Tax Update | August 2021

New Proposed Law with respect to the Taxation of Venture Capital Funds and Private Investment Funds Operating in Israel

For years, tax benefits have been provided to foreign investors participating in investment funds pursuant to specific rulings that were issued under the general authority of the Israel Tax Authority (“ITA”). An amendment to the law has now been proposed, which would adopt a new specific tax regime for venture capital funds and private equity that will regulate the tax benefits and the uniform criteria required, including the structure of the fund and the type of investments in respect of which tax benefits will be granted. This special regime is primarily focused on venture capital funds. We note that this regime is incomplete and does not cover many of the important aspects of the Israeli venture capital fund industry, which have been incorporated into the industry as a result of the aforementioned prior rulings.

Venture Capital Funds

The structure of the fund required for the purpose of receiving the tax benefits according to the provisions of the proposed regulations, must satisfy a number of conditions, including those listed below:

1. Investor diversification – In a partnership fund, there must be at least ten limited partners, who are not related to each other, either directly or indirectly. The respective holdings of each of the partners must not exceed 20% of the rights in the fund.
2. Diversification of investments in Israel – the amount that a qualifying investment fund invests in a single company cannot exceed 25% of the total amount of its qualifying investments.
3. There must be a minimum investment amount of $5 million in qualifying investments, with such investments to be made within a period of 48 months from the date on which the fund first held a share of a company in respect of a qualifying investment.
4. There must be a division between the limited partners and the general partners, both in their ownership structure and in the form of their contributions to the fund’s activities.

In addition to the above, the fund must be a “venture capital fund”. In this regard, a venture capital fund is defined as a limited partnership whose investments are in corporations whose main line of business is research and development or production of innovative and knowledge-intensive products or processes, in which the risk is higher than in investments in other types of businesses.

The ITA proposal also includes a definition of a “qualifying investment” as an investment in a company which all of the following requirements are met:

1. The company is a resident of Israel or a foreign resident whose main assets and activities are in Israel.
2. The main activity of the company is a “qualifying activity”, namely, a “manufacturing activity” as found in the definition of “industrial enterprise” in Section 51 of the Capital Investment Encouragement Law, including the establishment of national infrastructure.
3. The main value of the assets of the company does not derive from “rights” as provided in Section 97(b3)(2) of the Israeli Income Tax Ordinance, i.e., real estate rights or rights to utilize natural resources.
4. The company is not a “concentration factor” as defined in the Law for Promotion of Competition and Reduction of Concentration, 2013.

The following is an outline of the tax benefits offered to partners in a venture capital fund that has made a qualifying investment:

1. Exemption from capital gains tax for a non-resident limited partner in a venture capital fund, in respect of the sale of a security purchased or allotted as part of a qualifying investment. The benefit is intended to protect the foreign investor from the possibility that the realization of his/her investment will be classified by the tax assessment office as business income.
2. Tax exemption on dividend income and interest income for a non-resident limited partner in a venture capital fund.
3. The tax rate on income derived from the success fee for a non-resident general partner will be 15%.

With respect to 15% tax rate applicable to non-resident members of the general partners, although such controversial tax rate would be maintained under the proposal, the important mechanism to prevent double taxation that was included in prior ITA rulings, is absent. Traditionally, if a non-resident member of the general partners did not receive a foreign tax credit from its country of residence,  the ITA would issue a refund to such non-resident resident member for the Israeli tax regarding which it did not receive a credit. However, based on the proposal, only a resident of a treaty country would be eligible for such refund.

Furthermore, the proposal does not address the tax treatment of carried interest of the Israeli-resident members of the general partner.

Finally, we note that non-Israeli investors will continue to enjoy the broad exemption on capital gains, interest and dividend income of the funds’ qualifying venture capital investments.

Private Investment Funds

In addition, the proposal contains a temporary provision for a period of two years, that the benefit to a non-resident on the sale of a security purchased or allotted as part of a qualifying investment would also apply to a non-resident limited partner in a private investment fund that is not a venture capital fund. Since according to the ITA’s position the benefit of such investments is less than the benefit of venture capital fund investments, it is proposed not to establish the benefit above on a permanent basis, but rather, to examine towards the end of the two year period whether it is appropriate that such benefit be continued. However, according to the temporary provision, the tax benefits would not apply to income from dividends and interest, as opposed to the traditional approach that an exemption on such income was available to some of the non-resident investors.

Highlights and Summary

We would like to emphasize that this is a preliminary and undeveloped legislative proposal and there is still no certainty that this will lead to binding legislation. Our firm is involved in revising the current version of the proposed legislation, including discussions with the ITA. Based on such discussions, it is agreed by all that the draft legislation is insufficient and does not adequately cover all issues within the legislation’s intent to preserve the main terms and conditions of the old tax regime applicable to venture capital funds established for more than a decade in ITA tax rulings. We note however, that one change to the old tax regime will be made with respect to the rules of taxation on carried interest payable to Israeli participants, whereby a uniform tax rate will apply irrespective of the formula that is established regarding foreign participants.

For additional information please contact Adv. Oren Biran, partner and head of Tax department oren@gkh-law.com

Gross Law Firm (GKH) is one of the leading law firms in Israel, with over 170 attorneys. Gross Law Firm specializes, both in Israel and abroad, in various fields of law including Mergers and Acquisitions, Capital Markets, Technology, Healthcare and Life Science, Banking, Real Estate, Project Finance, Litigation, Antitrust, Energy and Infrastructure, Environmental Law, Intellectual Property, Labor Law and Tax. This alert is prepared as an informational service to clients and colleagues of Gross Law Firm 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.