Yesterday, July 12, 2016, the Israel Tax Authority (the "ITA") published on its website a draft circular addressing retention mechanisms of founders and key employees (the "Key Persons"), and in particular the Reverse Vesting mechanism (pursuant to which shares of Key Persons are subject to forfeiture rights which are extinguished gradually over a defined employment period) and the Holdback mechanism (pursuant to which a portion of the sale proceeds of Key Persons’ shares would be paid to them gradually over a defined period after completion of a sale transaction, subject to their continued employment with the company during such period).

According to the ITA’s publication, the purpose of the draft circular is to provide certainty with respect to the tax implications of transactions in the high-tech industry in which these mechanisms are common. Such certainty is particularly needed in light of the Hellman case[1]which was decided in October 2015, and in which consideration paid to Key Persons in connection with a company sale transaction was classified as employment income. The draft circular emphasizes the unique circumstances of the Hellman decision, and distinguishes them from the market-standard circumstances. The draft circular clarifies the ITA’s position that, subject to meeting certain conditions detailed below, the sale of shares to which the said mechanisms apply would be treated as a capital gains event (tax rate of 25% - 32%), and not as ordinary employment income (tax rate of up to 50%, depending on the marginal tax brackets).

We welcome the publication of the draft circular, which puts an end to some serious issues that preoccupied many in the high-tech industry in recent years. It should be emphasized that at this stage this is only a draft circular and the final version is yet to be published after receiving comments of professional associations. However, the draft circular reflects the ITA’s direction on these issues which is not expected to change.

Following is a general summary of the conditions prescribed in the draft circular with respect to each of the said mechanisms:

Reverse Vesting:

  1. The mechanism was set forth in advance and in writing at the time the company was established (or close to such date), or as a result of a substantial investment in the company (an investment of at least 5% of the company’s issued stock following the investment).
  2. Should the mechanism be utilized, only the company itself or other existing shareholders are entitled to buy the shares, and for no consideration or for their par value only, as agreed upon in advance and in writing.
  3. The shares of the Key Persons are classified as equity, and are ordinary shares which confer upon their holders rights that are identical to those of the remaining ordinary shares, the gain from the sale of which, but for the Reverse Vesting mechanism, would be classified as a capital gain. 

Holdback:

  1. The shares of the Key Persons are classified as equity, and are ordinary shares which confer upon their holders rights that are identical to those of the remaining ordinary shares, the gain from the sale of which, but for the Holdback mechanism, would be classified as a capital gain.
  2. The Key Persons have held the shares for at least six months prior to the signing of the transaction.
  3. The Holdback payment does not constitute additional consideration, but rather the price per share to be paid for such shares is the same as the price per share to be paid to the remaining holders of ordinary shares.
  4. The Key Persons enter into a new agreement after the closing of the transaction, or continue to work under their existing employment agreement, or an amended agreement, pursuant to which their compensation does not fall under the compensation received prior to the transaction.
  5. In its tax filings, the acquiring company accounts for the Holdback payment as consideration for acquisition of shares in the transaction, and does not take an expense deduction for the Holdback payment.
  6. The Key Persons report the sale of their shares, and to the extent the transaction consideration is fully paid in cash, they make a full tax advance payment with respect to the total consideration  received (including the Holdback payment portion of the consideration which remains unpaid). If any of the Key Persons does not eventually receive the total consideration, he will be entitled to amend his tax returns and obtain a tax refund. Where the transaction consideration is paid in shares or other rights, various tax deferral mechanisms applicable under the Income Tax Ordinance (New Version) of 1961 (the "Ordinance") may be utilized.

Subject to meeting the above conditions, the Holdback payment that is paid to Key Persons up to the price per share as determined with respect to the remaining sellers, will be taxable as a capital gain. If the price per share paid to Key Persons is higher than the price per share determined for the remaining sellers, the said difference will be taxable as ordinary employment income.

It should be noted that on April 19, 2016, the ITA published a ruling that addresses the Holdback mechanism[2]. In fact, the facts presented in the ruling and conditions set forth therein, are very similar to the conditions prescribed in the draft circular, with an important difference being that the ruling applied to preferred shares as well.  In this regard, the draft circular’s scope is narrower than the ruling. As mentioned above, the draft circular and the ruling are aimed, among other things, at addressing the uncertainty that arose in light of the Hellman decision, while clarifying that such decision addressed the additional compensation paid to Key Persons that exceeded the price per share that was paid to the other selling shareholders who were not Key Persons.

Additional Conditions Stipulated:

The draft circular does not apply in cases where the acquiring company is a related party, as defined in section 88 of the Ordinance, of the acquired company or its shareholders, as well as cases where a ruling was previously provided with respect to the shares.

In addition, the draft circular provides that the issuance of new shares other than at the time the company was established, for less than the market price, to a person who has an employer-employee relationship with the issuing company, and who is a controlling shareholder as defined in Section 32(9) of the Ordinance, will be taxable as ordinary employment income.

Accordingly, it is particularly important that the structure of these mechanisms, and amendment of existing mechanisms, be pursued carefully so as to meet the above conditions. In addition, with respect to mechanisms that do not meet the relevant conditions, it is recommended to consider requesting a ruling from the ITA that would guarantee capital gains treatment.