As Israel celebrates 70 years of independence, it is good to note what makes the start-up nation innovative and successful. A recent OECD report attributes this success in large part to venture capital (VC) funds (A Portrait of Innovative Start-Ups Across Countries).  On March 14, the Israeli Tax Authority issued updated guidance on the tax breaks for VC funds and their cousin, private equity funds (Tax Circulars 9/2018 and 10/2018). But that is only part of the story. Below we briefly review the tax regime for individual and fund investment in Israeli industry.

Individual investment in Israel:

The Law for the Encouragement of Capital Investments, 1959, has been upgraded many times over the years to attract investors into the Israeli economy, especially foreign investors. Currently, preferred income derived by preferred industrial and tech enterprises is liable to company tax of 6% – 7.5% in development area A, 6% – 16% elsewhere in Israel, without time limit. Dividends are taxed at 4 %-20%. The resulting combined tax burden on distributed profits is 9.76% – 32.8% subject to any tax treaty.

By contrast, the, regular company tax rate is 23%. The regular dividend tax rate is 30%-33% for 10%-or-more shareholders, 25%-28% for other shareholders, resulting in a combined tax burden on distributed corporate profits of 42.25%-48.41%, subject to any tax treaty.

There are also tax breaks in the tax laws for: capital gains of foreign resident investors in Israeli shares and bonds, agriculture, approved rental buildings, oil and gas exploration and production, movie productions. R&D grants typically range up to 50% or 60% in a development area, and up to 100% financing in designated incubators.

Employees may enjoy a 25% tax rate on gains from employee option or share plans approved under Section 102 of the Income Tax Ordinance.

Investment in Israel via Funds:

Over the years, the Israeli Tax Authority (ITA) has granted upfront tax rulings to VC funds and private equity funds with foreign investors, based on Section 16A of the Income Tax Ordinance. This partly matches Israeli tax to foreign tax and provides tax efficiency with certainty.

VC funds invest in start-up by subscribing to shares allotted to them. Private equity funds invest in mature companies in a range of fields mainly by buying their shares (i.e. from sellers).

Qualifying activities for VC and private equity fund investments include production, agriculture, tourism, transport, water, energy, tech, communications, construction (not real estate), computerization, security, medicine, software, biotech, nanotech, R&D in these, but not other services, trade or finance unless specially approved, nor real estate.

Fund Taxation:

In the case of VC funds which invest in qualifying investments (at least 75% in alotted shares), the fund and investors may enjoy an exemption from Israeli tax capital gains, dividends and interest, but only to the extent of their foreign investors and certain pension fund investors.  Management fees are taxable. The companies must be Israeli or Israel-related.

In the case of private equity funds, the fund may and investors may enjoy an exemption from Israeli tax on capital gains (not dividends or interest), to the extent of their foreign investors and certain pension fund investors. Dividends accruing to such investors who are individuals may pay a 15% tax rate. Regular Israeli rates would apply to dividends accruing to companies and interest and management fees accruing to any investor, subject to any treaty.

Israeli investors generally pay regular Israeli taxes. Israeli investee companies may get the above preferred enterprise tax breaks if they meet the conditions.

A bunch of additional conditions apply to VC funds and private equity funds including the following: at least 10 investors; no investor to hold more than 20% of the fund rights except one with up to 35%; limited partners must generally stay out of management of the fund; minimum 30% foreign investors; at least $10 million in the fund of which at least $5 million from foreign investors; at least $6 million is invested in qualifying investments which are Israeli companies that own intellectual property or their parent company OR at least 50% is invested in qualifying investments including 30% in Israeli companies that own intellectual property or their parent company; no more than 25% of the fund invested in any company; no more than 20% of the fund in a publicly traded company at the time of the investment; no investments in securities or deposits except out of investors’ money.

If not all the conditions are met, adjusted tax rulings are possible.

Fund Managers:

As for fund managers, an IVA Arrangement of April 6, 2003 between the Israeli Venture Association and the ITA may apply. Ordinary fees for services performed in Israel are taxed in Israel. As for success fees (“carried interest”), the tax rate may now be limited to 25% for Israeli resident individuals (not companies) on the foreign investors’ share in the fund, 15% for foreign residents from Israeli investments and 0% for foreign residents from foreign investments.

Comments:

The VAT treatment of funds and fund managers is still challenging. But all in all, the Israeli economy is set for another 70 years of sustained development. Happy Independence Day!

As always, consult experienced tax advisors in each country at an early stage in specific cases.

The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.
.