New Tax Ruling Regarding Holdback Amounts in an M&A Transaction

Background

On October 15, 2015, the Tel Aviv District Court published its judgment in the case regarding the proceeds from the XIV sale[¹], in which it ruled that a certain portion of the consideration allocated to former shareholders of XIV, who sold their shares in XIV, Ltd. to IBM, should be subject to tax as ‘earned income’ (currently at a maximum rate of 48%, plus 2% excess tax) and not as ‘capital gains’ (currently at a rate of 25%/30%[²], plus 2% excess tax).

In the XIV Decision it was stated that as part of the transaction for the sale of XIV, certain shareholders of XIV, Ltd. who were classified as ‘key employees’ of XIV, entered into agreements with IBM that included a holdback mechanism. Under such mechanism, an amount of USD 15 million out of the purchase consideration was to be paid to such key employees during a period of 3 years following the closing of the transaction on the condition that they would continue to be employed by IBM or any of its affiliates throughout such period.

In the XIV Decision Judge M. Altuvia stated that the aforementioned consideration amount should be classified as ‘earned income’ because it was in fact conditioned upon the continuation of the employer-employee relationship between the appellants and IBM.

It should be noted that the question of whether the aforementioned price-per-share that was paid to other former shareholders of XIV is somewhat unclear from the facts of this court ruling and some tax practitioners questioned the applicability of this court decision on future M&A transactions in which the factual circumstances may be different.

The Tax Ruling dated April 18, 2016 in a Nutshell

On April 18, 2016 the Israeli Tax Authority (the “ITA“) published a tax ruling regarding the taxation of holdback amounts in respect of a certain M&A transaction (the “Tax Ruling“, and the “Holdback Amounts“, respectively).

In the matter at hand, the entire share capital of an Israeli privately held company was purchased by a US publicly-traded company (the “Transaction” and the “Purchasing Company“, respectively). As part of the Transaction, 50% of the total consideration payable to certain shareholders who were ‘key employees’ was deposited and held by a trustee for a maximum period of 4 years as Holdback Amounts. These Holdback Amounts are to be paid to such shareholders provided that they continue to be employed or render services to the Purchasing Company or its affiliates.

According to the Tax Ruling, the Holdback Amounts are to be taxed as ‘capital gains’ in Israel under the following main conditions:

• The price-per-share to be paid to the ‘key employees’, which is calculated including the Holdback Amounts, is equal to the price-per-share paid to other company shareholders, holding the same class of shares. Any amount exceeding the price-per-share paid to other company shareholders holding the same class of shares (excluding interest or profits accrued therefrom) will be taxed as ‘earned income’;
• The ‘key employees’ will enter into a new employment agreement with the Purchasing Company with an appropriate salary which will not be less than their previous salary pre-acquisition;
• The Purchasing Company will not deduct the Holdback Amounts as an expense for Israeli tax purposes; and
• The ‘key employees’ will report and pay tax on their total consideration (including the Holdback Amounts) within 30 days from the date of closing of the Transaction. In the event that the Holdback Amounts will not be paid, such ‘key employees’ may file an amended Israeli tax return for the year 2016 in order to receive a tax refund, plus interest and linkage differences.

In this Tax Ruling, the ITA explicitly stated that the facts of the matter at hand are distinguishable from the facts of the XIV Decision.

We believe that the publishing of this Tax Ruling is important and creates some clarity for Israeli taxpayers. This is especially true with respect to the distinguishing of the facts of this matter and the XIV Decision, as now it can be inferred that the payments to be made to the ‘key employees’ in the XIV Decision were higher than the average price-per-share for other shareholders (if any).

We should state that our Tax Department was able to secure several tax arrangements with the ITA for Israeli entrepreneurs who were also subject to holdback arrangements after the date of the XIV Decision and prior to the date of publishing of the Tax Ruling. Our main approach for these types of situations, which was approved by the ITA in several tax settlements throughout the years, is that as long as the price-per-share is equal among same-class shareholders, and the salary of the ‘key employees’ after the transaction was not reduced, the Holdback Amounts do not create any benefit to the ‘key employees’ compared to other shareholders. It is the exact opposite – the ‘key employees’ are in fact in an inferior position compared to other shareholders, who received the entire consideration amount at the date of closing without any holdback arrangements.

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[¹] Tax Appeal 27431-08-11 Helman v. Tel Aviv 4 Tax Assessing Officer (October 15, 2015) (the “XIV Decision“).

[²] In general, capital gains accrued by Israeli resident individuals on the sale of shares will be taxed at the rate of 25%. However, if the individual shareholder is a “Substantial Shareholder” (i.e., a person who holds, directly or indirectly, alone or together with another, 10% or more of one of the Israeli resident company’s means of control) at the time of sale or at any time during the preceding 12 month period, such gain will be taxed at the rate of 30%.

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For additional information please contact:
Adv. Yaniv Erlich, Partner, Head of Tax Department
and/or Chen Tuvia, Adv. (CPA), Associate
Tel: +972 (3) 607-4547; emails: yanive@gkh-law.com; chent@gkh-law.com

This alert is prepared as an informational service to clients and colleagues of Gross, Kleinhendler, Hodak, Halevy, Greenberg & Co. (GKH) and the information presented is not intended to provide legal opinions or advice. Readers should seek professional legal advice regarding the matters about which they are particularly concerned.

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