1. Factual Background
a Delaware corporation with a wholly owned Israeli subsidiary ("BCo").
1.2.Two individuals ("Founders")
are the founders and the shareholders of all of ACo's ordinary shares.
Investors resident in the US hold Preferred A shares and a reserve of options
for common shares was set aside for employees.
1.3.New investors wanted to
invest funds in the share capital of the ACo and receive Preferred A-1 shares.
The new investors insisted that as result of their investment, the Founders
will be diluted to a lesser degree than the present investors in order to
retain their interest in ACo.
1.4.In order to accommodate the
demands of the new investors, ACo undertook a reverse split by amending its
certificate of incorporation so that the number of outstanding Preferred A
shares be decreased, thus resulting in an increase of the Founders’ holdings
(percentage wise), than would be due to them absent such a reverse split.
2. The Issue
Founders incur an Israeli tax liability as a result of the reverse stock split?
3.1.The tax opinion reviewed
the relevant sections under the Israeli Tax Ordinance ("Ordinance")
and the Israeli court rulings with respect to capital gains taxation, which
provide that in order for a capital gains tax to be levied on a taxpayer,
he/she must dispose of an asset.
3.2.In the case under
consideration although the Founders' shares may appreciate in value, the
Founders did not make any disposition. Hence they are not liable to capital
gains tax. The Founders could be liable to tax on the appreciation of their
shares if the latter were attributable to their employment, but in this case
the appreciation is attributable to an indirect result stemming from a new
financing round and bearing on ACo's shareholders including the Founders.
Assuming that the Founders employment agreements do not provide for the reverse
split, and assuming that they are fully compensated for their efforts, the appreciation
will not fall to be taxed under the aegis of section 2(2) of the Ordinance
which designates employment emoluments as a source of income, in line with
Israel's schedular system.
3.3.The tax opinion also stated
that the Israeli Tax Authorities ("ITA")
might attempt to tax Preferred A shares shareholders by contending that in
effect they disposed of some of their anti-dilution rights in favor of the
Founders. We do not believe that a contention of this sort if brought by the
ITA would have merit in the case under consideration.
3.4.We note that even if a
disposition was deemed to have taken place, those Preferred A shareholders of
United States residence could claim relief under the U.S.-Israeli Convention
With Respect To Taxes On Income.
3.5.Finally, under section
97(b3)1 of the Ordinance, if the Preferred A shares were purchased after July 1st,
2005, their sale will be exempt from Israeli taxes under certain conditions if
sold prior to December 31st, 2008, by residents of countries with
which Israel entered into a treaty for the prevention of double taxation, so
that even if a deemed sale occurred it would go tax free.