Taxation of venture capital and private equity funds

A Venture Capital (VC) fund is typically organized as a private partnership, investing in ventures and businesses with high risk, often in startups at the beginning of their journey that have relatively high growth potential. This investment is made with the expectation of future returns.

Venture capital funds provide not only financial investment but also offer guidance and advice to companies, utilizing their extensive connections across various fields. In exchange for their investment, the funds are allocated shares, sometimes at a specific discount, and/or future options. It’s important to note that a significant portion of the capital used by these funds for investment is raised from foreign investors and institutional bodies.

Venture capital funds play a central role in the technology sector, supporting companies engaged in the development of new products and services that have the potential to revolutionize existing industries and even create entirely new markets.

In Israel, there’s significant technological development in various fields such as fintech, cybersecurity, and more, leading many startups to enter the market in hopes of growing and generating future profits. Often, these companies raise capital from various investors, including venture capital funds.

Tax Arrangement Under Section 16(A) – Exemption for Foreign Residents

As mentioned, a large portion of investors in venture capital funds are foreign investors, and therefore, they may be subject to the tax arrangement under Section 16(A) of the Income Tax Ordinance, provided they meet the conditions set by the Tax Authority for this tax arrangement. This arrangement generally allows for a tax exemption for a foreign resident who is not an Israeli resident.

In order for a fund to benefit from the above tax arrangement, it must meet several cumulative conditions detailed in Income Tax Circular No. 9/2018.

It is important to clarify that this exemption, as per the circular, applies to certain types of income of a venture capital fund, and does not necessarily mean that all of the fund’s activities are included in the arrangement. Therefore, a fund with mixed income might be exempt from tax on certain types of income, while other types might be taxable according to Israeli tax laws.

The conditions for a venture capital fund to qualify for the tax arrangement under Circular 9/2018 are as follows:

1. Number of Investors: The fund must have at least ten investors who are not related to each other and are not part of the general partner, throughout the fund’s life.
2. Investor Dispersion: No investor can hold more than 20% of the fund’s rights, except for one investor who may hold up to 35%, throughout the fund’s life.
3. Types of Investors: The possible types of investors in the fund are:
   • Foreign resident investors
   • Israeli institutional investors exempt from tax under Section 9(2) of the ordinance
   • Israeli resident investors, including individuals and/or companies. It should be noted that the tax arrangement does not apply to these investors.

Moreover, the tax arrangement certifications apply only when the proportion of foreign investors in the fund exceeds 30% of the total investor composition.

4. Investment Commitments: The fund’s investment commitments and actual investments must not be less than $10 million, with at least $5 million of the total investments coming from foreign investors.
5. Investment Distribution: The fund must not invest more than 25% of the total funding from investors in any single company.
6. Types of Investments: The fund must invest in qualifying investments. Qualifying investments include investments in Israeli companies, companies’ resident in Israel, or companies related to Israel by virtue of their primary activity being the establishment or expansion of industry and factories in Israel, as well as research and development in various fields such as manufacturing, transportation, agriculture, tourism, water, energy, technology, communications, computing, security, medicine, biotechnology, and nanotechnology. Qualifying activity does not include real estate activities in Israel. For this purpose, a company related to Israel is a foreign company whose main assets and/or activities are located in Israel. Despite the above, no more than 20% of the fund’s total investment amount can be invested in Israeli companies that were publicly traded on the day of the investment.
7. Minimum Number of Qualifying Investments in Israel: The fund must invest a minimum amount in qualifying investments, based on the lower of the following alternatives:
   • At least $10 million, with at least $6 million of that 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% of the investment funds in Israeli resident companies and/or foreign companies holding Israeli resident companies.
8. Separation between Limited Partners and the General Partner: Only the general partner is authorized to manage the fund, and the limited partners in the fund cannot take an active part in managing the fund or in identifying investments for the fund. Furthermore, the limited partners will not have voting rights in the fund’s investment committee.

These conditions are cumulative, meaning the fund must meet all of them to qualify for the relevant tax arrangements under Section 16(A) of the ordinance and enjoy a tax exemption. According to the circular, and upon meeting these specified conditions, the revenues from the realization of qualifying investments will be exempt from tax for the foreign and institutional investors involved. For this matter, revenues from venture capital investments include income from shares, interest, and dividends.

Private Equity Fund

Private equity funds, which are private investment funds (private equity), are typically structured as private partnerships and have a structure similar to that of venture capital funds. It is important to highlight that, unlike venture capital funds, which focus on investing in early-stage companies with high growth potential, private equity funds primarily target more established companies that are often already generating profits. Additionally, private equity funds usually make investments by acquiring shares in the target company.

Tax Arrangement for Private Equity Funds According to Circular 10/2018

The tax arrangement, as mentioned under Section 16(A) of the ordinance, may also apply to private equity investment funds, under conditions similar to those outlined for venture capital funds, with necessary modifications. To address this, the Tax Authority issued a separate circular for these funds – Circular 10/2018.

If the eight detailed conditions previously mentioned are met, the revenues from the realization of qualifying investments will also be exempt from tax for private equity funds, specifically for the foreign and institutional investors involved. However, it should be clarified that, unlike Circular 9/2018, revenues from dividends and interest, as a general rule, are not included as tax-exempt income and are subject to the relevant tax laws – the tax rate for income from dividends will be 15% for individuals, and the corporate tax rate according to the ordinance will apply to investors who are not individuals or as per the lowest rate in applicable tax treaties. Interest income will also be taxed according to the rate established by law.

Our office assists investors and accompanies venture capital and private equity funds among the largest in Israel. Our office also supports similar processes such as capital raising, adding investors, and more. For further information, please contact us.