Hi-Tech And Startup Taxation | נמרוד ירון ושות׳

Taxation of venture capital and private equity funds

Adam Zur — Thu, 11 Dec 2025 08:44:40 +0000

In the investment world, there are two principal types of funds operating in the private investment sector: Venture Capital funds and Private Equity funds. Both play a significant role in company growth and economic development. However, they differ in their investments and the stage at which they enter.

The purpose of this article is to explain in a simple, clear, and practical manner how these funds are taxed in Israel. The article outlines the conditions for obtaining tax exemptions for foreign investors. It also highlights the key differences between the two types of funds.

What is a Venture Capital Fund?

A Venture Capital fund is a private investment vehicle that invests in early-stage, high-risk ventures. It primarily focuses on startups with substantial growth potential. A significant portion of the capital used to invest in these companies is raised by foreign and institutional investors.

Beyond capital investment, Venture Capital funds provide professional guidance and strategic advisory services. This is facilitated through their extensive connections across various fields.

In return for their investment, the funds receive equity and sometimes future options. This enables them to benefit from the company’s future success.

Venture Capital funds are a central factor in the technology sector. They contribute to advancing companies that develop innovative products and services. These have the potential to transform existing industries and create entirely new markets.

In Israel, technological development is substantial across various fields such as fintech, cybersecurity, and more. Consequently, numerous startups enter the market seeking growth and future profitability. These companies often raise capital from various investors, including Venture Capital funds.

Tax Arrangement under Section 16(a) of the Income Tax Ordinance – Tax Exemption for Foreign Investors

As noted, a large portion of investors in Venture Capital funds are foreign investors. Therefore, a tax arrangement provides a tax exemption for non-Israeli foreign residents. This exemption is granted under Section 16(a) of the Income Tax Ordinance. It applies only if the fund and foreign investors meet the conditions established by the Israel Tax Authority.

For a fund to benefit from the above tax arrangement, it must satisfy several cumulative conditions detailed in Income Tax Circular 9/2018.

It is important to clarify that the exemption under this circular applies to certain types of income. It does not require that all fund activities be included in the arrangement. Therefore, a fund with mixed income may be exempt on certain income types. Other income will be subject to tax according to Israeli tax laws.

Conditions for Obtaining the Tax Arrangement for a Venture Capital Fund under Circular 9/2018

Number of Investors – The fund must have at least ten investors. They must not be related to each other or part of the general partner. This requirement applies throughout the fund’s entire life.
Investor Distribution – Investors in the fund shall not hold more than 20% of the fund’s equity interests. However, one of the investors may hold up to 35% of the fund’s equity interests. This applies throughout the fund’s entire life.
Investor Composition – Eligible types of investors in the fund are:

Foreign resident investors.
Israeli resident institutional investors – institutional investors exempt from tax under Section 9(2) of the Ordinance.
Israeli resident investors – individuals and/or Israeli resident companies. The tax arrangement does not apply to such investors. It is worth noting that approvals for this tax arrangement apply only when foreign investors exceed 30% of the total investor composition.

4. Investment Commitment Volume – The fund’s investment commitments and actual investments shall not be less than $10 million. At least $5 million of total investments must originate from foreign investors.

5. Investment Diversification – The fund must invest no more than 25% of the total investor financing in a single company.

6. Types of Investments – The fund must invest in qualifying investments. Qualifying investments are investments in Israeli companies, Israeli resident companies, or companies connected to Israel. The connection means their main activity involves establishing or expanding industry and enterprises in Israel. This also includes research and development in various fields such as manufacturing, transportation, agriculture, tourism, water, energy, technology, communications, computing, security, medicine, biotechnology, and nanotechnology. Qualifying activity expressly excludes real estate activity in Israel.

For this purpose, a company connected to Israel is a foreign company whose main assets and/or activity are located in Israel. Nevertheless, no more than 20% of the fund’s total investment amount may be invested in Israeli companies that were publicly traded on the investment date.

7. Minimum Volume of Qualifying Investments in Israel – The fund must invest a minimum amount in qualifying investments. The investments must comply with one of the following alternatives, whichever is lower:

- At least $10 million, with at least $6 million 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% invested in Israeli resident companies and/or foreign companies holding Israeli resident companies.

8. Separation between Limited Partners and General Partner – Only the general partner may engage in fund management. Limited partners in the fund cannot take an active part in managing the fund or identifying investments. Additionally, limited partners shall not have voting rights in the fund’s investment committee.

As mentioned, these conditions are cumulative. The fund must meet each one of these conditions to receive the relevant tax arrangements under Section 16(a) of the Ordinance and enjoy tax exemption.

According to the above circular, and subject to meeting the detailed conditions, income from realizing qualifying investments will be tax-exempt. This applies to the portion attributable to foreign and institutional investors. For this purpose, income from Venture Capital investments includes capital gains, dividends, and interest.

What is a Private Equity Fund?

Private Equity funds are structured as private limited partnerships. They have a structure similar to Venture Capital funds. It should be emphasized that unlike Venture Capital funds that invest in startups in their early stages, Private Equity funds focus on more established companies. These typically already generate profits. Additionally, in Private Equity funds, investment is usually made through acquiring equity in the target company.

Conditions for Obtaining the Tax Arrangement for a Private Equity Fund under Circular 10/2018

The tax arrangement under Section 16(a) of the Ordinance may also apply to Private Equity investment funds. The conditions are similar to those published in the circular regarding Venture Capital funds, with the necessary adjustments. For this purpose, the Israel Tax Authority published a separate circular for these funds – Circular 10/2018.

Subject to meeting the eight conditions detailed above, income from realizing qualifying investments will also be tax-exempt in Private Equity funds. This applies to the portion attributable to foreign and institutional investors. However, unlike Venture Capital funds, income from dividends and interest is generally not included as tax-exempt income. The relevant laws apply to such income. Dividend income is taxed at 15% for individuals. For non-individual investors, the applicable rate is the corporate tax rate under the Ordinance or the lower rate under a relevant tax treaty. Interest income will also be taxed at the rate prescribed by law.

To conclude, the arrangements established in the Israel Tax Authority circulars (9/2018 and 10/2018) allow tax exemption for foreign and institutional investors. This applies to Venture Capital and Private Equity funds in Israel, subject to meeting cumulative conditions.

Strict compliance with these conditions enables funds to enjoy substantial tax advantages, while maintaining transparency and compliance with Israeli law.

Therefore, every investment fund and foreign investor is advised to seek professional tax advice before making investments in Israel. This ensures full compliance with legal requirements and maximizes existing benefits.

Our firm has extensive experience accompanying some of the largest Venture Capital and Private Equity funds in Israel. We have successfully obtained tax exemptions for foreign investors. Additionally, our firm assists with similar processes, such as capital raising and adding investors. For bespoke professional advice, please contact our Tax Department.

Questions and Answers

What is the main difference between a Venture Capital fund and a Private Equity fund?

Comprehensive Reform of Taxation in Israel’s High-Tech Sector – Changes to Corporate and Employee Taxation

Adam Zur — Thu, 04 Dec 2025 15:02:17 +0000

The Tax Authority’s Effort to Reduce Tax Uncertainty in Israel’s High-Tech Industry

On Sunday, November 2, 2025, the Ministry of Finance announced a comprehensive reform of taxation for the high-tech sector at a press conference. The reform was initiated jointly by the Ministry of Finance, the Israel Tax Authority (ITA), and the Israel Innovation Authority. Its main goal is to provide certainty for individuals and companies operating in the industry.

The reform addresses three areas: venture capital funds, high-tech companies and industry employees. This article focuses on the expected changes for companies and employees. To read about the changes related to venture capital fund taxation, click here.

The high-tech industry is Israel’s main growth engine. The authorities and the Ministry of Finance aim to preserve and enhance Israel’s attractiveness for these companies. The reform includes legislative changes and clarifications, as well as new ITA procedures. Some have already been published, while others are expected soon.

Changes in Corporate Taxation for High-Tech Companies

The changes in corporate taxation relate to two main areas. Mergers and acquisitions, and the operation of R&D centers in Israel.

Mergers and Acquisitions

Many acquisitions are carried out by merging the acquired company into the acquiring company’s corporate structure. Under Amendment 279 to the Tax Ordinance, published in early 2025, several relaxations were introduced to the conditions for executing tax-exempt mergers. The required size ratio between the acquiring and acquired companies was changed from 1:9 to 1:19, allowing the acquisition of smaller companies.

In addition, the portion of the transaction that shareholders can receive in cash increased from 40% to 49%. Shareholders may also sell the acquiring company’s shares immediately, without a waiting period of several years.

The ITA Commissioner stated that since the change took place, many companies have submitted merger applications under the new framework.

R&D Centers

Many companies operate in Israel through R&D centers. An R&D center is a company primarily engaged in providing research and development services to its foreign parent company (or another foreign group company). The payment received by the R&D center is based on a cost-plus method, meaning the payment equals its expenses plus a fixed profit margin. For example, if a 5% margin is set and relevant expenses are 100, the R&D center will receive 105 and retain a profit of 5.

In recent years, it has been argued that R&D centers generate a much greater share of the group’s profits than currently recognized. As a result, tax assessors have been reviewing whether the pricing method properly reflects their contribution. If the assessor determines that it does not, an assessment may be issued.

Such assessments increase the amount attributed to the Israeli R&D center. Either by setting higher profit margins or by shifting to a profit-split method, dividing the parent company’s profits between it and the R&D center. These changes increase the R&D center’s profits and its tax liability in Israel.

These discussions have created uncertainty among multinational companies operating in Israel. These companies operated under the assumption that they knew their expected tax liability. Tax assessments can now significantly alter that expectation. This uncertainty has raised concerns about continuing to operate in Israel, a situation the government seeks to avoid.

To address this, the ITA published a circular in February 2025, followed by the final version published on November 2^nd. The main points of the circular (subject to its conditions) are:

If a tax assessor wishes to issue an assessment to a company meeting the circular’s conditions, approval will be required from the Professional Division, the Deputy Commissioner for Planning and Economics, the ITA’s Professional Advisor, and the ITA Commissioner. The specific approvals depend on the case.
IP Exit from Israel- foreign companies acquiring Israeli firms often wish to transfer their intellectual property (IP) out of Israel. This raises valuation disputes. Under the circular, the ITA determines that, subject to compliance with its terms, the IP value will be up to 85% of the transaction value (less costs and additional payments). This eliminates claims of inflated valuations such as 120%. The company must apply to the Professional Division for approval and certainty. The division will confirm that, by the end of the seventh tax year following the transaction closing, the profit attribution method for R&D activity will remain cost-plus.
Private Tax Ruling- a company may request a ruling confirming that its R&D service pricing is at arm’s length. An Israeli company providing R&D services to a non-Israeli related party may apply to the Professional Division for approval.
Advance Pricing Agreements (APA)- if the foreign party is resident in a country with which Israel has a double taxation treaty, the Israeli company may request a bilateral or multilateral APA regarding its transfer pricing policy.

In his speech, the ITA Commissioner elaborated on the circular and clarified several issues. He explained that since rulings often take a long time, a time limit was introduced to encourage taxpayers to use this route. The ITA must respond within 180 days; if no response is provided by then, the company’s position will be automatically accepted.

The Commissioner also addressed additional topics:

Marketing Intangible under the Law for the Encouragement of Capital Investment– a tax assessor wishing to address marketing intangible issues under this law must obtain approval from the Professional Division Manager.
Pillar 2- in July 2024, the Ministry of Finance announced that starting in 2026, Israel will implement a global minimum corporate tax rate of 15%. The ITA is currently preparing clarifications on how this will affect industry companies.
The QSBS Issue under President Trump’s Tax Reform- the ITA will publish its position on this matter in the coming weeks.

Taxation of Israeli High-Tech Employees Returning to Israel

It is common in the high-tech industry for employees to relocate abroad for several years. In most cases, these employees hold stock options that may begin vesting while they are outside Israel. Currently, when they exercise the options after returning to Israel, they are taxed on the full amount, without considering the period spent abroad.

Accordingly, they are taxed at their marginal rate upon exercise (since these are not options under the capital gains track of Section 102 of the ITA). This situation has led many Israelis to delay their return until after exercising their options. To encourage Israelis to return sooner, the reform introduces significant changes. It offers two options to ease the tax burden:

Request to split the profit period between Israel and abroad, so that the portion vested abroad is not taxed in Israel.
Change the options track from employment income to capital gains, significantly reducing the tax liability.

Note: This does not apply to new immigrants or veteran returning residents, but only to Israelis who spent a few years abroad.

The tax reform introduces extensive changes to the taxation of the high-tech sector and demonstrates Israel’s commitment to the industry’s growth. It also reflects the government’s desire to attract and encourage investment in Israel and Israeli companies.

Nimrod Yaron & Co.- Israeli and International Taxation advises funds, high-tech companies, investors, and employees in the high-tech sector on tax planning tailored to their specific circumstances. To contact a representative from our firm, click here.

FAQ

When will the reform take effect?

Comprehensive Reform of Taxation in Israel’s High-Tech Sector – Changes to the Taxation of Venture Capital Funds

Adam Zur — Thu, 04 Dec 2025 14:33:51 +0000

The Tax Authority’s Attempt to Combat Tax Uncertainty in Israel’s High-Tech

On November 2, 2025, the Ministry of Finance, together with the Tax Authority and the Innovation Authority, announced a comprehensive reform of taxation. The reform aims to provide certainty and preserve and improve Israel’s competitiveness for the high-tech industry. The reform addresses three dimensions, venture capital funds, high-tech companies, and industry employees. This article focuses on the expected changes in venture capital fund taxation. To read about the expected changes for companies and industry employees, click here.

The high-tech industry is a central growth engine in Israel. Venture capital funds are the main investors in the industry. The funds enable young, high-risk companies to raise capital and continue expanding their operations. Therefore, to maintain industry growth, it is important to encourage and facilitate venture capital fund activity in Israel.

Venture capital funds entered Israel in the 1990s. Despite their presence in Israel, they had no certainty regarding their taxation. Thus, fund investors, including foreign investors seeking this certainty, had to approach the Tax Authority. The approach is through rulings- an expensive and lengthy process.

For the first time, as part of the reform of taxation and to encourage investment in Israel, the taxation of venture capital funds is being regulated. This is through new legislation and regulations expected to be published by the end of 2025. The changes address the taxation of the General Partner (GP) and the Limited Partner (LP).

Changes in General Partner (GP) Taxation in Venture Capital Funds

The General Partner in a venture capital fund is essentially the partner managing the fund. The new reform distinguishes between an Israeli resident General Partner and a foreign resident General Partner.

Until now, the taxation of carried interest for an Israeli resident General Partner depended on the identity and composition of investors. The tax ranged from 25% to 50%. The more exempt/foreign investors, the lower the taxation. This created a preference for foreign capital over local capital.

To correct this, under the reform, carried interest taxation will not depend on investor identity. It will stand at 27%. Additionally, carried interest will be classified as income from personal exertion. This means the surtax rate applied will be the lower rate, which stands at 3% for 2025. Furthermore, VAT on carried interest has been canceled.

It is very common for investors to require skin in the game from the General Partner. This means they also invest alongside them, typically in single-digit percentages. Without a ruling, this investment was taxed at full marginal tax. The presented change is to treat profits from this skin in the game (if invested up to 10%) as capital gains taxed at 10%.

A foreign resident GP was taxed at 15% on carried interest. This tax has been reduced to 10%. VAT on carried interest for the foreign resident GP will also be canceled. Skin in the game will also be considered capital gains for them. According to Section 97(b3), will be exempt from tax in Israel.

Changes in Limited Partner (LP) Taxation in Venture Capital Funds

Limited Partners in a venture capital fund are passive investors. The reform distinguishes between an Israeli resident Limited Partner and a foreign Limited Partner.

Passive investments by an Israeli resident Limited Partner, without a ruling, were taxed as business income. Under the reform, if the investment is in an Israeli resident technology company, regardless of the investment method (through a fund, directly, etc.), the profit will be taxed as capital gains.

A foreign resident LP sometimes faced claims of permanent establishment and classification of activity as active. Under the reform, like an Israeli LP, the profit will be viewed as capital gains. It will be exempt from tax in Israel.

Comparison of Tax Rates Before and After the Reform

Partner Type	Current Status	Change Under Reform	Notes
Israeli GP	Carried interest tax- 25% – 50% (depending on investor identity) + VAT Skin in the game- marginal tax	Carried interest- 27% + VAT cancellation Skin in the game- capital gains tax	The reform establishes a fixed tax rate regardless of investor origin
Foreign GP	Carried interest- 15% + VAT	Carried interest- 10% + VAT cancellation Skin in the game- exempt from tax in Israel
Israeli LP	Taxation as business income	Capital gains tax- 10%	Relevant only to investments in Israeli technology companies
Foreign LP	Discussions about permanent establishment/reclassification of activity as active	Defining profit as capital gains- exempt from tax in Israel	Relevant only to investments in Israeli technology companies

*The numbers presented in this table refer to situations where no ruling was obtained.

For further reading on current venture capital fund taxation, click here.

The tax reform presents extensive changes in high-tech industry taxation. It demonstrates the State of Israel’s commitment to high-tech industry growth. It also shows the desire to attract and encourage investments in Israel and Israeli companies. Its significant advantage is the certainty it provides. Under the reform, there will be no need to apply for a lengthy and expensive ruling. Instead, they will know directly what the relevant taxation is.

Nimrod Yaron & Co. – Israeli and International Taxation, accompanies companies, funds, investors, and employees in the high-tech industry. We provide comprehensive solutions to their relevant tax issues. To contact a representative from our firm, click here.

FAQ

When will the reform take effect?

Taxation of Stock Options for Non-Residents Who Became Israeli Residents – Israel Tax Authority Position for 2025

Adam Zur — Tue, 25 Nov 2025 13:22:47 +0000

Income Tax Circular 9/2025- Taxation of Employee Stock Options for Non-Residents Who Became Israeli Residents

In November 2025, the Israel Tax Authority Published the Income Tax Circular 9/2025. It addresses taxation of options for non-residents who became Israeli residents. Stock options are very common compensation for employees in Israel and abroad. Taxation of Israeli options is regulated in the Income Tax Ordinance (the Ordinance) However, taxation of foreign options that vested when an individual became an Israeli resident was not regulated.

This issue created uncertainty among many taxpayers. The Tax Authority published the circular to clarify its position. The circular addresses issues such as income classification and application of Section 102.

Taxation of Stock Options in Israel

Taxation of equity compensation for employees is anchored in Sections 102 and 3(9) of the Ordinance.

Section 102 regulates share allocation by an employment company. The section provides several alternatives for defining an employment company. These include an Israeli resident company and a non-resident company with a permanent establishment or development center in Israel approved by the Director of the Israeli Tax Authority. The section allows the company to report options through the capital track. In this track, income from exercising options is classified as capital gain and taxed at capital gains tax rates.

Options granted by companies not meeting the employment company conditions are taxed under Section 3(9). Under this section, income from exercising these options is classified as employment income and taxed at marginal rates. Income recognition timing is determined by work location during the vesting period. The income is divided among countries where the employee worked during this period, proportional to workdays in each country.

For further reading on employee stock option taxation, click here.

Key Differences Between Section 102 and Section 3(9) of the Ordinance

Subject	Section 102 Capital Track Through Trustee	Section 3(9)
Option Grantor	Employment company	A company that is not an employment company
Tax Event Date	Option exercise date	Earlier conversion of right to shares or sale of option
Income Classification	Capital gain	Employment income
Tax	Capital gain tax	Marginal tax

*Information in this table is updated for 2025.

Restricted Stock Units (RSUs)

Another equity compensation employees sometimes receive is Restricted Stock Units (RSUs). Under this compensation, the company commits to provide the employee a certain number of shares based on predefined conditions. At vesting, shares are issued, usually without active action by the employee. The tax event date for RSUs is the issuance date.

Treatment of RSUs under Section 102 and Section 3(9) is identical to options. An individual who received RSUs where the restriction period and share issuance began as a non-resident will pay tax in Israel upon actual sale. This income is classified as capital gain under Part E of the Ordinance.

Key Points of Circular 9/2025- Taxation of Income from Exercising Foreign Options

The circular addresses taxation of exercising foreign options by Israeli residents. These are options granted to an individual as a non-resident by an employer that is not an employment company. This exercise is classified as employment income of an Israeli resident taxable in Israel. The circular distinguishes between a returning resident, a veteran returning resident, and a new immigrant.

Returning Resident

A returning resident is someone who stayed outside Israel for between 6 and 10 years. A returning resident can spread the income under Section 3(9)(2) over up to six years. Their income is taxed as if given in equal annual installments during the spreading period. Income spread over a period when the individual was a non-resident is considered income generated outside Israel by a foreign resident and is exempt from Israeli tax. The remaining income is taxable in Israel. Credit can be obtained for foreign tax paid.

Veteran Returning Resident / New Immigrant

The circular distinguishes between situations where vesting ended as a non-resident versus as an Israeli resident. If vesting ended as a non-resident, all income from exercising options is considered foreign income and is exempt from Israeli tax. If vesting ended after becoming an Israeli resident, the income is divided according to workdays in Israel. Part of the gain is taxed in Israel. The rate equals workdays in Israel from return until vesting completion, divided by the total vesting period. The remaining gain is considered income generated abroad and is exempt from Israeli tax.

Application of Section 102 of the Ordinance

Instead of the tax track detailed above, the company can request the Tax Authority to change the tax track to the Section 102 capital track through a trustee. Income from exercising options after the track change is taxed under Section 102. If options were deposited with the trustee within 30 days, the application date is considered the option allocation date. Options not vested at allocation are taxed under Section 102. Cancellation of vested Section 3(9) options and allocation of Section 102 options constitutes a tax event for the company and employees. These options are taxed under Section 102.

Example of Applying the Circular – Returning Resident

An individual left Israel on January 1, 2017, and returned on January 1, 2024. This person is considered a returning resident, having been outside Israel for seven years. The individual received options from a foreign employer (not meeting the employment company definition) on January 1, 2021, which vested on January 1, 2023. The individual exercised the options on December 31, 2024, after returning to Israel. Income from this exercise was one million ₪, on which they paid foreign tax of 200,000₪

The company is not an employment company, so Section 3(9) applies. The option exercise date is the tax event date. The section allows spreading income from the grant date to the exercise date, proportional to workdays in each country. Three quarters of the period the individual was abroad. Therefore, three quarters of the income (750,000₪) is considered income generated outside Israel and is exempt from Israeli tax. The remaining income (250,000₪) is considered income generated in Israel by an Israeli resident and is taxed accordingly.

Foreign tax credit applies only for the period when options are considered Israeli income. Therefore, only one quarter of the tax paid is credited.

In Summary, Circular 9/2025 provides guidance on the taxation of foreign options exercised by Israeli residents. It details income classification, foreign tax credit, and more. The Tax Authority thus provides certainty on this matter for many taxpayers. Publication of this circular joins a recent trend of tax changes for new immigrants and returning residents.

Given all the changes implemented and expected, it is recommended to consult with a tax expert to maximize tax benefits and prevent double taxation. Nimrod Yaron & Co. – Israeli and International Taxation specializes in comprehensive tax advice for individuals making Aliyah or returning to Israel, including stock option matters. To contact a representative from our firm, click here.

FAQ

What is the taxation on the sale of options by an Israeli resident that were exercised as a non-resident?

The Holdback Mechanism

Adam Zur — Mon, 05 May 2025 12:24:25 +0000

When a company, typically a startup, is acquired, the buyers can implement several mechanisms aimed at strengthening the relationship between founders/key employees among themselves, between them and the companies, or between them and the investors/buyers. One of these mechanisms is the Holdback mechanism, which has become increasingly common in recent years.

The mechanism delays part of the consideration for founders/key employees and conditions it on their continued employment in the acquired company or another company in the group. This is done with the intention of maximizing the value gained from the acquisition.

In June 2017, the Israel Tax Authority published Income Tax Circular 5/2017 – Retention Mechanisms and Restrictions on Founders and Key Employees (Circular 5/2017). Among other things, the circular addresses the Tax Authority’s position regarding the taxation of consideration given under the Holdback mechanism.

What is the Holdback Mechanism?

The Holdback mechanism allows the acquirer of a company to condition part of the consideration on the fulfillment of a certain condition. For our purposes, the relevant condition is the continued employment of the founders or key employees in the acquired company or another company in the group.

The mechanism stipulates that all or part of the consideration for the shares of the founders or key employees is not paid to them immediately. Instead, it is deposited in trust or held by the acquirer for a specific period of time set under the Holdback conditions.

The consideration can be paid in one installment or in several installments, subject to meeting the condition of continued employment. There are cases where the consideration will be paid even if the founders or key employees do not continue their employment – death, disability, dismissal for certain reasons, or resignation for justified reasons.

Let’s look at a numerical example for illustration. Suppose a startup was acquired for 10 million NIS. The founder holds 20% of the shares, meaning they are entitled to a consideration of two million NIS. The Holdback mechanism could stipulate, for example, that half of the amount will be paid immediately, and the rest will be deposited in trust and paid to the founder in two equal installments provided they continue to be employed by the company.

The Haim Lehman v. Tel Aviv 4 Tax Assessor Case

The court case 47255-01-14 Haim Lehman v. Tel Aviv 4 Tax Assessor (hereinafter: the ruling) dealt with the taxation of consideration received by founders (who held key positions in the company) as part of an acquisition transaction. More specifically, the ruling addressed the classification of income (ordinary/capital) received by those key personnel as part of the acquisition of XIV Ltd. by IBM.

The consideration received by the key personnel for their shares can be divided into two parts. First, they received an amount according to the number of shares they held at the share price in the acquisition transaction. Additionally, they received additional consideration, which was given only to key personnel and paid over a period of three years. The additional consideration was subject to their continued employment in the company for the agreed period.

The court’s determination was that regarding the additional consideration, it constitutes employment income under section 2(2) of the Income Tax Ordinance. This is because it is a benefit received by key personnel within the framework of employer-employee relations. The court did not distinguish between the different types of consideration, and from this it can be understood that the entire amount is employment income.

Income Tax Circular 5/2017 – Retention Mechanisms and Restrictions on Founders and Key Employees

Circular 5/2017 was published in June 2017 and addresses two main topics – the Tax Authority’s position on the taxation of two mechanisms, the Reverse Vesting mechanism and the Holdback mechanism. In this article, we will focus on the Tax Authority’s position on the taxation of consideration under the Holdback mechanism.

To read about the Reverse Vesting mechanism and the Tax Authority’s position on the taxation of consideration under it, click here.

According to Circular 5/2017, consideration up to the share price will be taxed as capital gains. This is subject to the condition that the profit from these shares, if they had been sold before the mechanism was established, would have been taxed as capital gains, in which case tax will be paid at a rate of 25% – 30%. This is different from a situation where the consideration is classified as ordinary income, which is subject to marginal tax that can reach 50%.

Type of Consideration	Taxation According to Circular 5/2017	Taxation Without Meeting the Circular’s Conditions
Consideration up to the share price	Capital gains tax (25%-30%)	Marginal tax (up to 50%)
Consideration above the share price	Marginal tax (up to 50%)	Marginal tax (up to 50%)

Let’s return to the previous example. Recall that the consideration due to the founder for holding 20% of the company’s shares is 2 million NIS. In this case, all the consideration is at the share price and therefore all of it will be taxed as capital gains. Given that the founder is a substantial shareholder (holds over 10% in each of the means of control), the tax rate they are subject to is 30%. The amount of tax the founder will pay is 600,000 NIS, and the amount that will remain in their pocket is 1.4 million NIS.

Let’s assume a slightly different situation. The consideration due to the founder is still 2 million NIS. However, the value according to the share price is only 1.5 million NIS, meaning 500,000 NIS is considered consideration above the share price. Let’s assume that the founder’s marginal tax rate is 50%.

Now we can calculate the amount of tax and the amount that will remain in their pocket. We will distinguish between the consideration up to the share price and the consideration above the share price.

For the consideration up to the share price, tax will be paid at a rate of 30% – that is, 450,000 NIS.

For the consideration above the share price, tax will be paid at a rate of 50% – that is, 250,000 NIS.

The total tax to be paid amounts to 700,000 NIS, and the amount that will remain in the founder’s pocket is 1.3 million NIS.

If all of the founder’s consideration does not meet the conditions of the circular, tax will be paid at a rate of 50% on all of it, meaning 1 million NIS, and the amount that will remain in the founder’s pocket is only 1 million NIS.

These examples illustrate the gaps resulting from the classification of income, whether ordinary or capital.

Circular 5/2017 details several conditions that, if all are met, the consideration in part of the Holdback mechanism will be classified for the shares and taxed as capital gains, and they are:

Type of shares – The shares of the founders or key employees are ordinary shares, classified as an equity instrument and not as a liability. And they are not preferred shares, deferred shares, management shares, or redeemable shares. The rights that these shares confer are identical to the rights conferred by the rest of the shares of the same type. The rights include the right to dividends, voting rights, and the right to participate in the company’s assets in the event of the company’s liquidation. And the profit under these shares, if they had been sold before the Holdback mechanism was established, would have been subject to capital gains tax.
Duration of share ownership – At the time of signing the transaction agreement, the shares were held by the founders or key employees for a period of not less than 12 months.
These shares were sold as part of a transaction for the sale of all rights in the company.
As part of the transaction, the percentage of rights of the founders and key employees subject to the Holdback mechanism does not exceed 50% of all the rights they hold.
The additional consideration does not constitute additional compensation, but is part of the consideration for the shares of the acquired company derived from the company value agreed upon by the parties.
Continued employment – The founders or key employees sign a new employment agreement, continue under the same employment agreement or a revised employment agreement, and continue to work in the acquired company or another company in the group. The salary they will receive under the agreement is a reasonable salary that is not less than the salary they received before the transaction.
The consideration under the Holdback mechanism is recorded in the tax reports of the acquiring company as payment for the shares and not as salary payment. And it does not claim an expense in Israel for the consideration.

If the consideration paid to the founders or key employees exceeds the share price to which the other shareholders are entitled, the difference will be classified as employment income that will be subject to tax according to section 2(2) of the Income Tax Ordinance.

The provisions in Circular 5/2017 refer to situations where none of the following apply:

The acquiring company and the acquired company or its shareholders meet the definition of a relative in section 88 of the Income Tax Ordinance.
The acquired company was tax transparent at any stage since its establishment.
At the time of the transaction, the majority of the allocated capital in the company is held by relatives as defined in section 88 of the Income Tax Ordinance.
The Tax Authority has previously granted any of the company, founders, or key employees a tax ruling related to the shares discussed under the circular.

The Nimrod Yaron & Co. firm has extensive experience in accompanying merger and acquisition transactions, optimal tax planning, and implementation of Holdback mechanisms. When buying or selling shares, it is important to consult with a tax expert to ensure optimal tax payment considering the circumstances of the case. To contact a representative from our firm, click here.

Questions and Answers

What is the Holdback mechanism?

Continuation in the Exchange of Options

Adam Zur — Tue, 04 Jun 2024 07:59:03 +0000

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:

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.
The acquiring company allocated shares to all transferors of equal value.
All shares and rights to shares in the transferring company were transferred to the acquiring company.
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.
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.

Additional articles on Tax planning for Start-up and High-Tech:

Taxation of venture capital and private equity funds

Comprehensive Reform of Taxation in Israel’s High-Tech Sector – Changes to Corporate and Employee Taxation

Comprehensive Reform of Taxation in Israel’s High-Tech Sector – Changes to the Taxation of Venture Capital Funds

Taxation of Stock Options for Non-Residents Who Became Israeli Residents – Israel Tax Authority Position for 2025

The Holdback Mechanism

Continuation in the Exchange of Options

Taxation of RSUs – Restricted Stock Units

Adam Zur — Wed, 08 May 2024 09:09:18 +0000

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:

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.
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:

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.
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.

Additional articles on Tax planning for Start-up and High-Tech:

Taxation of venture capital and private equity funds

Comprehensive Reform of Taxation in Israel’s High-Tech Sector – Changes to Corporate and Employee Taxation

Comprehensive Reform of Taxation in Israel’s High-Tech Sector – Changes to the Taxation of Venture Capital Funds

Taxation of Stock Options for Non-Residents Who Became Israeli Residents – Israel Tax Authority Position for 2025

The Holdback Mechanism

Continuation in the Exchange of Options

Options for controlling shareholders and for self-employed

Adam Zur — Wed, 24 Apr 2024 15:06:28 +0000

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:

Firstly, we examine whether it is possible to qualify for the capital gains track of Section 102, considering various interpretations.
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.