Startup Taxation in Israel

Category: Startups | Reading time: approx. 9 minutes

A typical Israeli startup goes through three or four funding stages over its life, an employee option plan, fundraising from VC funds in the US or Israel, and — sometimes — an exit. At every one of these stops the founder meets the tax world: an Israeli company, a holding structure, the Capital Investment Encouragement Law, Section 102 for options, SAFE financing, and more. This article is a comprehensive guide — from incorporation through to exit.

Stage 1: Incorporation and Legal Structure

Most Israeli startups begin life as an Israeli limited company. Key considerations at incorporation:

• Whether and when to also incorporate a US company — a Delaware Inc. is standard for US VCs.
• Flip-up structure — transferring shares to a US parent at the time of US VC fundraising.
• Share-capital definition — Common, Preferred, Founders shares.
• Founders' agreements — Vesting, IP assignment, Non-compete.
• IP rights — transfer to the company and value creation in the company.

Stage 2: Employee Options — Section 102

Section 102 of the Income Tax Ordinance is one of the most important arrangements in the Israeli startup world. It allows granting employees options at reduced tax. Two main tracks:

1. Capital Gains Track (Trustee): maximum tax of 25%; a 24-month holding requirement with a trustee.
2. Ordinary Income Track (Trustee): marginal tax; mainly for options at an exercise price below market value.

A Non-Trustee track also exists but is less popular due to higher tax. Every Section 102 plan must be approved by the assessing officer before the first grant.

Options for Controlling Shareholders

Controlling shareholders (more than 10% of shares) are not eligible for Section 102 — they operate under Section 3(t), which imposes marginal tax on the income benefit.

Stage 3: Raising Investors

Traditional Equity Investment

Fundraising in exchange for share issuance. Usually not a tax event for the company or the founders — but affects future-option valuations (409A valuation).

Convertible Notes

A loan that can convert to shares in the future. At conversion — a tax event for the investor if conversion is at favorable terms (Discount, Cap).

SAFE — Simple Agreement for Future Equity

The most popular early-stage tool today. In Israel there are ongoing discussions about its classification (equity vs. debt), and accounting treatment changes accordingly.

Stage 4: Capital Investment Encouragement Law for Hi-Tech

Hi-tech companies meeting the conditions are entitled to tax benefit tracks under the Capital Investment Encouragement Law:

• Preferred Technology Enterprise — corporate tax of 12% (instead of 23%) on technology income.
• Special Preferred Technology Enterprise — tax of 6% for very large multinationals.
• Reduced dividend tax — 4% instead of 30%.
• Royalty and IP-income exemption under specified conditions.

Obtaining benefits is conditional on registration and meeting threshold criteria (R&D investment, revenue volume, percentage of research employees).

Stage 5: Exit — Selling the Startup

The moment all founders and employees have been waiting for. Types of exit and their tax implications:

• Share Deal — sale of shares. 25% capital gains for private investors, 23% for companies.
• Asset Deal — sale of the company's assets. Usually higher and more complex tax liability.
• IPO — public offering. Gradual realization of shares after a lock-up period.
• Acqui-Hire — sale based on enthusiasm for employees — tax classification varies.
• SPAC, Reverse Merger — complex but sometimes efficient.

International Issues — Foreign Founders, Global Activity

• Israel-US tax treaty — preventing double taxation for US-Israeli founders.
• Tax residency — "first-time returning resident" or "long-term returning resident" status confers benefits.
• Transfer Pricing — intra-group pricing in a holding structure.
• OECD Pillar 2 — impact of the global minimum tax on large companies.
• R&D agreements between Israeli and US companies — important for preferred-enterprise status.

Summary

An Israeli startup is not just a company — it is a complex legal-tax structure that is constantly changing. Professional advice from day one — not just after the big round — saves millions of shekels and prevents expensive mistakes. Choosing a CPA with hi-tech expertise is a critical strategic step in any startup journey.