Several weeks ago a (consentual) tax ruling was published on the subject of employee options – voiding options that at the time of vesting were dependent on an exit event and reissuing them on the “trustee capital gains” track (a track in which the benefit value is not recognized as a tax deductible expenditure by the company, and the employee is subject to capital gains tax – limited to 25% and not marginal tax of up to 47% – when the options are exercised).
The particular case in question was a private medical R&D company wholly owned by a private Dutch company. The parent company issued options to employees of the Israeli company in the “trustee capital gains” track.
The options plan asserted that the vesting of options is subject to a full change in control (an exit event). Since the position of the Tax Authority was that vesting conditional to an exit event violates the provisions of the Israel Tax Ordinance, the parent company sought to change the conditions of vesting to be time-dependent only. this was performed by canceling the original options and reissuing them under the conditions of the “trustee capital gains” track.
Without delving into all the fine details we’d like to point out that the tax decision allowed for swapping the options without payment of taxes at the time of the swap (even though ostensibly a tax event is incurred), and a linear mechanism would measure the value of the benefit derived from the old options, with marginal taxes paid on that at the time the new options are exercised.
To our understanding, the Tax Authority’s position is because the exit dependent vesting mechanism does not satisfy the conditions of the “trustee capital gains” track. On the other hand, however, the acceleration mechanism (of vesting dates) activated in the case of an exit does not contradict application of the provisions of this track; this position was even adopted as part of an earlier tax decision on this matter.
So, for example, in our opinion the establishment of a particularly long vesting period with the option of acceleration in the case of an exit satisfies the capital gains track conditions, even according to the Tax Authority’s approach.
Apart from the question of validity or logic of the Tax Authority’s position in the context of application of the capital gains track in the case described in the tax decision, there remains a question of how to relate to the vesting period that is not time-limited (other than by a future event), in the context of division of income from exercising options in the case of a change of residency status between the grant date and the exercise date.
The Tax Authority’s position (which we contest) is that the linear formula does not apply to the options based on the period the options are held as indicated in the provisions of exit tax (taxes paid when ceasing to be an Israeli resident), but rather is based on the vesting period.
Yet in the case described above, even taking into account the position of the Tax Authority, the linear formula would be applied based on the period held (equivalent under these circumstances to the vesting period), so that only the benefit associated with the period between the grant date and the residency cessation date relative to the period concluding with the company’s exit would be taxed.
In our opinion, as we’ve already indicated, the position by which the Israeli tax liable portion may also be eligible for the capital track as established by the Ordinance is also a valid one.