What are the two secrets of Israeli hi-tech success? First, the powerful can-do attitude described in the Start-Up Nation book by Dan Senor and Saul Singer. Second, less talked about, ESOPs – employee share (stock) or share option plans.
However, the Israeli Supreme Court has just ruled that tax breaks for dividends paid by a tech company don’t apply to employees who already enjoy ESOP tax breaks. No double tax breaks. This may affect many tech employees including olim.
Section 102 of the Income Tax Ordinance (ITO) is the main section governing any ESOP with Israeli resident employees. Where there is an “allotment of shares via a Trustee” to employees holding under 10% of a company, two main Israeli tax benefits are possible.
First, tax is generally deferred until the options or shares are realized, i.e. sold or removed from the Trustee.
Second, if the employing company chooses the “capital track”, (it usually does) the employer foregoes an expense deduction, but the employee pays tax of 25% (now up to 30% including surtax) on the realized taxable benefit.
The alternative track is the “salary track” with tax of up to 50% on the realized taxable benefit – but then employer can deduct the taxed benefit as an expense.
The Trustee’s job is to hold the shares or options on behalf of employees until tax is paid to the Israeli Tax Authority (ITA).The Trustee and the ESOP plan must be notified to the ITA who have 30 days to approve them. Various other rules apply under Section 102.
An Israeli company with a capital track ESOP paid dividends to its employees (Rehovot Assessing Officer vs Conduit Ltd, Civil Appeal 4077/23 of 19.3.26). The company qualified for various tax breaks for “preferred enterprises” and “privileged enterprises. These tax breaks are available to Israeli industry and technology under the Encouragement of Capital Investments Law, 1959 (“ECIL”). The ECIL tax breaks include reduced tax rates for dividends paid to shareholders – 20% in recent years for preferred enterprises and 15% for privileged enterprises mainly of earlier years.
What's the issue with the Supreme Court ruling?
Which tax rate applies to dividends paid to ESOP participants – 15%/20% under the ECIL rules or 25%-30% under the Section 102 ESOP capital track rules”
Judgement: The District Court had previously decided in favor of the taxpayer as the law seemed unclear. But the Supreme Court has just overturned the District Court decision.
The Supreme Court pointed out that in Section 102, “allotment of shares via a Trustee” refers to “shares, including any right conferred by them”. Such a right includes a dividend.
Also, the Section 102 “taxable benefit” is defined as “the consideration or value upon realization less costs incurred by the employee”. This is broad and includes dividends realized according to the Supreme Court.
The rationale given is that ESOP taxation is deferred under Section 102 until realization; also employees don’t invest capital in companies (although they become shareholders).
To sum up, the Supreme Court ruled that dividends paid to ESOP participants are taxable at 25%-30% under the Section 102 ESOP capital track rules, NOT 15%/20% under ECIL rules.
Implications:
The Supreme Court decision ends years of confusion. Even the ITA had said in a 2003 Circular and a published tax ruling that dividends may be paid directly to employees, bypassing the Trustee and taxed at ECIL rates. The Court said the ITA is allowed to correct itself. The ITA may be expected to chase for any undertaxed dividends following this case.
So the 25%-30% tax rate will apply to unvested and vested shares whenever they are realized i.e. sold or withdrawn from the Trustee.
Potential Additional Implications – Olim (immigrants):
Olim often face a related issue if they participate in an Israeli ESOP. Suppose an Oleh employee receives shares/options in a foreign (usually US) parent company while still in his/her ten year Israeli tax exemption period for foreign income and gains (“tax holiday’). The ITA strenuously claims that the 10-year tax holiday does not apply to Section 102 ESOPS applying the above principles.
The Supreme Court judgement appears to uphold Section 102 taxation i.e. 25%-30% tax and no tax holiday for ESOP gains. This is because Section 102 is “a separate unique and complete arrangement for the purposes of share allotment…to employees" (Judgement Para.33).
Wishing readers a Happy and safe holiday period.