LLC (Limited Liability Company) is a U.S. specific form of a private limited company entity; it has both "corporate" characteristics when it comes to its limited liability, and "partnership" characteristics, when it comes to its tax status.
Since the Israeli law does not recognize LLC, Israel Tax Authority (Hereinafter: "The ITA") defined it in ITA's circular 03/2002, as a "Body of Persons", referring to this definition in section 1 of the Israeli Income Tax Ordinance (New Version), 5721-1961 (Hereinafter: "The Ordinance"). In other words, the ITA classifies LLC only as a corporation. As a result, distribution of the profits of the LLC's to its members will be considered in Israel as dividends, which is different from the U.S. fiscal treatment, taxing the LLC similar to a partnership as a disregarded entity.
The conflict noted above caused a problem regarding foreign tax credit in Israel: when an Israeli resident is investing in a U.S. asset using an LLC, he will pay the U.S. tax as a sole proprietor on the income, while in Israel, the income will not be considered as his own income, but rather the income of the LLC. When the investment's profits will be distributed to the LLC's members, the ITA will consider those gains as dividends without granting any foreign tax credit as no actual tax was withheld at source in the U.S. on the dividends. This issue causes miscorrelation between Israel and the U.S. with regards to the income's attribution, and causes a problem with regards to the foreign tax credit- Israel sees the U.S. tax paid in the U.S. by the LLC and does not grant any foreign tax credit on the distribution of profits from the LLC to its Israeli members as it is classified as dividend income.
In order to deal with this problem of the foreign tax credit, the ITA published Circular 05/2004. According to this circular the Israeli member has the right to choose whether the LLC will be considered in Israel as a corporation or as a disregarded entity. In case the LLC is managed and controlled from Israel, it will be classified as an Israeli corporation subject to Israeli corporate tax. The LLC will report its income and will pay corporation tax with the right to deduct the tax it already paid in the U.S., and when the income will be distributed as dividend, the member will be taxed on that dividend.
If the LLC is not managed and controlled from Israel the member can choose to classify the LLC as a foreign corporation (even if it is...