The Israeli Tax Authority (ITA) has issued a draft circular that would improve the tax position of founders and key personnel of companies, especially in hitech, who agree to limitations, namely reverse resting shares or a holdback of exit consideration.

Typically, the continued work of these people for a minimum period is important to investors or purchasers.

The question is whether any gain is taxable as salary (up to 50% tax) or as capital gain (25%-32%).

When IBM acquired XIV and paid key personnel extra consideration for their shares above what other investors got, the District Court ruled the extra was taxable as salary (Haim Helman Vs. Tel-Aviv 4 Assessing officer, Tax Appeal 47255-01 of Oct 15, 2015).

The ITA draft Circular says there was no clear distinction in the judgment between the extra consideration and the main consideration, leaving open the question whether it was all taxable as salary.

Reverse Vesting Shares:

These are shares which are subject to limitations that are lifted gradually or in one go. According to the draft circular, capital gains tax treatment may be possible if:

–          The reverse vesting mechanism is fixed in advance in the incorporation documents, or shortly thereafter (in a shareholders’ agreement) and/or following a material investment in the company of at least 5% of its capital after the share issue;

–          If the founders do forfeit their shares (typically upon resignation, but not death, disability or other justifiable leaving), the company or other investors acquire the shares without consideration or at par value , as pre-agreed;

–          The shares are classified as ordinary (common) shares with full dividend and voting rights, not as liabilities, preferred shares, deferred shares, founders shares or redeemable shares (unless for no consideration or at par value);

–          If the shares were sold before the reverse vesting was put in place, they would qualify for capital gains tax treatment.

Holdback Mechanism:

Typically, following an exit, the purchaser places in escrow part of the consideration of the founders/key personnel pending the fulfillment of conditions. According to the draft circular, capital gains tax treatment may be possible if:

–          The shares are classified as ordinary (common) shares with full dividend and voting rights, not as liabilities, preferred shares, deferred shares, founders shares or redeemable shares (unless for no consideration or at par value);

–          The shares are identical to other ordinary shares;

–          The shares are held at least six months;

–          There is no extra consideration for those shares, the price per share is the same as that paid to the other shareholders;

–          The founders/key personnel enter into new employment agreements no later than completion of the exit deal, or continue to work pursuant to their old agreement, possibly with adjustment, for at least their old salary, for the same company or a group affiliate, for at least the holdback period (unless they resign or are dismissed);

–          The purchaser reports the holdback consideration as capital not salary in nature, and does not deduct it as an expense;

–          If the holdback consideration is cash, a capital gains tax installment must still be paid (in principle, within 30 days);

–          If the holdback consideration is shares (stock), a trustee-controlled plan must be implemented for at least two years according to Income Tax Ordinance Section 102, or M&A rules according to Income Tax Ordinance Sections 103-105;

–          If the founders/key personnel forfeit any consideration, they can request a retroactive adjustment of their share sale assessment.

Comments:

If adopted this Circular will clarify favorably several key issues.

First, after an exit, the founders of the acquired company  are subject to an earn-out period before they get their sale consideration. It was sometimes unclear whether such consideration was taxable as capital gain or as salary. Now it seems they may qualify for a 30%-32% tax rate if the above conditions are met, once the Circular is finalized.

Second, shareholders entitled to 10% or more of any means of control are ineligible for 25% tax on employee shares and share option plans under Section 102 of the Income Tax Ordinance. Now it seems they may perhaps qualify for a 30%-32% tax rate if they hold Reverse Vesting shares meeting the above conditions, once the Circular is finalized.

Another issue concerns timing. There is no commencement date in the draft circular. In fact, the draft circular is essentially an interpretation of existing law, so it seems interested parties in Israeli business and hitech can arguably apply the principles now, or even retroactively.

Let’s hope the Circular is finalized soon.

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

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