Your Taxes: An ESOP is not a fable

What are the ESOP tax breaks?

July 18, 2019 22:46
4 minute read.
US tax form

US tax form (illustrative). (photo credit: INGIMAGE)

The Nazareth District Court has ruled that dividend-only shares may qualify for the tax breaks of an employee share ownership plan (ESOP). The Court accepted that an ESOP is not a fable by Aesop or anyone else, to the chagrin of the Israeli Tax Authority (ITA) (Schochat V. State of Israel, Civil Appeal 55937-01 of July 4, 2019)

What are the ESOP tax breaks?

ESOP plans approved under section 102 of the Income Tax Ordinance can both reduce Israeli tax and defer it until cash is realized if various conditions are met. Both shares and share options are permissible.

There are different rules and tax rates relating to: 1) approved ESOP for employees-capital-gains approach, 2) approved ESOP for employees-ordinary income approach, and 3) unapproved options for employees.

The capital-gains approach is the favorite for employees with less than 10% ownership of the company. The gain is taxed at a fixed rate of 25%, and both the employer and employee are exempt from National Insurance contributions. The employer is not entitled to any expense deduction regarding the options. An approved Israeli trustee must hold the options or shares for at least 24 months. The tax is deferred until the employee realizes the options or shares or withdraws them from the trustee.
Section 102 plans must be in a prescribed format and notified to the ITA at least 30 days before the plan is first implemented. The plan and trustee must be approved by the ITA, but if there is no answer from the ITA within 90 days of the notification, they are deemed to be approved.

Facts of this case
A private company controlled by one individual issued a new class of shares to a manager, conferring rights to dividends only, so long as the manager was employed by the company. The shares were not transferable. If the employment ended, his shares became dormant. The manager received 22.7% of the new class of shares, entitling him to dividends equaling 9.99% of total dividends distributed by the company. Section 102 approval was requested in 2010. In 2012 a dividend was distributed, including NIS 11.8 million to the manager. In 2016 the ITA sought to review the ESOP.

The ITA claim
The ITA claimed the dividend of NIS 11.8 million should be reclassified as salary bonus taxable at 50%, rather than a dividend taxable, in this case, at 15%. The ITA claimed the dividend was paid at the whim of the company and other income of the manager was down by 77% in that year. Failing that, the ITA claimed the arrangement was artificial and should be disregarded. The ITA imposed a 15% “deficiency” fine on the alleged tax underpayment, i.e., 65% in tax and fines apparently.

What the court ruled
The court ruled that the company had filed the paperwork for a Section 102 employee share plan and the ITA did not reject it within the 90 day period prescribed by law. Therefore, the ITA was deemed to have approved the plan.
So the ITA was late, but did they have a point?

A trustee was appointed, so any tax arising was deferred until shares were realized. But what happens if there are only dividends, no realization? The court noted that the Section 102 rules require dividends to be reported to the ITA. More generally, Section 102 is intended to strengthen the connection between a company and its employees. The higher the profit of a company, the more that can be distributed as a dividend.

Why would an employee accept dividend-only shares? In this case, the manager thought it would strengthen his hand should there be an exit or new strategic investor.
The ITA claimed that forfeiture of the shares upon leaving employment contravened the Section 102 rules. The court ruled that the rules merely freeze the shares until tax is paid.

The court concluded that the Section 102 rules and legislative intent are met in the case of dividend-only shares. Therefore, the dividends should not be reclassified as salary.

Was it artificial?

The Court reiterated that issuing shares to an employee has a commercial and economic rationale – it strengthens the employer-employee relationship. There was no artificial transaction.

To sum up
The court accepted the dividend-only ESOP shares and canceled the fine. But the dividend is taxed at 25% under Section 102, not 15%.

Israel thrives on ESOPs. An ESOP is not a fable that can be dismissed lightly by the ITA. So, more ESOP checks can be expected by the ITA within the 90-day limit.

As always, consult experienced tax advisers in each country at an early stage in specific cases. The writer is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd.

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