Many entrepreneurs need to make a decision where to incorporate their company. Should the company be incorporated as an Israeli company or as a US corporation? The decision where to establish their startup can influence the future growth of the company and may be irreversible. This debate has been repeated recurrently over the years between practitioners, and no specific or final formula exists. The decision is mainly based on the international tax considerations resulting from the corporate structure. William Shakespeare's question, "To be or not to be?ˮ (spoken by Hamlet), could be rephrased in our context as, "To be or not to be (a parent) Israeli company?ˮ
In general, the founders of a company may consider, among other things, two alternative structures: an Israeli parent company with a US subsidiary or a US corporation with an Israeli subsidiary.
Below we set out certain tax aspects which need to be reviewed prior to making a decision as to the corporate structure and incorporation of a company.
Corporate Tax Perspectives
Israel Corporate Tax Rates: The tax regime in Israel provides a lot of benefits to Israeli companies. Israeli companies generally are subject to a corporate tax rate of 23% (as of 2018). US Corporate Tax Rates: Under the new "Trump Tax Reform", the rate of corporate income tax was reduced from 35% to a flat rate of 21% (effective for tax years beginning after December 31, 2017). The Trump Tax Reform also repealed the corporate alternative minimum tax (AMT) imposed under Section 55 of the Internal Revenue Code. In addition to the federal corporate tax rates, state and local taxes which are also imposed on corporations, vary by jurisdiction in the United States, and generally range between 1% and 12% (although certain states do not impose tax on income). It should be noted that under the Trump Tax Reform, domestic US corporations can claim a certain deduction of its foreign-derived intangible income, and as a result, the U.S. federal tax on foreign-derived intangible income (FDII) could be reduced to a rate of 13.125%.
Israeli Preferred Enterprise Tax Regime: The effective tax rate payable by an Israeli company that derives income from a "Preferred Enterprise" status under a special tax regime in Israel, could reduce a company's tax rate to 16% with respect to income attributable to its Preferred Enterprise (instead of a rate of 23%). In the event that the Preferred Enterprise is located in a specified development zone in Israel, known as "Development Zone A", the corporate tax rate would be reduced to 7.5%. Moreover, in the case of a technology company satisfying certain conditions pursuant to which it would qualify as a "Special Preferred Technology Enterprise", it may enjoy a reduced corporate tax rate of 6%, regardless of the company's geographic location within Israel. Being under such tax regime would also entitle the stockholders to reduced tax rates on dividend distributions.
Chief Scientist Grants: The Israel Innovation Authority (previously known as the Office of Chief Scientist), is a governmental agency providing, inter alia, funding platforms to early-stage entrepreneurs and mature companies developing new products or manufacturing processes. The funding is available for research and development undertaken in Israel. In general, a US parent corporation holding the intellectual property would not qualify for such funding.
ESOP: Our office represented Kontera in the Israeli Supreme Court in a transfer pricing dispute with the Israel Tax Authority with respect to the inclusion of the value of stock options in a transfer pricing agreement between a US corporation and its Israeli subsidiary, based on a cost plus mechanism. Unfortunately, in April of 2018, the Israeli Supreme Court ruled in favor of the Israeli Tax Authority that a stock-based compensation pursuant to an employee stock option plan (ESOP) needs to be included in the cost base of Israeli subsidiaries of multinational companies with no deduction available for such inclusions. As a result of this decision, the taxable income of an Israeli subsidiary is effectively increased by the value of the stock-based compensation plus the mark-up. Such deemed income and tax liability of an Israeli subsidiary would not be relevant in case of a different method of transfer pricing.
Investor/Founders Tax Perspectives
Israel Capital Gains Tax: Generally, pursuant to the Israel Tax Ordinance, a US investor in an Israeli company would be exempt from paying capital gains tax (assuming that such investor does not have a Permanent Establishment in Israel and is not a resident of the State of Israel). An exemption is also available for a holder of less than 10% [of the issued and outstanding shares of an Israeli company] under the terms of the income tax treaty between Israel and the United States. An individual who is an Israeli resident investor is subject to capital gains tax at the rate of 25% or 30% (in the event that the investor is considered a "Controlling Shareholder", as such term is defined in the Israeli Tax Ordinance), and Israeli corporate investors would be subject to tax on capital gains according to the Israel corporate tax rate.
US Capital Gains Tax: In general, the US capital gains tax rate is up to 20% for most assets held for more than a year (Long Term Capital Gains), plus state tax and Medicare tax. Capital gains tax rates on assets held for less than a year correspond to ordinary income tax brackets (Short Term Capital Gains).
QSBS – $10M Exemption from Capital Gains Tax: A US investor and /or US founder investing in a US corporation could benefit from tax exemption in the US on his/her capital gains upon selling his/her stock. This exemption does not apply to an investment in an Israeli startup company. Under the US Tax Code (IRC Section 1202), 100% of gain on the sale of Qualified Small Business Stock ("QSBSˮ) could be excluded from tax for US tax purposes for an amount of up to $10 million. The amount of gain excluded is not subject to the 3.8% Medicare tax, and is not subject to the alternative minimum tax rates. In addition, the gain may also be excluded from state and local taxes where such country follows the federal income tax laws. There are a few rules and conditions enabling such tax exemptions, for example: shares of QSBS must be acquired directly from the US corporation in exchange for money (or other property (other than stock)); QSBS must be held for more than five years; active business requirements and the corporation must be qualified as a small business (i.e. must not have aggregate gross assets in excess of $50 million). There is no doubt that this tax regime in the US is an incentive to US investors to invest in startups that were incorporated as US corporations rather than in an Israeli company.
First Year Claiming Tax Deduction for Investment Amount – Israeli Angel Tax Laws Incentives Israeli Investors: Investors in an Israeli R&D company can take an ordinary income deduction against any Israeli source of income (including compensation income) of up to approximately $1.4 million (5 million NIS). The taxpayer can claim such deduction in a year of investment. The "Angel Tax" laws provide certain conditions that the company needs to meet. US investors can also claim such deductions in Israel against other Israeli sources' taxable income (if any). This benefit does not apply to an investment in a US corporation.
Reclassification of Capital Loss Investments to Ordinary Tax Deduction – US Tax Code Incentives US Investors: On the other hand, the US Tax Code "Section 1244ˮ gives US investors (investing in a US corporation) also the ability to take an ordinary income deduction on losses (up to $50,000 or $100,000 on a joint return) rather than the standard capital loss deductions. In general, a US corporation shall be treated as a small business corporation if the aggregate amount of money received by the corporation for stock, as a contribution to capital and as paid-in surplus, does not exceed $1,000,000.
GILTI: As detailed and presented in the 2018 GKH October Newsletter discussing the impact of the GILTI rules on the High-Tech industry, in the event that 50% or more of rights or value are held by US persons in an Israeli company, each 10% US shareholder would be subject to tax in the US on the Israeli subsidiary taxable income. On the other hand, if a US investor invests in a US corporation, the GILTI issue would not have any impact assuming the Israeli company is subject to tax in Israel at the rate of 23% or a reduced tax rate of 16% (i.e. a Preferred Enterprise). If the founders incorporated an Israeli parent company holding a US subsidiary on day one, an inversion procedure may be required, with all tax implications involved in reorganizing a group of companies, taking into account that the intellectual property would continue to be owned by the Israeli company and any transfer of such intellectual property from Israel to the US may trigger an Israeli tax event.
Estate Tax: An Israeli investor holding shares in an Israeli company will not be subject to Israeli Estate Tax, as Israeli law presently does not impose estate or gift taxes. However, in case of an Israeli individual investor holding (directly or indirectly through pass-through entities) stock in a US corporation, and is neither a US citizen nor has a US 'domicile' for Estate and Gift tax purposes, the exclusion amount is usually limited to $60,000, and therefore all such investor value allocations in stock of US corporation (higher than $60,000) would be subject to US estate tax at the rate of approximately up to 40%, and executors for non US residents must file an estate tax return with the IRS. It should be noted that Israel and the US are signed on a Tax Treaty, however no provisions of estate tax exist to provide relief.
Summary: As can be inferred from the above, each structure has its pros and cons for the company, the investors and the founders, and in some cases such factors can influence each of the above players differently and adversely. Additional tax matters should be analyzed, such as the location of intellectual property in each structure, transfer pricing, Base Erosion and Profit Shifting (BEPS) rules, tax treaties, withholding tax considerations, management and control, tax treatment of losses, and more. Aside for taxation, further insights should be made as for the corporate governance, place of business, attractiveness to potential investors, location of customers, sector of operation and more. The QSBS tax benefit to US investors and the GILTI rules may change the balance scale in favor of incorporating a US corporation as a parent company. However, the analysis should be conducted on a case-by-case basis, taking into account that the taxation issue is a major factor to consider, but is not the only parameter to take into account as for the decision whether to be or not to be (a parent) Israeli company.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.