Investments via SAFE as a Tax Event

The Israel Tax Authority’s May 2023 guidelines state that, under particular circumstances, investments via SAFEs (simple agreement for future equity) will be considered an advance on a share investment account. That being the case, no tax event will transpire and no tax withholding obligation will apply when exercising the SAFE into shares.

A Discount in Lieu of Interest Income

SAFE transactions provide a quick and efficient fundraising solution to private companies that, inter alia, have no agreed value. With these transactions, the investor and the company sign a contract whereby the investor injects capital into the company immediately, but the shares in consideration of the investment are allotted at a later date. With such a transaction, the question of the value of the shares is deferred. No interest accrues during the period between the capital injection and its conversion into shares. Later, when the investment is exercised (and converted into shares), the investor receives a discount compared to investors in general fundraising rounds.

Thus, the question arises: does the discount the investor receives off the market value of the shares constitute taxable interest income?

If the benefit constitutes interest income, then the company shall withhold taxes when the SAFE is exercised. However, since the company does not pay the investor any cash at the time of the SAFE exercise, but rather transfers shares to it, the company must use its own funds to comply with the withholding tax obligation and remitting the taxes to the tax authority.

Israel Tax Authority’s Position

Up until publication of the guidelines in May 2023, the ITA did not express an official position on the matter. However, it appeared that, in such instances, there was a significant risk the ITA would determine that such an investment generates interest income to the SAFE holder. In other words, the event of converting the investment via a SAFE into shares is perceived as an event of exercising a right granted in the past. Thus, the difference between the price at which the investor receives the shares and their market price (which is, in fact, the discount component) will be deemed interest given to the investor, which is taxable.

For the first time, in its May guidelines, the ITA expressed its position regarding investments via SAFEs. It determined that, if particular conditions are fulfilled, an investment via a SAFE is to be deemed an advance on a share account. Therefore, no tax event will transpire and no tax withholding obligation will apply when exercising the SAFE.

However, the ITA’s guidelines include a long list of conditions regarding the company’s profile, the terms of the SAFE, and the conversion event. These conditions make it difficult for companies to obtain the exemption and thus necessitate an in-depth examination of each SAFE on its merits.

Key Conditions

1. The company must be an Israeli resident private company engaging in the high-tech sector at the stage when the majority of its expenses are for R&D (or for manufacturing or marketing products it developed as a result of its R&D efforts).
2. The majority of the assets held by the company are not real estate rights.
3. The company did not execute a fundraising round according to a known share price during the three-month period prior to the closing date of the SAFE.
4. The sum of the investment via the SAFE for a single investor does not exceed ILS 40 million.
5. The SAFE stipulates that it is not transferable without the company’s consent (except to a permitted transferee as predefined in the SAFE).
6. The investor is not entitled to a repayment of its investment other than by way of converting the SAFE into company shares or receiving a consideration at the sum it would have received for the shares if they were sold within the framework of the sale of all of the company’s shares, except in particular instances.
7. The SAFE will be converted into shares solely in conformity with the trigger mechanism predefined in the SAFE: at the time of a fundraising round, an IPO, an exit event, or an event of sale of most or all of the company’s assets.
8. The SAFE stipulates that the investor is not entitled to interest, royalties, or any other return from the date of its investment and until the SAFE is exercised.
9. The discount percentage to the investor does not vary as a function of a linear passage of time.
10. The company will not claim financing expenses for tax purposes in respect of the SAFE.

The above is only a partial list of all conditions stipulated in the ITA’s guidelines.

Actual Implementation of the Guidelines

The guidelines also specify the requisite conditions for converting the investment via a SAFE into shares and for exercising the shares. The guidelines further state that if a transaction does not fulfill the conditions stipulated in the guidelines, it will be examined according to the entire set of circumstances.

Note that the guidelines also state that the ITA reserves its right to examine the classification of the investor’s income from the sale of its shares (received as a result of the conversion of the SAFE) while taking into account the investor’s specific circumstances.

The numerous conditions and their complexity make it extremely difficult to treat the guidelines as a “manual,” since there are many exceptions and specific considerations. It appears the ITA has exerted efforts to increase certainty with respect to taxation of investments via SAFEs and to make it easier for investors via SAFEs, but it is doubtful if these guidelines are sufficient to create such certainty. Nevertheless, the guidelines do convey the ITA’s position that when an investment is essentially an equity investment, it will be treated as an advance on a share investment account and not as a loan bearing taxable interest.

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Barnea Jaffa Lande’s Tax and Corporate Departments are at your service to answer any questions about drafting SAFEs, to assist with such investments, and to handle the tax issues deriving from SAFEs.

Adv. Hanna Daher is a partner in the firm’s Tax Department.