Stock option recharge damage control - opinion

Who pays for hi-tech stock options?

Calculating taxes (photo credit: INGIMAGE)
Calculating taxes
(photo credit: INGIMAGE)
 Two of the things that drive Israeli hi-tech are chutzpah and stock options (or shares) for the employees. But who pays for it all? The Israeli Tax Authority (ITA) caused havoc with that question but fortunately they have now climbed down.
What havoc?
Many Israeli tech companies are part of international groups, and the parent corporation is often listed on a stock exchange, such as NASDAQ in the US. So, Israeli employees in such groups typically receive stock (shares) or stock options in the publicly traded parent corporation, not in the local Israeli subsidiary company.
In 2018, the Israeli Supreme Court ruled in the Kontera case that if the Israeli subsidiary is compensated for R&D on a cost plus basis, the value of the stock/stock options must be included in the cost base for transfer pricing purposes even if there is no cash cost to the group in issuing the stock/stock options.
At the end of 2019, the ITA issued a convoluted “reportable tax position.” If you don’t apply the ITA’s position in your tax return, you may have to report this to the ITA and face a tax audit.
Reportable Tax Position 70/2019 says that such recharges should be treated as a capital item in the financial statements of the Israeli subsidiary, not as a liability.
Here’s the sting. Payment of the recharge by the Israeli subsidiary to the international group counts as a taxable dividend according to this ITA position. This means stock/stock option recharges are apparently taxable as deemed dividends at rates ranging up to 25% subject to any tax treaty. Only there are insufficient profits, the item may be treated as a capital reduction according to detailed rules.
Moreover, if you don’t agree and apply the ITA’s position, you may have to report this to the ITA and face a tax audit. All this was bound to cause uproar in some hi-tech companies when preparing their 2019 Israeli tax returns.
Hypothetical Example
Suppose employees at an Israeli subsidiary company exercise stock options in their US parent corporation and sell them on NASDAQ for a gain of NIS 10 million. Assume the stock options are on the capital track of Section 102 of the Income Tax Ordinance (ITO). The employees should pay 25% income tax, i.e. NIS 2.5m.
The recharge from the US parent company must be computed according to generally accepted accounting principles (GAAP) – let’s assume the recharge figure is NIS 10m.
The Israeli company may have to pay tax (on a grossed-up basis) at the rate of 12.5% under the US-Israel tax treaty, (10m * 112.5/100 * 12.5%) i.e., NIS 1.41m.
And the company would add the recharge to its cost plus basis and pay company tax with no expense deduction under Section 102. Suppose it is on cost plus 10%, the company tax might be: (NIS 10m * 110% * 23% company tax) i.e., NIS 2.53m.
Total Israeli taxes in this hypothetical US parent example: around NIS 6.44m. or 64.4% of the stock gain.
Alternative interpretations and calculations are possible. But is also unclear whether the US (or any other country) would grant a foreign tax credit for Israeli tax on the deemed dividend under this Reportable Tax Position.
The solution
The ITA has climbed down by publishing Tax Circular 1/2021 dated January 27, 2021. The ITA says the recharge is not an expense. But the ITA concludes that the recharge need not be treated as a dividend if a number of conditions are met.
First, the recharge must be the same as salary expenses regarding the stock gain recorded in the financial statements of the Israeli subsidiary company applying GAAP.
Second, the recharge should not be conditional on any work.
Third, the recharge must be agreed upon up-front in an intercompany agreement signed before the stock or options were granted (not later).
Fourth, the recharge payment should only be for vested options or stock
Fifth, the option/stock gain is included in the arm’s length transfer pricing (Section 85A of the Income Tax Ordinance).
Sixth, any recharge payment not meeting the ITA’s conditions would be taxable as a deemed dividend, even if the payment is paid to a different company (not the parent corporation) in the group.
Comment
Without this Tax Circular, the start-up nation might have started to wind down. As discussed in the past, there is no tax tribunal system in Israel for assessing the reasonableness of ITA positions and interpretations. It is high time Israel copied the tax tribunal system in other countries.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
leon@h2cat.com
The writer is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd.