Taxation of venture capital and private equity funds

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

1. 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.
2. 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.
3. 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.

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