Innovation Authority Warns About Judicial Uncertainty

In the hitech world, you are only as good as your last few start-ups. So if 80% of them are being set up outside of Israel, the Israeli economy may be on borrowed time…..

The Israel Innovation Authority has published a Position Paper (“Concern About Disintegration of Israeli Hitech Due To World Developments And Possible Directions of Action, of April 30, 2023) commenting on challenges to the Israeli hitech sector. The challenges range from inflation to the Ukraine war to….uncertainty in the Israeli judicial system. The Position Paper is couched in diplomatic language but it sounds loud warning bells about “uncertainty” stemming from the judicial reform proposals.

About the Innovation Authority:

The Innovation Authority (“the Authority”) used to be called the Office of the Chief Scientist. The Authority is famous for helping to fund R&D projects for a diverse range of Israeli businesses. These include first-time entrepreneurs, young startups, growth companies, industrial corporations, and others.

R&D grants typically range up to 50% and up to 100% financing in designated incubators. Companies operating in a development area may receive additional grants of up to 10% – 25% . Funding ranges up to 75% in the minority, Ultra Orthodox and female sectors.

The Innovation Authority is responsible for formulating, integrating, and implementing Israel’s innovation policy to stimulate economic growth.

What the Position Paper Says:

Investments in Israeli hitech amounted to around $1.7 bn in the first quarter of 2023, the lowest since 2019. And hitech stocks on the Tel-Aviv Stock Exchange have been static since the beginning of the year while the NASDAQ top 100 are up around 20%. Why?

According to the Authority, “Quarter 1 of 2023 was characterized by accelerated processes to make changes in the structure of the judicial system and the relationship between the three authorities in the State of Israel [presumably the legislature, executive and judicial authorities]. The expectation of these changes has created very high uncertainty about the status of the judicial authority, having regard to both civil and business aspects, which go together, and consequently, uncertainty too about the stability of institutional governance in Israel. Instability generates the impression of uncertainty and reduces the viability of investments in Israel at present. In the light of these things, there is significant concern that Israel will soon be cut off from world capital flow trends and its share of venture capital may decrease.”

Incorporations Abroad:

The Authority points out that start-up founders must choose between: (1) forming (incorporating) an Israeli company, and (2) forming a foreign company with an Israeli R&D subsidiary in which case the IP (intellectual property) is usually abroad as well.

Before 2023, most start-ups were formed in Israel. In February, because of the uncertainty and risks to the Israeli business environment and entrepreneurs, the trend changed and the default case in the first quarter of 2023 is now to form start-up companies abroad. The Authority estimates 50%-80% of start-ups were set up abroad by Israeli entrepreneurs in the first quarter of 2023. The Authority expects the “absolute majority” of start-up companies will very shortly be set up abroad – above 80%.

Expected consequences:

The Authority finds the trend to form companies abroad troubling because of its potential future impact on Israeli economic growth, employment, productivity and tax revenues. Hitech is a prime contributor to Israeli growth – around 25% of Israeli business output. Incorporating abroad may rapidly affect the location of: IP and resulting corporate tax payments, CEOs, financial and other services, marketing, operations and production. Leading international economic bodies and rating agencies have surveyed the judicial proposals.  In addition, the Authority says an Israeli Treasury simulation in a separate Position Paper estimates that: “the influence of increased risk for investment in Israel resulting from judicial changes may lead to a loss of output of 1.6%-4.6% (out of 8.2% growth in 2021) and a decrease of around 8%-25% in employment levels in hitech”. All this may set Israel back many years.

Innovation Authority Recommendations:

The Authority says that uncertainty must be reduced by solving the political-judicial crisis, sooner rather than later. Also, the “Angels Law” giving tax breaks to investors should be renewed and incentives should be updated for IP registered in Israel.

Deja Vu?

Twenty years ago, exactly the same thing happened, for tax reasons. Back in 2003, Israel taxed investors and VC funds at 50% on M&A “exit” gains, so it became standard practice to incorporate US parent corporations with Israeli R&D subsidiaries. Consequently, marketing activity, exit gains and taxes thereon all accrued to the US and the Israeli economy crashed. The Israeli government was forced to obtain $9 billion in US loan guarantees and abandon 50% tax on exit gains.

History is now repeating itself. The Innovation Authority’s Position Paper should be heeded….

Additional Comment on “flips”:

The above discussion relates to new start-ups. If shareholders want to “flip” an existing Israeli company or its IP into a foreign company, that will generally trigger immediate Israeli capital gains tax (CGT). Israeli reorganization rules do not allow any transfer abroad to be tax deferred unless the ITA allow it, which is unlikely to be forthcoming. The ITA also claim that transferring abroad a going concern (functions, assets, risks) amounts to a taxable sale. Specialist advice is highly recommended.

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Next Steps:

Please contact us to discuss any of the above matters further, or any other matter.

(c) Leon Harris 28.5.23

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