A “Substantial Shareholder” – Or Not

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A “Substantial Shareholder” – Or Not

 

An individual who sells shares would be subject to tax on the real capital gains they accrue at a tax rate that would not exceed 25%, unless that individual is considered a “substantial shareholder” in that company (at the date of sale or during the 12 months prior thereto). In that case, the tax rate would not exceed 30%. A 3% “surtax” would be added if the individual’s income in that year, from various sources, exceeded approx. NIS 663 thousand.

 

A “substantial shareholder” is a person who holds, directly or indirectly, alone or “together with another” at least 10% of the “control mechanisms” in the body of persons whose shares are sold.

The term “control mechanisms” enumerates several criteria which determine whether or not the individual should be considered a “substantial shareholder”.

 

Most of the criteria found in the definition are clear and are relatively easy to check and measure – for example: an individual who has at least 10% of the right to profits, an individual who holds at least 10% of the voting rights in the general assembly, and an individual who holds at least 10% of the right to receive part of the balance of assets at the time of dissolution of the body of persons.

 

In addition to these, there is an additional criterion, which in recent years has frequently come up in negotiations with the Tax Authority after a share sale transaction – an individual who holds at least 10% of the right to appoint a director or CEO in the company. In contrast to the other criteria, we believe that examination of this criterion is not simple and cannot be measured easily, since what is holding at least 10% of the right to appoint a director or CEO in the company?

In order to try to answer this question, we shall describe the manner of appointing a director or CEO in a company, since in most cases, each of the aforementioned senior officials is appointed in a separate, unique process.

Appointment of a director in the company

 

In most cases, directors are selected based on a majority resolution among the company’s shareholders. In other words, a general assembly of the company’s shareholders is convened, and a vote is held among the shareholders regarding selection of the directors. We believe that in a situation where the shareholder holds less than 10% of the company’s shares, yet holds 10% or more of the voting rights in the general assembly convened to select directors for the company (a scenario that usually occurs for founders shares diluted below a percentage of 10%, yet which retain surplus rights for appointing directors), it is possible that this shareholder should not be seen as a “substantial shareholder” as a result. And we shall explain – we believe that, as long as a person does not have an exclusive right to appoint a director in the company (or if they do not hold the majority of the appointment rights, such that their choice is accepted automatically) it would not be possible to say they have the right to appoint a director in the company in practice.

Appointment of a company’s CEO

 

In most cases, and as stipulated in the provisions of the Companies Law, the board of directors is the body authorized to appoint a CEO in the company. Therefore, in a case where the company’s board of directors numbers ten members or less, ostensibly every shareholder who serves as a director in the company would be considered a “substantial shareholder”, even if they hold 0.01% of the shares in the company (since ostensibly they have 10% or more in the voting rights in board of director resolutions). We believe this was not the Legislator’s intent, and that this is an interpretation that is inconsistent with the provisions of the Ordinance, since appointment of a CEO is executed by a majority resolution among the members of the board or directors, regardless of the question whether the board members are shareholders in the company or not. That is to say, this is an equal right held by each director in the company, even if they do not hold shares in the company at all. This means that, as long as a certain director does not have an exclusive right to appoint a CEO (or if they do not hold the majority of the appointment rights, such that their choice is accepted automatically) it would not be possible to say they have the right to appoint a CEO in the company in practice.

In summary, determining if a shareholder meets the definition of “substantial shareholder” is not simple, and we believe there is a need to examine if the rights of the specific shareholder testify to a real ability to direct and control the company’s activity. We would like to add that our conclusions, as cited above, are also based on a comparison with other sections in the Income Tax Ordinance and even on the interpretation and professional circulars of the Tax Authority itself, although in assessment negotiations income tax inspectors tend to adopt a broad interpretation of the definition of substantial shareholder.

For additional information, contact Adv. (CPA) Doron Elmekiesse or Adv. (CPA) Tal Teri from our firm.