Israel-United States Tax Treaty
The Israel-United States Tax Treaty Does Not Insulate Israeli Citizens’ Capital Gains of from U.S. Taxes
Often, U.S. citizens who have permanent legal resident status in Israel are unclear about their tax obligations in the U.S. They may require additional guidance with regards to their duty to file a Foreign Bank Account Report (FBAR) FinCEN Form 114. We saw a perfect case in the U.S. Tax Court case of Cole V. Commissioner, T.C. Sum. Op. 2016-22.
Petitioner Elazar Cole was a U.S. citizen, and in 2010 became a permanent resident of Israel after moving there the year before. Cole qualified for a tax holiday in Israel in which he was exempt from taxation in Israel on his capital gain from outside of the country. (See the new version of the 5721-1961 Income Tax Ordinance on Israel’s Ministry of Finance website.)
Cole sold some shares of stock in a U.S. corporation in 2010 and raked in long term capital gains of around $114,000. He included those capital on his tax return. He was surreptitiously issued a notice of deficiency by the IRS and his case was subsequently heard in the U.S. Tax Court. Since the amount at issue was under $50,000 and Cole had made a request to be heard under its small tax case procedure, that is how his case was handled.
A foundational principle of the U.S. tax code is that U.S. citizens, and most residents, are taxed on all income from all sources. There is no exception with respect to where they live, or where they earn their income. Nonetheless, Internal Revenue Code section 894 stipulates that federal income tax law shall take into account provisions of any treaty obligations in the United States. The U.S. and Israel in fact have a tax treaty referred to as the “Convention between the Government of the United States of America and the Government of Israel with Respect to Taxes on Income.”
Mr. Cole’s argument was that Article 15, paragraph 1 of the Treaty provides that “[a] resident of one of the Contracting States shall be exempt from tax by the other Contracting State on gains from the sale, exchange, or other disposition of capital assets”. Simply put, he should be liable for U.S. taxes on capital gains because he was an Israeli legal resident.
The IRS countered Cole’s argument that it didn’t consider article 6, paragraph 3 of the treaty, widely known as the “savings clause.” The savings clause provides that “[n]otwithstanding any provisions of this Convention except paragraph (4), a Contracting State may tax its residents *** and its citizens as if this Convention had not come into effect.”
The Tax Court ruled in favor of the IRS. As the Tax Court pointed out, a savings clause is a fairly common treaty position and it had previously ruled on savings clauses in treaties between the United States and France, Canada, and Finland with similar outcomes. While the Court did not provide details, the result might have been different if Mr. Cole were not a citizen of the United States, but simply a resident of the U.S.
The moral of the story is that if you really want to avoid U.S. taxation, you might have to give up your citizenship. This process is known as “expatriation,” and entails both formally relinquishing citizenship, but also duly notifying the IRS, meeting certain criteria, and potentially paying an “exit tax.”
This did not come up in the Cole case, but another lesson is that U.S. citizens who reside in Israel are required to file FBARs, that is, assuming that they hold financial accounts containing more than $10,000 located in Israel, or any country outside of the United States.
For more information, consult with a tax attorney with experience in international tax matters.