Capital Gain Taxable to US Citizen Despite Clause in Treaty That Appeared to Exempt Item From US Tax Due to Being a Resident of Israel

Treaties between the United States and other countries provide for special rules that will potentially override the standard tax treatment found in the Internal Revenue Code.  The taxpayer in the case of Cole v. Commissioner, TC Summary Opinion 2016-22 believed he had found a provision that would remove from tax the gain on sale of stock he had disposed of following becoming a permanent resident of Israel.

Mr. Cole in the year in question was both a United States citizen and a permanent resident of Israel.  He had purchased shares of Neogen Corporation prior to moving to Israel.  After moving to Israel he sold those shares for a net gain of $114,947.

Under normal United States tax law, a United States citizen (which Mr. Cole remained) is taxable on all of his/her worldwide income.  But Mr. Cole believed that a treaty exemption would eliminate that tax for him.

As a new resident of Israel, Mr. Cole qualified for a ten year “tax holiday” that exempted from tax non-Israeli source capital gains.  He also noted that the Convention between the Government of the United States of America and the Government of Israel with Respect to Taxes on Income, U.S.-Israel, Nov. 20, 1975, Article 15 provides “[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…” with a set of exceptions to this rule that do not apply in this situation. 

So at first glance it appears that Mr. Cole had escaped taxation on the gain in the country in which he resided due to the Israeli tax holiday provision and in the United States due to the Convention rule that blocks taxation by the nonresident country.

The Tax Court pointed out that the Convention contains provisions other than just those found in Article 15.  And it found that a provision in Article 6, paragraph 3 is one that Mr. Cole should have referenced.

That provision provides:

Notwithstanding any provisions of this Convention except paragraph (4), a Contracting State may tax its residents (as determined under Article 3 (Fiscal Residence) and its citizens as if this Convention had not come into effect.

This provision, known as a “Savings Clause” is found in many of the treaties.  It has the effect of limiting the benefits of the treaty in various cases including, in this case, to a United States citizen that sought to benefit from Article 15. 

The Court noted that it has decided before that such savings clauses trump the specific clauses in the document (note that it begins with “Notwithstanding any provisions of this Convention…” which clearly indicates it takes precedence).  The Court noted that Article 6 contains (in paragraph 4) a list of provisions that override the savings clause—and that the capital gain rule found in Article 15 is not one of them.

The opinion notes:

The saving clause does not nullify the Convention; it nullifies the benefits provided by certain provisions to current citizens and certain former residents and citizens. Convention, para. 4603.13, at 107,017, para. 4604, at 107,053; see also Filler v. Commissioner, 74 T.C. at 410. The Convention provides that certain of its articles take precedence over the saving clause—but article 15 is not among them. Convention, para. 4603.13, at 107,017. In addition, the saving clause applies only to current citizens and certain former residents and citizens of a contracting state who currently reside in the other contracting state. Id.; para. 4604, at 107,053; see also Filler v. Commissioner, 74 T.C. at 410. As this Court has previously held, the saving clause operates to deny certain treaty benefits to U.S. citizens and it is valid. Abrahamsen v. Commissioner, 142 T.C. at 410-411; Duncan v. Commissioner, 86 T.C. at 974-975; Filler v. Commissioner, 74 T.C. at 410.

What happened here has happened to many inexperienced tax practitioners when doing research—performing your research under the influence of “confirmation bias” where the researcher knows the answer he/she wants (no taxation) and fails to look for any contrary guidance once he/she has found guidance that supports the desired position.

The existence of “overriding provisions” that may be far from a provision that is overruled in a specific case is not limited to tax treaties—we see it in the Internal Revenue Code as well.  This is one specific area where a researcher will find the use of treatises and tax guides helpful—while they are not authoritative in and of themselves, they can help direct the researcher to materials that could be easily missed when looking solely at a specific authoritative citation.