The taxation of employee benefits under share option schemes tends to interest a relatively major part of the public, mainly employers and employees of companies engaging in the field of technology and finance, in which it is nowadays acceptable to reward employees with such type of benefits. As is well known, the beneficial tax course, from the employees’ point of view, is the capital gains tax course which entitles employees to benefit from a lower tax rate of 25% on income generated by them from the options or shares, while on the other hand requires the employees to deposit their options or shares with a trustee for a limited period of at least two years. It should be recalled, in this context, that during 2012, the Israel Tax Authority (“the ITA”) published guidelines regarding the issue of "deposit with a trustee", which contained, inter alia, a requirement that a Board of Directors’ resolution will need to be adopted in respect of the granted options/shares (“the Grant Resolution”), which resolution, together with the letters of grant, should be sent to the trustee within a specified, limited period of time, as prescribed in the said guidelines. It should also be recalled that the option "life" period includes several relevant time frames, such as: the date of grant, the vesting date, the expiry of the tax limitation period, the exercise date and the date of sale of the shares.
In December 2018, the ITA published several new guidelines covering the area of employee share option plans which we will focus on below.
Firstly, Circular no. 18/2018 (“the Circular”), titled "Employee Capital-Based-Benefit Whose Vesting Depends on Performance" was published, within the framework of which the ITA sought to focus on the benefits' "vesting terms" that are usually subject to the discretion of the employer. Generally, there are a few common variations of vesting terms, with the most common of them being vesting based on a specific period of time (for example, completion of a period of employment of 4 years, with a pro rata portion of the options vesting each year). Other types of vesting terms require the attainment of performance targets (such as sales targets, an increase in the company's profits, etc.) or are dependent on market conditions (such as an increase in the market value of the company). According to the ITA’s position, in the event that the vesting terms are not sufficiently detailed, specific and certain in the Grant Resolution, then the date of grant will not yet enter into effect, so that the limitation period will only begin to be counted a later stage. In other words, if only a vague and general reference is made in the Grant Resolution to the vesting terms or the Grant Resolution leaves it to the future discretion of one of the company's organs to decide on the issue – then the limitation period will begin to run only from the date on which such terms are crystallized. Thus, for example, if the vesting terms provide that: (i) within one year from the date of grant the Board of Directors will convene in order to examine the scope of clients that the employee has recruited during the year for the purpose of deciding on the number of options to be vested; or (ii) the vesting date is dependent upon the speed of progress in the development of a certain product of the company – such terms will be deemed sufficiently measurable, fixed and defined, in order to establish the date of grant.
Likewise, the Circular also includes a discussion in the event that the vesting of the rights occurs upon an exit event (i.e., the full and outright sale of the company’s shares and undertaking) (“an Exit”) or on the date of issuance of an initial public offering of the company's shares (“an IPO”). Although in both such circumstances the vesting terms will be deemed sufficiently measurable, fixed, defined and known, the ITA holds the position that a grant in such circumstances cannot enjoy the beneficial tax courses under the Israeli Income Tax Ordinance [New Version], 1961 (“the ITO”) (including, as noted above, the lower tax rate of 25% under the capital gains tax course), largely because the employee's income will be considered a kind of cash bonus which is taxable just like a regular salary according to the marginal tax rate of the employee (up to 50%). The rationale for this notion is that the employee in these circumstances does not bear any capital risk as opposed to that borne by shareholders/option holders in the ordinary course (for example, in the case of underwater options). It should be recalled, in this context, that the common interpretation of the ITO is that any grant of options to employees immediately prior to an Exit or IPO (during the 90 day-period preceding such event) will result in forfeiture of the lower tax rate (25%).
According to a clarification subsequently published by the ITA, the latter guideline applies only with respect to a few cases in which the vesting is only dependent upon an Exit/IPO, thus making it relevant for a small portion of the compensation plans that, to the best of our knowledge, are adopted in practice, and not with respect to the more common cases under which the vesting terms are based on a period of time but with the inclusion of a provision for acceleration of the vesting period in the case of special events affecting the company (such as an Exit/IPO).
The Circular includes the possibility of changing the vesting terms (within 180 days from the date of publication of the Circular) for companies that are affected by the new guidelines, and in order to ensure their compliance therewith; in any event, a new grant date will be established for the purposes of calculating the limitation period.
Relocation of employees
Another issue discussed in the new guidelines concerns the manner of taxation of an employee who, after relocating to another country during the benefit period, generated income following the exercise of options or sale of shares held by him in the company. Thus, for example, an employee may be granted options while he/she is an Israeli resident and afterwards might be required to relocate to another country prior to exercise of the options into shares, or before the sale of the shares (in whole or in part). Similarly, on the other hand, an employee may be granted options while he/she is a non-Israeli (foreign) resident and at a later stage immigrates to Israel (in some cases, continuing to be employed in Israel by the same company/group).
It should be recalled, in this context, that both the applicable provisions of the ITO and guidelines published by the ITA deal with the complexity of deciding as to when the date of change of an individual's tax residency is deemed to occur (see, for example, ruling no. 2519/17 published by the ITA). With regard to the taxation of income in such circumstances, the common formula usually takes into account the pro rata portion of income that should be attributed as having been generated in Israel as opposed to the portion that should be attributed as having been generated abroad based on the amount of income multiplied by the number of days that have since elapsed from the date of grant of the options (or, as applicable, the beginning of the vesting period) until the date of relocation, divided by the number of days that have elapsed from the date of the grant of the options or the beginning of the vesting period, as applicable, until the date of completion of the vesting period.However, ruling no. 6539/17 as published by the ITA includes not very different treatment for employees who immigrate to Israel after working in a foreign subsidiary, with respect to which the provisions of section 3(i) applied (instead of the provisions of section 102). The formula for calculation of the "Israeli benefit portion" was similar in the reverse scenario (where an employee receives options as an Israeli and thereafter is relocated), but the taxable event would be deemed the date of exercise of the options into shares (and not the date of actual sale of the shares).
It should also be recalled that the taxation rules for income generated in such manner may differ in the foreign country from/to which the employee has emigrated/immigrated (for example, the foreign country may determine the taxable event as being the date of exercise of the options into shares, which, as noted above, is not the same as in Israel), and may thus give rise to a discrepancy and the double taxation of such income. In such circumstances, it is recommended that the provisions of the relevant double taxation treaty which such country has with Israel (if any) should be examined thoroughly and it may also be worthwhile at times to apply to the tax authority in the relevant country in an attempt to obtain a ruling with respect to the proper taxation of income.
In addition, the ITO also makes provision with respect to an Israeli resident who has relocated and is therefore subject to capital gains tax on all his capital assets, even if said assets were not actually sold (exit tax). This specific provision of the ITO also deals with share options that were granted to the Israeli resident prior to leaving Israel. The formula for calculation of the Israeli tax portion is generally the portion of profits produced on the date of the sale of the shares, multiplied by the period that has elapsed from the date of grant until the date of relocation, divided by the total holding period (from the date of grant until the date of sale). Said provision of the ITO gives rise to various questions of interpretation, including in relation to the provisions of the various tax treaties that may prevail.
Recently, a new ruling was published by the ITA (ruling no. 989/18) in a case dealing with a similar context. The issue at hand concerned an individual who was an Israeli resident until 2011, at which time he relocated to the US with his family. In 2014, said individual began working for a US company, which also granted him share options of the US company. In 2016 said individual returned to Israel with his family and was employed by an Israeli subsidiary of his former US employer company. At the time of immigrating to Israel, part (but not all) of the options had already been vested, thus leaving the balance of options unvested. In its said ruling, the ITA held, inter alia, that the portion of the profits that was produced outside Israel will be deemed as employment income produced outside Israel but received while the individual was an Israeli resident. As for the portion of the profits that was produced in Israel – the ITA held that this will be taxed at the regular income tax rate, similar to the taxing of other regular employment income, without the individual being entitled to a credit in respect of the US tax that was paid.
In other words, the ITA elected to tax the income generated from options that were vested outside Israel, while the individual was a foreign resident. It should be emphasized that this ruling contradicts previous rulings of the ITA, and it is doubtful whether they correlate with the wording of the ITO. This new position also reflects the position held by the ITA in ruling no. 2873/16 relating to the taxation of income of an individual who relocated to the US for several years and generated employment income (in the form of salary differentials and bonuses) from working for a US company, and who afterwards returned to Israel. In this latter case, the ITA held the view that the income so generated should be subject to Israeli tax (albeit with an entitlement to a credit in respect of the paid US taxes), since it was received in Israel. The rationale underlying the ITA’s position is that a salaried employee reports his/her income on a cash basis (i.e., at the time of actual receipt of the income), so that if the individual was an Israeli resident when receiving the said income (salary differentials), then the income should be subject to Israeli tax.