Israel Stock Options Ruling May Hurt Tech Companies

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By Matthew Kalman

Leaders of Israel’s tech industry said there could be “disastrous consequences” if Israel maintains its tax policy toward stock-based compensation granted to employees of high-tech multinational companies.

The Israel Advanced Technology Industries (IATI) association requested an urgent meeting with the finance minister and the head of the tax authority in a May 1 letter. IATI is an umbrella group representing Israel’s top tech companies, investors, research and development centers, and service providers.

The IATI was responding to an April 22 Supreme Court ruling ordering companies to include employees’ stock-based compensation in their “cost plus” pricing method—a decision that could allow the tax authority to review and potentially substantially increase tax liabilities for the past four years.

The ruling represents “a severe blow to the development of Israel’s high-tech industry” and in its wake “multinationals are liable to downsize or transfer their R&D centers to other countries,” wrote Karin Mayer Rubinstein, IATI’s CEO and president.

“The additional cost will harm the competitiveness of Israeli companies as R&D centers compared to R&D centers in the rest of the world,” the IATI wrote in a position paper accompanying the letter, forecasting a reduction in workload at Israeli subsidiaries operating as the R&D centers of high-tech multinationals and the possible “reduction in manpower in the R&D centers in order to finance the Israeli tax.”

“The tax authority’s stance does not accord with the desire of the state to encourage the high tech sector,” the IATI wrote.

Companies Could ‘Lose Their Edge’

Until the Supreme Court decision, companies hoped “they could still take the position that the option expenses should not be included in the cost plus method and reach some kind of a settlement with the tax authorities,” said Binyamin Tovi, partner in charge of international taxation at Shekel and Co. law firm in Tel Aviv.

“I do not think that IATI is overreacting,” Tovi said by email May 6. “Many countries in the world are trying to create tax benefits for the high-tech industry including the U.S., and Israel has to compete with these countries.”

Section 102 of Israel’s tax code allows employees, subject to certain conditions, to receive equity or options and pay lower tax on the gain when they are exercised. Companies will now have to decide whether to absorb the extra tax cost, or use another route under which the employees’ tax burden will increase, Tovi said.

Most multinationals give Israeli employees restricted stock units under Section 102 and they form a significant element of the salary package used to attract top employees to the country’s famed tech workforce, said Meir Halberstam, CFO of StoreDot Ltd. and former CFO of Broadcom Israel.

“It’s not something these companies can stop,” Halberstam told Bloomberg Tax May 7. “They’ll lose their edge in recruiting the best of the best. That’s what they are all trying to do. That’s the whole edge here.”

Thus, the companies think the ruling is “completely not reasonable,” and they may start to consider moving operations to countries where the tax regime is more favorable, he said.

“It hurts us because it looks ridiculous. We try to be smarter than other countries,” he said. “It’s not something that should have happened.”

“The Israeli market has a problem,” said Yuval Navot, a tax partner at Herzog Fox and Neeman law office in Tel Aviv. “Employees are more expensive than India, for example, which is a competitor. This ruling doesn’t add to the attractiveness of the Israeli market.”

How Can Companies Respond?

Companies could adopt various strategies to mitigate the tax increase, such as changing their group structure or moving their intellectual property to Israel.

“Not all multinationals are willing to do that” because Israel is likely to be a small part of the global operation, Navot told Bloomberg Tax May 6. “You have to change the transfer pricing methodologies within the group.”

Multinationals may abandon the “cost plus” method altogether, adopting a “time and materials” mechanism instead, said Sharon Shulman, tax managing partner for EY Israel.

“I think it’s going to have an effect,” Shulman told Bloomberg Tax May 7. “Most managements of the multinationals believed that the court would take a different approach.”

“Those companies don’t like surprises. I do think there is a risk to the industry,” Shulman said.

To contact the reporter on this story: Matthew Kalman in Jerusalem at correspondents@bloomberglaw.com

To contact the editor responsible for this story: Penny Sukhraj at psukhraj@bloombergtax.com

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