‘SAFE’ to invest in Israel: no tax on conversion ‘benefit’ for foreign investors – part one

‘Simple Agreements for Future Equity’ (SAFE) became mainstream in the last decade for the shaping of investments in innovative, young companies; and Israel was no exception. As of May 2023, the tax uncertainty for foreign investors, who often provide oxygen to promising young companies grasping for air in Israel’s famed technological ecosystem, has largely been resolved.

The Israel tax impact on foreign investors who would – at high personal financial risk – provide the next chunk of working capital to start-up initiatives by way of a SAFE had been unclear for years. The SAFE instrument squeezes an initial investment in a simple agreement promising the ‘investor’ shares at a discount in relation to the share price in an upcoming investment round. The ability of the SAFE holder to receive future shares is reminiscent of ‘convertible loans’. However, the investee does not pay interest on the amount of the SAFE, and does not have to repay even in case the investor is eventually not awarded any shares in the company. The share price at an ‘entitling event’ is lower than the price paid by new investors who join an equity investment round.

The Israel tax authorities would argue that there is a “discount” on the price SAFE holders pay, similar to ‘interest’. And if that is true, the company would have to charge 25-30% tax at source on the ‘benefit’ so gained by a foreign SAFE participant as claimed by the Israel tax authorities. The tax audit of a company that forgot to charge the tax at source on outgoing interests and the share price discount on convertible loans would result in the investee having to pay the source tax (grossed up on the net interest recognised), penalties, interest charges and even denial of the deduction of the interest paid.

To prevent this, the investee companies who would be aware of the risk would advise their investors to obtain a withholding tax permit from the regional tax office confirming the entitlement of the lender to the reduced rate of withholding tax on outgoing interests under a relevant tax treaty (10% - 15%). And then, once negotiating with the tax assessor for his confirmation, the treasury official would take the position that also a ‘discount’ he thought in the conversion share price should be taxed at source as interest by the issuing company .

As is clear, the issuance of shares against cancellation of the repayment of debt passes without cash transfer by either party. A converting lender would then either put cash on the table to cover the tax on the discount benefit, or the company would insist on issuing less shares, in lieu of payment of source tax on the discount.

Convertible loans, and other seemingly high-return financing instruments such as SAFEs, have traditionally been a point of great contention with the Israel tax authorities. The authorities typically want to collect 25% tax on the benefit of the discount, arguing it is an interest in disguise.

Financing agreements with foreign investors would not relate in detail to this substantial source tax risk accompanying a future conversion. Foreign risk investors are then unpleasantly surprised before the actual conversion, when the target company would require the investor to transfer cash. This allows the company to pay the 25-20% tax at source on the discount benefit or be issued substantially less shares to cover the tax. And although a SAFE is very different from a ‘loan’, the Israel tax assessors would insist that the share price discount on a SAFE is ‘interest’.

On May 16, at long last the Israel tax authorities published informal guidelines outlining when the right to a reduced share price against deposit of capital under a SAFE is not subject to tax.

These guidelines end many years of uncertainty, which has been a burden to many struggling high-tech initiatives With the presentation of its guidance the Israel tax authorities show their sensitivity to the crucial importance of tax certainty and transparency for Israel’s investment climate for foreign investors. Note that an official Circular will likely follow, eventually.

Firstly and importantly – in continuing the tax attractiveness of the investment climate – non-residents are eligible for exemption from tax, under Israel’s domestic tax laws, on gains from the sale of securities (inter alia, and mainly, ‘shares’) in an Israel company. This is provided the company’s value is not mostly derived from real estate in Israel. A SAFE that meets the conditions listed in the publication may classify as an ‘advance’ of equity on account of shares and not attract an obligation for the company to tax anything in relation to the SAFE at source.

The guidelines spell out the basic terms of, in Hebrew, the “green path”, a set of conditions to meet that allow for issuance of lower priced shares for SAFE deposit of advance capital (of up to 40 million New Israel Shekel) to qualify as an investment in ‘equity’ and not as a ‘loan’.

Read the second article in this series for an overview of these “green path” requirements.