What Are the Key Provisions of the US-Israel Tax Treaty?

The United States and Israel share a bilateral income tax treaty, effective since 1995, to address the taxation of individuals and companies with financial ties to both nations. The primary goals of the treaty are to mitigate instances of double taxation, where the same income is taxed by both countries, and to establish a framework for mutual cooperation to prevent tax evasion. The agreement sets forth specific rules to determine which country has the primary right to tax various categories of income. By establishing a clear hierarchy for taxing authority, the treaty aims to prevent jurisdictional conflicts and encourage cross-border commerce and investment.

Determining Residency for Treaty Purposes

Accessing the benefits offered by the US-Israel tax treaty begins with determining a taxpayer’s residency status. Under the treaty, the term “resident of a Contracting State” is defined by that country’s domestic laws. An individual is not automatically considered a resident for treaty purposes simply by being a citizen. Residency is based on whether an individual or entity is liable for tax in a country by reason of domicile, residence, or place of management.

For individuals considered residents of both the U.S. and Israel under their respective domestic laws, the treaty provides sequential “tie-breaker” tests to assign a single country of residence. These rules ensure a dual-resident individual is treated as a resident of only one country for applying the treaty’s provisions, and the tests are applied until residency is resolved:

• A permanent home available to the individual.
• The center of vital interests, evaluating where personal and economic relations are closer.
• The individual’s habitual abode, which looks at where they spend more time.
• Citizenship.

Taxation of Specific Income Types

The treaty establishes rules for how different categories of income are taxed, allocating taxing rights to prevent double taxation. For business income, a central concept is the “Permanent Establishment” (PE). The business profits of an enterprise from one country can only be taxed by the other country if those profits are attributable to a PE located there. A PE is defined as a fixed place of business, such as an office, branch, or factory.

For investment income, the treaty provides for reduced tax rates. The maximum withholding tax on dividends is 25 percent, with a lower rate of 12.5 percent if the recipient is a corporation that owns at least 10 percent of the voting stock of the paying company. Interest income is also subject to a reduced withholding tax, with the source country’s tax capped at 17.5 percent, and a lower 10 percent rate for interest on loans granted by banks and similar financial institutions.

The treaty also addresses income from real property and pensions. Income derived from real property, including rent, may be taxed in the country where the property is situated. For pensions and other similar remuneration paid to an individual, they are taxable only in the recipient’s country of residence. This ensures that retirees are not subject to tax on their pension income in the country from which it is paid if they live elsewhere.

The Saving Clause and Its Exceptions

A provision within the US-Israel tax treaty is the “Saving Clause,” found in Article 6. This clause allows the United States to tax its citizens and residents as if the treaty did not exist. This means a U.S. citizen living in Israel cannot use the treaty to reduce U.S. tax on their income, even if the treaty assigns primary taxing rights to Israel. The provision underscores the U.S. system of citizenship-based taxation.

The term “citizen” for the purpose of the Saving Clause can also include a former citizen who relinquished their citizenship for tax avoidance purposes, for a period of 10 years following the loss of citizenship. This extension prevents individuals from circumventing U.S. tax obligations by giving up their citizenship while retaining economic benefits connected to the country.

Despite its broad application, the Saving Clause has exceptions that permit U.S. citizens to claim certain treaty benefits. For example, the provisions related to relief from double taxation, as outlined in Article 26, are not overridden by the Saving Clause. Other exceptions include the articles governing social security payments and child support, allowing U.S. citizens to benefit from the specific treatment of these payments.

Relief from Double Taxation

The primary mechanism for relieving double taxation under the treaty is the foreign tax credit. The treaty obligates both countries to allow their residents to claim a credit for income taxes paid to the other country. For a U.S. resident or citizen, the treaty allows a credit against U.S. income tax for taxes paid or accrued to Israel.

This credit is subject to the limitations of each country’s domestic laws. In the United States, the foreign tax credit is calculated according to the rules of the Internal Revenue Code. The actual amount that can be claimed is determined by U.S. law, often involving calculations on Form 1116, Foreign Tax Credit. The credit is limited to the amount of U.S. tax liability on the taxpayer’s foreign-source income.

The treaty specifies that Israel must provide a similar credit to its residents for taxes paid to the United States. This reciprocal arrangement ensures that taxpayers in both countries receive relief. The goal is to ensure that the combined tax paid to both countries does not exceed the tax that would be owed to the higher-tax jurisdiction.

Required Disclosures for Treaty Positions

Taxpayers who rely on the US-Israel tax treaty to alter their U.S. tax obligations must often disclose this position to the Internal Revenue Service (IRS). This is done by filing Form 8833, Treaty-Based Return Position Disclosure. The form is required when a taxpayer claims a treaty benefit that overrules or modifies a provision of the Internal Revenue Code, resulting in a reduction of tax.

Filing Form 8833 is necessary in situations such as when an Israeli resident claims exemption from U.S. tax on business profits because they do not have a permanent establishment in the United States. The form requires the taxpayer to provide specific information, including the treaty articles that support their position. It also requires a brief summary of the facts and an explanation of the treaty-based position.

Failure to file a required Form 8833 can result in penalties. The penalty for an individual’s failure to disclose a treaty-based position can be substantial. This makes it an important compliance step for any taxpayer who is taking advantage of the treaty’s provisions to reduce their U.S. tax liability.