The Holdback Mechanism

When a company, typically a startup, is acquired, the buyers can implement several mechanisms aimed at strengthening the relationship between founders/key employees among themselves, between them and the companies, or between them and the investors/buyers. One of these mechanisms is the Holdback mechanism, which has become increasingly common in recent years.

The mechanism delays part of the consideration for founders/key employees and conditions it on their continued employment in the acquired company or another company in the group. This is done with the intention of maximizing the value gained from the acquisition.

In June 2017, the Israel Tax Authority published Income Tax Circular 5/2017 – Retention Mechanisms and Restrictions on Founders and Key Employees (Circular 5/2017). Among other things, the circular addresses the Tax Authority’s position regarding the taxation of consideration given under the Holdback mechanism.

What is the Holdback Mechanism?

The Holdback mechanism allows the acquirer of a company to condition part of the consideration on the fulfillment of a certain condition. For our purposes, the relevant condition is the continued employment of the founders or key employees in the acquired company or another company in the group.

The mechanism stipulates that all or part of the consideration for the shares of the founders or key employees is not paid to them immediately. Instead, it is deposited in trust or held by the acquirer for a specific period of time set under the Holdback conditions.

The consideration can be paid in one installment or in several installments, subject to meeting the condition of continued employment. There are cases where the consideration will be paid even if the founders or key employees do not continue their employment – death, disability, dismissal for certain reasons, or resignation for justified reasons.

Let’s look at a numerical example for illustration. Suppose a startup was acquired for 10 million NIS. The founder holds 20% of the shares, meaning they are entitled to a consideration of two million NIS. The Holdback mechanism could stipulate, for example, that half of the amount will be paid immediately, and the rest will be deposited in trust and paid to the founder in two equal installments provided they continue to be employed by the company.

The Haim Lehman v. Tel Aviv 4 Tax Assessor Case

The court case 47255-01-14 Haim Lehman v. Tel Aviv 4 Tax Assessor (hereinafter: the ruling) dealt with the taxation of consideration received by founders (who held key positions in the company) as part of an acquisition transaction. More specifically, the ruling addressed the classification of income (ordinary/capital) received by those key personnel as part of the acquisition of XIV Ltd. by IBM.

The consideration received by the key personnel for their shares can be divided into two parts. First, they received an amount according to the number of shares they held at the share price in the acquisition transaction. Additionally, they received additional consideration, which was given only to key personnel and paid over a period of three years. The additional consideration was subject to their continued employment in the company for the agreed period.

The court’s determination was that regarding the additional consideration, it constitutes employment income under section 2(2) of the Income Tax Ordinance. This is because it is a benefit received by key personnel within the framework of employer-employee relations. The court did not distinguish between the different types of consideration, and from this it can be understood that the entire amount is employment income.

Income Tax Circular 5/2017 – Retention Mechanisms and Restrictions on Founders and Key Employees

Circular 5/2017 was published in June 2017 and addresses two main topics – the Tax Authority’s position on the taxation of two mechanisms, the Reverse Vesting mechanism and the Holdback mechanism. In this article, we will focus on the Tax Authority’s position on the taxation of consideration under the Holdback mechanism.

To read about the Reverse Vesting mechanism and the Tax Authority’s position on the taxation of consideration under it, click here.

According to Circular 5/2017, consideration up to the share price will be taxed as capital gains. This is subject to the condition that the profit from these shares, if they had been sold before the mechanism was established, would have been taxed as capital gains, in which case tax will be paid at a rate of 25% – 30%. This is different from a situation where the consideration is classified as ordinary income, which is subject to marginal tax that can reach 50%.

Let’s return to the previous example. Recall that the consideration due to the founder for holding 20% of the company’s shares is 2 million NIS. In this case, all the consideration is at the share price and therefore all of it will be taxed as capital gains. Given that the founder is a substantial shareholder (holds over 10% in each of the means of control), the tax rate they are subject to is 30%. The amount of tax the founder will pay is 600,000 NIS, and the amount that will remain in their pocket is 1.4 million NIS.

Let’s assume a slightly different situation. The consideration due to the founder is still 2 million NIS. However, the value according to the share price is only 1.5 million NIS, meaning 500,000 NIS is considered consideration above the share price. Let’s assume that the founder’s marginal tax rate is 50%.

Now we can calculate the amount of tax and the amount that will remain in their pocket. We will distinguish between the consideration up to the share price and the consideration above the share price.

For the consideration up to the share price, tax will be paid at a rate of 30% – that is, 450,000 NIS.

For the consideration above the share price, tax will be paid at a rate of 50% – that is, 250,000 NIS.

The total tax to be paid amounts to 700,000 NIS, and the amount that will remain in the founder’s pocket is 1.3 million NIS.

If all of the founder’s consideration does not meet the conditions of the circular, tax will be paid at a rate of 50% on all of it, meaning 1 million NIS, and the amount that will remain in the founder’s pocket is only 1 million NIS.

These examples illustrate the gaps resulting from the classification of income, whether ordinary or capital.

Circular 5/2017 details several conditions that, if all are met, the consideration in part of the Holdback mechanism will be classified for the shares and taxed as capital gains, and they are:

1. Type of shares – The shares of the founders or key employees are ordinary shares, classified as an equity instrument and not as a liability. And they are not preferred shares, deferred shares, management shares, or redeemable shares. The rights that these shares confer are identical to the rights conferred by the rest of the shares of the same type. The rights include the right to dividends, voting rights, and the right to participate in the company’s assets in the event of the company’s liquidation. And the profit under these shares, if they had been sold before the Holdback mechanism was established, would have been subject to capital gains tax.
2. Duration of share ownership – At the time of signing the transaction agreement, the shares were held by the founders or key employees for a period of not less than 12 months.
3. These shares were sold as part of a transaction for the sale of all rights in the company.
4. As part of the transaction, the percentage of rights of the founders and key employees subject to the Holdback mechanism does not exceed 50% of all the rights they hold.
5. The additional consideration does not constitute additional compensation, but is part of the consideration for the shares of the acquired company derived from the company value agreed upon by the parties.
6. Continued employment – The founders or key employees sign a new employment agreement, continue under the same employment agreement or a revised employment agreement, and continue to work in the acquired company or another company in the group. The salary they will receive under the agreement is a reasonable salary that is not less than the salary they received before the transaction.
7. The consideration under the Holdback mechanism is recorded in the tax reports of the acquiring company as payment for the shares and not as salary payment. And it does not claim an expense in Israel for the consideration.

If the consideration paid to the founders or key employees exceeds the share price to which the other shareholders are entitled, the difference will be classified as employment income that will be subject to tax according to section 2(2) of the Income Tax Ordinance.

The provisions in Circular 5/2017 refer to situations where none of the following apply:

1. The acquiring company and the acquired company or its shareholders meet the definition of a relative in section 88 of the Income Tax Ordinance.
2. The acquired company was tax transparent at any stage since its establishment.
3. At the time of the transaction, the majority of the allocated capital in the company is held by relatives as defined in section 88 of the Income Tax Ordinance.
4. The Tax Authority has previously granted any of the company, founders, or key employees a tax ruling related to the shares discussed under the circular.

The Nimrod Yaron & Co. firm has extensive experience in accompanying merger and acquisition transactions, optimal tax planning, and implementation of Holdback mechanisms. When buying or selling shares, it is important to consult with a tax expert to ensure optimal tax payment considering the circumstances of the case. To contact a representative from our firm, click here.

Questions and Answers