The high number of merger and acquisition transactions ("M&A Transactions") conducted annually in Israel, the "start-up nation", has raised a lot of tax disputes and arguments between the Israeli Tax Authority ("the ITA"), and the parties to these transactions. In some cases, the Israeli tax ramifications resulting from M&A Transactions are highly significant, to an extent that affects the cost of the transaction, and even the worthwhileness of the transaction. One of the most common disputes between the ITA and the taxpayers relates to the classification of the considerations, specially hold back payments, that are paid by the purchaser of an Israeli company to the owners/founders of the company.
The mentioned above tax issue was discussed in October 2015 by the the district court in Tel-Aviv, in the case of Helman and others ("the Helman Case"). The verdict in the Helman Case, determined that the holdback payments paid by IBM to the sellers of an Israeli company, who were required to work in IBM, are deemed as employment income and not part of the sold shares price. The main underlying principle behind the decision in the Helman Case was that the holdback payments are conditioned to the continuous of the employment agreement.
Surprisingly, the ITA has recently published a new tax decision ("the Tax Decision"), which apparently appears to have similar circumstances to those of the Helman Case. The Tax Decision, relates to the taxation of holdback payments that were paid by an U.S. resident Nasdaq-traded company ("the Purchaser"), to the sellers of an Israeli private high-tech company, who are also employees of the company ("the Sellers" and "the Company"). According to the agreement between the Sellers and the Purchaser ("the Agreement"), 50% of the consideration paid to the Sellers would be held by a trustee for a four-year vesting period ("the Holdback Payments" and "the Vesting Period"), during which they would be transferred to the Sellers gradually, in accordance with the holdback agreements signed between the Purchaser and the Sellers ("the Holdback Agreements").
It should be noted that, in the circumstances relating to the Tax Decision, the Holdback Agreements provide that the Holdback Payments would be paid to the Sellers subject to their employment in the Company. However, the Sellers will be entitled to the Holdback Payments, even if they cease to provide their services to the Company due to death, disability, termination of employment by the employer (unless it is due to justified reason according to the employment agreement), or resignation due to justified reasons (according to the employment agreement).
Furthermore, it was declared by the Company that the Holdback Payments reflect a portion of the market value of the Company's shares as agreed between the Sellers and the Purchaser. It was also declared that the Holdback Payments would be classified by the Sellers as part of the cost of the Company's shares, and not as employment expenses. In addition to the Holdback Payments, during the entire employment period, including the Vesting Period, the Sellers would receive suitable consideration for the employment services provided by them, all in accordance with the personal employment agreements signed between them and the Purchaser.
In light of the above, and despite of the court verdict in the Helman Case, the ITA determined, in the Tax Decision, that the Holdback Payments would be deemed considerations for the Company's shares and, as such, would be taxable according to capital gain tax rates (25%, or 30% in the case of a significant shareholder), instead of progressive tax rates (up to 50% income tax, plus social security taxes) that apply on employment income. It was clarified that any future consideration that may be paid to the Sellers, in addition to the Holdback Payments, would be considered employment income and, as such, would be subject to progressive tax rates.
It should be noted that the sellers in the Helman Case have already appealed the district court verdict, and their case is being discussed in the Supreme Court in Israel ("the Supreme Court"). The extent of the influence that the Tax Decision will have on the decision of the Supreme Court and the final decision that will be given in the Helman Case is not yet clear. However, we are of the opinion that careful and accurate planning of the commercial and tax aspects of M&A Transactions and agreements will significantly reduce the risk of aggressive taxation, and avoid significant tax expenditures for both the purchasers and the sellers of Israeli companies or business activities.