Continuation in the Exchange of Options

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.

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