Riding the wave: navigating the Israeli tax landscape on stock consideration deals
With an increasing number of M&A deals in Israel involving a significant stock consideration element, Meir Linzen and Yuval Navot of Herzog Fox & Neeman explain the various options and their tax implications.
As cash becomes more expensive due to the recent dramatic increase in interest rates, many buyers are finding it more attractive to fund their acquisitions by issuing stock instead of paying cash. This allows buyers to conserve cash resources for other purposes, such as funding growth initiatives or paying down debt.
As a result, it has recently become increasingly common to see deals with a significant stock consideration component. This article summarises the key Israeli considerations in structuring these deals in a tax-efficient manner.
Key Israeli tax aspects
Under Israeli law, a share-for-share exchange is generally a taxable transaction for the selling shareholders of the target company. Non-Israeli residents are generally exempt from capital gains tax, subject to certain conditions (such as that the capital gain is not attributable to an Israeli permanent establishment of the seller and that the gain is not attributable to rights related to Israeli real estate). Shareholders who are Israeli residents are subject to tax assuming that they have a built-in gain embedded in their shares. Shareholders in a loss position are, of course, not subject to tax.
However, all selling shareholders may be subject to withholding tax, unless an exemption certificate is obtained from the Israel Tax Authority (ITA) and presented to the buyer or its paying agent before the payment of the consideration. Sellers are typically required to approach the ITA to obtain an exemption, either because they are exempt from tax or the transaction is a loss transaction, or to determine the exact amount of capital gains subject to tax, taking into account their cost basis in the shares.
Shareholders who receive share consideration for their shares can obtain certain tax rulings that allow for the deferral of tax on the sale of shares. The type of ruling available for shareholders depends on the structure of the transaction and the characteristics of the buyer and the target company (i.e., public or private companies). Although the tax-exempt treatment, as described below, requires obtaining a tax ruling in advance, in almost all cases the ITA will be willing to issue an interim tax ruling, which will allow for the deal to close without withholding tax on the share consideration, until the final tax ruling is issued.
Share-for-share exchange – ‘tax merger’ ruling
Where a buyer acquires at least 80% of all rights in a target company, the transaction may qualify as a ‘merger by share exchange’ for Israeli tax purposes. Sellers may receive tax-deferred treatment for a merger by share exchange transactions. This means that sellers of a target company's shares receive a carryover basis in the new shares of the buyer. If the buyer is a non-Israeli resident company, a tax ruling in advance (a 103K Ruling) is mandatory in order for sellers to be eligible for the tax-deferred treatment.
The 103K Ruling is complex and may take several months to obtain. The ruling can only be obtained if the fair market value of the buyer is not more than nine times the fair market value of the target company (or vice versa). The 103K Ruling sometimes requires a third-party expert valuation to support the value ratios.
The downside of the 103K Ruling is that it imposes numerous limitations, including the following (which is a high-level and non-exhaustive list).
1. Continuity of interest in the buyer
The existing shareholders and right holders in each of the buyer and the target company, immediately before the transaction, must retain at least 25% of their shares and rights, respectively, in the buyer for at least two years following the transaction date.
For this purpose, "existing shareholders and right holders" does not include shareholders and right holders whose shares/rights were publicly traded, unless such shareholders/right holders are "controlling shareholders".
A controlling shareholder, for this purpose, includes any person that holds, or is entitled to acquire, directly or indirectly, alone or together with a related person, at least 5% of the issued share capital, voting power, rights to profits or the distribution of assets in liquidation of the company or the right to appoint a director/officer in the company (and is not an Israeli pension or a mutual fund).
It is important to emphasise that this group includes Israeli and non-Israeli shareholders and right holders of the buyer and the target company, even if they are exempt from tax in Israel. The 103K Ruling applies to all shareholders (i.e., no election out). Therefore, all shareholders and other right holders that are part of the group mentioned above will need to comply with the continuity of interest requirement. Most shareholders will be required under the ruling to deposit their shares with a third-party trustee. In certain cases, non-Israeli shareholders can release their shares from the trust.
2. Continuity of interest in the target
Immediately after the transaction, the buyer must hold all the target company's shares transferred in the merger by share exchange. The buyer must retain at least 51% of all rights in the target company for a period of two years from the transaction date.
3. Continuity of business
The main economic activity of each of the buyer and the target company immediately before the transaction must be continued for at least two years following the transaction date.
4. Continuity of asset ownership
The majority of the assets owned by each of the buyer and the target company immediately before the closing must not be sold during the two-year period following the closing, and during this period, these assets must continue to be used in the ordinary course of the applicable company's business. ‘Assets’, for this purpose, does not include stock of inventory or tradeable securities.
5. Proportionality of share consideration
All sellers of target company shares must receive shares in the buyer of a single class in proportion to their holdings in the target company. The ownership percentage in the buyer, following the transaction, held by all rights holders must correspond to the ratio of the market value of the target company at the time of the transaction to the aggregate market value of both the buyer and the target company at the time of the transaction.
6. Cash consideration
Certain limitations apply with respect to a cash consideration. The buyer is allowed to buy out shareholders for cash only, provided all shares of the seller and all related parties are sold solely for cash in the transaction (i.e., they do not receive any buyer's shares).
Alternatively, a mix of shares and a cash consideration can be paid to the target company's shareholders, if the total consideration in cash does not exceed 40% of the total consideration and all the target company's shareholders receive the same percentage of cash and buyer's stock. This alternative is further conditioned upon the target company's shareholders holding at least 10% in the buyer post closing.
If a cash consideration is received in the deal, no tax relief is given in respect of the cash component and it is currently taxed.
7. Limitation on the transfer of IP
Typically, the 103K Ruling includes limitations regarding the target company's intellectual property (IP). Specially, the IP of the target company (including modifications and future derivative IP developed based on the existing IP) must remain with the target company post closing. The ITA will carefully review the development of future IP outside Israel to ensure there is no transfer of existing IP out of the target company.
Any change in the business model of the target company that results in shifting profits to other group companies is prohibited under the ruling. Typically, the 103K Ruling explicitly requires that the target company's assets, activity and technology (and derivatives thereto) will remain with the target company.
8. Other conditions
The ITA typically imposes additional conditions and limitations in the 103K Ruling. One such condition that is inserted is that a dividend distributed by the target company to the buyer from earnings accumulated until the closing, and in some cases a few years after the closing, cannot benefit from a reduced dividend withholding rate under a tax treaty.
Certain reporting obligations in connection with a merger by share exchange transaction also apply.
Share-for-share exchange with a public company buyer
Additional alternatives are available. Where the buyer is a publicly traded company and the share consideration consists of shares of stock that are registered for trade on a public exchange, sellers can obtain a ruling providing for a time-limited deferral of their tax event (a 104H Ruling). If the target company is also a publicly traded company, a ruling can be obtained that provides for a full deferral for some shareholders (an Interested Public Ruling).
Under a 104H Ruling, a shareholder that exchanged its shares in consideration for shares of a publicly traded company can postpone the tax event for two years with respect to 50% of the share consideration and four years with respect to the remaining 50% of the share consideration (unless the shares were sold before the end of the two- or four-year period).
If trading in the consideration shares is restricted, then the two- and four-year periods are extended for up to six months from the end of the restriction period (provided that the restriction is under applicable law; contractual restrictions on the sale of consideration shares are not respected for this purpose).
The 104H Ruling applies only to shareholders that affirmatively elect to apply the ruling. These electing shareholders will be required to deposit their shares in a trust company that will be responsible to withhold tax upon sale of the consideration shares and with respect to dividends received on account of such shares.
If the buyer and the target company are publicly traded, an Interested Public Ruling may be obtained. This ruling applies only to target shareholders that hold less than 5% of the share capital of the target company. Certain shareholders are excluded, such as directors and officers or shareholders that acquired the target company shares before the IPO. The Interested Public Ruling provides for a full deferral of the tax event for shareholders within scope.
Rollover of employee stock-based compensation rights
In addition to the above rulings, employees can be eligible for a tax-free rollover, provided that the employee stock-based compensation right was granted under Section 102 of the Israeli Income Tax Ordinance and at least 80% of the target company shares are acquired in the transaction. Generally, an employee is eligible to equity grants under Section 102 if they hold less than 10% of the share capital of the issuing company.
A tax-free rollover of employees' shares and options also requires a tax ruling in advance (but, in this case as well, interim rulings may be provided to allow the parties to close the transaction while discussions with the ITA regarding the final tax ruling continue).
The decision between the alternatives for a tax-free share-for-share exchange depends on the circumstances of each transaction, including the commercial intentions of the buyer post closing and the tax characteristics of sellers.
There is no ‘one size fits all’ in Israeli M&A. Deals can, and should, be structured in a manner that maximises the potential tax benefits for both parties of the transaction, while taking into account the goals and circumstances of each party. For example, as most non-Israeli sellers are exempt from Israeli capital gains tax, a transaction may be structured in a manner that results in a taxable (exempt) sale for non-Israelis but secures a tax-deferred treatment for Israeli resident sellers. To minimise tax leakage, all parties to a transaction must be willing to explore various structuring alternatives and be well aware of the intricacies of the Israeli tax-deferred provisions.