The United States Tax Court recently concluded that a taxpayer who was a U.S. citizen and permanent Israel resident was taxable on his capital gains. Although such gain might have appeared to have been excluded from U.S. tax under one provision of the U.S.-Israel income tax treaty, it was nonetheless taxable under the treaty’s “saving clause.”
U.S. citizens are subject to U.S. federal income tax on their worldwide income. However, under Code Sec. 894(a) , the Code is applied to any taxpayer with due regard to any income treaty obligations of the U.S. that cover that taxpayer. In general, Article 15 of the U.S.-Israel income tax treaty applies to capital gain. Paragraph 1 of Article 15 provides that “[a] resident of one of the Contracting States [i.e., one country] shall be exempt from tax by the other Contracting State [i.e., the other country] on gains from the sale, exchange, or other disposition of capital assets.” In other words, the right to tax capital gain is reserved solely to the residence State, subject to exceptions that would specifically allocate such right to the source State. Like other U.S. income tax treaties, the U.S.-Israel income tax treaty includes the traditional “saving clause,” which preserves the right of the U.S. to tax its owns citizens and residents on their worldwide income.
The Tax Court’s ruling involved Elazar Cole. After moving to Israel in 2009, Cole, a U.S. citizen, became a permanent resident of Israel in 2010. As a result of moving to Israel, he qualified for a 10-year Israeli “tax holiday,” which exempted him from Israeli tax on non-Israeli-source capital gain income. Before moving to Israel, Mr. Cole purchased 3,000 shares of stock in Neogen Corporation (Neogen), a Michigan incorporated entity. In 2010, he sold this stock and realized $114,947 of long-term capital gain ($157,012 proceeds # $42,065 basis = $114,947 gain). On his 2010 Form 1040, U.S. Individual Income Tax Return, Mr. Cole reported the $157,012 of proceeds from the sale of Neogen stock on Schedule D, Capital Gains and Losses. However, he did not include any of the proceeds in his taxable income.
On audit, IRS determined a $13,212 U.S. federal income tax deficiency and a $2,642 accuracy-related penalty under Code Sec. 6662(a) . The issue. The question before the Court was whether a U.S. citizen and a permanent resident of Israel could exclude from taxable income proceeds from the sale of stock made while he was a permanent resident of Israel. Parties’ positions. Mr. Cole argued that he was exempt from taxation under the U.S.-Israel income tax treaty.
On the other hand, IRS contended that this income wasn’t excluded from U.S. tax under that treaty. However, IRS conceded the Code Sec. 6662(a) accuracy-related penalty. Conclusion. The Tax Court held that Mr. Cole had to recognize the $114,947 long-term capital gain of attributable to his sale of Neogen stock. He wasn’t entitled to exclude the proceeds from his sale of this stock from U.S. taxation under Article 15(1) of the U.S.-Israel income tax treaty. The Court found that the proceeds were subject to U.S. federal income tax under the U.S.-Israel income tax treaty’s saving clause. The Court rejected Mr. Cole’s contention that disallowing the Article 15(1) exemption under the saving clause was unreasonable because such treatment effectively nullify the provisions of the U.S.-Israel income tax treaty. The Court reasoned that the saving clause did not nullify the treaty; it only nullified the benefits provided by certain provisions to current citizens and certain former residents and citizens.
The U.S.-Israel income tax treaty provided that certain of its articles took precedence over the saving clause, but Article 15 wasn’t among them. In addition, the saving clause applied only to current citizens and certain former residents and citizens of a Contracting State who currently resided in the Other Contracting State.
The Court similarly rejected Mr. Cole’s contention that the phrase “shall be exempt” in Article 15 of the U.S.-Israel income tax treaty and the phrase “may tax” in the Article 6 saving clause, taken together, indicated a limited application of the saving clause to Article 15. It also dismissed Mr. Cole’s argument that IRS’s concession on the Code Sec. 6662(a) accuracy-related penalty indicated that his position on the treaty was legitimate and proper.