Every employee in the high-tech industry (and these days also in other sectors of the economy) knows the term “ESOP” and often start-ups, with the aim of saving legal costs, also create an employee stock option plan and option grant agreements instead of salary (or as part of the salary) without first consulting a lawyer and an accountant who are knowledgeable in the field. The result, at times, may be severe “tax accidents.” A circular published by the Israel Tax Authority in December 2018 resulted in news headlines screaming a change in the tax policy regarding employee options, but in practice it only clarifies the obvious – proper real-time advice and duly drafted options agreements will avoid “tax accidents”.
Employees stock options are a combination of a salary alternative (allowing the company to spend less money) with an incentive for the employee – both to invest energy due the fact that the employee linked his future to that of the company, and to continue working for the company (through a vesting mechanism, according to which, only upon the passage of time or arrival to other benchmarks will the options become exercisable). In addition, the option mechanism, when duly structured, will allow postponement of the tax payment, sometimes until the employee sells the shares bought by exercising the options. Thus, the employee pays tax only when he “meets” with money and only when he has actually created an income for himself. Improper construction may result in early tax payments, but may also result in taxes on future income that may not realize. For example, it is possible that the employee will pay tax on receipt of 100 shares with initial value of 100,000 but later sell the shares at a lower price or (in the worst case) the company will shut down and the shares’ value would be zero (but the tax was paid for them, regardless).
In the circular, the Tax Authority clarified that while the vesting conditions of the options can be defined as the fulfillment of pre-conditions that are not only the passage of time (for example, the performance of the company or the employee), the conditions must be clear and may not depend on a late decision of the company. Moreover, the allotment of options may not be a simple monetary bonus that is merely disguised as options allotment under an option plan (for example, “options” that become vested only in the case of an “exit”, as opposed to a condition in the stock option plan that accelerates vesting in the case of an “exit event”). In the case of a “vague” drafting of the option terms, the Tax Authority may deem the options as granted only on the date that the option terms are determined and tax the employee with a regular income tax rather than a capital gains tax on the profit generated up to such date (tax that may reach the highest income tax rate instead of the 25% capital gains tax). Thus, for example, the circular provides an example of options which vesting depends on the decision of the board of directors in the future regarding the employee’s performance or the rate of development of a product of the company, and accordingly, the amount of options that will vest at such time. In that case, the date of the board of directors decision will be deemed as the date of the grant of the options (and the part of the profit generated until then will be taxed as income tax and not a capital gain).
While we do not consider the circular a policy change but merely a clarification by the Tax Authority as to the results of improper construction of stock options, the circular clarifies more than ever the importance of a clear and correct drafting of both the option plan and the individual option agreements thereunder, with the assistance of an attorney and an accountant whom are knowledgeable the field. If the vesting conditions are duly set, the employee has a large tax advantage. If they are not well worded, the company may have an exposure to claims.