Venture Capital Investments in Israeli Companies: A Tax Planner's Primer

Author:Dr. Doron Herman
Profession:S. Friedman & Co
Reprint of an article originally published in Tax Notes International on February 25, 2002

The crisis in the technology sector worldwide has been widely acknowledged. As financing sources dwindle and company valuations brutally cut, the uninitiated might conclude that venture capital investments in technology have all but vanished. The reality is, however, that venture capital still flows into the technology sector, albeit in smaller quantities and with greater prudence. In this new environment, in which continuing financing is not guaranteed and the "exit horizon" is measured in years rather than months, the need for careful tax planning of the investment structure is accentuated.

The Israeli technology sector, still vibrant and innovative, offers many investment opportunities. This article lays forward the general factors that need to be considered when planning an investment in an Israeli technology company and describes several common structures that are used for that purpose.

A. Israeli Taxation of Investments: General Principles

Before dwelling on the specific aspects of venture capital investments, the following provides a short exposition to the general principles governing investment taxation in Israel.

1. The Taxation of Income and Capital Gains

In general, gains realized upon the sale of assets can be treated as either business income or capital gains. When the assets involved are corporate securities, real estate or similar assets that are commonly used for long term investment, the inclination would be to treat the resulting gain as a capital gain. Nevertheless, Israeli courts held more than once that repetitive transactions in investment assets, in which the taxpayer manifests knowledge and expertise and employs a developed infrastructure, will result in classification of the gain as ordinary business income rather than capital gains1.

Ordinary income, of both active (business, vocation or employment) and passive character, is taxable under the Israeli Income Tax Ordinance, 1961 (ITO) if "…accrued in, derived from or received in Israel"2. This territorial scope of the Israeli income tax is broadened in certain situations, for example when income was derived abroad from a business, the management and control of which are exercised in Israel.

Capital gains are taxed under two separate laws: capital gains derived from the sale of real estate located in Israel (including the sale of shares in companies whose main assets are real estate) are taxed under the provisions of the Land Appreciation Tax Law, 1963. Capital gains derived from dispositions in any other asset are taxed under Chapter E of the ITO. In both cases the basis of the taxpayer in the asset sold is indexed to the Consumer Price Index so that the inflationary portion of the nominal capital gain is separated from the real gain. The inflationary gain is taxed at 0%3, whereas the real gain is taxed at the ordinary rates, i.e. up to 50% for individuals and a flat 36% for companies4.

When shares are sold as capital assets, several specific provisions apply in addition to the above: First, the part of the gain relating to undistributed earnings of the company is taxed at the reduced rate of 10%; second, capital gains derived from shares traded in Israel are exempt from tax, and if the shares are traded abroad the capital gain is taxed at the reduced rate of 35%.

Another important feature of the capital gains tax is its geographical scope: As mentioned above, the Israeli international tax system is based on the territorial principle. As a consequence, both residents and non-residents are subject to Israeli tax on capital gains derived from assets located in Israel or rights (direct or indirect) to such assets. In marked deviation from the territorial principle, however, the Ordinance imposes tax on the capital gains of Israeli residents worldwide.

2. Incentives for Capital Investments

Israel offers a wide range of incentives for capital investments, of which only those most relevant to technology companies will be discussed in the present context. The incentives benefiting technology companies are naturally those related to investments in industrial enterprises and in research and development activities.

The Law for the Encouragement of Capital Investments

The Law for the Encouragement of Capital Investments, 1959, offers incentives in the form of government grants, reduced tax rates and tax holidays to "Approved Enterprises", i.e., industrial enterprises recognized by the authorities as contributing to the strengthening of the Israeli industry, producing exports and expanding employment opportunities. Grants of up to 20% of the investment in fixed assets, or, alternatively, tax holidays of up to 10 years, are available to Approved Enterprises, depending on their location5.

All Approved Enterprises enjoy a reduced income tax rate of 25% for a period of 7 years from the first year they derive taxable income6. Furthermore, dividends distributed out of the Approved Enterprise's income are subject to tax at the rate of 15%, compared with the ordinary rate of 25% applicable to other dividends. Additional tax benefits are granted to companies in which foreigners are invested ("Foreign Investors' Companies"): these companies enjoy a further reduction in the tax on their income, correlated to the share of foreign investment in their equity. The effective tax rate of these companies is thus as follows:


Share of Foreign Investors in Equity






Corporate Tax Rate





Tax on Dividends






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