Israeli tech employees set for tax windfall worth millions

Ofer Levy is a software infrastructures team leader at an Israeli tech firm. A junior middle manager who has never sought publicity and certainly not asked to change tax arrangements on pay. However, a disagreement between him and the Israel Tax Authority has concluded with a precedent-setting ruling that could influence many employees who received share options on which they subsequently paid high tax rates on the dividends they received over the years.

Levy was asked by the Israel Tax Authority to file a request with the assessor and was surprised to discover that together with toolbar company Conduit, who he had worked for since 2013, he was required to pay thousands of shekels tax on dividends he had received during his employment there. The appeal he filed together with Conduit was accepted by the Lod District Court, which dismissed the Israel Tax Authority’s position that the status of employees with share options is no different from investors or entrepreneurs who pay tax on dividends.

Judge Samuel Bornstein’s precedent sets that employees working in companies with a reduced tax track of 15% or 20% – a track chosen by most tech companies – are required to pay a reduced tax on the dividends, and not the full rate of 25% charged on those who sell their shares, for example, during an IPO or sale of a company.

In practice, investors and entrepreneurs at these tech companies have always enjoyed reduced tax rates on dividends, but employees were given another status because the Tax Authority did not always recognize them as investors, but saw them as someone who only enjoyed the fruits of success. But the company’s loyal employees, who held the options and workers’ shares, were required to pay 25% tax to the Tax Authority on the dividends, without really understanding whether this was justified or legal.

However, in its ruling the court accepted Ofer Levy’s petition, because employees are not just passive shareholders, but invested in the company through the waiver they made in their salaries, in exchange for options.

“Just as companies have to invest in preferred enterprises and just as businesspeople should be encouraged to invest in companies with preferred enterprises costs, so that human capital – employees who receive options and shares should be encouraged,” Judge Bornstein wrote in the case. “The idea behind the taxation arrangement in section 102 of the Income Tax Ordinance (the section that regulates the manner of taxation on options, AG) is intended, among other things, to tighten the relationship between the employee and the company, in which case it is not just a company, but one with a preferred enterprise.

“From this perspective, the employee is wearing the hat of an employee, but also a shareholder’s hat, even at a stage where their shares are held by the trustee. The Tax Authority stresses that at this point, the employee has not yet paid tax and is therefore lawfully like any other shareholder, and it relates to the employee as a “flawed” shareholder, or as if the shares are held ‘conditionally’ and are still subject to tax payment. However, the full ownership of the shares is not contingent on property law and corporate law, because if that were the case, the employee would not have received the dividend for them.”

The ruling puts an end to the existing confusion

Adv Amit Kriegel of Moshe Mizrachi Noach Kriegel & Co. law firm who represented Levy said, “The Tax Authority had no orderly policy on the tax on dividends, as section 102 actually refers to the realization of shares that originate from options. “The Tax Authority would turn to the trustees of the options and take 25% tax from the dividends. Sometimes it worked and sometimes it didn’t. The new ruling by the court has put an end to this. In practice, this precedent will change the results for many employees. “It applies to any employee who has received shares under section 102 of the Capital Track, with the shares of a company that is entitled to the benefits of the Law for Capital Encouragement – whether it is a private or public company. It is also relevant retroactively, so employees in a similar profile who have paid 25% tax over the past six years on dividends can submit reports to the tax authority and receive the excess tax that they paid.”

Dr. Yifat Aran assistant professor of business law at University of Haifa Faculty of Law said, “This is an exciting ruling because it has given the court an opportunity to discuss more basic questions from a technical point of view about a law that creates more specific tax arrangements. On the basis of this ruling rests a question regarding the status of employees holding shares. Historically, the return on the capital tended to be higher than the rate of growth of the company’s overall productivity.

“In addition, work income is subject to heavier taxation than a return on capital. At the same time, the importance of human capital is increasing, so talented workers become the bottle neck in the growth of tech companies rather than not having sufficient cash. So it is not surprising that employees who are sought-after human capital are looking to become shareholders in their employers and not work for a salary in cash only. For tech employees, the decision about who to work for is largely the most significant investment decision they will make because of the capital reward component that has the potential for a life changing result.”

She continues, “The question is whether our judicial system will recognize the rights of employees-investors in the same way that it protects the rights of capital investors. In previous cases that were not related to tax law, but rather to corporate law, Israeli courts referred to employees as less compared with other shareholders. The claim was that they were given the shares for free as an incentive and they did not really taken into account investment considerations when choosing the job.

“Judge Bornstein ruled unequivocally that there is no justification for the inferior status of employees compared with other shareholders. Instead of accepting the Tax Authority’s position that employees are not genuine shareholders whose investments are worth encouraging, the judge explained that employees may not be investing money, they are investing human capital, and in choosing employers they make an investment decision similar to financial capital investors. This is an important statement and it is hoped that other judges will adopt it. “

Tax Authority: We are studying the ruling

The ruling is also revealed that Conduit, a company that developed ad-based toolbars and encouraged users to replace their search engine default, had received a significant 15% tax benefit on dividends. This decision was dramatic for investors including the Benchmark and Yozma funds, and private investors who enjoyed a tax benefit worth hundreds of millions of shekels.

According to the ruling, the company distributed dividends of NIS 1.5 billion in 2011 and 2012, NIS 208.1 million in 2015, and NIS 311 million in 2016. In total, the shareholders and employees received dividends worth NIS 1.84 billion.

Deloitte Israel partner Gabi Waisman who specializes in employee mobility and capital remuneration told “Globes, “There is no doubt that for here onwards when distributing dividends to these employees, companies will adopt the ruling and deduct only 15% tax as set by the court in the precedent, and won’t adopt the position of the Tax Authority according to which 25% should be deducted.

“Not only that, but following the ruling, a wave of tax refunds is expected by many employees who have had tax deducted in the past and will now seek to invoke the ruling set by the court and receive the tax difference that is owed them. In the case of the Conduit ruling which was discussed, the tax difference was about NIS 10 million, so it is possible to imagine the tax difference deducted from the overall number of employee from whom dividends were distributed from the profits of preferred enterprises. An interesting point will be regarding the position of the Tax Authority regarding tax reports that have already been submitted by employees in the past, where no tax refund was required. Will they now be allowed to correct the tax report and demand the tax refunds they are entitled to? There is doubt about it. “

The Israel Tax Authority said, “We are studying the ruling.”

Published by Globes, Israel business news – en.globes.co.il – on March 2, 2023.

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