Employee Options Under Section 102

The grant of options and shares to employees is one of the main compensation tools used by technology companies, growth companies, and international groups. The purpose of this type of compensation is clear: to benefit from the favorable tax regime under Section 102 of the Israeli Income Tax Ordinance, and in particular from the capital gains track, which, subject to meeting the required conditions, may result in tax at a rate of only 25% and a deferral of the tax event until the date of exercise.

In practice, however, not every grant of options automatically falls within Section 102. A deviation from even one condition – the identity of the granting company, the status of the recipient, the holding structure, the use of a trustee, the timing of reporting, or the manner in which the plan is structured – may materially change the tax outcome.

What Is Section 102?

Section 102 regulates the taxation of grants of shares or rights to acquire shares to employees and office holders. In the appropriate structure, and subject to compliance with the requirements of the section, it is possible to benefit from tax deferral and, in some cases, from a preferred capital gains track. The section distinguishes between grants made through a trustee and grants made without a trustee, and between the employment income track and the capital gains track.

Under the capital gains track, where all conditions are met, the income at the time of exercise may be subject to tax at a rate of 25%. By contrast, where the conditions are not met, or where the grant does not fall within the framework of Section 102, the result may be taxation as employment income or business income at marginal tax rates, and sometimes also a tax event at an earlier date.

Key Conditions for the Application of Section 102

To benefit from the Section 102 regime, the following questions should be examined, among others:

• Is the company a “employing company” as defined in the section? For example, if an employee in Israel receives options from a foreign company that does not have the appropriate connection to Israel as required by law, Section 102 may not apply at all.
• Was the grant made through an approved trustee, where this is the relevant track?
• Were the plan and the trustee approved as required?
• Was the relevant holding period maintained? For example, an employee who exercises the shares before the end of the required period may not be able to benefit from the capital gains track.
• Is the recipient of the grant an “employee” or office holder, and not a controlling shareholder? For example, a person who holds a controlling interest in the company, or who will become a controlling shareholder as a result of the grant, is generally not eligible for the Section 102 track.
• Is the grant of a share or a right to acquire a share structured in a manner consistent with the section?
• Are there special circumstances, such as listing for trading, termination of tax residency, or cross-border employment relationships?

Common Pitfalls – and Their Implications

The granting company is not an “employing company” for purposes of Section 102

One common pitfall arises when an employee in Israel receives options from a foreign company, but there is no corporate structure or Israeli foundation that allows the company to fall within the definition of an “employing company” under the section. Section 102 applies to an Israeli resident company, and, in certain circumstances, also to a foreign resident company that has a permanent establishment or research and development center in Israel, if this has been approved.

Where the foreign company does not meet these conditions, it may not be possible to benefit from the Section 102 track at all. In such cases, it is necessary to examine whether another tax arrangement applies. Sometimes the implication is a less favorable tax treatment, whether under Section 3(i), as ordinary employment income, or otherwise, depending on the facts and the structure of the grant.

The recipient of the grant is not an “employee” for purposes of the section

The section applies to an employee, including an office holder, but not to a controlling shareholder. Therefore, where the recipient of the grant holds, or is expected to hold as a result of the grant, an interest that amounts to control under the law, the Section 102 track may no longer be available.

Even where a person provides services to the company but is not employed by it as an employee, it is important to examine carefully whether that person can be regarded as an “employee” for purposes of the section. In practice, the definition does not always align with how the parties describe the relationship.

An independent service provider instead of an employee

In many cases, companies work with consultants, freelancers, or service providers who issue invoices, and wish to grant options to them as well.

Where there is no employment relationship for legal purposes, such a grant will generally not benefit from the Section 102 track. On the other hand, there are cases in which a substantive examination of the circumstances of the engagement may support a different conclusion. This is an area where it is especially important to conduct a specific analysis before the grant is made, and not after the fact.

Incorrect use of a trustee or failure to comply with procedural requirements

Even where all the right parties are in place, implementation errors may compromise the track. For example: incomplete reporting, an application that was not filed on time, a plan that was not drafted properly, improper deposit with a trustee, or exercise before the end of the period.

Exercising too early

Under the capital gains track, one of the requirements is that the shares be held by a trustee until the end of the statutory period. Exercising before the end of the period may deny the benefit of the capital gains track and result in taxation as employment income.

What Happens if Section 102 Does Not Apply?

Where the grant does not meet the conditions of Section 102, this does not necessarily mean that the grant is invalid. Rather, the tax outcome may be different. In appropriate cases, the income may be taxed as employment income, business income, or under other mechanisms set out in the Ordinance, including in circumstances where Section 3(i) applies. The question of whether the option is tradable, when the benefit arose, and the economic nature of the grant may also be relevant.

In simple terms: not every option granted to an employee is “102”, and not everything that is not “102” is taxed in the same way. The precise classification depends on the facts.

Why Is It Important to Review This in Advance?

Because correcting errors after the fact is more difficult, more expensive, and sometimes simply impossible. An error in classification, in the definition of the offeree, in the trustee arrangement, in the timing of the notification, or in the structure of the grant may affect not only the tax rate, but also reporting, withholding tax, the company’s expenses, employment relationships, agreements with employees, and even investment transactions or exits.

Therefore, in any significant grant – and certainly where a foreign company, employees in Israel, service providers, substantial shareholders, founders, or changes in the group structure are involved – it is advisable to pause and examine in advance whether Section 102 indeed applies, which track applies, and what is required in order to preserve the desired outcome.

Nimrod Yaron & Co. specializes in Israeli and international taxation. Our team is composed of professionals with years of experience at the Israel Tax Authority, together with experience at leading firms and law offices, bringing a combination of legal and economic perspective. We advise private and public companies, Israeli and foreign companies, global venture capital funds, and clients seeking focused advice in clear and practical language. We also work with a professional network of accounting firms and law firms around the world, in order to provide comprehensive support in cross-border matters.

If you are considering an option plan, granting rights to employees or office holders, operating in an international structure, or seeking to ensure that the grant indeed meets the conditions of Section 102, it is important to obtain tailored advice in advance, before the grant or exercise.