Will Trump's Tax Reforms Cause High-tech Companies to Flee Israel?

Experts ponder the threats emerging from the new U.S. tax regime

U.S. President Donald Trump displays his signature after signing the $1.5 trillion tax overhaul plan at the White House, December 22, 2017.

Donald Trump may be Prime Minister Benjamin Netanyahu’s favorite world leader these days, but the Trump tax reforms voted into law by Congress last December are causing Israeli officials a lot of anxiety.

Israel’s Finance Ministry and the Israel Tax Authority had been undertaking a host of measures aimed at creating a favorable tax environment for big businesses and high-tech in particular, but their work threatens to become undone by the reforms whose centerpiece is a sharp drop in the American corporate tax rate to 21% from 35%.

Officials are concerned the lower rate will encourage Israeli tech companies to relocate in the United States. Unlike most other Israeli businesses, tech companies are global businesses that can easily pick up and go to where the environment is the most favorable.

The particulars of the reform are still not clear, but policy makers at the treasury, Israel Innovation Authority and tax authority are already struggling to address the challenge. Netanyahu told a group of anxious tech executives at a meeting a month ago that he was confident he could build on Israel’s special relationship with the U.S. to win exemptions, but the tech industry isn’t as confident.

Is the U.S. simply lowering the corporate rate and that’s all?

No. While the lower corporate rate has garnered considerable attention, the reform measures are very complicated and many elements of the legislation promise to make the U.S. a much more attractive place to base a business than the headline rate indicates.

Does Israel remain an attractive place to invest?

“You have to distinguish between Israel and American companies. If I’m an Israeli company looking at the U.S. tax rate, it’s 21%, or 13% for export companies. But you have to add in state taxes,” explained Sharon Shulman, a managing partner at Ernest & Young specializing in taxes.

“By comparison, by virtue of the Law for Encouraging Investments, the Israeli rate for export companies is 12%, so Israel remains attractive. But that’s a simplistic analysis. There are new mechanisms that make it difficult for companies to domicile outside the U.S. and that changes things,” he said.

What was the situation prior to the reform?

Moshe Bina, senior manager for international taxes at accounting firm Deloitte Israel, said that since the 1970s, the U.S. had deployed the tax-deferral model: American companies with foreign subsidies didn’t have to pay tax on the intellectual property they held so long as it was not repatriated to their home country.

To encourage foreign companies to register their IP in Israel instead of tax shelters like Ireland, a year ago Israel introduced for tech companies that did that lowered the tax rate to between 6% and 12%.

“This track was considered especially attractive before the Trump reforms,” said Bina. “Israel planned to tax them at 6% in expectation that they would not have to pay tax in the U.S., if the money remained in Israel.”

So what is changing?

The reforms effectively do away with the deferred-tax model, explained Bina, in order to lure back the trillions of untaxed dollars American companies are sitting on overseas.

“What the Americans are trying to do is tax those assets, held by foreign subsidiaries, with a 15.5% rate on cash and near-cash holdings and an 8% tax on non-cash holdings. You can spread out the payment over eight years,” he said.

What is the GILTI tax and what will be its impact?

GILTI stands for Global Intangible Low-Taxed Income, which is a tax on the profits of foreign subsidiaries of American companies, said Shulman. Thus an Israel-based subsidiary will be faced with a tax of 10.5% up to 2025, going up to 13% thereafter. Until the reforms, there was no tax like this at all, so long as the money wasn’t repatriated to the U.S.

“In this situation an Israeli company can be a disadvantage because it will be taxed by the Americans, so it might be better for the company set itself up in America from the start,” he said.

So, it’s going to preferable for new startups to establish themselves in the U.S.?

“I think we’ll continue to see new companies forming in Israel,” said Shulman.

His reason is this: “If a company is doing research and development – which means years of tax-recognized losses before it becomes profitable, it could be set up as American and it will pay on the cost-plus model (a system where Israeli operations are taxed based on expenses) . With the plus component you have to take into account employee stock options. In a tax situation like this, being an Israeli company is preferable.”

Will the reforms affect exits?

“Over the last decades the Israeli market has been strong and Americans worked with and bought Israeli startups,” said Shulman. “Now people are definitely rethinking things. If they’re thinking about an exit, it could be – and I say this with caution – that if a U.S. company comes along and buys an Israeli company with IP it may affect the price.

“It could create a situation that if there’s a dilemma between buying an Israeli company and an American one in the same field, there could be a preference for the American company. Still, we don’t believe that tax considerations alone drive a business decision like this.”

Will the reforms deter foreign companies for registering their IP in Israel like the government wants?

“Transferring IP to the U.S. is not a simple tax event, and I don’t think that we’ll see a movement of IP to the U.S.,” said Shulman. “There is still some wariness regarding U.S. tax rates – companies will want to see if the reforms survive over time. What will happen if the Democrats win the next elections?”

Still, he doesn’t think the impact of the reforms will be neutral. “It has certainly stopped Israel’s momentum in terms of making the country tax-attractive for multinational companies.”

Will it deter overseas companies from setting up Israeli R&D centers?

Bina: “Israelis are still in demand and Americans want to work with Israeli engineers. However, trying to convince foreign companies to leave their IP in Israel won’t work, because the reforms are deterring American companies from doing it.”