So you came up with an idea, established a company, and started the startup activity. After some time, the moment you hoped for has arrived – foreign investors have started showing interest in you. During the exploratory process, these investors explain that they are very interested in investing in you, but from their perspective, the investment needs to be made into a foreign company in a low-tax environment.

What is a “shell flip”?

Recently, we have witnessed a widespread trend of requests for changes in the holding structure of Israeli companies. As part of this structural change, the shareholders of a company incorporated as an Israeli company will alter their holdings so that the Israeli company they own will be transferred to the full ownership of a new foreign parent company. After the structural change, the shareholders will hold shares in the parent company, which will hold all of the equity of the Israeli company. The common name for this type of structural change is a “shell flip.”

Such a structural change has various implications and effects, including legal and tax consequences. Additionally, it is important to remember that this process requires preparations in Israel and also reporting obligations in the country of residence of the parent company. This article will focus on the relevant tax implications in Israel for shareholders and the possible solution.

Why perform a shell flip?

There are many decision variables that influence the decision to perform a shell flip, such as:

• Attracting Foreign Investors: As mentioned earlier, some investors are not willing to invest directly in an Israeli company but prefer to invest in a foreign company, sometimes due to favorable tax reasons.
• Geopolitical Reasons: There are markets with which Israeli companies cannot engage in direct economic relations for various reasons, so a shell flip sometimes provides a solution for these communication routes.
• IPO: Sometimes, IPOs through non-Israeli companies can be conducted more easily on stock exchanges outside of Israel.

The Legislator

The default assumption is that a change in the holding structure constitutes a taxable event at the level of shareholders, who essentially transfer their holdings in the Israeli company in exchange for shares in the parent company. However, the Israeli legislator recognized in 1994 the need to provide a solution that allows companies and investors to make necessary structural changes from a business and economic perspective. Accordingly, the legislator allows the deferral of the tax event when transferring the shares, provided that the structural change does not materially lead to a true economic realization, due to the maintenance of economic ownership of the transferred assets. Recently, the relevant law has undergone amendments and adjustments, softening the limitations associated with structural changes, partly because the legislator understood the scope of frequent changes in the global world and the business need to perform a “shell flip.”

Preparations

As mentioned, a shell flip is a structural change that allows for the deferral of the tax event. If it involves a foreign parent company (the common situation), an approval is required, which can be obtained by requesting a tax ruling from the Income Tax Authority.

To ensure that the requested tax deferral is not used to reduce the tax liability of the shareholders or the company at the time of the structural change and that the change has a legitimate business and economic purpose, the legislator has imposed several limitations and conditions that shareholders and companies participating in the structural change must adhere to. Additionally, here are some key limitations:

Limitations

• Dilution: First, the allocation of rights in the parent company must be identical to the proportion held before the transfer by the shareholders of the Israeli company while maintaining the value of the rights as it was. Also, as part of the “shell flip,” no compensation, either in money or equivalent value, should be transferred. Additionally, during the “required period” (a two-year period from the date of the structural change), existing shareholders before the structural change 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, dilution is not restricted, provided that shareholders before the structural change do not sell their holdings during the required period.
• Dividend Distributions: According to tax rulings issued by the Tax Authority, special provisions and restrictions are set regarding dividend distributions. It should be noted that, usually, in startup companies in their early stages, where losses are primarily accumulated, the restrictions are not significant.
• Trust: Additionally, according to tax rulings, all rights in the parent company held by shareholders who are subject to tax (Israeli residents) as well as shares in the Israeli company must be held in trust. The purpose is to enforce the tax on shareholders liable for tax in Israel and to check compliance with the dilution limitations. Conversely, foreign shareholders must declare their status as foreign residents and provide a tax residency certificate from their country of residence.

Changes in the Law – The Green Route

Recently, due to various reasons, requests for tax rulings for shell flips have become more common. Generally, requesting a tax ruling from the professional department of the Income Tax Authority is a lengthy process which, in some cases, can be an obstacle to transactions requiring immediate structural changes. Therefore, and due to the increasing need to perform “shell flips,” the Tax Authority has recently allowed, subject to certain conditions, to carry out a “shell flip” using a “green route” intended to simplify and expedite the process.

The “green route” is designed for shell flips involving a foreign parent company, provided that several conditions are met, such as, among others: the country of residence of the foreign company has a tax treaty with Israel to prevent double taxation, the corporate tax rate in that country exceeds 15%, the withholding tax rate on dividends under the treaty is at least 10%, the incorporation date of the Israeli company is after January 1, 2018, and more. For clarity, it should be noted that similar provisions have been established within the green route regarding dilution limitations, dividend distributions, and trust requirements as described above.