To be or not to be an Israeli company

By OREN BIRAN
THE TEL AVIV skyline (photo credit: REUTERS)
THE TEL AVIV skyline
(photo credit: REUTERS)
Many entrepreneurs need to make a decision where to incorporate their company. Should the company be incorporated as an Israeli or US corporation? The decision where to establish their start-up can influence the future growth of the company and may be irreversible. This debate has been repeated recurrently over the years between practitioners, and no specific or final formula exists. The decision is mainly based on the international tax considerations resulting from the corporate structure. The founders of a company may consider, among other things, two alternative structures: an Israeli parent company with a US subsidiary or a US corporation with an Israeli subsidiary.
Each structure has its pros and cons for the company, the investors and the founders, and in some cases such factors can influence each of the above players differently and adversely. The following is a certain tax aspects to consider prior to making the decision.
Israeli parent company
• The tax regime in Israel provides a lot of benefits to Israeli companies. Israeli companies generally are subject to a corporate tax rate of 23% (as of 2018).
• The effective tax rate payable by an Israeli company that derives income from a “preferred enterprise” status under a special tax regime in Israel, could reduce a company’s tax rate to 16% with respect to income attributable to its preferred enterprise (instead of a rate of 23%).
• In the case of a technology company satisfying certain conditions pursuant to which it would qualify as a “special preferred technology enterprise,” it may enjoy a reduced corporate tax rate of 6% regardless of the company’s geographic location within Israel.
• The Israel Innovation Authority (previously known as the Office of Chief Scientist) is a governmental agency providing, inter alia, funding platforms to early-stage entrepreneurs and mature companies developing new products or manufacturing processes.
• Generally, pursuant to the Israel Tax Ordinance, a US investor in an Israeli company would be exempt from paying capital gains tax (assuming that such investor does not have a permanent establishment in Israel and is not a resident of the State of Israel). An exemption is also available for a holder of less than 10% [of the issued and outstanding shares of an Israeli company] under the terms of the income tax treaty between Israel and the United States.
• An individual who is an Israeli resident investor is subject to capital gains tax at the rate of 25% or 30% (in the event that the investor is considered a “controlling shareholder,” as the term is defined in the Israeli Tax Ordinance), and Israeli corporate investors would be subject to tax on capital gains according to the Israel corporate tax rate.
• Investors in an Israeli R&D company can take an ordinary income deduction against any Israeli source of income (including compensation income) of up to approximately $1.4 million (NIS 5m.). The taxpayer can claim such deduction in a year of investment. The “angel tax” laws provide certain conditions that the company needs to meet. US investors can also claim such deductions in Israel against other Israeli sources’ taxable income.
• In the event that 50% or more US persons (i.e. holds an Israeli company each 10% or more), US investor in an Israeli parent company would be subject to tax in the US on the Israeli subsidiary taxable income based on the GILTI rules. On the other hand, if a US investor invests in a US corporation, the GILTI issue would not have any impact – assuming the Israeli company is subject to tax in Israel at the rate of 23% or a reduced rate of 16% (preferred enterprise). If the founders incorporated on day one an Israeli parent company holding US subsidiary, an inversion procedure may be required, with all tax implications involved to reorganize the group of companies as US parent with Israeli subsidiary taking into account that the IP would continue to be owned by the Israeli company and any transfer of such IP from Israel to the US may trigger an Israeli tax event.        
American parent company
• Trump’s new tax reform reduced corporate income tax from 35% to a flat rate of 21% (effective for tax years beginning after December 31, 2017). In addition to the federal corporate tax rates, state and local taxes which are also imposed on corporations, vary by jurisdiction in the United States, and generally range between 1% and 12% (although certain states do not impose tax on income).
• In general, the US capital gains tax rate is up to 20% for most assets held for more than a year (long term capital gains), plus state tax and Medicare tax. However, a US investor and/or US founder investing in a US corporation could benefit from tax exemption in the US on his/her capital gains upon selling his/her stock up to $10m. This exemption does not apply to an investment in an Israeli start-up company. There is no doubt that this tax regime in the US is an incentive to US investors to invest in start-ups that were incorporated as US corporations rather than in an Israeli company.
• US investors (investing in a US corporation) have the ability to take an ordinary income deduction on losses (up to $50,000 or $100,000 on a joint return) rather than the standard capital loss deductions. In general, a US corporation shall be treated as a small business corporation if the aggregate amount of money received by the corporation for stock, as a contribution to capital and as paid-in surplus, does not exceed $1,000,000.
• In the event that 50% or more of rights or value are held by US persons in an Israeli company, each 10% US shareholder would be subject to tax in the US on the Israeli subsidiary taxable income. On the other hand, if a US investor invests in a US corporation, the GILTI issue would not have any impact assuming the Israeli company is subject to tax in Israel at the rate of 23% or a reduced tax rate of 16% (i.e. a preferred enterprise).
As can be inferred from the above, each structure has its pros and cons for the company, the investors and the founders, and in some cases such factors can influence each of the above players differently and adversely. Aside for taxation, further insights should be made as for the corporate governance, place of business, attractiveness to potential investors, location of customers, sector of operation and more. The analysis should be conducted on a case-by-case basis, taking into account that the taxation issue is a major factor to consider, but is not the only parameter consider as for the decision whether to be or not to be (a parent) Israeli company.
The author is a partner and head of the GKH Tax Department.