The Israeli Tax Authority has just issued a much needed “green channel” procedure for handling and approving share options in private companies. Share option plans are very popular in the Start-Up nation in the tech sector and many other sectors.
The idea is that part of an employee’s compensation package isn’t paid in cash, it is paid in options or shares (=stock) of the employing company or its parent company.
To sweeten the deal, the employee’s tax rate is limited to 25% rather than up to 50% if a number of conditions are met according to Section 102 of the Income Tax Ordinance (see below).
The problem is that in the case of a private company, it is not possible for the employee to cash in his sharews at market value on a stock exchange. Instead, the employing group must arrange to buy back the shares via call or put options at a price that might not be market value, i.e. open to abuse. The Israeli Tax Authority (ITA) adopted a position that call or put options amounted to a breach Section of Section 102, unless the options were called or put at market value when the individual’s employment ended….This was stated in a controversial published tax ruling in 2011 (2578/11).
Realizing the adverse consequences if private companies cannot offer employees share options, the ITA has re-thought its position and issued a more lenient tax ruling (8736/14) and a “Green Channel” procedure for implementing it (Form 923).
What Does Section 102 Say?
Plans approved under section 102 can both reduce Israeli tax and defer it until cash is realized if various conditions are met.
There are different rules and tax rates relating to: (1) approved options for employees – capital-gains approach; (2) approved options for employees – ordinary income approach; (3) unapproved options for employees; (4) unapproved options for major (10-plus percent) shareholders and non-employees.
The capital-gains approach is the most popular alternative in practice, for employees with less than 10% ownership of the company. The gain is taxed at a fixed rate of 25%, and both the employer and employee are exempt from National Insurance Institute (NII) payments. The employer is not entitled to any expense deduction for tax purposes regarding the options. There must be an approved Israeli trustee who holds the options or shares for at least 24 months. The tax is deferred until the employee sells the options or shares or withdraws them from the trustee.
If the employer is a public company, any discount at grant will be taxed upon realization at regular income rates; the discount at grant being the difference between the exercise price and the average value of the company’s stock in the 30 days preceding the grant.
Section 102 plans must be in a prescribed format and notified to the ITA at least 30 days before the plan is first implemented.
If the holding period condition is not complied with (e.g., premature sale, etc.), the employee will pay regular income tax at his applicable rate, as well as NII contributions.
The above refers to the capital-gains approach. Separate rules apply in other cases.
What Does Form 923 Say?
Form 923 provides a clear path for private companies to issue share options to employees pursuant to a Section 102 plan, applying the “net exercise” approach. That means the employee exercises options and converting them to shares of the company without payment, or by paying just the par value of the stock, but the number of shares depends on the paper gain upon conversion.
For example, a company issues 10 options to an employee, with a conversion price of NIS 20 each. The market price of the shares upon conversion is NIS 100 each. So the total conversion price is NIS 200 (=10 * NIS 20) and the paper gain then is NIS 800 (=NIS 1,000 – NIS 200). So 8 shares can be issued upon the conversion (=NIS 800/NIS 100 ). If more shares are issued, they are taxed at marginal regukar rates of up to 50%.
Under the net exercise approach, call and put options are not allowed. The options granted must be part a capital plan settled using capital instruments according to accounting standards FAS123R, IFRS2 and Standard 24 in Israel.
The market price should be determined by an independent valuer, taking into account all relevant economic and business factors, including cash flow, liabilities, ability of the company to function on its own as a going concern and financial stability.
Form 923 must be filed before adopting a net exercise mechanism.
When calculating the gain and tax, no other reliefs or foreign tax credits will be allowed….
It remains to be seen whether the net exercise approach is indeed the breakthrough needed to make stock option plans work in private companies. Time will tell.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.
As always, consult experienced tax advisors in each country at an early stage in specific cases.