On July 4, 2019, the District Court in Nazareth (the "Court") issued a significant court ruling which addresses compliance with Section 102 of the Israeli Income Tax Ordinance [New Version] 5721-1961 (the "Ordinance" and "Section 102") and in specific requirements for compliance with the Trustee Capital Gains Route under Section 102(b). Although the case addressed a specific employee equity plan and the position taken by the Israeli Tax Authority (the "ITA") according to which the plan did not comply with the requirements of Section 102, the court ruling includes general determinations regarding compliance with Section 102. The ruling was issued by the District Court and is therefore still subject to possible appeal to the Supreme Court.
The first most important determination made by the Court is that the equity plan is intended to provide the company and the employee with certainty with respect to the grants made under the equity plan and their tax implications. Therefore, it was ruled that once an equity plan has been approved by the ITA, including when the plan is deemed approved due to the lapse of 90 days from submission without objection (as determined in Section 102 of the Ordinance and the Israeli Income Tax Rules (Tax Relief in Issuance of Shares to Employees), 5763 – 2003, the ITA will generally not be able to claim the plan is not compliant with Section 102.
The Court goes on to determine that Section 102 applies to any class of share in the share capital of the company. The Court determines that cash dividends paid on shares taxed pursuant to the Trustee Capital Gains Route of Section 102 will be subject to tax at 25%, including when the dividends are paid during the two year holding period. The Court further determines that the existence of a put option or call option does not necessarily disqualify awards from beneficial tax treatment, including where shares are converted into dormant shares upon termination of employment, as long as the equity plan and the awards fulfil the purposes underling Section 102.
The circumstances of the specific case are as follows: A company adopted an equity plan under which various employees were issued a special class of shares. These shares had only dividend rights and could not be transferred. Upon termination of employment the shares were to be converted into dormant shares. Dividends distributed to the employees were taxed at dividend tax rates. The ITA claimed that the dividends should have been taxed as ordinary income and not as a dividend. The appeal was filed by one of the employees of the company. The Court ruled in favor of the employee other than with respect to the tax rate which was determined at 25% and not at the reduced tax rate available to cash dividend distributions from a "preferred enterprise".
This is the most significant and extensive court ruling with respect to Section 102 which has been published since it was introduced in its new version in 2003 and will in no doubt have material impact on common practice in the field of employee equity plans in Israel.
We believe it is likely that the ITA will file an appeal and are uncertain as to the position the ITA will take with respect to the court ruling. The future implications remain to be seen.