Employee Stock Options – Mechanism for Accelerating the Vesting Period

We believe this to be an important publication, in that it conveys certainty and stability for the general public of option holders in Israel.

As is known, section 102 of the ITO regulates the manner of taxation and reporting duties that apply upon exercise of the share options that are issued to employees, as well as the conditions which, once fulfilled, the profit deriving from such exercise will be taxed at the capital level.  Nevertheless, the provisions of section 102 of the ITO do not address the matter of the vesting period and the various acceleration mechanisms, that are common in the Israeli economy.

Within the context of the Position Paper, the ITA clarified its stance that in a vesting acceleration mechanism classified as “single trigger” acceleration, whereby unvested options will be accelerated and become fully vested upon the sale of all or a majority of the company’s shares or assets (“an Exit Event”) or when the company’s shares are first listed for trade (“an IPO”) – the accelerated vesting will not be perceived as a violation of the provisions of section 102 of the ITO and the profit deriving from sale of the shares will be taxed at the capital level.

Moreover, the Position Paper clarifies the ITO’s stance with respect to the vesting mechanism classified as “double trigger acceleration”, whereby unvested options will be accelerated and become fully vested upon the satisfaction of two cumulative conditions: (a) the occurrence of an Exit Event; and (b) termination of the employee-employer relations due to the Exit Event.  The Position Paper thus clarifies that the application of this type of acceleration mechanism will also not lead to a violation of the provisions of section 102 of the ITO, and that the tax liability deriving from options accelerated due to the implementation of this mechanism will be considered as follows:

1. For cash consideration – if at the time the cash consideration is received the share price paid by the acquiring company was higher than or equal to that paid by it on the closing date, the employee will be taxed at the capital level. Conversely, if at the time the cash consideration is received the share price paid by the acquiring company was lower than that paid by it on the closing date, the employee’s income will be divided into two components, as follows: (1) portion of the cash consideration multiplied by the ratio obtained by dividing the difference between the share price paid by the acquiring company on the closing date and that paid by it on the date of actual receipt of the consideration upon sale of the acquiring company’s shares on the closing date, will be classified on the date of receipt of the consideration as work income in the hands of the employee and thus subject to marginal tax; and (2) the balance of the consideration will be taxed at the capital level.
2. For cash-equivalent consideration based on shares of the acquiring company (Equity Instrument Granted) – consideration in equity of the acquiring company that is allotted within the ambit of an Exit Event to an employee for unvested options as at the closing date will be taxed at the capital level.

The Position Paper further clarifies that, in the event of implementation of the acceleration mechanism upon termination of the employee-employer relations not within the ambit of an Exit Event or IPO – the income for options whose vesting will be accelerated will be classified as work income and thus be subject to marginal tax in the hands of the employee.

The Position Paper duly emphasizes the importance of tax planning when crystallizing employee compensation plans.  As can be discerned, intelligent tax planning, that takes into account, among other things, the conditions enumerated in the Position Paper, may lead to a significant reduction in tax that will apply on the date of exercise of the share options and their vesting.