Corporate global mobility: flips by Israeli tech companies

Yuval Navot
Herzog, Fox & Neeman, Tel Aviv
navoty@herzoglaw.co.il

Ronen Avner
Herzog, Fox & Neeman, Tel Aviv
avnerr@herzoglaw.co.il

Background

The discussion surrounding the location of incorporation of tech startups has been a part of the Israeli high-tech market since its inception and has evolved over the years. In recent years, many Israeli-incorporated companies have grappled with the question of whether to undergo corporate restructuring by placing a non-Israeli company at the top of their holding structure. This is often considered in the context of raising funds from investors, which is the driving force behind the existence and growth of startups.

Reasons for a flip

Non-Israeli investors sometimes prefer to invest in a non-Israeli company rather than an Israeli one. For example, US investors benefit from significant tax incentives when purchasing shares in a company defined as a qualified small business, which under US tax law must be a US-incorporated company. These investors may qualify for a capital gains tax exemption upon selling shares in such a company in the future, subject to certain conditions. Also, a US parent corporation helps to avoid controlled foreign corporation (CFC) and passive foreign investment company (PFIC) tax rules at the investor level. The Israeli company will be a CFC and the US parent corporation, rather than the investors, will be subject to US Internal Revenue Code (IRC) Section 952 Subpart F and the Global Intangible Low-Taxed Income (GILTI) tax rules.

There are also other reasons for a flip. Institutional investors are sometimes restricted by their incorporation documents from making investments outside their jurisdiction. Some investors prefer to invest in companies incorporated in a jurisdiction where they are familiar with the legal environment and the relevant legal documents and do not wish to spend time examining investments in companies incorporated in other countries. Certain US venture capital (VC) funds are reluctant to invest in a non-US entity, particularly if they are granted a board seat.

Is it really a flip?

Corporate relocation involves having shareholders (and any other rightsholders, such as option holders) transfer their shares (and other equity rights) in the Israeli company to a newly formed non-Israeli company, most commonly a Delaware corporation. Although commonly referred to as a ‘flip’, effectively this is not really a ‘flip’, but rather just a dropdown of shares and other equity rights to a non-Israeli company. For the sake of simplicity, we sometimes refer to this dropdown as a ‘flip’ in this article.

Such dropdown creates an immediate tax event for Israeli shareholders and rightsholders, while non-Israelis are generally tax exempt. The tax event can be deferred but a decision from the Israel Tax Authority (ITA) must be obtained. The ITA published guidance on the so-called ‘green route’, which allows Israeli companies formed on or after 2018 to be granted such a decision in a matter of weeks if they satisfy the conditions therein and the new parent company is resident in a country according to which Israel has a tax treaty in place. For companies formed prior to 2018, such a decision can still be obtained albeit not as part of the green route process.

The related ITA requirements:

• the intellectual property (IP) limitation, namely the IP (including modifications and future derivative IP developed based on the existing IP) must still be owned by the Israeli company. The ITA will carefully review any development of future IP outside of Israel to ensure that there is no transfer of existing IP;
• the dilution limitation, which requires that existing shareholders and rightsholders keep at least 25 per cent of their shares and rights, respectively, in the non-Israeli company for at least two years following the flip. Their ownership stake must not be reduced below 25 per cent either through dilution or a sale. Furthermore, the existing shareholders and rightsholders need to deposit their shares and rights with a third-party Israeli trustee in order to secure the necessary tax payments. In certain cases, non-Israeli shareholders can release their shares from the trust; and
• other restrictions, made up of various requirements that must be met to qualify for a flip decision. For example, the non-Israeli parent company must maintain ownership of the Israeli company for at least two years after the dropdown date. In addition, there are some limitations on treaty dividend withholding tax rates for distributions made by the Israeli company to the parent company.

Implications on exit

If the Israeli company’s IP is transferred post-closing to a buyer (in cases where the buyer wishes to consolidate the IP into its global IP structure), there are two levels of Israeli tax, namely corporate tax and dividend tax on the after-tax consideration for the IP sold (assuming the buyers repatriate the after-tax IP consideration rather than keeping it in the newly acquired company). When an Israeli company is the IP owner and does not have a non-Israeli corporate parent, structuring options may exist to eliminate the dividend tax. However, in regard to a company that has undergone a flip and is owned by a non-Israeli corporate parent, eliminating the dividend tax will be very challenging.

In addition, a US parent corporation (which as noted is the common resulting parent in a flip) might be a less attractive target entity for potential non-US purchasers. It may be an even less attractive structure to certain potential US purchasers, for example due to the impact of a IRC Section 338 election.

Buyers may factor these potential tax leakage considerations into the proposed acquisition price. Therefore, this issue should be carefully analysed before proceeding with a flip, weighing such drawbacks against the potential advantages.