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Many Israelis have difficulty remembering where they are - they work round the clock in English with Americans and participate in deferred compensation or stock option plans. Most of those plans have to meet both US and Israeli tax rules, if the employer is a multinational group.
In this article, we briefly review some new US regulations that may be relevant to many people: US and Israeli multinational groups; Israelis who relocate to the US; and US citizens and green card holders in Israel.
Section 409A of the US Internal Revenue Code ("IRC") deals with "Nonqualified Deferred Compensation" plans, which may include: stock option plans, restricted stock units, stock appreciation rights ("phantom stock" - bonuses linked to stock price increases), deferred compensation and employment severance payments including conditional leaving bonuses.
The new regulations state that any amount deferred after January 1, 2005, that does not meet the requirements of the regulations will be exposed to accelerated and increased US taxation.
Section 409A will apply to the above plans where the grant, entitlement or vesting date is on or after January 1, 2005, and to grants vested before then if the plan was materially modified (as defined) after October 3, 2004. The final regulations will be effective from January 1, 2008.
Any deferred compensation that does not meet the rules will trigger an immediate US tax liability as soon as the benefit vests, plus a 20% penalty and interest 1% above the underpayment rate.
The regulations stipulate a number of cases that are excluded from the harsh Section 409A rules:
* Incentive stock option plans (ISO) pursuant to IRC Section 422
* Employee stock purchase plans (ESPP) pursuant to IRC Section 423
* Restricted stock plans
* Options where the exercise price is no less than the market price of the stock on the date of grant - according to valuation rules in the regulations
* Compensation deferred to less than 2.5 months after the end of the year in which the employee became entitled to the compensation.
Material modifications to the terms of deferred compensation - such as option repricing, extending the exercise period, acceleration of entitlement, changes following a merger or acquisition (M&A) - may be deemed a new grant that must meet the Section 409A rules.
Since the final regulations will be effective at the beginning of 2008, corporations that employ US persons need to check now whether their deferred compensation plans meet the requirements in the regulations. That includes Israelis who relocate to the US and become US residents. There are a number of transitional rules for amending plans in 2007.
Among the courses of action to consider are: terminating an old plan; adopting a new plan that meets the rules; adapting an old plan to make it comply - for example, amending the exercise price according to an up-to-date revaluation.
What about the Israeli tax rules? Salary and bonuses are usually taxed when they are received. Detailed rules in Section 102 of the Income Tax Ordinance apply to employee share option plans and share purchase plans. Preferential tax treatment is permissible for certain qualified plans called Section 102 plans.
Under Section 102 of the Israeli Income Tax Ordinance, employers may chose between alternative rules for treating resulting benefits as:
* Salary income - the employer deducts an option expense but the employee is subject to income tax at regular rates of up to 48% (in 2007) plus national insurance contributions) and
* Capital gains - the employer receives no deduction and the employee is subject to capital gains tax at a rate of 25% (except for any discount on the date of grant in public companies, which is treated as salary income).
If the options are issued by a parent or affiliated company of the Israeli employing company, the parent or affiliate must make an intercompany "charge back" of the employee gain as a condition of the expense deduction by the Israeli employing company.
For options granted on or after January 1, 2006, to obtain the capital gains tax treatment, the options must be held by a trustee for at least two years after their grant date. For salary treatment, the minimum holding period is one year.
The tax authorities must approve the trustee and receive notice concerning a Section 102 plan at least 30 days before the implementation of the plan. For further details see the article in this column on February 21: "Your Taxes: Tax implications of your stock options."
What happens if you relocate?
In brief, Israelis who relocate their center of living abroad and stop being Israeli residents, will be taxable at rates of on their unrealized gains upon departure under "exit tax" rules in Sections 100A and 102 of the Israeli Income Tax Ordinance.
US citizens and green card holders living in Israel will be taxed under the tax systems in both countries subject to a detailed system of foreign tax credits and/or an exclusion in the US.
Specialist advice should be obtained before and after relocating to or from Israel, as there may well be a risk of double taxation. This often occurs when different countries impose tax on employment benefits at different times.
The above is only a brief overview. As always, consult experienced tax and legal advisers in each country at an early stage in specific cases.
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Leon Harris is an International Tax Partner at Ernst & Young Israel, Leonard Hirsh is a Human Capital Principal at Ernst & Young New York, Hilli Peri-Yaniv is a Human Capital specialist at Ernst & Young Israel.
This article is not intended to be used and cannot be used for the purpose of avoiding any penalties in the US.