Dear Clients, Colleagues and Friends,

Yesterday, the Israel Tax Authority (“ITA“) published circular 1/2021 (the “Circular“) addressing the ITA’s views on the tax treatment applicable to recharge payments relating to grants of stock-based compensation (“SBC“) in multinational groups. For the most part, the Circular is consistent with the draft circular published by the ITA less than a year ago. We note from the outset that the ITA’s views in published guidance (including circulars) reflect its own views and are not binding on Israeli courts.

Background:

It is often the case that SBC granted to employees in a multinational group, is not necessarily granted by the direct employing entity but rather, by the ultimate parent company of the multinational group, especially if such parent company is a public company (the “Issuing Company)”. It is also not uncommon for the Issuing Company to charge the direct employing company for the expenses it incurs in connection with such equity grants (known as recharge payments).

The Circular:

The ITA sets forth its views in the Circular as to when recharge payments should be treated as a dividend (or capital reduction), which is generally subject to withholding tax, and when such payments can be treated as reimbursement of expenses to the Issuing Company which are not subject to withholding tax. The Circular follows on an-ITA favorable Supreme Court decision in two appeals which were consolidated into one case confirming the need to include SBC accounting expenses in the cost-base for purposes of determining the income of an Israeli R&D subsidiary implementing a cost-plus arrangement under the TNMM/CPM transfer pricing methods. Read more on this topic in our previous client updates here and here. We note that the Supreme Court did not address the issue of the recharge payments.

The Circular clarifies that all of the following conditions must be met for the recharge payment to be respected as a reimbursement to the Issuing Company and not a dividend (or capital reduction).

• The recharge payment to the Issuing Company is with respect only to vested equity compensation. Unlike in the previously published draft, the ITA clarified in the Circular that this also applies to equity that vests gradually, with respect to the portion that has vested. Note that there is no requirement in the Circular that the holding period pursuant to Section 102 of the Israeli Income Tax Ordinance (the “Trustee Capital Gains Route“), which under the Trustee Capital Gains Route is 2 years from the date of grant, has lapsed.
• The recharge payment to the Issuing Company in respect of each vested equity instrument is based on the value ascribed to the accounting expense recorded for such instrument in the financial statements of the employing company (which generally reflects fair market value at the time of grant), according to generally accepted accounting principles. Based on this, there is no need for recharge agreements to address situations whereby the value of the SBC awards decreases between the time of grant and vesting, and the potential tax treatment of such reduction in value as a dividend. In the past, this concern lead companies to recharge for the lesser between the SBC award value at vesting and the SBC award value at grant.
• The recharge payment is made pursuant to a recharge agreement entered into between the Issuing Company and the company employing the employee prior to the date of grant of the equity instruments. This condition basically means that a recharge agreement must be in place prior to the grant date of the SBC awards to the employees.
• The entire equity based compensation accounting expenses in connection with the grant of the equity instrument are included in the cost-base, per said Supreme Court decision.

To the extent that these conditions are not met, the recharge payment is deemed a dividend (or capital reduction) even to the extent paid to an Issuing Company that is not the direct (or even indirect) parent company of the company making the recharge payment.

The Circular further clarifies that a company that is a party to a recharge agreement that satisfies the conditions listed in the Circular, and that makes recharge payments in accordance with such conditions, is exempt from reporting obligations pursuant to Reportable Position number 70/2019 (read more on the topic of Reportable Positions in our previous client updates here  and here.

We note that the Circular does not address the timing of the recharge payment. The recharge cannot occur prior to vesting due to the requirement to recharge only for vested awards. However, the actual recharge may occur at a later date, for example following realization by the employee.

Based on the foregoing conditions, companies that do not have recharge agreements in place should consider adopting such agreements in order to be able to repatriate cash without being subjected to Israeli withholding tax. Another area in which recharge agreements are useful for publicly traded companies granting SBC under the Trustee Capital Gains Route relates to tax deductions by the Israeli company. Under Israeli law, an Israeli company is entitled to a tax deduction in an amount equal to the lesser of the ordinary income component of the SBC award taxed in the hands of the employee and the participation amounts charged to the Israeli company. This is normally the case with respect to the grant date value of RSUs and restricted shares in publicly traded companies. Although some taxpayers take the position that no actual payment is required by the Israeli company to evidence a “charge”, the more conservative approach is for the Israeli company to make a cash payment to the Issuing Company.

We are at your disposal to provide comprehensive advice targeted to your specific circumstances and needs and to develop appropriate recharge agreements. While, as noted, the Circular reflects the ITA’s views, it is apparent that properly preparing and documenting recharge agreements is crucial to avoid adverse tax implications.

We would be happy to assist you with any additional information or inquiry you may have in this respect.

Sincerely,

The Tax Department

Herzog Fox & Neeman