In recent months we have witnessed several exit deals where Israeli hitech companies have been sold for a pretty penny.
But suppose some of the consideration payable to the founders and key employees is held back and subject to staying on for a period as an employee in the post-acquisition group?
Is their consideration all treated salary taxed at rates of up to 50%? Is the tax payable before the consideration is actually received? These are big issues in the Israeli tax law.
Fortunately, the Israeli tax Authority has just issued an important Tax Circular which may resolve these issues if certain conditions are met (Tax Circular 5/2007 of June 12, 2017).
What is the hold-back mechanism?
According to the Circular, the holdback mechanism involves consideration for shares in the purchased company, paid in shares or cash, being placed in escrow for a pre-agreed period.
The consideration is released gradually or in one go, if they are employed by the acquiring group.
The consideration is paid in full if they don’t continue to serve due to death, disability, termination not for cause (i.e. not due to severe failure of the employee), or resignation in justifiable circumstances.
Circular indicates that matters came to a head after IBM bought an Israeli company, XIV for around $300 million in 2008. The Israeli District Court that held back share consideration was taxable at rates of up to 50% as salary because the share price paid was in excess of that paid to other shareholders (Haim Helman v. Assessing Officer Tel-Aviv 4, tax appeal 47255-01-14 dated October 15, 2015).
Unfortunately, the Court did not distinguish between the share price paid to other shareholders and the excess. In another anonymous case, the taxpayer accepted a suggestion of the Supreme Court on February 6, 2017 according to the Circular.
When is capital gain tax treatment okay?
The Circular specifies an arrangement for allowing capital gains tax treatment of holdback consideration (25%-33% Israeli tax) rather than salary taxation (up to 50% Israeli tax) in the case of founders/key employees up to the share price, i.e. not the excess in the above Helman case.
In brief, all the following conditions must be met unless the ITA allows otherwise:
First, the share must be ordinary shares which are classified as capital instruments, not debt, nor 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.
Second, the sold shares were held at least 12 months before the deal was signed.
Third, all the company’s shares were sold.
Fourth, no more than 50% of all rights received are subject to the holdback mechanism.
Fifth, the holdback consideration is part of the share consideration, not additional compensation, and is the same as that paid to other shareholders that with no holdback who hold a material interest in the company of at least one third.
Sixth, the founders/key employees sign a new employment agreement and receive a reasonable salary no less than their old salary
Seventh, the acquiring company must report the holdback consideration as share consideration, not salary, and not claim it as an expense.
Eighth, any excess over and above the price paid to others of that share class will be taxed as salary.
Ninth, the founders/key employees must report the sale transaction (presumably within 30 days) pay a tax installment on the cash consideration. To the extent holdback consideration is not yet received, the seller may “amend” his annual tax return for the year of sale accordingly, and tax may be refunded.
Tenth, the above holdco procedure is not available in the case of related party purchasers, companies that were ever fiscally transparent, and anyone who ever received a tax ruling regarding the shares concerned.
If the above conditions cannot all be met, the Circular says it is possible to apply to the Israeli Tax Authority for a specific ruling
These conditions may sound garbled but they aim to get round 50% taxation and the fact that capital gains are generally taxable within 30 days.
In our experience, since the acquiring group must withhold tax from the consideration, usually 25% unless otherwise agreed, the tax procedures will in practice need to be refined by way of an advance tax ruling.
It is unclear what happens in the case of an asset sale deal rather than a share sale deal. It is also unclear whether third party service providers may enjoy the above arrangement.
All in all, the Circular is welcome news for Israeli firms that manage to make an exit deal and sell their shares.
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