Hi-Tech And Startup Taxation | נמרוד ירון ושות׳ https://y-tax.co.il/en/category/hi-tech-and-startup-taxation/ מיסוי בינלאומי ומיסוי ישראלי Tue, 04 Jun 2024 08:05:31 +0000 en-US hourly 1 https://wordpress.org/?v=6.7.1 https://y-tax.co.il/wp-content/uploads/2020/03/cropped-android-chrome-512x512-1-32x32.pngHi-Tech And Startup Taxation | נמרוד ירון ושות׳https://y-tax.co.il/en/category/hi-tech-and-startup-taxation/ 32 32 Continuation in the Exchange of Optionshttps://y-tax.co.il/en/continuation-in-the-exchange-of-options/?utm_source=rss&utm_medium=rss&utm_campaign=continuation-in-the-exchange-of-options Tue, 04 Jun 2024 07:59:03 +0000 https://y-tax.co.il/?p=36121Continuation in the Exchange of Options – Aspects of Employee Options in Structural Changes Many companies, especially early-stage companies (often startups, but not necessarily), grant stock options to their employees. The options mechanism is primarily intended to retain employees in the company and incentivize them to ensure the company’s success, as the company’s success is […]

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Continuation in the Exchange of Options – Aspects of Employee Options in Structural Changes

Many companies, especially early-stage companies (often startups, but not necessarily), grant stock options to their employees. The options mechanism is primarily intended to retain employees in the company and incentivize them to ensure the company’s success, as the company’s success is also their success. When a company grants options to employees, it creates an obligation to allow those employees to exercise their rights in the future and convert the options into company shares.

During a structural change in the company that granted the options, a forced sale of the options alongside the transferred company shares occurs. The forced sale is considered a tax event for option holders due to the sale of their rights in the company, an event interpreted as the “realization” of the right, and therefore, ostensibly taxable.

Section 104H of the Income Tax Ordinance outlines the rules by which, despite the occurrence of the forced sale event, tax deferral applies until the “realization date” of the options as defined in Section 102 of the Ordinance. This section addresses companies transferring their shares to another company in exchange for allocated shares traded on the stock exchange of the acquiring company. The tax deferral is not automatic but requires approval from the Tax Authority Director by submitting a request for a pre-ruling.

Tax deferral is not automatic but requires approval from the Tax Authority Director through a pre-submitted request for a tax ruling.

The conditions for deferring the tax event are outlined in Section 104H of the Ordinance, as follows: The forced sale event/tax event occurs upon the exchange of shares as described in the section:

  • “Share Exchange” – the transfer of shares of a company (in this section – the transferring company), including rights to purchase shares (in this section – the transferred shares), in exchange for the allocation of shares listed for trading on the stock exchange, in another company, with or without additional consideration (in this section – the acquiring company and the allocated shares);

The conditions for deferring the tax event are specified in Section 104H(b)(1) of the Ordinance:

If all the following conditions are met, a tax continuity will apply, meaning the transferred rights will be considered as if the employee options were initially granted by the acquiring company:

  1. The market value of the allocated shares (including the additional consideration) in the acquiring company has not changed from their value in the transferring company before the transfer. In other words, there is an absolute identity between the transferred rights and the allocated rights in the acquiring company.
  2. The acquiring company allocated shares to all transferors of equal value.
  3. All shares and rights to shares in the transferring company were transferred to the acquiring company.
  4. A request was submitted to the Director to confirm that the share exchange meets the conditions. The request must be submitted 30 days in advance, and approval from the Tax Authority management for tax deferral must be obtained.
  5. The allocated shares must be deposited with a trustee. The trustee’s role is to supervise the fulfillment of the above conditions and ensure tax payment upon actual realization.

Ruling 6852/12 established specific instructions for the trustee’s supervision, withholding tax obligations on additional consideration for the share exchange, and monitoring the process’s correctness until the actual realization of rights. The trustee’s role ends after the actual realization of rights.

Note that if consideration was transferred during the continuation in the exchange of options, the additional consideration element for the exchange of options will be taxable for the right holders receiving the consideration.

Submitting the request in advance is critical for deferring the tax to the “realization date” as defined in Section 102 of the Ordinance. Without prior approval from the Tax Authority, the default is that the structural change is a taxable capital gains event.

For questions and professional guidance on these matters, please contact our office.

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Taxation of RSUs – Restricted Stock Unitshttps://y-tax.co.il/en/taxation-of-rsus-restricted-stock-units/?utm_source=rss&utm_medium=rss&utm_campaign=taxation-of-rsus-restricted-stock-units Wed, 08 May 2024 09:09:18 +0000 https://y-tax.co.il/?p=34906Many companies, especially in the technology and startup sectors, choose incentive plans for their employees. The most well-known and common means of incentivizing company employees

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Many companies, especially in the technology and startup sectors, choose incentive plans for their employees. The most well-known and common means of incentivizing company employees is by granting options convertible into company stock. In recent years, companies seeking to incentivize their employees have begun to utilize another tool that has become increasingly common over time – Restricted Stock Units (RSUs).

What are RSU (Restricted Stock Units)?

RSUs are stocks that the company commits to grant to an employee after the vesting period, upon the signing of the agreement between the parties. The vesting period is a period during which the employee has no access to the allocated stocks, and only upon the end of the period is entitled to receive them. In other words, during the vesting period, the employee has only the right to the stocks, while after the vesting period, the employee actually owns the stocks. After the vesting period, the stocks are automatically issued, and there is no cost to the employee for exercising them. The stocks belong to the employee, and they are free to hold onto them for a period of their choosing and sell them when they see fit. Since the stocks are issued to the employee at no cost, the profit, or at least the absence of loss, is assured. So even if the value of the stock drops to zero, they won’t lose money.

Options

RSU

Employee cost

When exercising the options, the employee is required to pay an “exercise cost”, which is actually the discounted share price that the employee can convert the option into a share within the framework of the options agreement granted to him.

No cost on the part of the employee.

Profit potential

If during the sale of the share, the actual price of the share is higher than the exercise price of the share, then there will be a profit for the employee.

No loss is certain because the stock is issued to the employee at no cost on his part.

Date of realization

As long as the redemption option is valid, the employee may send a redemption request to the company plus the redemption cost, and it will issue or sell him a share.

The share is issued automatically according to the date agreed upon (the end of the blocking period).

Expiry date

Options have an expiration date from the moment they mature if they have not been converted into shares. In addition, the employee has the right to exercise the options for a short period after the end of his employment (usually 90 days).

There is no expiration date because it is a share that belongs to the employee (there is only a blocking period, as mentioned).

Therefore, some view the RSU compensation method as the preferred compensation method over other options. It’s important to note that the choice of compensation method for the employee is in the hands of the company, and it is the company that determines the compensation policy for the employee.

RSU Taxation

The Income Tax Ordinance considers the granting of RSUs a taxable event in every respect, and the applicable rules depend on how the incentive plan was implemented. In this article, we will discuss the taxation for an RSU stock plan that meets the requirements of Section 102 of the ordinance.

Section 102 stipulates that the tax liability will occur not at the time of the grant or allocation of the share but at the time of exercise. The exercise date is extended under Section 102 under two possible alternatives:

  1. In the allocation of shares on a trustee track – the date of transferring the shares from the trustee to the employee or the date of the shares’ sale by the trustee, whichever is earlier.
  2. In the allocation of shares on a non-trustee track – the date of the share’s sale by the employee.

The ordinance allows every company to choose between two allocation tracks through a trustee – the ’employment income track’ and the ‘capital gain track’. The ‘capital gain track’ or ‘capital track’ is considered more favorable by employees because the tax imposed on them in this track is the lowest. In this track (capital gain track), there are two options:

  1. An employee who exercises the shares granted to him/her within less than 24 months (‘violation’) – all the profit from the sale will be classified as employment income according to the marginal tax rate on income. In case of a violation, the company is not allowed a deduction.
  2. An employee who waits 24 months from the date of grant until the exercise date –
    • if it concerns a share that is not traded on the stock exchange in Israel or abroad – the tax on the profit will be capital gains tax at a rate of 25% (before additional tax).
    • If it concerns a share traded on the stock exchange in Israel or abroad or that was listed for trading within 90 days from the date of the grant –
    • The income equal to the share price in the 30 days preceding or following the grant date will be classified as employment income for tax purposes and will be subject to the employee’s marginal tax rate.
    • The rest of the profit will be classified as capital gain, and the tax rate on the remainder will be only 25% (before additional tax).

As mentioned, there are additional tracks for allocating shares under Section 102 of the ordinance, such as the employment income track and also allocations in the non-trustee track. Unfortunately, this article does not have the scope to cover all the differences between the various tracks, but attention must be paid to the tax implications that will vary with each track. For more information on this topic, click here.

In summary, there are many considerations and calculations when you come to exercise shares granted to you by the company. It is important to be familiar with the track chosen by the employing company and to ensure that the timing of the exercise is optimal both in terms of the time elapsed since their grant and in terms of the share value at that time.

It is recommended and advisable to conduct tax planning through professionals specialized in taxation to ensure that the tax liability on the exercise of the shares is minimized.

Feel free to contact us and arrange an introductory meeting.

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Options for controlling shareholders and for self-employedhttps://y-tax.co.il/en/options-for-controlling-shareholders-and-for-self-employed/?utm_source=rss&utm_medium=rss&utm_campaign=options-for-controlling-shareholders-and-for-self-employed Wed, 24 Apr 2024 15:06:28 +0000 https://y-tax.co.il/?p=34010Classification of the grant of options as employment income and the date of tax payment – options granted to a controlling shareholder/option granted to service

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Classification of the grant of options as employment income and the date of tax payment – options granted to a controlling shareholder/option granted to service providers.

When a company grants options to employees, the prevailing preference for both companies and startups as well as for employees is to apply the capital gains track under Section 102 of the Income Tax Ordinance, such that a 25% capital gains tax is applicable and the tax is deferred until the sale date (or the date the shares are transferred from the trustee to the employee). For more information on the possible taxation routes for an option according to Section 102 of the Ordinance, click here.

When dealing with individuals who are not employees as defined in Section 102 of the Ordinance, the ‘tax benefits’ of the section do not apply. In such cases, marginal tax may already apply at the time the options are granted according to Section 2 of the Ordinance (Section 2(1) – earnings or profits from business, or Section 2(2) – earnings or benefit from employment). This means taxation at a higher rate according to tax brackets – up to 50% tax, and also the tax date – at the time the options are granted.

As part of tax planning and consulting, our office examines the case and the options for minimizing taxes according to the following order of preference:

  1. Firstly, we examine whether it is possible to qualify for the capital gains track of Section 102, considering various interpretations.
  2. If not, we will attempt to apply Section 3(9), so that at the very least – the tax event date will be deferred, and the employee or service provider will not be required to pay for the tax benefit before actually receiving any income.

As for the first option – checking whether Section 102 can be applied – the employee must not be a controlling shareholder. If dealing with a director of the company who is not a controlling shareholder, the section can be applied to them, subject to certain conditions. If an employee receives several options that make them a controlling shareholder, in many cases, we can make a separation that allows at least partial application of the section. Sometimes this requires reviewing agreements and drafting opinions, but in many cases, it is very beneficial for that employee.

Occasionally, the mere fact that someone is employed via an invoice does not prevent them from being defined as an employee, and this is assessed based on the criteria for establishing employee-employer relations as stated in case law, including the tests of obedience and supervision, the equipment test, and more.

As for the second option, namely, when we conclude that it is not possible to benefit from the capital gains track and the application of Section 102 of the Ordinance, under certain circumstances, there is room to argue that the income from options should not be taxed at the time of grant according to Section 2 of the Ordinance, but rather to defer the tax event as stipulated in Section 3(9) of the Ordinance. This is subject to certain conditions, including that the options are not traded on a stock exchange.

Tax planning as detailed in this article can lead to very significant savings in the taxation of options granted to controlling shareholders or service providers, and many of our clients have already benefited from these savings.

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Employee options – Forms for green trackshttps://y-tax.co.il/en/employee-options-forms-for-green-tracks/?utm_source=rss&utm_medium=rss&utm_campaign=employee-options-forms-for-green-tracks Wed, 24 Apr 2024 11:37:14 +0000 https://y-tax.co.il/?p=34000What is a “green track”? A ‘Green Track’ is a streamlined process whose primary goal is to shorten procedures with the tax authority in certain

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What is a "green track"?

A ‘Green Track’ is a streamlined process whose primary goal is to shorten procedures with the tax authority in certain areas. This process is designed to establish predefined frameworks and criteria, allowing the tax authority to make a taxation decision based on the declarations and commitments of the applicants, through the filling and submission of a specific form for each type of request. The specific forms for each request are constructed in a fixed template of general details, a description of the facts, a detailed request, the requested tax arrangement and its terms, and a declaration and commitment. Our office handles all stages of the request, starting from the submission stage up to the receipt of the required tax decision, including assessment discussions and representation in front of the professional department at the tax authority, while paying attention to accuracies and important points that could prevent significant exposures. In this article, we will focus on the area of employee options and shares.

Detail and explanation of the forms found within the Green Track.

Form 906: Allocation of Units for Share – RSU (Restricted Stock Unit)

For RSU share allocations to be included under the tax tracks of Section 102 of the Income Tax Ordinance (the Ordinance), it is required to approve this before allocating the shares to employees and to establish that these shares will become options in the future of the employees. Only then, after the vesting period, will it be possible to apply the tax provisions of Section 102 of the Ordinance to the shares, even though these are shares at the time of their allocation without any additional realization from the employees.

To view the form, click here.

Form 911: Repricing of Employee Options

This is a request from the tax authority’s manager intended to regulate anew the pricing of employee options in cases where a change has occurred in the benefit to employees, such as when the market value of the company’s shares drops or for any other reason.

To view the form, click here.

Form 912: Net Exercise of Options for Employees in a Public Company (NET EXERCISE)

The purpose of this referral to the tax authority with a request to be included in the Green Track is to ensure that the tax liability of the employees at the time of exercising the options is not adversely affected by the implementation of a net exercise mechanism. Net exercise is a taxation mechanism that taxes only the amount of the benefit, simplifying the direct taxation procedures and bypassing the technical process of option allocation, share purchase, sale, and taxation.

To view the form, click here.

Form 916: Switching from Section 3(i) Option Plan to Section 102 Capital Track with a Trustee

Section 3(i) of the Ordinance defers the tax obligation on the benefit received by a controlling shareholder until the options are exercised, subject to meeting certain conditions. An allocation track under Section 3(i) is taxed at employment income rates, which can be as high as 50%. This request is intended to switch the option plan allocated under Section 3(i) to an option plan under Section 102 of the Ordinance, a capital track with a trustee for controlling shareholders who are also employees. The choice of the allocation track at the time of allocation is crucial in terms of the taxation of the shares at the time they are exercised. Therefore, it is important to consult with a professional expert in the field before choosing the allocation track.

To view the form, click here.

Form 917: Switching Option Plans from Non-Trustee to Trustee-Based

There are various types of employee option allocation plans. This request is designed to change the allocation track from a non-trustee to a trustee-based employee option allocation plan. This means that the trustee holds the options allocated within the framework of the allocation and acts as the tax authority’s executing hand against the allocating company.

To view the form, click here.

Form 922: Adjustment Mechanisms for Changes in Capital, Distribution of Benefit Shares, and Dividends

This request is intended to protect the level of benefit for the employee in the case of a decrease in the share value at the time of exercising the options compared to the share value at the time of receipt. For this purpose, adjustment mechanisms have been set up to address changes in the company’s capital structure as a result of capital changes and/or distribution of benefit shares and/or distribution of dividends/rights.

To view the form, click here.

Form 926: Allocations to Employees under an ESPP (Employee Stock Purchase Plan) with a Trustee

This request is designed to apply the provisions of Section 102 of the Ordinance to the shares issued to employees under the ESPP in the capital gain track with a trustee. This involves a compensation plan for employees who have the right to purchase shares of the parent company where they are employed and have voluntarily made payments from their salary (exercise premium) during the option vesting period.

It should be noted that there is also Form 927, which serves the same purpose, but should be filled out when there is no trustee.

To view Form 926 (with trustee) click here.

To view Form 927 (without trustee) click here.

Form 928: Exchange of Options/Shares Allocated as Part of a Company Share Sale Transaction

In the case of a Merger/Acquisition Involving a Company that Has a Share Allocation Plan under Section 102 of the Ordinance, it is crucial to obtain a tax decision to preserve the continuity of the employee’s rights under the existing plan, while canceling the options and allocating equivalent options for the rights that were canceled. To obtain this decision, certain conditions detailed in the ‘Green Track’ must be met to maintain the continuity of rights under Section 102 of the Ordinance.

To view the form, click here.

It is important to be mindful and consult with professionals who specialize in all aspects of employee option taxation even at the decision-making stage of a new allocation/change in an existing allocation. This is due to the importance of complying with the conditions and restrictions of Section 102 of the Ordinance to apply the preferred tax rules of Section 102. Contact us, and we will coordinate an introductory meeting with you as soon as possible.

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Employee Options – Limitations and Solutions for Applying Section 102https://y-tax.co.il/en/employee-options-limitations-and-solutions/?utm_source=rss&utm_medium=rss&utm_campaign=employee-options-limitations-and-solutions Wed, 24 Apr 2024 11:28:49 +0000 https://y-tax.co.il/?p=33991As a rule, everyone wants their options to fall under the 25% capital gains tax track stipulated in Section 102 of the Ordinance. Everyone also

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As a rule, everyone wants their options to fall under the 25% capital gains tax track stipulated in Section 102 of the Ordinance. Everyone also hopes that Section 102 will apply to the options granted to them, given the deferral of the tax event until the shares are sold or received from the trustee.

However, many clients who consult with us do not meet the conditions of Section 102 and the 25% capital gains tax track. In some of these cases, a relevant solution can be found through specific tax planning advice.

Main Obstacles and Possible Solutions

The first obstacle

Is the definition of an employer in Section 102, which only applies when the options are granted by an ’employing company’ as defined in Section 102. This includes an Israeli company, a sister company of an Israeli company, or a parent or subsidiary of an Israeli company. Therefore, if the client is employed in Israel by a foreign company without a related entity in Israel, they cannot benefit from Section 102 but would instead receive stock warrants typical of options received by an investor in the company, and Section 3(i) of the Ordinance would apply—resulting in earlier taxation at marginal rates.

Is there a solution?

Sometimes, through tax minimization consulting. Occasionally, it may be relevant for the foreign company to establish a permanent establishment in Israel, subject to approval by the tax authorities and with additional implications. At times, it is indeed relevant for the foreign company to open a subsidiary in Israel (for other reasons as well). It is also possible to try to apply for a ruling if there are significant and substantive reasons for applying Section 102 of the Ordinance.

The second obstacle

Is the definition of an employee. To benefit from the conditions of Section 102, one must fit the definition of an employee outlined in this section. An employee is defined as ‘including someone who holds a position in the company, except for a controlling shareholder’. That is, an employee who holds 10% of the rights in the company or the right to appoint a manager and becomes a controlling shareholder as a result of the allocation—Section 102 will not apply to the options.

Is there a solution?

Each case should be discussed on its own merits; sometimes we recommend separating the options so that at least some of them may fall under Section 102.

The third obstacle

Involves freelancers who provide services and issue invoices to the company.

The solution

Is to examine whether an employee-employer relationship exists according to the criteria of jurisprudence and whether Section 102 could apply (provided that the additional conditions specified in Section 102 are met).

How are those options that do not fall under Section 102 taxed?

Such options are taxed as employment income or business income at marginal rates according to Section 2 of the Ordinance and often according to Section 3(i) of the Ordinance at marginal rates, depending on the case facts and, among other things, if the option is tradable. In cases where there is no connection to employment and it is purely an investment, entirely different rules apply.

In summary, there are limitations and complexities to applying Section 102 of the Ordinance, but expertise in the field can yield significant tax savings. For more details, contact us.

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Reverse Vestinghttps://y-tax.co.il/en/reverse-vesting/?utm_source=rss&utm_medium=rss&utm_campaign=reverse-vesting Mon, 08 Apr 2024 15:46:19 +0000 https://y-tax.co.il/?p=33114Reverse Vesting, also called Reverse Stock Vesting or a Reverse Vesting Period, is a mechanism that allows a company to buy back shares from senior

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Reverse Vesting, also called Reverse Stock Vesting or a Reverse Vesting Period, is a mechanism that allows a company to buy back shares from senior employees and founders.

The reverse vesting mechanism stipulates that a senior employee/founder/investor (hereinafter: the senior employee) can purchase shares at the beginning of their tenure with the company, unlike options which are typically exercisable only after a vesting period has concluded (for more information, it is recommended to read our additional articles on options, detailed below). However, it sets specific conditions under which the company can repurchase the shares during a certain period. Thus, the employee is required to wait out the vesting period defined in the agreement before they can ‘leave the company with all the purchased shares’ without restrictions. The mechanism defines the conditions and the period during which the company has the right to repurchase the employee’s shares, in whole or in part, as well as the price at which the company can repurchase the shares. After the period has ended and provided that the senior employee has met the objectives, the shares of the senior employee are no longer restricted and are owned without any limitations.

Reverse vesting is usually regulated in the founders’ agreement or in a separate agreement signed as part of a funding round in the company, and it protects the interests of the company, investors, and other shareholders.

This mechanism is designed to prevent situations where a senior employee who leaves the company benefits from a significantly larger shareholding compared to their responsibility for its continued growth, thus ensuring that voting rights are maintained with those who are actively responsible for its operations. In effect, this encourages employees/founders to remain with the company for a longer period. Venture capital firms are the most common users of this mechanism.

A common restriction on the senior employee’s shares in reverse vesting is the company’s right to repurchase upon termination of employment. It should also be noted that it is customary to cancel the reverse vesting mechanism in the event of an offering and sale of the company’s rights.

Reverse Vesting Tax

In 2017, the Israeli Tax Authority issued Circular 5/2017 (hereafter, “the Circular”) regarding retention mechanisms and restrictions on founders and key employees, which addressed the taxation related to the Reverse Vesting mechanism. The Circular sets cumulative conditions, which, if met, would still classify the operation of this mechanism as capital income rather than earned income. This classification is significant because while earned income could be taxed at marginal rates of up to 50% of the income, capital gains are subject to rates of only 25% to 30% (depending on whether the senior employee holds a substantial shareholding).

The conditions for capital gains tax despite the reverse vesting mechanism are detailed as follows:

  • The mechanism must be predetermined and documented in writing either at the company’s inception or shortly thereafter (up to six months) or during a significant investment in which at least 5% of the company’s issued share capital is issued. If the mechanism is activated, only the company or other shareholders in the company can purchase the shares from that founder or key employee.
  • The compensation for the purchase of the shares is their stated value or the price paid for them at the time of purchase.
  • The shares of the founders or key employees are ordinary shares, identical in their rights to other shares of the same type.

Additional conditions are outlined in the circular.

Another question that arises is whether the application of the reverse vesting mechanism on shares is subject to capital gains tax at that time. According to Section 88 of the Income Tax Ordinance, a sale that is liable for capital gains tax is any action or event as a result of which an asset leaves a person’s possession. It could be argued that the application of the mechanism does not constitute a sale for tax purposes and therefore does not create a liability for capital gains tax, as in practice no asset has left the senior employee’s possession; the shares were in their possession before the mechanism was applied and remained so after the application of the Reverse Vesting mechanism.

Each case should be examined on its own merits, including all conditions related to the agreements and shares, in light of exposure to marginal (progressive) tax rates, especially if the conditions in the circular are not met. There may also be tax implications for the other shareholders. Contact us for a  consult on issues of stock and options taxation.

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Taxation of venture capital and private equity fundshttps://y-tax.co.il/en/taxation-of-venture-capital-and-private-equity-funds/?utm_source=rss&utm_medium=rss&utm_campaign=taxation-of-venture-capital-and-private-equity-funds Mon, 01 Apr 2024 13:44:40 +0000 https://y-tax.co.il/?p=32669Venture Capital A Venture Capital (VC) fund is typically organized as a private partnership, investing in ventures and businesses with high risk, often in startups

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Venture Capital

A Venture Capital (VC) fund is typically organized as a private partnership, investing in ventures and businesses with high risk, often in startups at the beginning of their journey that have relatively high growth potential. This investment is made with the expectation of future returns.

Venture capital funds provide not only financial investment but also offer guidance and advice to companies, utilizing their extensive connections across various fields. In exchange for their investment, the funds are allocated shares, sometimes at a specific discount, and/or future options. It’s important to note that a significant portion of the capital used by these funds for investment is raised from foreign investors and institutional bodies.

Venture capital funds play a central role in the technology sector, supporting companies engaged in the development of new products and services that have the potential to revolutionize existing industries and even create entirely new markets.

In Israel, there’s significant technological development in various fields such as fintech, cybersecurity, and more, leading many startups to enter the market in hopes of growing and generating future profits. Often, these companies raise capital from various investors, including venture capital funds.

Tax Arrangement Under Section 16(A) – Exemption for Foreign Residents

As mentioned, a large portion of investors in venture capital funds are foreign investors, and therefore, they may be subject to the tax arrangement under Section 16(A) of the Income Tax Ordinance, provided they meet the conditions set by the Tax Authority for this tax arrangement. This arrangement generally allows for a tax exemption for a foreign resident who is not an Israeli resident.

In order for a fund to benefit from the above tax arrangement, it must meet several cumulative conditions detailed in Income Tax Circular No. 9/2018.

It is important to clarify that this exemption, as per the circular, applies to certain types of income of a venture capital fund, and does not necessarily mean that all of the fund’s activities are included in the arrangement. Therefore, a fund with mixed income might be exempt from tax on certain types of income, while other types might be taxable according to Israeli tax laws.

The conditions for a venture capital fund to qualify for the tax arrangement under Circular 9/2018 are as follows:

  1. Number of Investors: The fund must have at least ten investors who are not related to each other and are not part of the general partner, throughout the fund’s life.
  2. Investor Dispersion: No investor can hold more than 20% of the fund’s rights, except for one investor who may hold up to 35%, throughout the fund’s life.
  3. Types of Investors: The possible types of investors in the fund are:
    • Foreign resident investors
    • Israeli institutional investors exempt from tax under Section 9(2) of the ordinance
    • Israeli resident investors, including individuals and/or companies. It should be noted that the tax arrangement does not apply to these investors.

Moreover, the tax arrangement certifications apply only when the proportion of foreign investors in the fund exceeds 30% of the total investor composition.

  1. Investment Commitments: The fund’s investment commitments and actual investments must not be less than $10 million, with at least $5 million of the total investments coming from foreign investors.
  2. Investment Distribution: The fund must not invest more than 25% of the total funding from investors in any single company.
  3. Types of Investments: The fund must invest in qualifying investments. Qualifying investments include investments in Israeli companies, companies’ resident in Israel, or companies related to Israel by virtue of their primary activity being the establishment or expansion of industry and factories in Israel, as well as research and development in various fields such as manufacturing, transportation, agriculture, tourism, water, energy, technology, communications, computing, security, medicine, biotechnology, and nanotechnology. Qualifying activity does not include real estate activities in Israel. For this purpose, a company related to Israel is a foreign company whose main assets and/or activities are located in Israel. Despite the above, no more than 20% of the fund’s total investment amount can be invested in Israeli companies that were publicly traded on the day of the investment.
  4. Minimum Number of Qualifying Investments in Israel: The fund must invest a minimum amount in qualifying investments, based on the lower of the following alternatives:
    • At least $10 million, with at least $6 million of that invested in Israeli resident companies and/or foreign companies holding Israeli resident companies.
    • At least 50% of the fund’s total investment amount, with at least 30% of the investment funds in Israeli resident companies and/or foreign companies holding Israeli resident companies.
  5. Separation between Limited Partners and the General Partner: Only the general partner is authorized to manage the fund, and the limited partners in the fund cannot take an active part in managing the fund or in identifying investments for the fund. Furthermore, the limited partners will not have voting rights in the fund’s investment committee.

These conditions are cumulative, meaning the fund must meet all of them to qualify for the relevant tax arrangements under Section 16(A) of the ordinance and enjoy a tax exemption. According to the circular, and upon meeting these specified conditions, the revenues from the realization of qualifying investments will be exempt from tax for the foreign and institutional investors involved. For this matter, revenues from venture capital investments include income from shares, interest, and dividends.

Private Equity Fund

Private equity funds, which are private investment funds (private equity), are typically structured as private partnerships and have a structure similar to that of venture capital funds. It is important to highlight that, unlike venture capital funds, which focus on investing in early-stage companies with high growth potential, private equity funds primarily target more established companies that are often already generating profits. Additionally, private equity funds usually make investments by acquiring shares in the target company.

Tax Arrangement for Private Equity Funds According to Circular 10/2018

The tax arrangement, as mentioned under Section 16(A) of the ordinance, may also apply to private equity investment funds, under conditions similar to those outlined for venture capital funds, with necessary modifications. To address this, the Tax Authority issued a separate circular for these funds – Circular 10/2018.

If the eight detailed conditions previously mentioned are met, the revenues from the realization of qualifying investments will also be exempt from tax for private equity funds, specifically for the foreign and institutional investors involved. However, it should be clarified that, unlike Circular 9/2018, revenues from dividends and interest, as a general rule, are not included as tax-exempt income and are subject to the relevant tax laws – the tax rate for income from dividends will be 15% for individuals, and the corporate tax rate according to the ordinance will apply to investors who are not individuals or as per the lowest rate in applicable tax treaties. Interest income will also be taxed according to the rate established by law.

Our office assists investors and accompanies venture capital and private equity funds among the largest in Israel. Our office also supports similar processes such as capital raising, adding investors, and more. For further information, please contact us.

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Everything you need to know about the taxation of options for employeeshttps://y-tax.co.il/en/everything-you-need-to-know-about-the-taxation-of-options-for-employees/?utm_source=rss&utm_medium=rss&utm_campaign=everything-you-need-to-know-about-the-taxation-of-options-for-employees Wed, 17 Jan 2024 11:48:36 +0000 https://y-tax.co.il/?p=30946The Tax Aspects of Employee Stock Options The increase in the percentage of employees in the hi-tech industry brings with it a discussion about granting

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The Tax Aspects of Employee Stock Options

The increase in the percentage of employees in the hi-tech industry brings with it a discussion about granting stock options to employees. However, for every option and every consideration, there is taxation. Employee stock options raise many questions about the tax implications. Here is everything you need to know about options and taxation.

The rationale behind providing stock options to employees is the recognition that employees are stakeholders in the economic venture and share common interests with both the employees and the company. In the case of granting options to employees, there are various taxation methods outlined in Section 102 of the Income Tax Ordinance. This section allows for taxation at a capital gain rate in some cases. However, if options are granted to service providers to the company without formal employee-employer relationships, Section 102 of the ordinance does not apply, and Section 3(9) regarding taxation at progressive rates comes into effect.

Below is an overview of the aspects and taxation possibilities for the option recipient under Section 102 of the Income Tax Ordinance.

Employee Stock Options in Private Companies – Taxation

Taxation of Allocation of Options to Employees through a Trustee in the Capital Gain Route in a Private Company (Section 102(b)(2)):

By this route, as long as the employee waits for the vesting period to end (24 months), they will be taxed at a rate of 25% on the capital gain. If the employee does not wait for the vesting period to end in this route, the tax rate at the time of exercise will be according to the individual tax bracket they fall into. This way the company will not withhold any value from the options, whether the employee waits for the vesting period to end or not.

  • Advantages: Assuming the employee waits for the vesting period, the tax rate applied to the employee is lower than their individual tax bracket.
  • Disadvantages: The vesting period is longer, lasting 24 months, and the company cannot deduct expenses for granting the options to the employee. It should be noted that if employees believe there is a possibility that they will not wait for the vesting period to end, it is recommended not to choose this route. This is because the employee’s tax rate in the case of early exercise will be based on their individual tax bracket, and the company will not be able to deduct expenses for granting the options.
Allocation through a trustee in the employment income route (Section 102(b)(1)):

In the event that the company chooses this route, the employee will be subject to tax at the ordinary income tax rate upon the completion of the vesting period (12 months). In addition, National Insurance and additional tax will apply. The less the employee is willing to wait for the end of the vesting period to exercise the option, the more the employee will pay for the benefit at the higher tax rate between the grant date and the exercise date. In any case, the employee will have deductions for actual expenses incurred (payment to the trustee, additional cost for the option, etc.). For this purpose, exercising implies the early date between the grant of the option/share to the employee or the sale of the option/share by the trustee. From the company’s perspective, it is more beneficial to classify the value of granting the options to the employee as salary.

  • Advantages: The vesting period is short, lasting only 12 months, and the company can deduct the benefit value as employment income.
  • Disadvantages: The employee’s tax rate will be based on their individual tax bracket.
Allocation without a trustee for non-traded options (Section 102(c)(1)):

In this route, the company directly transfers the options or shares to the employee without using a trustee and without a vesting period. The benefit value will be subject to tax at the employee’s individual tax rate at the time of allocation. This is because the options or shares are considered clear substitutes for salary.

  • Advantages: In this case, there is no vesting period, and the company can deduct the allocation of options as salary expenses.
  • Disadvantages: In this option, the employee pays a tax at the moment of allocation based on their individual tax bracket.
Allocation through a trustee for options in a public company (Section 102(b)(3)):

According to this route, the benefit value must be calculated at the exercise date. When calculating an average net adjusted value from the benefit, a component of the value will be taxed at the marginal tax rate, and the remaining portion, if any, will be taxed at a rate of 25%. The net adjusted average value will be calculated as follows: the value of the shares at the grant date (calculated based on the average of the 30 days preceding the grant date). If the company is registered for trading within 90 days from the grant date, then the average of the first 30 trading days will be considered. The value should be adjusted for the exercise date (by multiplying it by the partial exercise index divided by the grant index). Any expenses incurred by the employee should be deducted from the presented value, adjusted to the exercise date. For the company, the expense will be recognized as the employee’s income under Section 2(1) or 2(2) as applicable, meaning, as the amount of the net adjusted average value from the benefit. The vesting period in this route is 24 months.

  • Advantages: On the one hand, it allows the allocation of the employee’s benefit to be partially recognized as capital gain, and on the other hand, it acknowledges a partial expense for the company.
  • Disadvantages: Both the expense for the company and the income for the employee are not fully recognized as capital gain. Additionally, there is a relatively long vesting period (24 months), and in cases where the option is exercised before the vesting period, the employee will be subject to marginal tax on the entire amount, while the company will not incur expenses beyond those allowed when the employee did not exercise the option before the vesting period.
Allocation through a trustee in the employment income route (Section 102(b)(1)):

This is applicable to private companies: for this route, if the company chooses it, the employee will be subject to tax at the end of the vesting period (12 months) at the marginal tax rate, in addition to National Insurance and supplementary tax. If the employee does not want to wait until the end of the vesting period to exercise the option, they will pay tax on the benefit value at a higher rate between the allocation date and the exercise date. In any case, the employee will also be subject to withholding for actual expenses incurred (payment to the trustee, additional cost for the option, etc.). For this purpose, exercising means the earliest date between transferring the option/stock to the employee or selling the option/stock by the trustee. From the company’s perspective, it is more favorable to recognize the value of the options as employment income.

  • Advantages: The vesting period is short, lasting only 12 months, and the company is allowed to recognize the value of the benefit as employment income.
  • Disadvantages: The tax rate applied to the employee will be according to their individual marginal tax rate.

Rules regarding the application of Section 102

All the regulations presented above do not apply to a substantial shareholder, even if the shareholder also acts as an employee of the company. In order for the allocation to be classified as “allocation of shares through a trustee,” as defined in Section 102 of the Ordinance, there is a requirement to deposit the beneficial owner’s shares in the hands of the trustee – both at the time of the allocation and up to 45 days thereafter. As mentioned, service providers cannot be included under Section 102, as it applies exclusively to employees and is subject to Section 3(t) of the Ordinance – taxation according to tax brackets. In Decision 1138/18, the Tax Authority clarified the essence and broadened the definition of the employer in Section 102 of the Ordinance. According to the Ordinance’s definition, the employer must be a company. In this decision, they treated partnerships as if they were companies. The Tax Authority confirmed that the allocation of options to partnership rights falls under the provisions of Section 102 of the Ordinance.

Termination of Employee Relationship – Employer and Tax Aspects of Employee Options

According to the Tax Authority, if a salaried employee becomes a shareholder and provides their services through the company, options cannot be granted under the provisions of Section 102 of the Ordinance. This is because the Tax Authority views this as a termination of the employee-employer relationship, and after such a change in employment status, the provisions of Section 3(t) of the Ordinance will apply.

In Taxation Decision 5236/14, a case of a company seeking approval from the Tax Authority for an allocation under the capital gains route to a former employee was discussed. This was because the additional allocation of options resulted from the company’s commitment to an allocation that was granted to the former employee during their employment with the company.

After legal discussions between the company and the former employee regarding their entitlement to options, the Tax Authority determined that the allocation of options to the former employee should be subject to Section 3(t) rather than Section 102. Therefore, the tax event will occur at the time of converting the options into company shares, and the former employee’s income will be classified as employment income.

This decision was made for the following reasons:
  1. Section 102 of the Ordinance applies to grants from an employer to an employee, and the examination of the employee-employer relationship is on the day of the grant of the options.
  2. The purpose of Section 102 is to strengthen the relationship between the employee and the company. It aims to encourage the employee to participate in the company’s success by granting them a share of the company’s capital, motivating them to promote the company. This purpose is not achieved when options are granted to a former employee who is not actively involved in the company’s activities. Additionally, Section 102 is not intended to serve as an alternative to retirement payments or retirement arrangements for employees, which are dealt with under Section 9(7) of the Ordinance.
  3. A legal commitment that arose while the employee-employer relationship was still in place but was not implemented in the form of option grants does not constitute an allocation for the purposes of Section 102 and must be accompanied by a deposit with a trustee.
  4. An employer who did not see fit to include its commitment to grant options to the employee during the employment period does not fulfill the provisions of Section 102 of the Ordinance, and at the same time, the employee cannot fall within the framework of Section 102 (unless approved by the company).
In cases where Section 102 can be applied despite the absence of formal employment relationships between the option recipient and the granting company, there are certain conditions to consider:
  • The option recipient can also be an employee of the company that grants the options if the company granting the options has control over the recipient company.
  • The option recipient can be an employee of a company that has control over the company granting the options.
  • Even in the absence of formal employment relationships, criteria based on labor law principles can be recognized as employee-employer relationships. These criteria may include tests such as the test of subordination and supervision, as well as the test of integration.
  • The option recipient can hold a position in the company that is not considered an employee (e.g., a director or CEO). However, the definition of an officeholder in the Income Tax Circular 3/03 has been narrowed to include only those who serve as directors, CEOs, or those directly subordinate to the CEO.

These conditions allow for the application of Section 102 in situations where there may not be formal employment relationships but where certain criteria or control relationships exist between the option recipient and the granting company.

From this, it can be inferred that individuals who meet the defined criteria, such as senior executives in a company who do not have formal employer-employee relationships, can independently provide management services (through invoicing) and still benefit from the favorable tax provisions offered by Section 102 of the Income Tax Ordinance.

In certain cases, the tax authority regards individuals who provide services under the guise of an officeholder as service providers in disguise of officeholders.

In many cases, service providers may prefer to avoid taxation according to the marginal tax rates set in Section 3(t) of the Income Tax Ordinance and may request to apply Section 102 instead. The tax authority takes into consideration situations of service providers operating under the guise of officeholders, and we must take this into account:

A service provider employed as an independent contractor (through invoicing) will not be eligible for the grant of options under Section 102 of the Income Tax Ordinance, unless all the mentioned conditions are met:
  • The individual is a director of the company
  • The individual is a permanent employee of the company who invests most of their effort and time in the company
  • The service provider is not an employee or partner in a consulting firm, law firm, etc.

In any tax-related process or inquiry, it is important to consult with a tax professional – contact us today!

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