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Taxation Employee Equity Compensation in Israel – Special Measures During the Covid-19 Challenge

Israel Updates / Apr 12, 2020

As all are aware, the Corona pandemic has also caused Israeli companies, including local group companies of multinationals, to release employees on unpaid leave or to even terminate their employment. Typically, employees of Israeli high-tech companies have often been awarded options and other equity benefits, complementing their employment terms. Among the current uncertainties for employers and employees world-wide, and especially in Israel, is how the current global virus battle will impact the rules and existing tax relief for employee options and equity benefits. The high degree of technological innovation of industry in Israel resulted in Israel’s 2003 implementation of quite lenient tax treatment regarding security-based compensation to employees.

How will the current situation impact the implementation and interpretation of the rules and conditions for tax benefits on employee share based compensation?

Your tax team at Pearl Cohen in Tel Aviv creates some order for you.

Beneficial tax treatment in Israel for employee options; a refresher

Section 102 of the Israel Income Tax Ordinance (“102“) allows the employer to choose between a number of tax favoured routes for the granting of equity awards to employees and holders of office in Israel.

An employer may choose for employee options to be taxed either as Regular Employment Income or Capital Gains Income, with the first route being more favourable for the employer, and the second more favourable for the employee.  Options issued under a Regular Employment rule will be taxed at regular progressive income tax rates (and subject to national insurance and health care premiums) and the employer may recognize related expenses in the year when the employee eventually sells.

Under the Capital Gains route part -or all- of the gain will be charged with the reduced flat gains tax rate of only 25% (and no national insurance premiums due) at the date of sale, while the employer will not be entitled to recognize any expenses in relation to the relevant options. For both routes, the options must be placed in the hands of a trustee for a fixed lock-up period of time during which the employee may not exercise the options and other limitations apply.

One of the major benefits for employees is that the actual payment of tax for both these routes only becomes relevant at the date of the sale of the shares by the employee rather than the date of the option award or its’ vesting.

A grant of shares without administration by a trustee (a route not favoured in Israel) is taxed as Regular Employment Income at the date of grant, subject to progressive tax rate, national insurance and health care premiums. The employer will be entitled to deduct expenses for tax purposes, whilst expenses in relation to an award of options or RSU’s without a trustee may not be deducted.

In principle the right to buy shares in the ‘employing’ company (or in a related group company) under any of these tax favoured routes requires that the conditions of the option are fixed beforehand; including the ‘exercise price’ and the ‘vesting period’. The vesting period is usually set on 3-4 years of employment and the rights mature generally in equal portions.

Covid-19 publication of temporary relaxation administrative requirements

To date, April 8 2020, Israeli Tax Authorities (“ITA“) have published the following regarding the compliance requirements for 102 options during the Covid-19 period.

Requirement of deposit with a trustee –  trust companies offering trustee services under Section 102 with an approval of a relief in the requirements of deposit of the option award agreements allowing companies granting equity awards under the administration of a trustee do not have to actually deposit the plan within the regular 90 day period from the date of the grant.  In order to comply with the deposit requirements, the trustee now only needs to receive a copy of the board resolution within 45 days of grant and an excel file with the details of the grant, employees who have been awarded options and the terms of the options.

The above interim arrangement will be valid for grants approved before May 1, 2020. We know that the tax authorities may consider extension of this period for the purpose of administrative ease.

Approval Option Plan by ITA – Under the existing 102 rules, if the tax authorities do not respond within 90 days from the date that an option plan was submitted, the issuer of the option plan may presume the plan “approved”.  The Emergency Regulations (of March 27, 2020) confirmed, among many other things, that the days from March 22, 2020 until May 31, 2020 shall not be relevant for the count of the 90 days afforded to ITA, effectively giving an extended period of time to review option plans submitted. These regulations did not extend the minimum 30-day waiting period required between filing of the plan and the ability of an employer to award option or share grants.

The 90-day period after the dismissal of an employee

Under most option plans, when an employee leaves his/her employment, whether voluntarily or because of a dismissal, he/she will have 90 days to exercise the options vested to date and to decide whether the employee wants to pay the exercise price and  invest in shares in the company. Surely an employee who has the monetary means will gladly pay the required exercise price when the options are “in the money”; when the exercise price is lower than the share value or price. In the event that a sizeable number of options have matured the required investment can be quite significant and a former employee will probably only decide to pay the exercise price when he believes in the company.

Employees holding matured options who have now left the company on unpaid leave or who have been released from their service shall now have to decide what to do with their options and whether to exercise or not?

Most option plans prescribe that a redundant employee with a claim to vested option rights has 90 days’ time to decide whether or not to exercise. The current fall of the stock exchanges around the world (April 2020) has, for now, resulted in a decrease of the stock prices of most public companies and thus an option holder may find that the exercise price he needs to pay is higher than the share value of the stock on the date of the exercise. Further, the employee will have understood that the intrinsic potential for a profit on the future sale of the shares may be low, making the decision to pay an exercise price an even riskier affair in challenging economic times.

Therefore, companies may consider extending the 90-day period for employees entitled to decide whether or not to use their options.   Equity plans include different terms and conditions regarding option awards upon termination of employment and during unpaid leaves of absence. Employees should look closely at their option agreements and the option plans of the company in order to figure out what provisions now apply.  In most cases the Board of a company has the authority to change the terms of an option plan.  However, note that the published position of ITA has been that any change in the exercise date, or in the terms of the option may increase the tax rate on the income generated by a future sale of the shares to that of Regular Employment Income, while the change in the option terms may “re-set” the date of the count of the obligatory 2 year lock-up[1] to the date of the change of the option terms (from the date of the initial option award).

It is expected that that the current situation will encourage ITA to re-visit its’ views on the negative tax consequences associated with these very likely changes that corporate life may want to implement.

With respect to unpaid leave, the continued vesting of rights may provide undisturbed accrual of stock benefits for employees. Again, not every plan actually contains support for continued vesting during a leave of absence. Also, on this matter employers are recommended to review the terms of their plans to understand the tax risks that could occur when adopting special or new vesting rights in relation to existing plans, especially now that continued vesting is expected to take center stage.  Of course, companies developing their option plans right now should make sure that flexibility as to option terms are already included in the option plans.

Retaining valuable employees

Unrelated to the current crisis, Section 102 allows an employee to only pay tax once income is generated from the sale of stock. In Israel, unlike other countries, the tax rules favour employees by giving a postponement of the tax event until an actual sale of the securities, thus easing the choice for an employee who finds exercise of the options are subject to a deadline.

Finding out whether options are “in the money” is a task not easily performed, especially in the present COVID-19 turmoil; employing companies themselves do not even know. Employing companies may lower the exercise price, as a gesture, but this will require submissions and reporting to ITA and may sometimes trigger certain restrictions, such as the going into effect of a (new) two-year lock-up period.

For employers who have had to reduce salaries or cut down the number of staff, equity compensation remains a very interesting compensation tool for employees, which does not trigger extra immediate cash costs to the company. It is possible, under 102 rules, to grant employees additional awards, maybe even shares free of payment unleashing any immediate tax.

In these challenging times, this is something to consider which may increase employee commitment and a willingness to return to the company when the storm has passed.

Feel free to approach our team.

[1] Section 102 – flat reduced capital gains tax benefit regarding options and the obligatory 2 year lock up period designed to ensure the application of the capital gains benefit (instead of progressive tax rates)