What is an “Employing Company”

Company stock options

Company stock options have become a popular incentive for employees in the high tech and other fields in recent years. Employees receive options from the employing companies that can be exercised gradually in order to keep the employees in the company for the long term.

Section 102

Section 102 of the Income Tax Ordinance includes several routes, with the capital gain route being the most common and preferred route – taxation at a rate of 25%- as long as there is full compliance with the conditions of Section 102 of the Ordinance, including holding by a trustee for two years prior to the realisation of the shares.

However, section 102 applies to “Employing company” as defined in that section only! So that an employee employed by a company that does not meet this definition will not be able to benefit from the capital gain route specified in section 102 of the ordinance.

The definition of an employing company includes the following options:

(1) An employer who is a company resident in Israel or a company resident abroad that has a permanent establishment or a research/development center in Israel, if the manager (i.e., the professional department in the administration of the Tax Authority) has approved it;

(2) A company which has control over the employer or which the employer has control over the company;

(3) A company in which that person has control over the employer;

That is, if the employer is not Israeli, it is necessary that there will be at least a related company incorporated in Israel – a parent company /subsidiary company/ sister company, or at least a fixed place of business in Israel, while the latter option is subject to the approval of the tax authority. In cases where these conditions are not met, it is possible to try to submit a Track Ruling application to the Tax Authority, as long as there are significant considerations in favor of the applicability of Section 102 of the Ordinance.

It will also be noted that the definition of an employer does not include a partnership, but it is specifically stated that the employer must be a company. In the income tax decree (types of partnerships that must be considered as a company) it is established that a partnership for oil exploration and production, as well as a research and development partnership, will be considered a company.

The term permanent establishment or fixed place of business does not have a definition in the decree, but it is defined in the convention for the prevention of international double taxation and appears in taxation decisions. Below, examples will be detailed.

Taxation Decision 253/12 “Existence of a Permanent Establishment for a Foreign Company Employing an Individual Employee from Israel – Taxation Decision in the Agreement”

The taxation decision dealt with a foreign company that provides services abroad, which has no clients in Israel. The company entered into an employment agreement with an employee resident in Israel (hereinafter: the “employee”). The company employed the same employee as an investment portfolio manager. The employee’s role includes, among the permit, managing investment portfolios in one of the company’s teams, developing and implementing the team’s strategy, monitoring portfolios that are at risk of a decrease in value, and more. The independence of the Israeli worker is limited, and among other things, the trading strategy and the implementation of her ideas must be approved by the team leader.

The foreign company requested to approve the method of taxing the foreign company’s profits arising from the employee’s activities in Israel. It was determined that the employee’s work would create a permanent establishment for the company in accordance with the provisions of Section 5(1) of the treaty for the Prevention of Double Taxation between Israel and the United States. That is, it was decided for a company whose majority of its activities, employees and customers are in a foreign country, that one employee who works from Israel establishes a permanent establishment in Israel.

Article 5(1) of the tax treaty between Israel and the United States

Section 5(1) of the aforementioned treaty defines the term “permanent establishment” as a fixed place of business through which a resident of one of the contracting states engages in industrial or commercial activity.

Below are listed several options that will be considered a “fixed place of business”, and among them, a branch, an office, a factory, a warehouse and so on. However, it is noted that the options that will be included under the definition of “permanent place of business” will not amount to what is specified in the treaty itself. An exception was also established according to which a permanent place of business used only for the purpose of storage or goods and so forth will not be considered a permanent establishment.

The OECD Model Tax Convention

The OECD Model Tax Convention is a model for countries concluding bilateral tax conventions, and plays a crucial role in removing Tax related barriers to cross border trade and investment. It is the basis for negotiation and application of bilateral tax treaties between countries, designed to assist by providing means for setting on a uniform basis that most common problems that arise in the field of international double taxation. Most of Israel’s tax treaties are based on this model.

The OECD model convention defined “permanent establishment” as one of the following two alternatives:

1. The business activity in the country of origin is carried out through a fixed place of business available to the foreign corporation.
2. The business activity in the country of origin is carried out through the activity of a dependent agent, who has the authority to enter into contracts on behalf of the foreign corporation.

According to interpretation of the OECD Model Tax Convention, three cumulative conditions must be fulfilled in order for the activity to be considered a “permanent establishment:

1. The existence of a physical place of business;
2. Permanence of the physical place of business;
3. Managing the business of the foreign corporation through the permanent place of business.

In conclusion, for the purposes of the applicability of section 102 of the Ordinance, it is necessary for the employing company to meet the definition of “employing company” stated in this section, that is, to be a company and not a partnership (with the exception of the detailed above) and also to be a related company in Israel or a permanent establishment in Israel. We listed examples regarding the cases that are considered a permanent establishment and found that in some cases even one employee can establish the existence of a permanent establishment.

For additional information on obstacles and limitations to the applicability of Section 102 of the Israel Tax Ordinance, and possible solutions proposed and implemented by our office, you should contact our office for initial consultation.