The Israel Tax Authority (ITA) has issued instructions for the non-taxation of SAFEs (Simple Agreement For Future Equity). A SAFE has become a popular way of financing hi-tech start-ups in recent years, so non-taxation is nice. The instructions weren’t passed by the Knesset, but were issued in a letter of May 16, 2023 from the Senior Deputy Director for Professional Matters at the ITA, Roland Am-Shalem, to an organization called IATI, the Israeli Advance Technology Industries (Instructions on Tax Aspects Applicable to Investments in a Company Via a SAFE, May 16, 2023).
According to the Instructions, a SAFE is an agreement whereby an amount of money is invested now in a company in return for shares to be issued later, by which time the shares in the company may be worth more. A SAFE enables a private company to raise money quickly and efficiently, while postponing the question of the valuation of the shares until a larger subsequent fundraising round, when the valuation becomes more reliably agreed.
The investor who invests now does not receive interest, but will typically receive a discount to the price fixed in the next big fundraising round. The amount invested now divided by the discounted price determined later gives the number of shares to be issued later.
An example: Avi invests now NIS 0.5 million pursuant to a SAFE at a discount of 10% to the next big fundraising price which turns out be NIS 1,111 per share. The 10% discount is therefore NIS 111 per share, the discounted price per share is NIS 1000 and Avi receives later 500 shares (NIS 500,000/NIS 1000).
What is the taxation of the NIS 111 discount per share and the shares worth NIS 500,000 that Avi later receives? The surprising answer is no Israeli tax (until an ultimate sale), if certain conditions are met.
Safe No-Tax Conditions
The ITA Instructions specify conditions for exemption from income tax, withholding tax and capital gains tax when a SAFE agreement is converted to shares. Instead, cash paid under a SAFE is considered payment on account of shares.
Briefly, SAFE exemption conditions include the following.
First, the company is a private Israeli resident company active in hi-tech.
Second, most of the expenses from incorporation to the SAFE signing, or in the prior three years per audited financial statements, were R&D or production and marketing of products developed from the R&D. The R&D is ongoing upon the SAFE signing. Most of the value of the assets of the company must not be related to real estate or natural resources.
Third, the company did not raise capital at a known valuation in the three months before closing the SAFE agreement.
Fourth, no SAFE investor invests more than NIS 40 million.
Fifth, SAFE investors may transfer their rights only with the company’s consent.
Sixth, the SAFE is not referred to as a loan agreement. The investor cannot receive interest. The discount cannot change over time. The SAFE investor gets no lien over company assets. The company cannot claim finance expenses or liability revaluation losses.
Seventh, conversion of the SAFE to shares must be according to the predetermined SAFE procedure, or an “exit” or an IPO. The SAFE investor cannot change his mind.
Eighth, at least 25% of capital subsequently raised is not from SAFE investors.
Ninth, shares from the safe cannot be realized for cash until 12 months after signing the SAFE or nine months after conversion to shares, UNLESS most shareholders sell to a third party unrelated to the company or investors holding no more than 25% of the shares of the company.
Tenth, upon conversion of a SAFE to shares, the same price before discount is applied to all shares of the same class.
If some all these conditions are not met, the ITA may review a SAFE based on the circumstances. If all the conditions are met, the ITA may still review things e.g. investors who are directors or employees or in business. Subsequent share sales by Israeli residents are taxable….
These Instructions apply to SAFE agreements signed by the end of 2024, unless other instructions are issued before then.
Hitech investors will be pleased that converting a SAFE to shares may not be taxed in Israel, only subsequent sales by Israeli residents are generally taxed.
Unfortunately, the ITA’s instructions do not say whether 17% VAT applies! Foreign investors should also check the treatment of SAFEs in their home country.
As always, consult experienced advisers in each country at an early stage in specific cases.
The writer, email@example.com, is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd