As you go through the “Option & Share Plan for Employees” Section of the Due Diligence Handbook and the various articles I’ve written on options you will notice myriad references to tax authorities in general and the ITA (Israeli Tax Authority or Mas Hachnasah) in particular. That’s because, as we discussed here, national tax authorities are central in establishing rules and requirements relating to the structure and operation of option programs. And they do go to freaking town. In the UK, for instance, there are four (4!!!) types of tax-advantaged employee share “schemes”. (In its defense, HMRC is at least thoughtful enough to provide information on each of these schemes in a lovely, clear and well-organized website, which has saved this CFO a ton of time.)
Israel also has a several different option grant options. As such, I thought an overview of Israeli tax-advantaged ESOP’s would come in handy. For this, I have teamed up with Odelia Pollak, Adv., CEO of ESOP – EXCELLENCE, which offers trustee and a wide range of other ESOP management services.
Note that the below applies to options issued by private companies. But then, if you are a publicly- traded company, you no doubt have a CFO and do not need my website. 🙂
First, a warning
One key item that Odelia pointed out is that there is nothing, but really, nothing, that the ITA loves more than finding reasons to NOT allow people to claim tax benefits. If they can find a hole in a plan or in a grant—some minor violation of a reporting obligation or eligibility requirement—they will. In fact, if you pay attention, I think you will find this to be a recurring motif in this article.
So without further ado…
Well, a little bit of further ado. An important definition
A controlling shareholder is, broadly speaking, someone who owns 10% of a company’s shares, who has rights to 10% of a company’s profits or who has the right to appoint a director of the company (even if they own less than 10% of the shares). Note that, in calculating this 10%, one takes your shares and any shares held by your “relations” as defined by the ITA (e.g. family members, your spouse’s family members and your partners if you are operating as a partnership). Odelia asked me to point out here that the definition of a “relation” is very broad so check with your legal counsel or trustee if there is any doubt as to someone’s status.
Why is this important? If you are reading this and you are the founder of a startup, you probably hold more than 10% of your company’s shares. This means you are a controlling shareholder, and neither you nor your “relations” will be able to participate in company tax-advantaged option schemes. You can all still receive options though—I’ve included a description at the end—they just won’t have the tax benefits. (You see? Here is the motif! You shall see it again….)
So, what are the key differences between the option options? (That counts as a pun, right? I’m pretty sure that counts as a pun.)
As you look at different programs, the key variances tend to fall into the following categories:
- Who can and cannot receive options or shares under the program
- Tax points (when the option or share is subject to tax; there may be more than one)
- The tax rate applicable at each tax point.
- Whether the employer can claim grants as an expense in their tax return
- Administration requirements
- Reporting requirements
- Other program limitations
Alternative Tax Tracks –Tax Advantaged ESOP
In general, again, unless they are a controlling shareholder, options to employees and/or company officers (see more on officers below) are granted under Section 102 to the Israeli Tax Ordinance (“Ordinance”, for short). There are three different tax tracks under Section 102:
- Programs overseen by a Trustee:
- Capital-gains track;
- Ordinary income track
- Programs not overseen by a Trustee.
The default track is “no trustee” which is also the suckiest of the three tracks, as you shall see.
If you want to go with a trustee administered plan, this requires an actual declaration and submission of an ESOP program and other paperwork to the ITA 30 days in advance of making the first grant. Grants issued before that 30 day deadline (or, heaven forbid, before submitting the paperwork to the ITA) will not be eligible for tax benefits.
Each of the above tax tracks results in different taxation results for both the company and the employee and each requires different administration and reporting. As such, before making the election, it’s a good idea to sit down with your legal counsel and/or your trustee to review the various options in depth and get advice as to which one is best suited for you. Bear in mind that while you can change to another tax track in the future, this can only be done once every several years and the new tax track will only be for new grants; there is no retroactive application to grants that were made under previous tracks or plans. In addition, you will need to notify the ITA. And as to that, “minimize, as much as possible, your correspondence and dealings with the ITA” is a FINE rule to live by, in my humble opinion. Do your homework upfront—your legal counsel and trustee will help you—and try to avoid a future redo.
Another Odelia Warning! Not all Company Officers are created equal when it comes to tax benefits
In Israel, Board members are considered Company Officers, so they should be eligible for the Trustee plans. And they are…but not all board members and not always. Advisory board members are not eligible. And if you are paying your board members, they need to be paid directly, as individuals. If the Board member is having you pay to, say, a management company, then BOOM! He’s ineligible for tax benefits.
So speak with your legal counsel or trustee before you issue options or shares to directors.
102 Trustee Administered Capital-Gains Track vs. 102 Trustee Administered Ordinary Income Track
The key variances between the two trustee-administered programs have to do with (1) the tax rate paid by the employee on their ESOP grants and (2) whether or not the employer can claim the value of the benefit granted as an expense on their tax return.
| Capital Gains Track | Ordinary Income Track | |
| How are ESOP grant earnings taxed? | As capital gains. Payment of tax is at lovely reduced capital gain rates (generally 25%).
|
As employment income. Payment of tax is at the employee’s marginal tax rate rate PLUS National Insurance (Bituach Leumi) PLUS Health Tax (Mas Briut). This can total up to around 60%. (AAAAIIIIIEEEE!!!!)
|
| Can employer claim option grant expenses on their tax return? | No | Yes |
For all trustee-administered plans:
- Calculation and payment of any tax is deferred. First, so long as the options remain options and continue to be held by the trustee, there is no tax. Once the options are exercised, tax is only due once the shares are sold or once the shares are released to the employee, whichever comes first.
- The options (or resulting shares) must be held in trust for a minimum length of time in order to qualify as a “trustee administered” plan. For the capital gains track, this is at least 24 months after the grant date and for the ordinary income track, it’s 12 months. If the holding period is breached, the tax benefits will be forfeited and the grant will fall under the category of “102 Option programs without a trustee” (see below).
102 Option programs without a Trustee
These are basically the worst of both worlds. ESOP grant earnings are taxed as employment income, so at the employee’s marginal rate plus National Insurance and Health Tax. The employer cannot claim option grant expenses on their tax return. However taxes are still only due once the employee has sold the shares.
Option grants not under 102
Remember where we were talking about controlling shareholders? If someone does not qualify for a grant under Section 102, their options will fall under Section 3(i) of the Ordinance. In addition to controlling shareholders, this will also apply to grants made to suppliers or advisors. In this case, the grants are taxable at two points:
| When is the ESOP grant taxed? | How are ESOP grant earnings taxed? | |
| Tax point 1 | When the options are exercised (conversion to shares) | As employment/earned income. Payment of tax is at the employee’s marginal rate plus National Insurance and Health Tax. Taxable income is equal to the difference between the exercise price and the actual value of the shares on the date of exercise.
|
| Tax point 2 | When the shares are sold | As capital gains. Tax rate of 25% |
A final word of caution
The above is intended to give you a general understanding of what is going on and why. But it’s really broad overview. I left out a ton of information because a full description would be massively long and boring. Suffice it to say that, as one might expect from anything tax related, the reality is far more detailed. If you are setting up an ESOP, please sit down with a professional and do it properly. Not doing so can end up costing you and your employees lots of money. The ITA IS out to get you and cancel your tax benefits. Don’t let that happen!