In order to understand US tax policy, the Israeli investor must first understand the structure of the US government. The US is a federal presidential republic, a union of states that created a “super entity” to which they relinquished some of their governmental authorities. Each member of the federation has its own government and laws, but is also subject to federal law, meaning it cannot pass any legislation that counters federal law. It can, however, add to it.
What’s relevant for the matter at hand is understanding that the investor might find themselves subject to taxation on a federal level, state level, and sometimes even a municipal/county level.
The federal authority in charge of taxation for the US Department of Treasure is the IRS – Internal Revenue Service.
The Israel-US tax treaty and internal taxation law regulate all matters of taxation between the two countries and prioritize according to various conditions.
Section 4.4 of the treaty determines “Income and gains (including royalties) to which Article 7 (Income from Real Property) applies shall be treated as income from sources within a Contracting State only if the real property (or, in the case of property referred to in paragraph (3) of such Article 7, the underlying real property) is situated in that Contracting State.”
According to section 7, “Income from real property, including royalties and other payments in respect of the exploitation of natural resources and gains derived from the sale, exchange, or other disposition of such property or of the right giving rise to such royalties or other payments, may be taxed by the Contracting State in which such real property or natural resources are situated.”
The implication is that the US, where the assets are located, has precedent taxation rights, whereas Israel has secondary rights.
Definition of US residency:
- Substantial Presence Test: physical presence in the US for 31 days during the current year, and 183 days during the 3-year period, including the current tax year, according to the following calculation:
- All of the days you were present in the current year;
- One-third of the days present in the preceding tax year;
- One-sixth of the days present in the preceding two tax years.
For example: D was present in the US every year between 2018—2020. D is NOT a US resident, because the 2020 tax year is calculated as 120 days, 2019 is calculated as 40 days (120/3) and the 2018 tax year is calculated as 20 (120/6). According to the presence test, D resided only 180 days in the US, which is less than the required amount.
- The Green Card Test:
The definitions of residency are presented here in a simplistic manner; there are also qualitative tests that can determine in matters pertaining to tax residency.
Most investors will not be determined as US tax residents, but as non-resident aliens. This requires us to understand two terms pertaining to taxation for these aliens:
- Effectively Connected Income (ECI) – income from a business or trade in the US. This comes with the obligation to file and pay taxes according to brackets.
- NEC – income from sources other than a business or trade in the US. These are, primarily, passive FDAP (Fixed, Determinable Annual or Periodic) income that owes a fixed 30% tax or any other rate determined by the tax treaty.
Section 871 of the US tax code refers to non-resident alien taxation and determines the source of income and division according to ECI and NEC
