Is an ESOP a fable?

Below we discuss some of the recent ESOP tax developments.

Calculating taxes (photo credit: INGIMAGE)
Calculating taxes
(photo credit: INGIMAGE)
Israeli hi-tech employees are highly motivated people who regularly work wonders of a technological nature. Part of that motivation comes from employee share option plans (ESOPS) which may provide a tax break if things go well in the tech company concerned.
But on the tax side, there have been developments that may dampen some of the share option enthusiasm.
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; (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.
Below we discuss some of the recent ESOP tax developments.
ITA caught napping:
In July 2019, we reported a major defeat for the Israeli Tax Authority (ITA). The Nazareth District Court ruled that dividend-only shares may qualify for Section 102 tax (Schochat vs State of Israel, Civil Appeal 55937-01)
The ITA claimed that a 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 employee was down by 77% in that year.
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.
The court went on to say that missing the 90-day time limit should not be an issue for the ITA. Issuing shares of any sort to an employee has a commercial and economic rationale – it strengthens the employer-employee relationship. There is no artificial transaction.
Employee can’t vote?
In December 2019, the Haifa District Court ruled there is nothing wrong with insisting that employees enter into a voting proxy agreement with the Section 102 Trustee. So long as tax is unpaid on the option or share benefit, the individual (an ex-employee in this case) cannot demand receiving voting rights himself (Ofer Navon vs Sol Chip Ltd, 19042-03-18).
ITA tightens up:
It turns out the ITA is a sore loser and found a way of overturning the Schochat case. On December 28, 2019, the ITA issued a reportable tax position that ESOP shares must confer full rights to profits and to voting (number 68/2019). If a taxpayer adopts a different position, that person may have to disclose this to the ITA on Form 1346. This requirement only applies in bigger cases where the tax advantage exceeds NIS 5m. in the tax year or NIS 10m. over 4 years and the person’s income that year exceeds NIS 3m. (capital gains $1.5 million). But a voting proxy agreement is not a denial of voting rights according to the ITA. Also reportable are cancelable shares as well as shares redeemable or subject to a call or a put option at a price that is not market value.
The ITA reads a lot into the Section 102 ESOP requirements for employees based on their interpretation of the law. Wouldn’t it be better to amend the law or just leave things simple for employers and employees?
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,