Received Options Under Section 102 of the Ordinance? Beware! The Tax Authority Could Be After You

Newsletter 02/2021

Received Options Under Section 102 of the Ordinance? Beware! The Tax Authority Could Be After You

As a rule, many start-up companies have a practice of granting their employees capital remuneration through various instruments, such as: options, RSUs, shares etc. The capital gains track in Section 102 of the Income Tax Ordinance enables the taxation of income derived from the exercise of capital instruments as capital gains (25% tax rate) and not as employment income (a marginal tax rate that could reach 50%), provided all the Section’s conditions are met. It is also possible to execute grants to senior officials and directors under this track.

In a series of cases recently handled by our firm, at the time of sale of the shares in an exit, assessment negotiations arose with the Israel Tax Authority, in which the tax assessors argued that not all conditions of the capital track had been met, and therefore the income should be taxed by a marginal tax.

The reason for this stems from the fact that, in addition to the few simple conditions detailed in Section 102 of the Ordinance, there is a kind of oral law, which includes allowances and prohibitions that are not necessarily written in the law, yet are reflected in the Tax Authority’s policy. At the time of an exercise event, there is a practice in which the purchaser’s attorneys execute due diligence and transfer cases they consider problematic for examination by the Tax Authority.

Due to the above, usually an employee or company is granted time to present a specific certification from their assessment officer regarding the rate of tax to be withheld at source. Where they are unable to present certification on time, tax is withheld as employment income according to their marginal tax bracket.

Below are examples of cases in which our firm was recently required to engage in negotiations with the Tax Authority regarding the classification of income from options, in light of allegations by the Tax Authority or the purchaser in the transaction that the allocation of the options or RSU did not meet the conditions of the capital track:

1. The right to appoint a director – According to the Tax Authority’s approach, an employee’s right to appoint a director in the company, even if partial (together with another person), as may be reflected in the company’s articles of association, founder’s agreement etc., could disqualify the transaction from a capital gains tax rate.
2. Options whose payment date was extended during the employee’s period of employment.
3. A company decision to extend the possibility to exercise the option beyond the end of the employee’s period of employment (GPT).
4. A PUT/CALL option – An option for the company to buy the capital instruments from the employee under certain circumstances, concurrently with an employee option to sell the same capital instruments back to the company.
5. The existence of special rights under the options, compared to other employees, such as voting rights.

In light of the scope of exposure stemming from the Tax Authority’s policy regarding granting capital instruments under Section 102 of the Ordinance, we recommend you consult with attorneys knowledgeable in the field prior to an exit, in order to minimize possible tax exposure in the future, since at the time money is exchanged the difference between paying marginal tax and capital gains tax can be very significant.

For additional information, contact Adv. Yair Benjamini from our firm.