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SAFE Investment – should it be Treated as a debt instrument or as equity? Israeli Tax Authority’s Publication Provides Some Guidelines

Client Updates / May 21, 2023

By: Doron Motai

Using SAFEs (Simple Agreements for Future Equity) has become a common practice to finance start-up companies at their very initial stages, where the actual value of these companies is yet to be determined. This instrument defers the decision on the company’s value to a later stage, and still allows the company to raise funds, under the understanding that the value would be determined in the future and based on such determination the SAFE would be converted into the company’s shares. Typically, SAFEs allow a certain discount, meaning that the investor’s future entitlement to shares would be calculated based on a higher amount than his actual investment.

The Issue
Given that there are some timing differences between the execution of the SAFE and the conversion into shares, there has been some unclarity regarding classification of SAFEs for Israeli tax purposes – whether it should be classified as equity or as debt.
If it were classified as a debt instrument, then the discount component should have been treated as interest and the company should have withheld tax upon conversion of the SAFE into shares. If, however, it is classified as equity, then the transaction should be classified as such from the outset and no withholding tax should apply upon conversion of the SAFE into shares.

The ITA Publication
The Israeli tax authority has recently published its view on this matter, clarifying the conditions under which it would treat a SAFE as an equity instrument.
Generally speaking, these conditions imply that the instrument should have characteristics of equity, rather than of debt. Moreover, the publication divides the conditions into three groups, as elaborated in the attached Annex.
The ITA provides that if all of these conditions are met, then the investment through SAFE would be considered as an advance payment for shares. In these circumstances, there would be no tax event upon conversion and the company would not have to withhold tax.
Such position of the ITA would apply to all the SAFE transactions that comply with the terms prescribed in the publication and executed by December 31, 2024, or until any preceding publication of the ITA. The publication also provides that a failure to meet all the conditions should not, in and for itself, determine the classification of the SAFE.

1. Conditions related to the profile of the company:

  • An Israeli resident company of the hi-tech industry, the majority of whose expenses are for R&D, or production, or marketing of products it developed.
  • The R&D activity is performed by the company at the time of execution of the SAFE.
  • The company has not raised capital under a prescribed share value for three months before closing of the SAFE.
  • The company does not deduct, for Israeli tax purposes, any interest expenses associated with the SAFE.

2. Conditions of the SAFE agreement

  • The total amount of the SAFE does not exceed NIS 40.
  • The company’s approval is required for assignment of the investor’s rights under the SAFE, unless there was a designated assignee that was prescribed in the SAFE agreement.
  • The agreement is not headed a “loan” or a “debt” agreement.
  • Conversion of the SAFE into capital would be performed only under the terms prescribed in the SAFE agreement, as part of certain events such as capital raising round, IPO, a sale of shares by most of the company’s shareholders, or a sale of most of the company’s assets.
  • The investor is not entitled to repayment of his investment other than conversion into shares and there is no specified date for such a repayment, unless in case of a liquidity event. In such case, the SAFE instrument is inferior to other debt instruments, equals preferred shares and superior to ordinary shares.
  • The SAFE agreement provides that in case of liquidity the investor is entitled to repayment up to the principal amount of his investment.
  • The SAFE agreement does not provide the investor with entitlement to interest or royalties, etc. at the period between the investment and the conversion.

3. Conditions associated with the conversion of the SAFE into shares

  • The conversion would occur as part of a capital raise event, in which at least 25% of the capital that was raised was not from the SAFE holders.
  • Realization of the shares would occur after at least 12 months of the execution of the SAFE; or 9 months from the conversion of the SAFE into shares.
  • Notwithstanding the above, the prescribed period may be shorter, if the realization of the shares occurs as part of a sale transaction (conditions are elaborated in the publication)
  • The SAFE investors receive the same price that other shareholders of the same type receive for their shares (after neutralization of the pre-determined benefit for the SAFE holders).

As always, we are available for any questions in this matter;

Doron Mutai, Head of the IL Tax Practice Group,