional risk is that the IRS will deem the employer’s contributions as income and tax this every year as additional income for the taxpayer. 

In the case of death, if the beneficiary is a US citizen this will be deemed as income for any US taxpayer 

Provident Funds and Education Funds 

Clients accumulating assets in local provident funds or education plans and plan to withdraw lump sums in the future at retirement (Aligned with Israeli Tax planning and exemptions). 

US Accountants generally deem the accumulated assets in these mandatory plans as a deferred instrument and will tax the income as income when the client withdraws the money as a lump sum. (the whole of the withdrawal will be taxable income for the taxpayer in his US reports). 

Risks: 

The US tax service will deem this as a PFIC and tax the fund’s income each year at the highest level of tax (all pension funds report and compete on gains/losses every year). 

When the client redeems the money the employer’s contributions will be taxed as income in the US even if it is tax-exempt by Israeli law. This means that all tax planning in Israel by retirement professionals could be worthless for US citizens. 

An additional risk is that the ITA will not recognize the tax paid in Israel, and the result will be double taxation. 

The IRS will deem the employer’s contributions as income and will tax this every year as additional income for the taxpayer. 

In the case of death, if the beneficiary is a US citizen this will be deemed as income for any US taxpayer. 

Severance accumulations  

Employers contributing to severance in retirement accounts under clients’ names and clients who plan to withdraw lump sums or annuities in the future at retirement (Aligned with Israeli Tax planning and exemptions). 

US Accountants generally deem the accumulated assets in these mandatory plans as a deferred instrument for the client and will tax the income as income when the client withdraws the money as a lump sum or an annuity (or drawdown). In this scenario, the whole of the withdrawal will be taxable income for the taxpayer in America regardless of the exemptions or laws in Israel. 

Risks: 

The US tax service will deem this as a PFIC and tax the fund’s income each year at the highest level of tax (all pension funds report and compete on gains/losses every year). 

When the client redeems the money, all the withdrawals will be taxed as income in the US even if it is tax-exempt by Israeli law. This means that all tax planning in Israel by retirement professionals could be worthless for US citizens. 

An additional risk is that the ITA will not recognize the tax paid in Israel, and the result will be double taxation. 

The IRS will deem the employer’s contributions as income and will tax this every year as additional income for the taxpayer. 

In the case of death, if the beneficiary is a US citizen this will be deemed as income for any US taxpayer and there is no tax exemption at all. 

Saving for Children through National Insurance Plans in Israeli Retirement accounts. 

The Israeli Finance Minister has launched a  “Savings Plan for Every Child” that is creating a stir among US-Israeli citizens, as it poses the dilemma of having to choose for their children a bank savings plan that pays low interest or a plan that could potentially expose them to double taxation.

Israel’s National Insurance Institute has sent out letters to parents informing them that as of January 2017 the Institute will open a savings plan for each child below the age of 18. The Institute will inject 50 shekels per month into the plan and retroactive amounts will also be paid into the new fund, for the period between May 2015 to December 2015, for children who qualify. 

At the age of 18, the National Insurance will pay into the account a 500 shekel grant, and the amounts accrued will be available for the young adult. If these savings won’t be drawn until the age of 21, then the National Insurance Institute will add an additional 500 shekels to the savings plan. 

Parents must decide who will manage the savings fund and are given the choice between choosing a banking institution or a Kupat Gemel, a deferred savings plan.

However because the parent has a choice, Israel’s Kupot Gemel will be considered without a doubt by the US Internal Revenue Service (IRS) as a PFIC (Passive Foreign Investment Company) and are thus subject to PFIC rules for reporting and taxes.

The banks’ option offered as part of the new savings plan is generally “a poor investment strategy with minimal to zero interest resulting in very poor growth on the account based on present rates” 

In addition, Israel charges taxes on these Kupot gemels only at the termination of the funds, he said, so “Israel will not recognize earlier taxes paid, leading to the potential of a double taxation issue for these citizens with dual US-Israeli citizenship.”

It is not yet clear who is responsible to report this PFIC, the parent, the child, or both? If it is the parent, then there may be greater tax implications to consider.

Correction 190 and voluntary accumulation in Israeli provident funds

The Israeli Tax Authority has given significant tax benefits for Israeli who want to contribute significant lump sums in provident funds and give them tax deferral and tax reduction benefits on CGT. 

Voluntary contributions to provident funds are deemed as a PFIC and will be taxed accordingly. If the US tax authority is lenient on Israelis it is because of the MALTA treaty and this is only for mandatory contributions. 

Malta – US treaty 

US Taxpayers and Foreign Pension Plans

Many countries allow workers to defer pre-tax dollars into retirement accounts that then accumulate tax-free until retirement. These systems of tax-deferred savings and investment exist everywhere for the same reasons they exist in the United States: governments want to encourage workers to accumulate private savings to support retirement expenditures without exclusive reliance on state pension systems.

Foreign pension plans commonly encountered by Americans abroad include:

  • Swiss Pillar Pension System
  • Canadian RRSPs
  • Hong Kong Mandatory Provident Fund (MPF) and Occupational Retirement Schemes Ordinance (ORSO)
  • Singapore Central Provident Fund (CPF)
  • Australian Superannuation
  • French Caisses de Retraites
  • UK Employer-Sponsored Pension Schemes and SIPPs
  • Israeli mandatory pension Plans. 

Unfortunately, the US worldwide system of citizen-based taxation was instituted before modern pension plans and long before the advent of an internationally mobile workforce.  Consequently, current US tax laws do not favor participation in most foreign pension plans and the IRS generally views foreign pension plans, including ones “qualified” under local tax rules, as “nonqualified” under US tax rules.

However, some US income tax treaties allow foreign pension plans to be treated as qualified for US tax purposes. One such example is the United States-United Kingdom income tax treaty. Unlike many tax treaties the United States has with foreign countries, the US-UK treaty addresses pensions comprehensively, with rules related to contributions, earnings, and distributions. For example, while living in London, an American can deduct, for US tax purposes, contributions to their UK pension plan. This deduction is only available while the US taxpayer resides in the United Kingdom. Additionally, it applies only to the extent the contributions or benefits qualify for tax relief under HMRC (UK tax authority) rules and the HRMC relief may not exceed the relief that is allowed in the United States under IRS regulations.

Outside of the United Kingdom, these special tax treaty provisions are rare: Most foreign pensions do not enjoy tax-favored status. For example, the United States does not have tax treaties covering pension contributions with many popular expat destinations such as France, the Netherlands, Hong Kong, Israel, and Singapore. Absent such a comprehensive tax treaty, an American expat participating in a foreign pension plan cannot deduct contributions from their US gross income and must take extra steps to properly report the pension assets.

Malta Pensions and “Offshore Pensions Schemes” for American Citizens

Increasingly, American expats in locales such as Singapore, Hong Kong, Israel, and Dubai are being marketed offshore pension schemes based in the Mediterranean island nation of Malta. Many offshore financial advisors promote these plans as a tax-efficient way for American expats to save for retirement while working abroad.

The United States and Malta recently signed a modern double tax treaty that provides tax benefits for US expats. 

The US-Malta double taxation treaty signed in 2010 created a flurry of activity in the US expat finance space because key provisions of the treaty permit American taxpayers to accumulate untaxed gains in a Malta pension and then withdraw those assets tax-free. 


What to do with Pensions?

FATCA is essentially forcing the IRS to confront the fact that the US system of global taxation is inconsistent with normal participation in traditional methods of retirement and investing for American workers abroad. 

However, because these problems with FATCA have not yet been resolved, US taxpayers don’t have the option of ignoring foreign pensions. American expatriates need to become familiar with the relevant tax laws that affect their foreign pensions.

Given the potential tax exposure and large penalties, it is important to plan ahead to understand the tax treatment of these pension plans and their tax reporting requirements.  To avoid future problems, Americans living abroad should also be aware of the tax treatment of contributions to and distributions from these foreign plans—taxation of distributions must be minimized, fees reduced, and the investment options of the pension plan must be analyzed. After a careful analysis, it might not be efficient for an American abroad to participate in a foreign pension plan or for them to simply maximize their contributions. Careful asset allocation across different accounts such as a taxable brokerage, 401k, IRA, Roth IRA, and a foreign pension is essential to achieve tax efficiency and maximum after-tax returns for successful retirement saving and greater overall wealth accumulation. Ultimately, most Americans abroad will find that US onshore investments, managed with an eye on tax efficiency and cross-border tax compliance are the best way to build wealth.

For more information, consult our Guide on Investing and Financial Planning for Americans Living Abroad.

Possible Solutions for US Expats in Israel

  1. Investing through an IRA account and then buying only assets that are aligned with FATCA and PFIC legislation. 
  2. Investing in a pension fund via a US feeder fund. De facto the Pension fund is monitored and regulated in the US and the client will have the freedom to invest as he sees fit for his family. 
  3. Investing in a Pension Fund that is governed in Malta, the account and asset management of the fund will remain in Israel. 

Non-Pension monies and assets.

Mutual Funds and Managed Accounts. 

Foreign mutual funds and managed accounts may seem attractive to an American living abroad. However, in the view of the IRS, a foreign mutual fund is considered a Passive Foreign Investment Company (PFIC) and is a tax nightmare for US tax filers. For a US citizen or a US permanent resident who is living and working outside the US and investing their savings through a non-US financial institution, they need to understand PFICs quickly. PFICs are subject to special, highly punitive tax treatment by the US tax code. Not only will the tax rate applied to these investments be much higher than the tax rate applied to similar or identical US registered investments, but the cost of required accounting/record-keeping for reporting PFIC investments on IRS Form 8621 can easily run into the thousands of dollars per investment each year. In addition to this, US citizens cannot deduct losses of bad years from good years. 

Solutions for US citizens 

For US citizens living abroad and are looking to invest hard-earned money, these are the alternatives. 

  1. Invest their money in the US Even if you live in Israel they can still keep and invest their money in the US. 
  2. Invest in US domiciled funds. Non-US-domiciled funds can be classified as PFICs. Many funds and platforms are opening feeders in the US to comply with US regulations. 
  3. Invest in yielding real estate or loan notes that are complaint.
  4. Only invest in platforms that have documented opinions or rulings that they are compliant.  

The challenge of owning a Controlled Foreign Corporation (CFC)

What is a ‘Controlled Foreign Corporation (CFC)?

A controlled foreign corporation (CFC) is a corporate entity that is registered and conducts business in a different jurisdiction or country than the residency of the controlling owners. Control of the foreign company is defined, in the US, according to the percentage of shares owned by US citizens.

Controlled foreign corporation (CFC) laws work alongside tax treaties to dictate how taxpayers declare their foreign earnings. 

A US person who owns equity in a non-US corporation generally is taxable on

the earnings of such a corporation only when those earnings are distributed to such person as a dividend. Under the Subpart F rules, however, a US person who owns at least 10 percent of the vote or value (a “US shareholder”) of a “controlled foreign corporation” (“CFC”) is currently taxable on its pro-rata share of, among other things, certain passive income (e.g., rents, royalties, interest) and certain related-party income (e.g., sales or service income earned from related parties) generated by the CFC even if such income has not been distributed.

A non-US corporation is a CFC if more than 50 percent of the vote or value of the non-US corporation is owned, directly or indirectly (and applying certain constructive stock ownership rules) in the aggregate by one or more US shareholders.

There are numerous exceptions to the characterization of income of a CFC as:

Subpart F income. One exception, under Section 954(b)(4), is the “high-tax kick out” or “HTKO” exception. The HTKO exception generally provides that income of a CFC that would otherwise be treated as Subpart F income will not be so treated if such income is subject to non-US tax at a rate that equals at least 90 percent of the highest US federal corporate income tax rate in effect in the year in question.

Based on the current US federal corporate income tax rate of 21 percent, a non-US tax rate of at least 18.9 percent is sufficient for an item of CFC income to qualify for the HTKO exception.

Under the 2017 Tax Act, the above-described Subpart F rules were expanded to include GILTI, a new, broader, category of CFC income that is includable in the US federal taxable income of a US shareholder of a CFC.

About the Author
Dan Dobry was the founder of the Union of Financial Planners in Israel (UFPI), served as the first Chairman and President of UFPI. Dan was the Global Council Representative for Israel for the Global Community (FPSB) from 2012 - 2018 and from January 2019 is a member of the Committee for Standards and Qualifications for the European Union (SQC).
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