Israel: Draft Of A New Income Tax Circular - Employees Preservation Mechanism And Restrictions On Founders And Key Employees

Last Updated: 13 April 2017
Article by Leor Nouman

On July 12, 2016, the professional division of the Israeli Tax Authority ("ITA") published a draft of a new income tax circular, entitled "Employees' Preservation Mechanism and Restrictions on Founders and Key Employees" ("the Circular"). The Circular wishes to provide special and lenient treatment and taxation in connection with Reverse Vesting and Holdback Payments, which are usually provided to key employees and founders of start-ups or corporations, by their employers, investors or co-founders.

Before we further review the Circular, we would like to bring to your attention that this Circular was published only a few months after the publishing of a tax decision concerning the taxation of Holdback Payments which were paid by the purchaser of an Israeli company to the founder of the said company ("the Tax Decision"). The Tax Decision, which was reviewed by us previously (in our article dated January 8, 20151), demonstrated a surprising turnabout in the approach of the ITA, by determining that, under the circumstances of the Tax Decision, the Holdback Payments would be considered capital payments that are taxed as capital gain (25-30%), and not as an employment income that would be liable to marginal tax (up to 50%).

The Circular separately reviews the different characteristics of the Reverse Vesting mechanism and the Holdback Payments mechanism, on which the Circular provisions will apply. The Circular specified that the Reverse Vesting mechanism that was determined as part of the purchase agreement or the establishment agreement of a company, in order to insure that the founders and employees of the company will continue to develop and promote the company and preserve its attractiveness by imposing restrictions on the shareholders' control of the shares, and which fulfills after the conditions of the Circular, will not, by itself, affect the classification of the income derived out of the sale of the shares, as capital payments.

As to the Holdback Payments, the Circular reflects an approach that is similar to the approach applied in the Tax Decision. The Circular provides that Holdback Payments, up to the price of the sold shares, which fulfill a number of conditions, will be subject to capital gain tax. The conditions detailed in the Circular include, inter alia, holding the shares by the seller at least six months before the transaction date, and receiving an appropriate employment salary in consideration of services rendered. It should be noted that any payment received by the shareholders, that is above the share price, will be classified as employment income and subject to marginal tax.

Although the final version of the Circular has not yet been published, it is obvious that the ITA is keen to specify clear and specific instructions, in order to enhance the certainty of the taxation of complex mechanisms that are usually included in M&A agreements. The current draft of the Circular sheds enough light on the position of the ITA in this regard, and we recommend consider carefully and accurately reviewing the provisions of the Circular, in order to optimize the M&A agreements and transactions, by reducing the tax amplifications.  

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