"In this world nothing can be said to be certain, except
death and taxes." Benjamin Franklin strikes again.
However, in the world of high tech and Israeli tax there has been
some uncertainty as to whether entrepreneurs, whose shares are
subject to a reverse vesting mechanism or a holdback upon their
sale, should be paying income or capital gains tax.
Reverse Vesting
Most start-ups are founded by several entrepreneurs and the equity
is divvied up among them. This is a good thing, it is hard to
create a successful venture alone, and the composition of the
founding team will be a factor in an investor's investment
decision. The risk however is that an entrepreneur will leave the
venture prematurely and with his shares. To reduce this risk, and
to ensure that all entrepreneurs have skin in the game, we advise
both entrepreneurs and early investors that entrepreneurs'
equity should be subject to a reverse vesting schedule.
In other words, the entrepreneurs' shares are tied to their continued performance and involvement in the start-up. If they leave within a predefined period, they are required to return a portion of their shares. However it is not a perfect solution. The risk is that the tax authorities may view the shares as consideration for employment and therefore subject to income tax at a rate of up to 50%, rather than capital gains tax which has a lower tax rate of 25% – 32%.
Earlier this month the Israel Tax Authority (ITA) published a
draft circular presenting its position that provided the following
conditions are met, the sale of such equity should be considered a
capital gain and not income:
(i) The reverse vesting mechanism was agreed in advance and in
writing at the time the company was incorporated (or soon
thereafter), or was a result of a substantial investment in the
company (at least 5%).
(ii) The reverse vesting mechanism dictates that only the company
or other existing shareholders are entitled to buy the forfeited
shares, and that such sale shall be for no consideration or for
their par value.
(iii) The shares subject to the reverse vesting mechanism are
ordinary shares, with identical rights to the other ordinary shares
in the company.
(iv) But for the reverse vesting mechanism, the gain from the sale
of the shares would have been considered a capital gain.
Holdback
When a purchaser buys a company, s/he usually demands that management stay on to ensure the company's continued success. With slavery abolished, the best way to ensure this is to holdback some of the consideration due to the selling entrepreneurs and key employees as part of the sale. These funds will then only be released upon the expiry of a predefined employment period. Accordingly, the same risk mentioned above with respect to reverse vesting applies; the tax authorities will view the deferred payment as consideration for employment and not a capital gain and it will be taxed at a higher rate.
The draft circular illustrates that the ITA also believes that
such payment should be treated at the lower capital gains rate
provided that the following conditions are met:
(i) The shares are ordinary shares, with identical rights to the
other ordinary shares in the company.
(ii) But for the hold back mechanism the gain from the sale of such
shares would be considered a capital gain.
(iii) The entrepreneurs/key employees held such shares for at least
six months.
(iv) The holdback payment does not include any additional
consideration, and equals the consideration that would have been
due to the entrepreneurs/key employees at the closing of the sale
– i.e. the same price per share paid to all ordinary
shareholders.
(If the price per share is higher, only the difference will be
taxable as employment income.)
(v) The entrepreneurs'/key employees' salary is not reduced
going forward.
(vi) The purchaser accounts for the holdback payment as
consideration for the purchase of shares in the transaction and not
salary.
(vii) The entrepreneurs/key employees report and fully pay their
taxes for the sale of their shares – including in connection
with the unpaid holdback payment. (If in the end an
entrepreneur/key employee does not receive the total consideration,
s/he will be entitled to a tax refund).
While this is only a draft circular it reflects the ITA's opinion. On the one hand this is good news for entrepreneurs. If the position is adopted, there will be certainty that the gain from a sale of their shares will be treated as a capital gain and not income, and it will be taxed more favorably.
However, on the other hand it comes at a price. An entrepreneur's negotiating power to resist a reverse vesting mechanism (demanded by a dominant founder or an earlier investor), or a holdback, on the grounds that s/he will be unfairly taxed as a result, will be diminished.
“Originally published on the TOI website“
Originally published August 23, 2016
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
