Israeli Taxes: Collision with venture capital funds averted

The reasons for the Israeli emphasis on hi-tech are many and varied, but the lack of natural resources, the influx of Russian engineers and government R&D grants have all played a part.

By LEON HARRIS
October 4, 2006 07:44
4 minute read.
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taxes88. (photo credit: Courtesy)

In 2004, the Organization For Economic Cooperation and Development (OECD) concluded in a report that between 1999 and 2002 investment in high-technology sectors - communications, information technology and health/biotechnology - was the highest in Israel, reaching over 0.6 percent of gross domestic product (GDP) compared with 0.3% of GDP in the US and Canada; 0.25% in Sweden; and 0.2% in the United Kingdom. This was because Israel has had marked success in attracting venture capital. In fact, venture capital funds, fondly known as "VCs" have invested around ten billion dollars in Israel over the last dozen years. The reasons for the Israeli emphasis on hi-tech are many and varied, but the lack of natural resources, the influx of Russian engineers and government R&D grants have all played a part. On the tax side, it wasn't always plain sailing. In the 1990s, Israel imposed taxes on sale gains of the VC funds at rates of up to 50% and deemed the gains to be ordinary business income rather than capital gains. This is unlike the practice in the US, UK and other countries. However, all this changed in 2001 when the IRS in the US refused to allow US investors a credit for such Israeli taxes. This resulted in a policy shift in Israel that averted a collision with VC funds, their investors and the IRS. The Israeli Tax Authority has announced in Circulars and in its "Professional Instructions" (known as Habak in Hebrew) a policy of issuing advance rulings allowing an upfront exemption from capital gains tax to VC funds and their investors if the investors are foreign residents and certain other conditions are met. This is pursuant to Section 16A of the Income Tax Ordinance, which allows the Director of the Tax Authority to reduce Israeli taxes if they are not creditable abroad by a foreign resident. In general, such advance rulings must meet the following conditions, among others: * The ruling will be issued to a foreign limited partnerships and foreign investors in them. In a limited partnership, the investors (limited partners) generally cannot participate in the management of the partnership; instead a general partner (GP) with unlimited liability will manage or arrange the management of the partnership. If the GP is a company, its liability may, in practice, be limited. * Israeli resident VC investors will usually invest in a separate co-investor limited partnership and pay Israeli taxes - generally 20% pursuant to an amendment implemented in 2006. Israeli resident institutional investors (provident and pension funds, etc.) will be exempt provided their level of control does not exceed certain levels, generally 25%. * The Fund (one or more limited partnerships) will be required to raise investment commitments totaling at least ten million dollars, of which at least five million dollars must be from foreign investors. * There must generally be at least ten investors (foreign or Israeli) none of whom hold more than 20% of the fund. In the case of a "fund of funds" the underlying investors are counted. * The Fund must invest at least 50% of its monies in "qualifying investments" in Israel. These are investments in Israeli companies whose principal activity is the establishment or expansion of plants in the field of industry, agriculture, tourism, transportation, construction, water, energy, communications, computers, medicine, biotechnology, or research and development in the aforementioned. * At least 30% of the Fund's monies must be invested in Israeli resident companies that own the know-how that is developed and/or in foreign companies with Israeli resident subsidiary companies that own the know-how that is developed. * All investments in such Israeli companies or Israel-related companies must be effected directly via a permanent business office of the Fund in Israel. Furthermore, as an added sweetener, the Israeli Tax Authority may grant a separate ruling allowing the VC fund managers to enjoy a 25% tax rate (rather than up to 49%) on their carried interest. The carried interest is success-related bonus, usually 20% of gains generated after returning capital to the limited partners. An approved trustee must hold the carried interest rights for at least two years. It should also be noted there is now an exemption from Israeli capital gains tax for foreign investors in Israeli publicly traded companies and private R&D intensive companies that meet certain conditions. In addition, foreign investors are exempt upon a sale of Israeli securities if they were resident for at least 10 years preceding the date of acquisition of the investment in a country that has a tax treaty with Israel; they acquired their investment between July 1, 2005 and the end of 2008; and they notify the Israeli Tax Authority of their acquisition within 30 days. This assumes the gains are not attributable to a permanent establishment (generally a fixed place of business) nor shares in companies that principally owned real estate at the time of the investment and in the two years before the sale. leon.harris@il.ey.com The writer is an International Tax Partner at Ernst & Young Israel.


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