Background
The Israeli Capital Investments Encouragement Law 1959 ("Law"), was enacted with the aim of encouraging capital investments and economic initiatives in such a manner that priority will be given to technological innovation through various tax benefits.
Commencing 2017, following amendment 73 to the Law[1], substantial tax benefits are granted to companies that own a "preferred technological enterprise" ("Technological Company").
A Technological Company is entitled to reduced tax rates for its technological revenues. In addition, the shareholders of technology companies are entitled to reduced tax rates for their income from dividends distributed from those companies.
The tax benefits for a Technology Company and its shareholders
Reduced corporate tax payment - The "normal" corporate tax rate in Israel is 23%. A Technology Company is entitled to a reduced corporate tax rate depending on the location of its activity - a Technology Company located in Development Zone A[2] is entitled to a reduced corporate tax rate of 7.5%; and a Technology Company located in non-development areas is entitled to pay a reduced corporate tax rate of 12%.
Reduced dividend tax payment - the "normal" dividend tax rate in Israel is 25% or 30%[3] (depending on the shareholder's holding in the company). When distributing a dividend from a Technology Company, its shareholder is entitled to a reduced dividend tax at a rate of 20%.[4]
The reduced tax rate for dividend distribution is also maintained in the case where the shareholder owns the Technology Company through a holding company that he owns[5] - dividend distribution from the Technology Company to the holding company is exempt from tax (being a dividend between Israeli companies); Subsequently, the distribution of a dividend from the holding company to an individual, which originates from the dividend received by the holding company from the technology company, is subject to a tax rate of only 20%.[6]
Below is a table illustrating the tax savings "to the final pocket" for a shareholder who owns a Technology Company, compared to a shareholder who owns a regular company: [7]
| Technology Company | A regular company | ||
| Other Zone | Development Zone A | ||
| 12% | 7.5% | 23% | Corporate tax |
| 20% | 20% | 25%/30% | Dividend for shareholder (individual) |
| 29.6% | 26% | 42%/46% | Weighted tax rate "to the final pocket" before additional tax |
The main conditions for classifying a company as the owner of a preferred technological enterprise entitled to tax benefits[8]
The Law lists three main conditions for receiving the tax benefits:
(1) The company's income is "technological income";
(2) the company is a "preferred company";
(3) The company owns a "preferred technological plant".
First condition - the existence of technological income
Technological income is income derived from software developed by the company. The law makes it possible to receive tax benefits for a wide range of technological income, inter alia[9]: income from granting the right to use software (e.g.: selling software in the White Label model); Income from a software-based service (SAAS) (for example: selling advertising space on the Internet and on smart TVs); and more.
Second condition - the existence of a preferred company
Preferred company - a company that was incorporated in Israel or a partnership which members were incorporated in Israel.
Third condition - the existence of a preferred technological plant
The existence of a preferred technological enterprise requires compliance with many conditions - some are cumulative and some are alternative. Below is a list of the main cumulative conditions[10]:
- Sales abroad (export conditions) - it is required that 25% or more of the technology company's revenues be received from customers who are residents of foreign countries numbering at least 15.4 million inhabitants[11] (if this condition is met, the tax benefits are received on all of the company's revenues, including revenues from Israeli customers).
- Employment of R&D employee - it is required that the amount of R&D workers employed by the company in an annual weighted calculation, be 3 workers, or 20% of the company's total workers, whichever is higher.[12]
Emphasis regarding the terms of employment of R&D employees:
2.1 An R&D employee is an Israeli employee. If the company receives R&D services from an Israeli subcontractor,[13] he can be classified as an R&D employee provided that he and the company have an employee-employer relationship and he provides services only for the company (and not for other customers).
2.2 The R&D employee must only engage in research and development, such as: programming, quality control (QA), product characterization, UX/UI, etc. An employee who deals in issues other than research and development (such as: marketing, management, etc.) will not be classified as an employee R&D.
2.3 In calculating the weighted annual amount of R&D employees, the employee's work period in the company during the year and part-time work, if he did not work full-time, must be taken into account.
Example: An R&D employee who worked full-time in the company from July to December (six months) will be counted as half an R&D employee in an annual weighted calculation.
Another example: an R&D employee who worked for the company during the entire tax year to the extent of half a position and all of his time is spent exclusively on research and development - will be counted as half an R&D employee in an annual weighted calculation. On the other hand, a full-time employee, who only spends 50% of his time on research and development and the rest of his time is spent on other issues (such as: marketing) - will not be counted at all in the R&D employee record.[14]
- The company's employees are required to come and work from the company's offices.
- The research and development expenses[15] of the company in the three years preceding the year in which the benefits are sought[16] are at a rate of at least 7% of its total revenues (in some cases the research and development expenses can be measured from the "net" revenue cycle (gross profit) and not from the "gross" cycle).[17]
Obtaining preliminary approval from the tax authorities regarding the company's compliance with the provisions of the Law.
Due to the complexity of the Law and the conditions necessary to receive the benefits, it is recommended to contact the tax authorities with a request for a preliminary taxation decision (pre-rolling) which regulates in advance the position of the company as the owner of a preferred technological enterprise and provides certainty regarding its entitlement to the tax benefits. As a rule, the taxation decision approves tax benefits for five years (subject to compliance with the conditions of the taxation decision in each year in which the company is entitled to the tax benefits). At the end of the five years, it is possible to seek an extension of the tax benefits for another five years. In some cases, the decision can be applied to years that have already passed (as long as an annual report has not yet been submitted to the tax authorities).
In cases where the company is not entitled to receive a taxation decision, it is possible to contact the tax authorities as part of an application for "green route" tax benefits. In this track, the company requests to be classified as having a preferred technology plant in retrospect. This request is submitted as part of the annual reports. The company's eligibility to receive the tax benefits will be examined by the assessor as part of an assessment hearing. In an application for tax benefits within the framework of a "green route", as opposed to an application within the framework of a taxation decision, there is no certainty that the application will be approved by the tax authorities.
Summary
Our office has extensive experience in accompanying technology companies in everything related to examining their compliance with the conditions of the law and obtaining a preliminary taxation decision granting them tax benefits. In recent years, our office has accompanied and handled taxation decisions for many technology companies, among others: companies engaged in the development of platforms in the field of online advertising; development of software for commercial arenas; software development in the field of crypto and blockchain; software development in the field of electronic commerce; software development in the field of online learning; software development in the field of mapping and visualization; software development in the field of medical technology; and more.
We will be happy to be at your service for any question or request.
[1] Amendment 73 to the law was made within the framework of the Economic Efficiency Law (Legislative Amendments for the Implementation of the Economic Policy for the 2017 and 2018 Budget Years), 2016-2017
[2] Such as: various peripheral areas (Ashkelon; Yokneam; industrial areas in Be'er Sheva; Afek Industrial Park; and more); as well as certain areas in Jerusalem (for example: Mount Khotzim);
[3] Plus additional tax at the rate of 3% if applicable
[4] Plus additional tax at the rate of 3% if applicable
[5] As long as it is an Israeli company
[6] Plus additional tax at the rate of 3% if applicable
[7] Plus additional tax at the rate of 3% if applicable
[8] For further detail, see Income Tax Circular 9/2017 on "Amendment 73 to the Capital Investments Encouragement Law". Taxes no/4 C-1
[9] This list is not closed and does not exhaust the range of possibilities
[10] It will be clarified that even if the company does not meet all the conditions necessary to be recognized as a preferred technology company, it is still possible in many cases to receive a taxation decision for it confirming its classification as a "regular" preferred company, which grants it various tax benefits that are not reviewed in this memorandum
[11] Each of the member states of the European Union can be seen as fulfilling this condition (including countries with populations of less than 15.4 million inhabitants, such as: Cyprus, Lithuania, etc.)
[12] For example, if the company employs 12 employees, the number of R&D employees should be at least 3 employees. If the company employs 20 employees, the number of R&D employees should be at least 4 employees
[13] A subcontractor who is a licensed dealer, not a limited company.
[14] However, for such an employee, part of his salary cost will be classified as R&D expenditure, according to the relative part of his time spent on R&D
[15] Such as: the salary cost of the R&D employees; the relative part of the salary cost of employees whose part of their time is invested in R&D; The cost of subcontractors in the field of R&D, etc.
[16] or from the date of the establishment of the company, if it was established during the said three years
[17] Subject to compliance with the provisions of the decree to encourage capital investments (deduction of income transferred to another in a technological enterprise), 2018