The Strategic Need for Restructuring and the Tax Solution
The modern business world is dynamic and competitive. Companies are required to demonstrate flexibility and continuous adaptability to changing realities, whether that involves rapid growth, entering new markets, or dealing with operational challenges. In many cases, the existing legal and corporate structure, which served the company well in its early years, becomes a limitation that slows its development. This is where the strategic need to implement a restructuring comes into play.
The business rationale for restructuring is broad and can stem from countless reasons:
- Capital raising and bringing in investors – new investors, and particularly venture capital funds, often require a “clean” and simple holding structure.
- Preparation for an initial public offering (IPO) or exit – Creating an efficient corporate structure that is attractive to the capital markets or to a potential acquirer.
- Splitting activities – Separating activities with different characteristics (for example, real estate activity from high-tech activity) for managerial focus, efficient allocation of resources, or risk management.
- Merging synergistic activities – Joining forces with another company to achieve economies of scale, expand market share, or reduce costs.
- Operational and management considerations – Streamlining the holding structure, simplifying processes, and aligning with the updated business strategy.
However, any transfer of an asset from one company to another, or from a shareholder to a company, constitutes a “sale” under the general tax rules and is therefore taxable. This is a tax event. Without a special arrangement, even a restructuring carried out for purely business reasons and without any real “economic realization” would have required the companies involved to pay capital gains tax or betterment tax, sometimes in significant amounts. Such a tax liability would have made most restructurings economically unviable, thereby harming economic efficiency and the growth of the economy.
This is where Part E2 of the Income Tax Ordinance comes into the picture, forming the heart of Israel’s restructuring regime. The rationale behind it is simple yet powerful: to recognize that a restructuring carried out for legitimate business reasons, and that does not involve any real economic realization of profits, should not be treated as a tax event. Instead, the law allows for a tax deferral, not a tax exemption. The tax on the gain accrued in the transferred assets is not cancelled. Rather, it is deferred to a future date, when the assets or the shares received in consideration are sold to a third party.
The purpose of this article is to serve as a comprehensive guide to understanding the options, conditions, and implications of using the key sections in Part E2 of the Ordinance. It is also intended to highlight the paths available to entrepreneurs, managers, and business owners who are considering strategic reorganization.
The article aims to present a practical and clear picture, combine actionable points, and highlight key planning issues – especially where the transaction is combined with capital raising, the entry of investors, an exit, or an offering.
Common mistakes to be aware of in advance
- Mixing consideration – Receiving consideration that is not shares only (including cash, rights, or other benefits) where “shares only” is required may disqualify the tax deferral.
- Timing of steps – Taking material actions during the restriction period (for example, capital raising, equity changes/allocations, or merger and sale transactions) without advance planning may lead to a breach of the holding conditions or the asset holding requirement.
- Unsupported valuation – Lack of a valuation basis for the asset or the shares (and sometimes also the absence of an opinion/valuation report in appropriate cases) may create disputes with the Israel Tax Authority (ITA) and impair compliance with the “value ratio” requirement.
- Breach of the “asset holding” condition – Selling, transferring, or materially changing the transferred asset during the restriction period, where the absorbing company is required to hold the asset, may lead to cancellation of the tax deferral.
The common and key alternatives for carrying out a restructuring with tax deferral
Transfer of an asset by an individual or a company in exchange for an allotment of shares (Section 104A of the Ordinance)
This route, which is a cornerstone of restructuring law, allows an asset owner (an individual or a company) to transfer the asset to a company (the absorbing company) and receive shares only in return, without the transfer being classified as a taxable “sale” at that time.
Cumulative conditions for applying for the section:
- Transfer of all rights – The transferor is required to transfer all of its rights in the asset to the absorbing company.
- Consideration in shares only – The sole consideration granted to the transferor for the asset is an allotment of shares in the absorbing company. Receiving any additional consideration, such as cash or other rights, disqualifies the application of the arrangement.
- Value ratio – The market value of the shares allotted to the transferor must be equal to the market value of the transferred asset.
- Minimum holding percentage after the transfer – Immediately after the transfer, the transferor must hold at least 90% of each of the rights in the absorbing company (right to shares, profits, appointment of directors, voting, and the like).
- Restriction period – For two years from the date of transfer, the transferor must continue to hold at least 25% of each of the rights in the absorbing company. In addition, the absorbing company must hold the transferred asset for the entire same period. Breach of these conditions may lead to retroactive cancellation of the tax deferral.
Common examples of breaching the restriction period conditions:
- Significant dilution of the transferor(s)’ holding(s) in the absorbing company during the restriction period (for example, due to share allotments/a financing round), in a manner that falls below the required holding threshold.
- Sale of the transferred asset by the absorbing company within the period during which it is required to hold the asset.
- An additional restructuring or an additional transfer affecting the holding conditions or the identity of the holders, without prior review of the implications under Part E2.
Transfer of a jointly held asset by several owners (Section 104B(a) of the Ordinance)
This section expands the principle of Section 104A and allows multiple owners of a jointly held asset (including a registered or unregistered partnership) to transfer it jointly to an absorbing company, in exchange for shares.
Cumulative conditions for applying for the section:
- Transfer of all rights in the joint asset – All owners are required to transfer all of their rights in the asset.
- Consideration in shares only and value ratio – Similar to Section 104A, the only consideration is shares, and the value of the shares allotted to each transferor must be equal to the value of its portion in the asset.
- Preservation of the holding ratios – The holding ratio of each of the transferors in the rights of the absorbing company, immediately after the transfer, will be identical to its holding ratio in the joint asset prior to the transfer.
- Restriction period – Similar to Section 104A, a two-year cooling-off period applies, during which the transferors must hold, in aggregate, at least 25% of the company’s rights, and the company is required to hold the asset.
*Expansion: Transfer of jointly held shares (Section 104B(g)(1) of the Ordinance)
This section provides a solution where a number of shareholders in a particular company (for example, a holding company) wish to transfer their shares to an absorbing company. Shares are not a classic “joint asset”, since each shareholder has separate ownership over its block of shares. Section 104B(g)(1) provides that, for the purpose of restructuring, the shareholders will be viewed as if they hold a joint asset. This enables them to carry out the transfer under Section 104B(a) and benefit from a tax deferral.
Transfer of an asset between sister companies (Section 104B(v) of the Ordinance)
This route allows an asset to be transferred between two (or more) companies that are commonly owned by the same shareholders in the same holding percentages (a sister companies structure), with no consideration at all. The purpose of the section is to allow internal reorganization of assets within a group, for business reasons, without creating a tax charge.
Cumulative conditions for applying the section:
- Identical ownership – The rights holders in the transferring company and in the receiving company, and their holding percentages, must be identical.
- Restriction period – For two years from the date of transfer, the holding percentage of the original shareholders, both in the transferring company and in the receiving company, will not fall below 25%.
Tax implications in restructurings – deferral, not exemption
It is important to emphasize that restructuring under these sections does not grant a full exemption from tax, but rather a deferral of tax. The meaning of the deferral is as follows:
- Betterment tax and capital gains tax – The tax event is deferred. The absorbing company “steps into the shoes” of the transferor. The acquisition date and the original cost of the asset as they were in the hands of the transferor “carry over” to the absorbing company. The tax will be paid only when the absorbing company sells the asset to a third party. Similarly, for the transferor, the original cost of the transferred asset becomes the value of the shares it received as of the transfer date.
- Purchase tax – In the case of a transfer of a right in real estate, despite the deferral of betterment tax, a purchase tax liability may apply at a reduced rate of 0.5% of the value of the transferred right, subject to the requirements of the law, the circumstances of the transfer, and the classification of the asset.
In practice, “tax deferral” means that the tax is not cancelled but deferred. The tax base, the acquisition date, and the original cost “continue” with the asset or with the shares. Therefore, future actions relating to the asset or the holding structure (as relevant) are the ones that may trigger tax liability.
In summary, the provisions of Part E2 of the Ordinance provide essential and flexible tools for reorganizing corporate structures. However, these are complex arrangements that include substantive conditions and restriction periods. Breaching them may lead to retroactive tax charges. Accordingly, carrying out a restructuring requires careful planning and professional legal and tax support.
How do you move forward the right way?
Restructurings under Section 104 can be an effective tool for achieving business objectives, but they require a precise fit with the right route and careful planning of conditions, valuation, and timelines – especially when the transaction is combined with fundraising, the entry of investors, an exit, or an offering.
At Nimrod Yaron & Co., we combine accumulated experience from senior roles at the Israel Tax Authority (ITA), alongside professional work at Big 4 firms and law offices, with practical representation of private and public companies, Israeli and foreign, and global venture capital funds. The firm maintains extensive relationships with accounting firms and law offices in Israel and worldwide, and a team that helps our clients receive a comprehensive tax framework – at eye level, with personal service and the availability of a boutique firm.
FAQ
What is the treatment of an involuntary sale during the restriction period?
The law provides that a sale that is not dependent on one’s will, such as expropriation proceedings or compulsory liquidation, will not be considered a breach of the restriction period condition and will not impair the tax deferral granted.
Is an exchange of assets under other sections of the Ordinance considered a "sale"?
An exchange of assets under Section 96 of the Ordinance is not considered a “sale” for purposes of breaching the asset holding condition during the cooling-off period.
Can an investor be introduced or can a financing round be carried out during the restriction period?
The entry of an investor or raising capital during the restriction period may affect the holding percentages required under the relevant route, and in certain cases may be considered a breach of the arrangement conditions.
