The following is a guest post by Dan Shamgar, Partner at Meitar Liquornik Geva Leshem Tal.
Following the recent tax changes in the United States, many entrepreneurs are wondering whether it still makes sense to incorporate their company in Israel, or whether the United States should be the preferred location. If you’re one of them, perhaps the following overview will bring you some clarity.
FIRST, A QUICK BACKGROUND: In the 1990s, Israeli-based high-tech companies that sought to raise funds, expand markets and eventually go public, were often advised that the preferred way to incorporate – was in Delaware. But much has changed since. The high corporate tax rate in the United States, coupled with generous tax incentives in Israel, gave Israel a clear tax advantage.
What really made the difference wasn’t the tax considerations, but the fact that Israeli companies were able to successfully raise money and go public on NASDAQ with almost no “Israel discount factor”.
Indeed, in the past 20 years, the majority of the successful technology companies incorporated in Israel because there was no good reason to incorporate in Delaware and suffer a much higher tax rate.
Trump’s tax reform, officially titled the “Tax Cuts and Jobs Act of 2017” or the “TCJA”, cut taxes significantly. The biggest change is the reduction of the federal corporate income tax rate from 35% to 21%, although most companies will still have a combined tax rate of 26-31% due to State taxes. State tax in California and in New York is 9-10%. By comparison, the regular corporate income tax rate in Israel is 23%.
Delaware or Israel?
The question we must answer is, should technology companies consider incorporating in Delaware and not in Israel? Or perhaps restructure to have a Delaware company as the parent of a multinational group?
If I had to answer this question in one sentence, it would be “it depends on your future plans for development, but in most cases, probably not”.
There are a couple of reasons why I would still prefer to incorporate in Israel:
1. “The Carrot” – Israel still offers better tax benefits.
While the regular corporate income tax rate is 23%, technology companies can enjoy much better rates if they satisfy certain conditions. This has been true in the past, with certain companies enjoying “tax holidays” of up to ten years without any taxation and it is still true today.
The most common programs available today are the “preferred enterprise” and “preferred technological enterprise” where companies can enjoy tax rates of 16% and 12%, respectively, and an even lower rate of 7.5% if there are significant operations in “Zone A” cities. Also, the various assistance programs offered by Israel’s Innovation Authority (formerly the OCS) are available only to Israeli companies.
2. “The Stick” – Israeli Tax Law Restrictions.
A company is taxed as an Israeli company if it is incorporated in Israel. However, it will also be taxed as an Israeli company if it was incorporated outside of Israel but is managed and controlled in Israel. The Israeli tax authority’s position is that in order to not be managed and controlled from Israel, a company must show that its day-to-day activities and all its substantial decisions are conducted outside of Israel.
The ITA has won almost every tax court case where this issue has come up. Flying the board to NY for a meeting may be good for your frequent flier account, but will not be enough to prevent this exposure. As a result, we advise our clients that
the only way to truly avoid being managed and controlled from Israel is to really place the management outside Israel. This means having key people (usually this will include founders) relocate to the United States and establish real operations and headquarters there.
If a company is not willing to do that, incorporating in Delaware won’t help, it will just make matters worse as the company may end up being subject to two tax regimes since both Israel and the US would consider the company as resident in that country for tax purposes.
The Rules of the game for IP Ownership are changing.
Under conventional tax planning, a company could be incorporated in one place (the United States, for example), own highly valuable assets such as IP in other country (preferably low-tax countries such as Ireland, Bermuda, Cayman Islands, etc.) and shift income to those low-taxed countries. But the rules of the games are changing.
The OECD BEPS project seeks to create game-changing rules that will allocate income not based on formal ownership but based on a functional approach that looks to core value driving components.
For technology companies this means, first and foremost, where their R&D activities take place. People matter and they cannot live in a cloud. What this means is that if a technology company chooses to incorporate in Delaware, it needs to have real R&D activities in the United States if it wants to successfully defend the way its profits are allocated between countries.
In the future tax world, a structure with a U.S. company with few people that will operate an R&D center in an Israeli subsidiary, invites tax scrutiny and the company may discover that the ITA has a very different view as to how it should be allocating its profits between its entities.
Who should be on top?
Since most technology companies will seek to have US activities, there will almost always be a structure with at least two companies, with either an Israeli parent and a U.S. subsidiary, or a U.S. parent and an Israeli subsidiary. The group must then carefully plan its operations and inter-company relationship to achieve the lowest global effective tax rate.
Since both the United States and Israel have encompassing transfer pricing rules and “controlled foreign company” regulations, every tax strategy must consider how both countries’ laws will apply and how to avoid double taxation. In that regard, the TCJA tax reform did not make the United States more attractive as a jurisdiction, to the contrary. This is true primarily for technology companies where most of the “brains” will remain in Israel.
A group with an Israeli top company that owns its IP can generally achieve a better global effective tax rate than a group with a U.S. top company.
That being said, there are some new changes to consider. The TCJA has created some significant incentives for U.S.-based multinationals to “bring their cash home, and keep it at home”. Some companies can achieve lower corporate tax rates if they have true development of IP in the United States and significant export activities. VC and private equity funds are less impacted and they are expected to continue investing. From time to time there will always be the investor who will demand that the company “inverts” to the United States, a process that is quite difficult tax wise, but we find this to be the small minority of cases.
In view of all of this, in most situations we still recommend to Israeli-based technology companies to incorporate in Israel. Most investors recognize the benefits of having an Israeli company, and the success of many Israeli companies in the last decades is a testament to that.
NOTE: Special thanks to Shaul Grossman, Partner at Meitar Liquornik Geva Leshem Tal, for his contribution to this post.