Some Israeli tax updates on employee retention payments (holdback amounts) and the transfer of an IP during a share purchase transaction

On June 12, 2017, the Israeli Tax Authority ("ITA") published a Circular who deals with retention mechanisms and limitations on key employees and founders (especially in respect of startup companies). Specifically, said circular provides guidelines regarding the taxation of two common mechanisms: Reverse Vesting and Holdback.

As for the second type of mechanism, the circular prescribes conditions that must be fulfilled in order for the full holdback amounts to be considered a capital gain (instead of a work income). The conditions are, generally, as follows:

1.      Conditions regarding the Seller's shares:

1.1.The shares must be classified as equity instruments (not as liabilities).

1.2.The shares cannot be classified as preferred/management/deferred/redeemable shares. In other words, the shares must be classified as regular shares.

1.3.The shares must contain dividend, voting and participation rights in the Company's assets in the event of liquidation.

1.4. If the shares were sold in a regular sale, the profit from their sale would have been considered (by the ITA) to be capital gain.

1.5.The Seller held the shares for a period of at least one year prior to the transaction date.

2.      Conditions regarding the transaction:

2.1.The Seller's shares are sold as part of a transaction in which all the rights in the Company are sold.

2.2.The percentage of the rights in the Company held by the Seller subject to the holdback does not exceed 50% of the total rights held by them.

2.3.The holdback amounts are not an additional remuneration, but only an integral part of the Company shares' transaction (between a willing seller and a willing buyer).

2.4.The share price to be paid to the Seller shall be the same as the price per share to be paid to the other Shareholders.

3.      Conditions regarding the Sellers:

3.1.The Sellers will enter a new employment agreement (or, alternatively, continue to work under the existing one) according to it they will earn a wage that shall not be less than their salary prior to the transaction.

3.2.The Sellers will report to the tax authorities on the Company shares sale and will pay a tax advance payment for the full consideration attributed to them (including their share in the holdback amount).

3.3.In relation to the relevant Seller, in case he/she will not receive a part of the holdback amounts (eventually), he/she will be entitled to amend his/her tax report for the sale's year, and the tax which relates to

the part that has not been paid will be returned (plus interest and linkage).

3.4.The Sellers will not be able to demand any expenses under the Income Tax Ordinance regarding the holdback mechanism.

4.      Conditions regarding the Acquiring Company:

4.1.The Acquiring Company shall refer the holdback payment in its tax reports as a payment for the sold shares (and not as a payment for the Sellers salaries).

4.2.The Acquiring Company will not be able to demand any expenses under the Income Tax Ordinance regarding the holdback mechanism.

4.3.The Acquiring Company and the Company whose shares are sold and/or shareholders are not "relatives" for the purpose of the Ordinance. In addition, the shareholders who hold most of the share capital of the

purchased company (more than 50%) are also not considered as "relatives".

5.      Conditions regarding the Purchased Company:

5.1.The Purchased Company and/or sellers have not received any previous tax decisions regarding the relevant shares from the Tax Authority.

5.2.Since its incorporation, the Purchased Company has never been a transparent body.

It is important to note that the above Circular - which presents clear and detailed conditions regarding a payment of holdback amounts - was published as a result of the recent judgement of the Israeli court in the Hellman case, which dealt with holdback amounts.

Therefore, our conclusion is that it is now possible to take a position by which holdback amounts will be considered capital gains, even without receiving a ruling from the tax authorities. Of course, this is subject to compliance with all the Circular conditions.

Secondly, an Israeli judgement of the Israeli district court was published recently which deals with the taxation of an IP transfer. In this matter, Microsoft acquired an Israeli start-up ("Gteko") for US$ 90 million. Shortly afterwards, Gteko employees were transferred to Microsoft to continue providing services to existing customers. Several months later, an additional agreement was signed between Gteko and Microsoft for the sale of Gteko's IP for US$ 26.6 million - consideration that was calculated on the basis of an opinion prepared by a consulting firm. Most of the dispute centered on the gap between the price paid for the sale of the shares (US$ 90 million) and the price of the intellectual property transaction (US$ 26.6 million). Gteko's claim was that the consideration in the IP agreement reflects the market value of the sold assets, and that the gap between the transactions prices is the "added value" for Microsoft beyond the assets "pure value". On the other hand, the Tax Authority claimed that the consideration for the IP was low and did not reflect the real market value of the transaction. In their opinion, since the transaction is between related parties, it should be taxed according to its market value and not according to what was determined between the parties. According to the Tax Authority's position, the value of the activity transferred from Gteko is the value of the consideration for the shares.

Unprecedently, the court rejected most of the tax appeal submitted by Gteko. In the court's opinion, when the R&D activity was transferred to Microsoft and did not remain in Gteko's possession (in fact, there was almost nothing retained by Gteko), the conclusion was that the IP was also transferred. The court pointed out that in this case, Microsoft acquired Gteko's shares in order to integrate Gteko's skilled staff in the development of Microsoft products. All the employees, including management, marketing and development personnel, were then transferred to Microsoft. According to the judgment, at this stage Gteko's interests were withdrawn from Microsoft's; in such a way that Gteko became an "empty corporate shell". In conclusion, the court ruled that the value of the IP transfer transaction was derived from the proceeds of the share transaction, when a number of minimal payments (such as a bonus paid to employees) should have been deducted from this value (more or less 10 million). In other words, the transaction value is $ 80 million, and not as declared by the acquired company (26.6 million).