The Israeli Tax Authority published final instructions regarding Reverse Vesting shares on June 5 (Circular 5.2017. This will be of interest to many people in the Start-Up Nation.
Until now, founders and key personnel holding 10% or more of a company seemed to miss out on the opportunity to pay only 25% tax on stock options. This is because Section 102 of the Income Tax Ordinance only allows such tax breaks to employees with an interest below 10% in the company concerned.
Now, the Israeli Tax Authority has published a back door way for 10%-or-more founders and key personnel to enjoy capital gains tax rates on their shares (30%-33%), rather than up to 50% using reverse vesting shares (Tax Circular 5/2007 of June 12, 2017).
What is the reverse charge mechanism?
A reverse vesting mechanism is not the same as a share option plan, but the economic effect can be similar.
According to the Circular, the reverse vesting mechanism involves imposing restrictions on the shares of founders and key employees which are gradually lifted if they keep working at the company. The mechanism is typically specified in founders’ agreements when a company is formed or in a separate agreement at the time of a capital raising round to meet a demand from investors. Sometimes the mechanism involves a lien on the shares, placing the shares in trust, or obtaining pre-signed share transfer documents.
The usual situation in which shares of founders/key employees are purchased from them under the reverse charge mechanism is upon their dismissal. Typically, such restrictions are lifted and the shares stay in the ownership of the founder/key employee in cases of death, disability, termination not for cause (i.e. not due to severe failure of the employee), or resignation in justifiable circumstances (such as material adverse change in the function, substantial salary decrease not across the board, relocating the work place far away, and so forth). It is customary to cancel the mechanism in the event of an IPO or exit event.
Also, the share transfer price under this mechanism, is pre-fixed, such as zero, par value, or at the cost of the founder or key employee.
Capital gains tax treatment, including tax rates of 25%-33%, is permissible for founders and key employees, upon a sale “in practice” of the shares, if the conditions in the Circular are met and capital gains tax would have applied anyway….
The reverse vesting procedure must be fixed in advance when the company is founded or within 6 months thereafter or, interestingly, following a substantial investment in the company i.e. at least 5% of the issued capital after the issue.
If the reverse vesting procedure is triggered (i.e. the shares are to be forfeited apparently), it is fixed in writing in advance that only the company and/or other shareholders may acquire the shares of the founder or key employees, as pre-agreed, at price of zero, par value or the price paid when the shares were purchased, so long as the purchase was not less than their market value.
The shares of the founders or key employees must be ordinary shares which are classified as capital instruments, not debt, preferred shares, subordinated shares, management shares or redeemable shares (unless redeemable at par value or for no consideration).
The shares must have the same rights as other ordinary shares. The shares must confer rights to dividends, voting and liquidation surplus.
If the shares are sold to the company or to other shareholders according to the reverse charge mechanism, capital gains tax treatment tax treatment and rates should apply, provided the cost and purchase date will be as fixed at the time of incorporation/acquisition of the shares and the consideration, if paid, is paid by the company or other shareholders.
The company may not deduct any expense regarding the reverse charge mechanism.
The Circular will be of keen interest to founders and others holding an interest of 10% or more in the company. It is important they do so, as they then have “skin in the game”, meaning they have an interest to make the company succeed.
Clarification is needed on some aspects, including the requirement to apply the reverse charge mechanism as pre-agreed, at price of zero, par value or the price paid when the shares were purchased, so long as the purchase was not less than their market value. Can only the company or other shareholders purchase the shares from the founder/key employee? What about external service providers?
As always, consult experienced tax advisors in each country at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd