July 14, 2016
A Draft Tax Circular Published by the Israeli Tax Authority Regarding the Taxation of Company Founders
Background
On July 12, 2016, the Israeli Tax Authority (the “ITA“) published a draft tax circular (accessible at the following link: https://goo.gl/LKK7B7) (the “Draft Tax Circular“), addressing the ITA’s tax treatment of 2 familiar mechanisms used to retain founders and ‘key employees’ (the “Key Persons“), with their companies, and/or acquirers of start-up companies: the Reverse Vesting Mechanism and the Holdback Mechanism.
The novelty of the Draft Tax Circular is mainly in reference to the Reverse Vesting Mechanism. The Holdback Mechanism was discussed in our Tax Bulletin from April 2016, addressing a previous tax ruling published by the ITA in connection with Holdback Amounts (as defined below) in M&A transactions. According to the Draft Tax Circular, under certain conditions, consideration paid for the sale of company shares held by Key Persons that are or were subject to a Reverse Vesting Mechanism or a Holdback Mechanism will be taxed as ‘capital gains’.
Reverse Vesting Mechanism:
• General Description – The Reverse Vesting Mechanism was commercially introduced in order to ensure that Key Persons continue to be engaged with a company by imposing restrictions on the shares of Key Persons for a limited period of time, which are gradually removed, subject to the Key Person’s continued engagement with the company.
• Tax Implications – According to the Draft Tax Circular, consideration paid to Key Persons for the sale of their shares that are or were subject to the Reverse Vesting Mechanism, will be taxed as ‘capital gains’ in Israel under the following main conditions:
• The Reverse Vesting Mechanism is imposed on the shares either upon incorporation and/or following a ‘significant investment’ (i.e. an investment in at least 5% of the company’s share capital post-investment).
• The company and/or other shareholders of the company will only be able to repurchase the shares owned by the Key Persons for no consideration or for consideration equal to the nominal value of the shares.
• The Key Persons’ shares are classified (for accounting purposes) as equity-based awards (i.e. not as liabilities) and as ordinary shares (i.e. not as preferred shares, deferred shares, management shares or redeemable shares). Additionally, the shares must include the same rights as the other similar-class shares, and be entitled to dividend distribution, voting rights and the right to participate in company assets upon liquidation.
• The company and/or other shareholders will not claim any deductions for Israeli tax purposes on their tax returns with respect to the Reverse Vesting Mechanism, including advisory and/or any professional fees in this regard.
• Had the shares been sold prior to becoming subject to the Reverse Vesting Mechanism, the gains from such sale would have been taxed as ‘capital gains’.
Holdback Mechanism:
• Under the Holdback Mechanism, a portion of the total consideration payable to Key Persons for the sale of the company’s shares will be gradually released to the Key Person, subject to their continued engagement with the company or the acquiring company (the “Holdback Amount“).
• The taxation of Key Persons subject to the Holdback Mechanism was discussed in our Tax Bulletin from April 2016, addressing Tax Decision 4253/16 published by the ITA, in connection with the taxation of Holdback Amounts in M&A transactions.
• The Draft Tax Circular generally states that the Holdback Amount will be subject to tax as ‘capital gains’ under the following main criteria:
• The price-per-share paid to the Key Person, calculated including the Holdback Amounts, is equal to the price-per-share paid to other company shareholders, holding similar-class shares. It should be noted that if the price-per-share received by the Key Person exceeds the price-per-share received by other shareholders, the excess amount will be taxed as ‘earned income’ and not as ‘capital gains’.
• The Key Person’s shares are classified (for accounting purposes) as equity-based awards (i.e. not as liabilities), as ordinary shares (i.e. not as preferred shares, deferred shares, management shares or redeemable shares). Additionally, the shares must include the same rights as the other similar-class shares, and be entitled to dividend distribution, voting rights and the right to participate in company assets upon liquidation.
• The shares were held by the Key Person for a period of at least 6 months prior to the date of signing the applicable M&A agreement.
• The purchasing company will classify the Holdback Amounts paid to the Key Person on its tax returns as consideration for shares and not as wages.
• The company and/or other shareholders will not claim any deductions for Israeli tax purposes on their tax returns with respect to the Holdback Amounts, including advisory and/or any professional fees in this regard.
• The Key Person will either enter into a new employment or engagement agreement with the company or the acquirer that will become effective, at the latest, at the ‘closing date’ of the transaction, or continue their employment under their current employment or engagement agreement or a revised one, according to which they will receive a proper wage (not less than their wage prior to the transaction).
• The Key Person will report and pay tax on their total consideration (including the Holdback Amounts). In case the Holdback Amounts will not be paid, such Key Persons may file an amended tax return in order to receive a tax refund, plus interest and linkage differences.
We believe that the publication of this Draft Tax Circular is important and creates certainty for Israeli Key Persons in start-up companies, who are subject to either the Reverse Vesting Mechanism or the Holdback Mechanism with respect to their shares. In order to secure the taxation of the consideration paid to Key Persons as ‘capital gains’, the aforementioned criteria should be taken into account while drafting all relevant agreements among founders and investors.
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Read Bulletin in PDF: 
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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
