“In this world nothing can be said to be certain, except death and taxes.” Benjamin Franklin strikes again.  However, in the world of high tech and Israeli tax there has been some uncertainty as to whether entrepreneurs, whose shares are subject to a reverse vesting mechanism or a holdback upon their sale, should be paying income or capital gains tax.

Reverse Vesting 

Most start-ups are founded by several entrepreneurs and the equity is divvied up among them. This is a good thing, it is hard to create a successful venture alone, and the composition of the founding team will be a factor in an investor’s investment decision. The risk however is that an entrepreneur will leave the venture prematurely and with his shares. To reduce this risk, and to ensure that all entrepreneurs have skin in the game, we advise both entrepreneurs and early investors that entrepreneurs’ equity should be subject to a reverse vesting schedule.

In other words, the entrepreneurs’ shares are tied to their continued performance and involvement in the start-up. If they leave within a predefined period, they are required to return a portion of their shares. However it is not a perfect solution. The risk is that the tax authorities may view the shares as consideration for employment and therefore subject to income tax at a rate of up to 50%, rather than capital gains tax which has a lower tax rate of 25% – 32%.

Earlier this month the Israel Tax Authority (ITA) published a draft circular presenting its position that provided the following conditions are met, the sale of such equity should be considered a capital gain and not income: (i) The reverse vesting mechanism was agreed in advance and in writing at the time the company was incorporated (or soon thereafter), or was a result of a substantial investment in the company (at least 5%).  (ii) The reverse vesting mechanism dictates that only the company or other existing shareholders are entitled to buy the forfeited shares, and that such sale shall be for no consideration or for their par value. (iii) The shares subject to the reverse vesting mechanism are ordinary shares, with identical rights to the other ordinary shares in the company.  (iv) But for the reverse vesting mechanism, the gain from the sale of the shares would have been considered a capital gain.

Holdback

When a purchaser buys a company, s/he usually demands that management stay on to ensure the company’s continued success. With slavery abolished, the best way to ensure this is to holdback some of the consideration due to the selling entrepreneurs and key employees as part of the sale. These funds will then only be released upon the expiry of a predefined employment period. Accordingly, the same risk mentioned above with respect to reverse vesting applies; the tax authorities will view the deferred payment as consideration for employment and not a capital gain and it will be taxed at a higher rate.

The draft circular illustrates that the ITA also believes that such payment should be treated at the lower capital gains rate provided that the following conditions are met:  (i) The shares are ordinary shares, with identical rights to the other ordinary shares in the company.  (ii) But for the hold back mechanism the gain from the sale of such shares would be considered a capital gain. (iii) The entrepreneurs/key employees held such shares for at least six months. (iv) The holdback payment does not include any additional consideration, and equals the consideration that would have been due to the entrepreneurs/key employees at the closing of the sale – i.e. the same price per share paid to all ordinary shareholders.  (If the price per share is higher, only the difference will be taxable as employment income.) (v) The entrepreneurs’/key employees’ salary is not reduced going forward.  (vi) The purchaser accounts for the holdback payment as consideration for the purchase of shares in the transaction and not salary. (vii) The entrepreneurs/key employees report and fully pay their taxes for the sale of their shares – including in connection with the unpaid holdback payment. (If in the end an entrepreneur/key employee does not receive the total consideration, s/he will be entitled to a tax refund).

While this is only a draft circular it reflects the ITA’s opinion. On the one hand this is good news for entrepreneurs. If the position is adopted, there will be certainty that the gain from a sale of their shares will be treated as a capital gain and not income, and it will be taxed more favorably.

However, on the other hand it comes at a price. An entrepreneur’s negotiating power to resist a reverse vesting mechanism (demanded by a dominant founder or an earlier investor), or a holdback, on the grounds that s/he will be unfairly taxed as a result, will be diminished.