Israeli High-tech Exits Reap Billions - for Investors, Not the State

How is it that when Israeli high-tech startups are sold for billions, the only taxes paid come from the employees?

Young employees working at a high-tech company.
Bloomberg

Last week was especially packed with news of exits in the Startup Nation: On Sunday morning, we learned that online casino gaming company Playtika from Herzliya was being sold to a consortium of Chinese companies for $4.4 billion in cash. Three days later TheMarker revealed that Israeli internet company Iron Source is conducting negotiations for a sale to a Chinese firm in the same industry for $1.8 billion.

Similar to other exits, these two huge deals – which involve firms whose core businesses are located in Israel – raised the question of how much Israel will profit from the sales. The expectation is that Israel, whose economy to a certain extent relied on the local innovation industry as a growth engine, will earn a nice profit for taxpayers, too, from these huge deals. But it turns out that only a very few people know how much tax money the state coffers will see from these exits.

In the first half of 2016, 45 Israeli startups were sold for a total of $3.3 billion, based on data from the IVC research firm and the Meitar Liquornik Geva Leshem Tal law firm. This amount is 41% of the total for all of 2015. So how much of this money did the government collect in taxes? It seems that the total was actually quite small.

In the background is a change in the law, now being debated as part of the Economic Arrangements Law for 2017. The changes would bring in more tax revenue from industry. The proposed changes would include lowering corporate tax for technology companies to only 12%, from 16% today, in the center of the country. The large multinational technology corporations would pay only 6% corporate tax.

The implications of these changes in corporate tax rates for high tech firms is that the development centers of the over 300 multinational firms in Israel, with some 190,000 employees (according to figures the Finance Ministry published last week) pay only 100 million shekels ($26.2 million) to 200 million shekels a year in taxes.

NIS 20 billion on salaries

These very same companies spend over 20 billion shekels a year in Israel, with most of this amount going out as salaries to their developers and engineers. But the government collects almost nothing from these companies in tax revenues, which operate on a cost plus basis, in which they calculate the price of their products and service based on the suppliers' price plus a small, fixed profit margin.

The government makes almost nothing on the exit.

To examine what Israel really receives from its Startup Nation – or how much state coffers take in – we examined how much tax revenue the state receives from a successful startup, beginning from when it is founded through a sale in a sizeable exit to a multinational corporation, and it then being turned into a development center for the multinational employing workers in Israel.

Our examination and analysis of the data were conducted by the accounting firm Deloitte Israel, and we examined the life cycle of a fictional startup, but one that represents a large number of the firms in the high-tech sector: software, internet, information security and media startups.

The conclusion that jumps out at you is that most of the taxes paid by the high-tech industry come from the employees’ own pockets. Maybe this is not really surprising if we consider that startups invest large amounts in development, and as a result often pay very high wages. At the same time, they lose money for years at the beginning, so they don’t pay corporate taxes.

But even major financial events for the startups, such as an exit, bring in little tax revenue, especially in the relatively common case in which the shareholders are foreign investors exempt from paying Israeli capital gains taxes.

Most tax revenues from startups come from the taxes paid by employees. In the “standard” startup, employees will pay income and other taxes, as well as the capital gains taxes on the Israeli investors in the case of an early exit. In more mature companies, the state will take in corporate taxes too, says Ophir Sulami, a CPA and partner at Deloitte Israel, and head of their mergers and acquisitions department. .

The basic assumptions behind the examination was that the company is registered in Israel and operates in the center of the country (where it does not get tax breaks like companies located in the periphery are entitled to). These assumptions are not of course obvious. “Israel has a lot of companies it does not see much tax revenues from,” says Sulami. “The country’s challenge is to create attractive tax rates for companies. Most of the markets for startups are outside of Israel, and the capital mostly comes from overseas too. The state benefits as long as it provides opportunities and convenient conditions for a company to operate in Israel. We operate in a competitive sector, it is possible that a company can set up its operations outside of Israel,” he said.

In the scenario we examined, the company was sold for $100 million – after raising investments of $25 million. On the day of the exit, half of the shareholders in the company were Israeli – including the Israeli investors, angels and venture capital funds – the founders and the employees. This is a relatively optimistic scenario, because in many cases the shares are held by foreign investors, including foreign investors in Israeli venture capital funds, who since 2009 have been exempt from capital gains taxes on investments in Israeli companies.

This means that Israelis will receive $50 million of the sum – of which $40 million will be net profit, after deducting the investment. Capital gains taxes for shareholders will be 27% to 32% of the net amount, estimates Deloitte. The government will take in $12 million in capital gains taxes as a result. Out of this amount, employees will pay about $1 million for their options, which on the day of the deal represented 5% of the share capital of the company. The employees will pay 25% capital gains tax on these options.

According to this model, it would seem in a huge deal like Playtika the Israeli government will not take in any capital gains tax at all, because the stock passes from American investors to the new Chinese owners. The state’s only chance to take in some money is from the payments to the management and workers, some $100 million to $200 million of the deal.

The exit marks the main tax event in the life of the company, as far as the Israeli taxman is concerned. In the firm’s early years, it loses money. Even after it begins to bring in revenues – and maybe even profits – the company still does not pay corporate income tax because it has very large cumulative tax losses to offset any profit. For example, even a large and successful Israeli company such as Wix.com still does not pay corporate income tax, and this will continue to be the case for at least another five years.

No investment, no tax

The government actually could have received much higher tax payments, if Israeli investors were more involved in investing in Israeli high-tech companies. This applies mostly to Israeli institutional investors, which very rarely invest in Israeli venture capital funds. Such investments would expose them to high risks, but they would also benefit from the large profits – and the government would enjoy much higher capital gains taxes from them. Today, most of the capital invested in Israeli venture capital funds comes from foreign investors, who are exempt from these taxes.

After completing the exit, we assumed the company would continue to report to the tax authorities in Israel, pay corporate income tax and the employees would continue to pay taxes on their wages. Corporate income tax would be based on a cost plus model.

If the purchasing company decides to make its Israeli unit into a center for providing research and development services only, or decides to transfer the intellectual property out of Israel, the government will receive an additional sum for the intellectual property leaving the country. In this case, the value of the intellectual property in the exit will be estimated, and the buyer will be exposed to a demand from the Tax Authority to pay 25% capital gains taxes on this amount. In such a case, if the startup received grants from the Chief Scientist’s Office in its early years, it will be required to pay royalties to the state of up to six times the amount of these grants it received.

In comparison, the employees will pay income and other taxes for the entire period they work. This is an important point, because in our scenario we chose a successful company that has significant sales of $20 million a year on the day it is sold, and even has profits.

In practice, most Israeli startups do not succeed. Less than 10% of them reach the exit stage and most startups are still losing money when they reach an exit – so most have actually never paid anything in corporate income tax at all. But the employees of even the unsuccessful, money-losing firms still pay large amounts of income tax throughout all those years. For a country that has a major part of its industry in small high–tech startups, this adds up to quite a significant amount of money.

Then how can Israel still make more money from the taxes on the high–tech sector? The more support the government provides and the more ways it enables raising money for these companies, then the less the firms will need foreign investments and the more they will remain under Israeli control – and the higher the tax revenues that will result, says Sulami.

In future exits, Israel can receive a reward for its government support, for example by increasing the budget of the Chief Scientist’s Office for such companies. This may make the state more of a speculator, but it is the economy’s growth engine, he says.

So is Israel making money off of high–tech and startup employees? We don’t need to have too much sympathy for this group of workers, they earn twice the average salary, on average. These employees continue to make the wheels of the Israeli economy turn. But in the name of remaining globally competitive, Israel has decided to tax the workers, and not the companies. Maybe the time has come to listen to the workers too; after all they are the ones paying the bill.