A tax ruling has been published recently, which deals with the taxation of income from the exercise of options by a returning resident. “Spoiler” – the Tax Authority has determined that income from options that have vested outside of Israel when the individual was a foreign resident is taxable in Israel, and thus it has retracted its position in previous tax rulings. This tax ruling constitutes a continuation of a previous tax ruling regarding the taxation of a salaried employee, in which too it was determined that income (salary differences and bonuses), which has been generated by the individual abroad at the time that he was a foreign resident, will be taxable in Israel, if it has been received by him after he returned to be a resident of Israel (on a cash basis).
A brief description of the case:
The case concerns an individual who was a foreign resident for about five and a half years (between the years 2011 and 2016), in the course of which he worked in an American company and received options for shares in the Company, which vest over a particular period of time. After he returned to Israel, the individual continued to work in an Israeli company which belongs to the same group.
The question that stands at the foundation of the ruling:
Is an individual chargeable to taxation in Israel in income deriving from the exercise of options (and the sale of the shares thereunder), even if they vested in a period in which he was a foreign resident and only exercised when he was a resident of Israel?
The tax ruling and its implications:
The Tax Authority’s position so far as regards the taxation of options in the hands of employees as a result of a change in residency, was that at the time of the exercise, the part of the profit that has been produced in Israel and abroad has to be calculated, in accordance with the vesting period, and the part that was produced abroad, when the individual was a foreign resident was not taxed in Israel. This was determined, for example, in previous tax rulings.
In the tax ruling under discussion, it was determined explicitly that the new position, which has been determined, annuls and replaces the position that had been adopted in the tax decisions that are mentioned above. What has led the Tax Authority to change its position? For the provisions of the law have not changed and no binding case law has been determined in the Courts. Has the Tax Authority been mistaken for more than a decade? It is not reasonable. It would seem that the change in the position derives simply from the interest of collecting more tax from assessees.
In respect of the timing of the exercise, it was determined in the decision that this will be at the time of the sale of the shares deriving from the exercise of the option, and not at the time of the conversion into shares, which is in accordance with the mechanism that is set in the Israeli Tax Ordinance. This determination contradicts what is stated in all of the previous tax rulings, and it was appropriate to determine that in this connection too, the current tax ruling annuls and replaces previous rulings.
By the way, it would appear that the explanatory words in the OECD’s model treaty specifically support the determination of the time of the exercise on the basis of the conversion of the option into share (which also allows countries to determine otherwise). How may the determination of the timing of the exercise be of influence in other cases?
If for example, the employee exercises the option into share before he returns to Israel, then in such a case if the timing of the exercise is at the time of the conversion of the share, then all of the profit that is attributed to income from labor will not be chargeable in Israel, and the capital gain on the sale of the share afterwards may be exempt from tax in Israel, insofar as may be relevant. The current tax ruling brings up absurd scenarios.
Thus for example, in accordance with the tax ruling, an individual who holds options that have vested in fill and which have been converted into shares prior to his return to Israel, the profit from the sale of the share, insofar as it has been sold after his return to Israel, will still be considered as income from labor that will be chargeable with taxation in Israel, even if it is clear that at the time of the return, the individual has a capital asset and it makes no difference if this has come into his hands under the force of a labor relationship or whether it is property that he has paid for with his own private money.
So what do we do?
Consideration needs to be given to the possibilities for converting the options into shares before returning and even of selling the shares (in case the Tax Authority may seek to tax the profit from the sale if it is executed after returning). Insofar as the individual may be required to pay a higher rate of tax on the conversion of the option and/or on the sale of the share in a foreign country, consideration should be given to determining residency in a third country as “an intermediary station”, in which it will be possible to sell the rights, prior to the return to Israel. There may be additional creative solutions.
In any event, in our opinion, it will be possible to defend a position that contradicts the position taken by the Tax Authority, which is reflected in the tax ruling that is under discussion, pursuant to which the reporting basis that applies to an individual (a cash basis) is not supposed to change the substantive taxation that applies, but rather it only determines the timing, as has been determined in case law, for example on the subject of other sections that are quantifying and timing sections and not original sections that are binding in and of themselves.
And one final question – where is it determined that an employee and a services provider are required to report their income on a cash basis?