The downsides of stepping up
The State of Israel is a country that, historically, has absorbed immigrants. In 1948, it had 800,000 residents, while, in 2014, its population numbers around eight million.
According to the last report by Israel’s Central Bureau of Statistics, the Jewish population of the State of Israel numbers six million. Of them, 4.5 million are native-born Israelis, and 1.5 million were born abroad. Approximately 850,000 of those Israelis who were not born in the country were born in Europe or America. About 120,000 Jews made Aliyah (i.e. immigrated to Israel) over the past decade alone, from Europe, the US and Canada. The population of European or American immigrants in Israel (including offspring born in Israel) today comes to about two million.
Under these circumstances, it is only natural that there will be many instances in which an Israeli resident will receive a gift, or obtain assets by way of inheritance or a will.
Some of those involved in matters of inheritances or gifts generally think or advise that receipt of an asset from a foreign resident by way of inheritance or gift is not subject to tax, and, thus, the tax considerations are not substantial and do not require special handling. This view is correct as far as receipt of cash is concerned, but it is not so when an Israeli resident receives from a foreign resident an asset such as property abroad or shares in foreign companies. The receipt of such assets is not subject to tax at the time of their receipt, but, when they are sold, tax is applicable, sometimes at high rates. The default position is that the tax also applies to any increase in the assets’ value that took place prior to their coming into the possession of the Israeli resident.
Step-up versus default method of filing
At the beginning of 2010, the Israel Tax Authority published a form allowing the recipient of an inheritance or gift to fix a new original price and new acquisition date for the inherited or gifted asset (a ‘step-up’). To the inexperienced eye, this may appear attractive but, as always, appearances can be deceiving. Proper consideration should be given as to whether or not to accept the Tax Authority’s proposal, which may turn out to have nasty consequences.
The default option (based on ‘stepping into the testator’s shoes’) is that the acquisition date is that on which the testator acquired the property.1 If the heir requested a step-up, the acquisition date will be the date of inheritance (or the date of receipt of the gift). The acquisition date is relevant, among other things, for the purposes of calculating tax. Under Israeli law, different periods in which the asset was in the taxpayer’s possession are subject to different tax rates.
Take, for example, an asset purchased in 1990 and gifted in 2014. Under the ‘stepping into the testator’s shoes’ method, the property will be taxed on its real profit at a rate of up to 50 per cent for the period from 1990 to the end of 2002, at a rate of 20 per cent from 2003 to the end of 2011, and at a rate of 25 per cent for the balance (higher rates may also apply). Using the step-up, upon the sale of the asset, it would be taxed as though acquired in 2014, and the tax would be at a rate of 25 per cent on the real profit.
Original price or market value
The default method is that the original price is the one at which the testator acquired the asset. If the heir requests a step-up, the market value of the asset will be set at its market value on the testator’s date of death (or the date on which the gift was made). Here, the original price and acquisition date are of great importance, since, in the default calculation, it often turns out that the bulk or all of the capital gains are inflationary profit, and, as such, are tax-exempt in Israel since 1993. On the other hand, if the heir applies for a step-up, the capital gain will be real gains. There is no inflationary profit allowed under this method, even if an extended period has elapsed since the inheritance. Where that is the case, the application for a step-up will change the future sale of the asset from one that is tax-exempt to one that is fully taxable. This consideration is an important one, particularly in instances in which it is not intended to sell the asset in the short term.
Under the default procedure, the proof required is, in most cases, the testator’s purchase documents. If the heir applies for a step-up, they must provide a valuation by a certified assessor. Should the market value set by the assessor be lower than the testator’s purchase price, in most cases a step-up application would not be appropriate, since one cannot claim a loss through this process. That is, with the step-up, although the value will be recorded at a lower price than the testator’s acquisition price, no loss will be recognised. By contrast, under the default method, it may be possible to realise a loss on the sale, and to offset it against other income.
Under the default method, there is nothing to prevent the heir from offsetting their losses (even if they occurred prior to the receipt of the inheritance) against the capital gains from the sale of the asset. By contrast, with the sale of an asset to which a step-up has been applied, the only losses that may be offset against capital gains from the sale are those created from the date on which the asset came into the recipient’s possession. Consideration needs to be given to both past losses and expected losses. In this regard, it should be made clear that the Tax Authority’s position on this topic is not definite, but we believe that, since the Ordinance establishes an original price for an asset that was obtained by way of inheritance or gift, there is no reason that, when stepping into the testator’s shoes (the default method), depreciation should not be claimed against that original price. In the case of a step-up, however, it is expressly forbidden to claim depreciation on the value of the asset.
Liability to foreign tax
Since we are dealing with an asset located abroad, it is highly likely its sale will also be subject to tax abroad. Under the default method, all of the foreign tax will be allowed as a credit against the Israeli tax on the sale. If the heir has applied for a step-up, the foreign tax will be allowed as a credit only on that portion of the profit that exceeds the value as at the date of death. In the case of the default method, any excess credit will be allowed as a credit against other assets, or may be carried forward to future years, like any other credit. In the case of a step-up, the excess credit is wiped out, and is in effect lost. Therefore, in any decision regarding a step-up, any expected foreign tax also needs to be taken into account. In the default instance, the proof may take the form of a will, the testator’s purchase documents or, in the case of a gift, a declaration (affidavit) by the donor. In the case of a step-up, a certificate from the foreign tax authorities that the asset was transferred may be required as proof. Such bureaucratic requirements, their cost, and the implications of applying to tax authorities abroad need to be considered prior to making a decision in this matter.
Inheritances and gifts deriving from a foreign resident have substantial tax implications. The decision on whether to file an application for a step-up or to adopt the default method requires proper consideration of the tax implications of each approach. This consideration should be made for each of the alternatives separately, taking into account the various tax rates for each period, the inflationary portion of the change in value, credit for foreign taxes, losses, the possibility of obtaining a depreciation credit, and the bureaucratic process of each of these options. There is no certainty, prior to reviewing these matters, that a step-up will be the most desirable approach. In planning a will during one’s lifetime, other possibilities may also be appropriate, such as bequeathing cash sums whose source is the sale of the assets of the estate.
- 1Where reference to an inheritance is made, the same rules apply to a gift
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