November 21, 2019
A Guide for the Perplexed: Inversion "Flip"
By Lili Kazel, Oron Zeevi and Itay Falb
So you (the founders) have thought of an idea, incorporated a company (an Israeli company) and have begun to operate as a startup: development, recruitment, seeking investors, etc... You are developing, growing and expanding and what you hoped for is finally happening - foreign investors are considering investing in your company. During the interest stage, those same investors explain to you that they are very interested in investing in your company, however, as far as they are concerned, the investment must be made into a foreign company... What? Why?
What is an inversion (Flip)?
The above short story is not a fictional one, but a common reality. We have recently witnessed a widespread trend of requests for the restructuring of Israeli companies. As part of the restructuring, the shareholders of an Israeli-incorporated company will change their shareholding so that the company they own (hereinafter: "the Israeli Company") will be transferred to the full ownership of a new company (hereinafter: "the Parent Company"). Following the restructuring, the shareholders will hold the Parent Company, which will hold the entire share capital of the Israeli Company. The common name for this type of restructuring is "Flip" (or "corporate inversion").
Naturally, this type of restructuring has a vast array of implications, including both legal and tax-related. In addition, it should be kept in mind that the Flip requires preparation and even involves monetary expenses (i.e. payments to consultants, governmental fees, etc.), as well as additional reporting requirements in the Parent Company's country of residency. In this article, we will focus on the relevant Israeli tax implications for the shareholders as well as possible solutions.
Why should Inversion be done anyway?
Many factors may influence the decision to perform an inversion, such as:
· Foreign Investors Investments - Following the example above, there are investors who are not willing to invest directly in an Israeli company, but wish to invest in a foreign company (usually in their country of residency). A common example of this are U.S. investors who have concerns of investing in non-US companies and even add performing a Flip as a contingency to their investment in the Israeli Company. Such demands have intensified in light of the tax reform enacted in the U.S. at the end of 2017 (also known as "Trump reform").
· Geopolitical Reasons - There are markets with which Israeli companies cannot maintain direct economic relations for various reasons, therefore, an inversion may sometimes solve such issues.
· Public Offering - Sometimes a public offering of shares through non-Israeli companies can be made more easily on stock exchanges outside of Israel, also there are cases where the company is required to be a resident of a particular country in order to offer its shares to the public in that country.
So what is the problem?
The default position is that the inversion restructuring would be considered a tax event at the level of the shareholders, which in effect constitutes a transfer of their shareholding in the Israeli Company in exchange for shares in the Parent Company. At the same time, the Israeli legislature understood (since 1994) the need to provide a solution that allows companies and investors to execute corporate restructuring for legitimate commercial and economic purposes. Accordingly, the legislature permits the deferral of the tax event upon transfer of the shares, given that in essence it does not give rise to any real economic realization of assets. This is due to the preservation of beneficial ownership of the transferred assets. Recently, the relevant law has been amended and adjusted such that the constraints involved in restructurings have been alleviated. This is, in part, because the legislator understood that the global world is changing as well as the increased need to perform a Flip.
So what should be done?
As mentioned, an inversion is a restructuring which allows to defer the tax event until the date of the ultimate sale. If the Parent Company is a foreign company (the standard case), an approval is required, which may be obtained by approaching the Israeli Tax Authority (hereinafter: "the ITA") for a tax decision (tax ruling). Generally speaking, applying for a tax decision from the Professional Department of ITA is a lengthy process that a company should be prepared for.
There is no rose without a thorn
A number of restrictions and conditions have been imposed on the shareholders and the companies participating in the inversion to ensure that the requested deferral of the tax event is not conducted to reduce the tax liability of the shareholders or the company, and to ensure that the inversion is done for business and economic purposes. In addition, in practice when applying for a tax decision, the ITA places additional restrictions and conditions. The primary limitations are outlined below.
Dilution - First, it is required that the allocation of rights in the Parent Company will remain identical to the prior rights held by the shareholders of the Israeli Company while maintaining the value of transferred rights. Also, no monetary transactions can occur during the inversion. In addition, during the first two years of the restructure (hereinafter: "Required Period")" the existing shareholders must hold at least 25% of the rights in the Parent Company, and the Israeli Company cannot be sold during this period. It should be noted that in "R&D-Intensive Companies" there are no limitations on dilution, provided that, among other things, the shareholders after the restructuring will not sell their holdings during the Required Period.
Dividend Distribution - As part of the tax decisions provided by the ITA, special provisions and limitations regarding dividend distributions have been set. It should be noted that often in early stage startups, where losses are mainly accrued the restrictions are not material.
Trustee - In addition, as part of the tax decisions, all rights in the Parent Company held by taxable shareholders (residents of Israel) as well as shares of the Israeli Company, must be deposited in a trust. This mechanism is used to enforce the taxation of the Israeli taxable shareholders and to ensure that the dilution restrictions are upheld. On the other hand, foreign shareholders are required to declare that they are foreign residents and to provide a residence certificate for tax purposes from their country of residency. In our experience, this approval is not easy to achieve, as in many countries the process of issuing such certificate is lengthy.
The green track
Due to the various reasons outlined earlier, requests for tax decisions with respect to inversions have become more common practice in recent years. This procedure is lengthy and can, in some cases, complicate or hold deals which require immediate restructuring. In accordance to the growing need to perform inversions, the ITA has recently made it possible to perform a Flip using a "Green Track" which simplifies and expedites the process, subject to certain conditions.
The "Green Track" is intended for a Flip into a foreign Parent Company, as long as number of conditions exist, as follows: the foreign company is a resident of a country which Israel has a tax treaty with (hereinafter: the " Treaty "); The corporate tax rate in the target country exceeds 15%; The withholding tax on dividends according to the Treaty is at least 10%; The Israeli Company's date of incorporation is after January 1, 2018, and more. It should be clarified that similar limitations regarding dilution, distribution of dividends and the trust arrangement, as mentioned in the paragraphs above, are incorporated in the "Green Track".
In this article, we briefly reviewed the process that many companies may experience during their lifetime. As described, there are many legal, tax and operational aspects to consider before choosing to carry out a Flip.
In addition, it should be kept in mind that the entire process, from decision until completion of the restructuring and obtaining an approval from the ITA may take several months, even with the publication of the Green Track, due to all the prerequisites that must been fulfilled. Accordingly, companies must be prepared for a Flip with the understanding that even if it is possible to take part in the Green Track, it is not necessarily a fast track.
In Hebrew, the common term is "Hipukh Sharvul", which means a sleeve reversal. We could not find the official reason for the name, however, it can be said that it visually describes a restructuring as discussed in this article.