Hi Tech Taxation

According to the Law for the Encouragement of Research, Development and Innovation, a scientific employee who meets the following conditions will be entitled to a tax rate of no more than 35% of his or her income during the benefit period (18 months):

• The employee is entitled to a sabbatical year from his or her place of employment.
• The employee is employed during this period in research and development that has been approved by the Chief Scientist
• The employee has received approval from the Innovation Authority.

Employee Stock Purchase Plan (ESPP) allows employees to purchase shares of their employer's stock at a discounted price in an efficient and convenient way, by contributing a portion of their salary to the purchase of the shares. This is a common and accepted practice worldwide for employees to purchase shares.

In light of the above, the Israel Tax Authority has published two green reporting paths: Form 926 - ESPP with a trustee in the capital gains tax path; Form 927 - ESPP without a trustee.

Many companies (mainly in the technology sector), practice to incentivize their employees through options, shares or participation units (hereinafter: "the employee benefit"), in order to retain their employees for the long term. The entitlement to the employee benefit is defined, among other things, by the company through a "vesting period" - a period defined in time and/or performance and/or market conditions, which only if it exists, the employee is entitled to become a full-fledged shareholder. Under Section 102 of the Income Tax Ordinance and the rules issued under it (dealing with the taxation of the allocation of shares to employees), no special provisions were set for the vesting period, except for a minimum period of two years in the capital gains track through a trustee, and the matter remains at the discretion of the allocating company.

In light of the above and in order to provide certainty regarding the taxation of the employee benefit (both from the perspective of the allocating company and from the perspective of the employee), the Israel Tax Authority issued this circular expressing its position on when an employee benefit that is contingent on performance or market conditions will be considered an allocation that meets the requirements of Section 102 of the Income Tax Ordinance.

We note that the circular also states that in some cases, a vesting period that is contingent on an event such as an EXIT or an IPO, does not fall within the scope of Section 102 of the Income Tax Ordinance. And the shares allocated will be seen as those given within the framework of the employment relationship and the income arising from them will be classified as employment income according to Section 2(2) or 2(1) of the Ordinance.

The purpose of the Hold Back mechanism is to divide the proceeds that are due to a founder or key employee in connection with the sale of his or her shares in the company, in light of the buyer's desire to ensure that the founder or key employee will continue to work in the company for a long period of time after the sale of his or her shares. If the founder or key employee ceases to work in the company during the specified period, he or she will not be entitled to the remaining proceeds.

For a share sale transaction containing the Hold Back mechanism to be considered capital gains in the hands of the founder or key employee, it must meet the conditions of the Israel Tax Authority as published in the circular "Mechanisms for Preserving and Limiting Founders and Key Employees".

Similarly to a company that conducts research and development for a foreign resident, companies that meet the conditions of the law and are defined as biotechnology or nanotechnology companies or have qualified knowledge (knowledge that was developed in Israel and a patent was registered for it or that the Innovation Authority determined that it is qualified knowledge) will also be eligible for tax benefits such as reduced tax rates on their income from this activity.

According to the conditions specified in the Law for the Encouragement of Capital Investments, a company that holds a permit from the Innovation Authority stating that it is a company that conducts research and development for a foreign resident and meets the requirements of the law, will be entitled to reduced tax rates on its income from R&D for a foreign resident.

Section 20A of the Income Tax Ordinance allows an individual or company to deduct any amount of an expense incurred for the purpose of research and development, except for an expense incurred on an asset for which a depreciation deduction is required under Section 21 (depreciation of assets). It should be noted that in order to receive the deduction for R&D expenses, it is necessary to meet a number of additional conditions specified in the section.

The purpose of the Reverse Vesting mechanism is to preserve and strengthen the relationship between the founders or key employees and the company. This is done by imposing restrictions on the founders' or key employees' shares for a certain period of time and defining their rights and obligations in relation to the company's activities. This mechanism is usually regulated in the founders' agreement or as a requirement of an investor in the company (who will price its investment, inter alia, on the assumption that the founders or key employees will continue to work in the company to develop its assets). In addition, as part of the regulation of the mechanism, the price of the shares that the company or the other shareholders are entitled to purchase from the founders or key employees is also determined.

For a share sale transaction containing the Reverse Vesting mechanism to be considered capital gains in the hands of the founder or key employee, it must meet the conditions of the Israel Tax Authority as published in the circular "Mechanisms for Preserving and Limiting Founders and Key Employees."

Section 102 and the rules issued under it, set out the tax treatment in the event of the allocation of options or shares to an employee. The section distinguishes between two main scenarios:

Allocation through a trustee

• The allocation was made by an employer company.
• The shares and rights acquired under them were deposited with a trustee at the time of allocation until the end of the minimum maturity period set out in the section.

Taxation options for allocation through a trustee

• Income from employment track: In this track, the employee's income at the time of realization will be taxed as income under Section 2(1) or 2(2) less the employee's purchase and sale expenses.
• Capital gains track: In this track, the employee's income at the time of realization will be taxed as capital gains (tax rate of 25%).
• Exception: The share/option allocated is of a public company or a company that was listed for trading within 90 days of the allocation. In this case, the taxation of the income in the hands of the employee will be split into two - part of the income will be taxed under Sections 2(1) or 2(2) of the Ordinance, and the rest will be taxed at a tax rate of 25% (capital gains).

Allocation without a trustee

In general, allocation of shares without a trustee will be subject to tax at the time of allocation as income under Section 2(1) or 2(2) of the Income Tax Ordinance, and at the time of realization (sale of the share or option, "exit tax" - Section 100A of the Income Tax Ordinance "exit tax") the employee will be liable for his income under capital gains.

Clarification:

It should be noted that the section sets out exceptions to the above, and additional provisions, and in any case, it is advisable to consult with an expert.

A significant tax break is granted to companies that are defined as research-intensive companies (the conditions for this definition are detailed in the Income Tax Ordinance and regulations under it). In accordance with the provisions of the regulations (Restructuring of Research-Intensive Companies), the company will be eligible for flexibility in the conditions that it will have to meet when making a restructuring.

SAFE transactions provide a solution for rapid and efficient capital raising for private companies, which are characterized, among other things, by the absence of an agreed-upon valuation, and by the fact that a contract is signed between the investor and the company whereby capital is immediately injected by the investor, but the allocation of shares on its behalf will be made at a later date, in order to postpone the challenge of dealing with the question of the valuation of the company's shares, until the company's more significant and wider capital raising, in which a valuation will be agreed upon with the investors, and as a result, the fundraising price will constitute a reliable valuation estimate. Therefore, during the period between the injection of capital and its conversion into shares, the injection of capital does not bear interest and at the time of conversion into shares, the investor will receive a discount compared to the investors in the larger fundraising.

Since the difference, between the number of shares actually received by an investor in a company in a SAFE transaction and the number of shares that can be purchased at market value (hereinafter: "the difference"/"the benefit"), is derived from a difference in the market value of the company between the date of the investment and the date of actual receipt of the shares, the question arises whether the difference constitutes interest income in the hands of the SAFE investor or whether the transaction from its inception to its end constitutes an investment in the company's shares.

According to the position of the Israel Tax Authority, subject to certain conditions, the investment in the company under the SAFE transaction will be seen as a down payment on shares. In other words, there will be no tax event at the time of conversion by the investor and the company will not be subject to a withholding tax obligation. The entire consideration for the sale of shares will be seen as consideration that the investor will receive for the realization of the shares.

It should be noted that if the conditions are not met, then the transaction will be examined according to the general circumstances, in order to determine whether to see the transaction as a down payment on shares, as the repayment of a debt, which contains income from interest for the investor, or as a transaction of a different type, and accordingly, the tax liability will be determined by the tax authority.