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In many companies, especially in the tech sector, stock options are an integral part of the salary package. Start-ups grant them when cash is in short supply to encourage employees to stay and help the company succeed, while publicly traded companies grant them to enable employees to benefit like investors from the rise in their stock market price. In short, socialism meets capitalism.
How do stock options work? That is a question for a lawyer and there are many possibilities. In a typical case, an employee is granted an option to buy stock (shares) in the employer company or its parent company at a fixed price in the hope of selling the stock later at a higher price. This is usually not an immediate process - instead the options "vest" over a period of time. The terms will be as specified in a stock option plan adopted by the employing company or group.
There are also "restricted stock" plans in which there are no options - instead the stock is issued at the outset but only released to employees over time if and when they meet performance targets or other conditions.
The use of stock options has become widespread globally, but the tax treatment tends to vary in different countries, making it difficult for multinational corporations to provide uniform treatment for all its employees around the globe. The big question is whether the employee must pay tax on a paper gain before selling the options or shares. A second question is what happens if a person relocates to another country while still holding stock options or stock.
So what is the Israeli tax treatment of stock options? In general, salary and employees pay income tax upon receipt of salary and the value of fringe benefits (up to 48%) as well as national insurance salary (up to 12% for employees, up to 5.68% for employers, on the first NIS 35,760 of monthly income)
However, in the case of stock options, there are four types of stock option plans for Israeli tax purposes, as follows:
* Approved options for employees - capital gains approach
* Approved options for employees - ordinary income approach
* Unapproved options for employees
* Unapproved options for major shareholders and non-employees
The first three plans are prescribed in Section 102 of the Income Tax Ordinance, the last is covered in Section 3(i) of that law. The employer selects the type of plan desired prior to the date of grant and cannot change the type of plan for a period of at least a year following the year in which options were first issued under the plan.
Section 102 stipulates that an employee won't be taxed upon the grant of options or stock, only upon the deemed realization date. Section 102 plans must be in a prescribed format and notified to the Israeli Tax Authority (ITA) at least 30 days before the plan is first implemented and a trustee approved by the ITA must be appointed to help administer the plan.
The perennial fear of the ITA is that someone who receives options will forget to pay the tax when they turn them into cash. So the task of the trustee is to hold the options or stock on behalf of the employees until tax is paid. The trustee may be an employee or director/office holder who did not receive options under the plan, but not major (10+%) shareholders.
Approved options for employees - capital gains approach:
This is the most popular alternative in practice as the employee pays reduced tax, which is deferred until he or she realizes a gain. In brief:
* Employees are deemed to realize a taxable capital gain upon the sale of shares after the exercise of options or upon the release of shares or options from trust (rare in practice), whichever is first.
*The gain is taxed at a fixed rate of 25%, and both the employer and employee are exempt from national insurance (social security).
* The employer company will not be entitled to any expense deduction for tax purposes regarding the options.
* The options must be held in trust for at least two years after the date of granting the options and lodging them with the approved trustee. (Different rules apply if the options were granted before 2006).
* If these rules are broken (premature sale, etc.), the employee will pay regular income tax at regular rates (up to 48%) as well as national insurance contributions but the employer still gets no expense deduction for tax purposes.
* If the employer is a public company, any discount at grant will be taxed upon realization at regular rates as above; the discount at grant is the difference between the exercise price and the average value of the company's stock in the 30 days preceding the grant.
Approved options for employees - ordinary income approach:
Under this approach, the employee benefit is treated like salary (not capital gain):
* Therefore, the gain is added to other earned income and taxed at regular income tax rates upon realization of the gain - upon the sale of shares after the exercise of options or upon the release of shares or options from trust, whichever is first.
* Income tax will be payable (up to 48%) as well as national insurance salary (up to 12% for employees, up to 5.68% for employers)
* The options must be held in trust for at least one year after the date of granting the options and lodging them with the approved trustee. (Different rules apply if the options were granted before 2006).
* The employing company may deduct the employee gain as an expense when the employee is taxed on it.
* 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.
* If these rules are broken (premature sale, etc.), the employee will be taxed at full rates at the time of the sale on the higher of the following amounts: the paper gain upon grant (plus interest and indexation for inflation) or the gain upon sale.
Unapproved options for employees:
These are options granted under Section 102(c) to the Income Tax Ordinance, without an approved trustee.
* If the options/stock are not publicly traded on an Israeli or foreign stock exchange, full income tax (up to 48%) and national insurance contributions will apply when the employees realize a gain.
* If the options/stock are publicly traded, full taxes will apply immediately.
* The employer will not receive an expense deduction.
* Quarterly and annual reports must be filed with the Israeli Tax Authority.
Unapproved options for major (10+%) shareholders and non-employees:
These options are granted under Section 3(i) to the Income Tax Ordinance. Full income tax (up to 48%) and national insurance contributions will apply to the paper gain arising upon exercising the options, whether or not the resulting stock is immediately sold.
What about foreign stock option plans? In a multinational group, Section 102 allows employees of an Israeli group to be granted stock options or stock of an overseas parent company. Since Section 102 requires a trustee and a plan in a prescribed format, it is customary to add the text of the Section 102 format as an Annex to the parent company's plan for Israeli employees and appoint an approved Israeli trustee to administer it in coordination with the parent company's administrators. In our experience, the Israeli Tax Authority usually accepts this mode of operation but requires a Hebrew translation of the entire plan as a condition for approval.
Procedural matters for approved plans: There is a requirement to report within 30 days after the end of each quarter and annually regarding options granted.
Other tips regarding stock option plans: It will be necessary to consider the generally accepted accounting rules for stock option plans - they are generally not a hidden "off balance sheet" item. Avoid issuing stock options on a back-dated basis. Avoid promising Section 102 stock options to employees under a new plan prematurely - first notify the Tax Authority of the plan and wait 30 days - otherwise the employees will pay have to full Israeli tax immediately. If the Israeli company is a party to a cost sharing arrangement (joint venture for developing and exploiting new technologies), check the need to recognize stock option plan costs under accounting and tax rules - especially if a US company is also involved.
As always, consult experienced professional advisors in each country in specific cases.
The writer is an International Tax Partner at Ernst & Young Israel.