On June 12, 2017, the Israel Tax Authority (the “ITA”) published on its website a circular (the “Circular”) addressing the tax implications of two major retention mechanisms of founders and key employees (the “Key Persons”) that are commonly used in the high tech industry: (i) the Reverse Vesting mechanism whereby shares of Key Persons are subjected to forfeiture rights that expire gradually over a defined employment period; and (ii) the Holdback mechanism whereby a portion of the sale proceeds of Key Persons’ shares are paid to them gradually over a defined period following the sale transaction, subject to their continued employment with the acquired company during such period.  

This Circular is a final version of a draft circular (the “Draft Circular”), which was released in July 2016 following the Hellman decision[1] and the market uncertainty that it created regarding taxation of retention mechanisms.[2] While the Draft Circular provided significant indication on the ITA’s position with respect to the issue at stake, the Circular provides a more desired level of certainty. For the most part, the Circular is consistent with the Draft Circular in setting the conditions which, if met, would result in preferable capital gains treatment with respect to the sale proceeds of Key Persons’ shares that are subject to the said mechanisms, as opposed to the higher ordinary employment income tax rates. There are, however, certain modifications that were made. We provide below a general summary of these conditions as reflected in the Circular.

Reverse Vesting:

  1. The mechanism was set forth in advance and in writing at the time the company was established (or within half a year of the company’s establishment), 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. Only the company itself or the other existing shareholders are entitled, upon a forfeiture event, to purchase shares of Key Persons, for no consideration, for their par value, or for their original price paid for the shares, as agreed upon in advance and in writing.
  3. The Key Persons’ shares are ordinary shares, classified as equity, confer upon their holders rights that are identical to those granted by all other ordinary shares of the same class, and the gain from the sale of which, but for the Reverse Vesting mechanism, would be classified as a capital gain.​

Meeting these conditions, as noted, would secure capital gains treatment with respect to the sale proceeds from the sale of such shares. 

Holdback:

  1. The Key Persons’ shares are ordinary shares, classified as equity, confer upon their holders rights that are identical to those granted to all other ordinary shares of the same class, and 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 twelve months prior to the signing of the sale transaction agreement (previously 6 months in the Draft Circular).
  3. The Key Persons’ shares are sold as part a transaction in which all of the rights in the company are sold.
  4. The percentage of the Key Persons’ rights in the company that are subject to the Holdback mechanism is not more than 50% of all of the rights held by them in the company.
  5. The Holdback amount does not constitute additional consideration; the price per share paid to the Key Persons is identical to that paid to all holders of ordinary shares. For this purpose, the Circular provides that this condition will be presumed met if, upon the sale of the company's shares, non-Key Person shareholders (who are not subject to a Holdback mechanism) hold at least one third of the means of control of the company.
  6. The Key Persons enter into new employment agreements that are effective (at the latest) on the date the transaction closes, or continue to work under their existing employment agreements, or amended agreements, whereby their compensation is not lower than their compensation prior to the transaction.
  7. In its tax filings, the acquiring company records the Holdback amount as consideration for the acquisition of shares in the transaction, and does not take an Israeli tax deduction for such Holdback amount.
  8. The Key Persons report the sale of their shares to the ITA and are generally required to make an advance payment of the full tax liability amount in connection with the total consideration received (including any amount in escrow or the Holdback amount, disregarding that these remain unpaid). If a Key Peron does not eventually receive the total Holdback amount, he/she will be entitled to amend his/her tax return to obtain a tax refund plus interest and linkage differentials. Where the deal consideration is paid, wholly or partially, in shares or other rights of the acquiring company, various tax deferral mechanisms applicable under the Income Tax Ordinance (New Version) of 1961 (the “Ordinance”) may be available.
  9. The acquiring company must not be a related party, as defined in section 88 of the Ordinance, of the acquired company or its shareholders (including the Key Persons).
  10. The holders of the majority of the issued capital of the acquired company (including the Key Persons), are not related parties under section 88 of the Ordinance.

Subject to meeting these conditions, the Holdback amount that is paid to Key Persons (up to the price per share payable to the remaining sellers of shares of similar class), will be taxable as a capital gain, and any excess will be taxable as ordinary employment income.  

Additional Notes:

The Circular does not apply where the acquired company was, at any point since its incorporation, a transparent entity for tax purposes.

The Circular clarifies that the issuance of new shares to Key Persons (other than at the time the company was established) who are either employed by the company or are controlling shareholders as defined in section 32(9) of the Ordinance, for no consideration, or lower-than market value consideration, will deem any such difference as ordinary employment income.  

It is particularly important that the structure of retention mechanisms, or 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.