Aspects of Taxation In
The Establishment Of Start-Ups
Adv. Amit Gottlieb, Partner and Adv. CPA Dvir Saadia
Original Hebrew article published in Bizportal
Transformation of a great idea into an incredible success and one which generates profit is a protracted road. It is not without reason that most start-ups fail to meet their potential. Generally, the initial focus is on the implementation of the “idea”: characterizing the target audience, setting goals, developing a model for generating revenue and evaluating the expenses required to implement such an “idea”. It is precisely at this stage that one tends to overlook a principal aspect that has far-reaching implications – the TAXATION aspect.
Taxation aspects, in their complexity, are often cast aside in the early stages of the start-up, thus for example an entrepreneur who is targeting the European market may tend to incorporate his company in the target country. On the face of it, it makes sense to do so. In practice, tax aspects follow the development of the start-up from its early days and also to the exit stage, whilst understanding and planning of tax aspects throughout the start-up’s activity can generate higher profitability for the entrepreneurs, decrease tax expenses, and sometimes serve as the basis for its preservation and success.
In the majority of cases, tax matters arise at a later stage and making changes could be in many cases expensive or impossible. Investors and even future buyers may be reluctant to enter the venture solely due to tax exposure or incorrect construction of the tax framework. So how does one go about this properly, as of the development stage at home through to initial funding, and to the “exit” stage.
Examining the structure and manner of incorporation
The natural tendency to incorporate as a company in the future operating country is not always correct. In fact, the type of activity, the target audience, the location where development is to be carried out and future aspirations are fundamental aspects that affect the place and the manner in which the start-up should be incorporated. Proper incorporation can save a lot of tax (such as in the case of capital investment incentive laws), enable effective offsetting of losses and also lead to the maximization of profit in the future.
The natural tendency to incorporate as a company in the future operating country is not always correct. In fact, the type of activity, the target audience, the location where development is to be carried out and future aspirations are fundamental aspects that affect the place and the manner in which the start-up should be incorporated. Proper incorporation can save a lot of tax (such as in the case of capital investment incentive laws), enable effective offsetting of losses and also lead to the maximization of profit in the future.
Use of alternative payment mechanisms
Cash (or liquidity) is the beating heart of any start-up, certainly at its starting point, enabling flexibility in its management and development. One way to maintain cash flow is to use alternative means of payment – such as paying service providers and employees with shares/warrants. Various mechanisms exist in different countries for making cashless payments, however it is important to remember that these mechanisms entail a tax consequence, both for the company and the recipient, and thus serious consequences during the funding and exit stages.
Using freelancers
Globalization, technological advances, and more so the recent Covid pandemic, have led to the operation of entities in different parts of the world as independent service providers. The expansion of this phenomenon has given rise to a number of material taxation issues such as: Does the withholding tax obligation apply when paying such employees? Should VAT be added to the payment? Moreover, do the said freelance workers form a “permanent establishment” in their country of operation with regards to the corporation? Correct and proper planning of such issues will prevent exposure, excess tax liabilities and the need for proceedings vis-à-vis the tax authorities.
Turning the dream into reality – recruiting investors
Facing the initial funding stage? Before you sign and agree for any investment, it is essential to discuss how the investment should be made: whether it’s a capital investment in the company’s shares, or an investment through a SAFE mechanism or even a convertible loan, there are many options by which the funding can be carried out. Beyond the commercial aspect, there is a tax effect both on the manner of funding within the company itself and amongst its shareholders. For example, the manner of funding can affect the company’s expenses, i.e., while obtaining funding through a convertible loan, or cause changes of the controlling shareholders in the company, affecting related parties and requiring the application of transfer pricing rules.
And with regards to transfer prices, it is important to remember that even though the global expansion of your company is a welcome move, global activity within a group of companies around the world consequently requires the application of transfer pricing rules, meaning, pricing of the transactions in accordance with market prices.
The sale of the shares or “Exit”
Execution of a profitable sale of your shares shall trigger a tax event – that’s basic – but usually there is a time difference between the date of signing the share sale agreement and the date of “closing” and sometimes even between the date of receiving the consideration. Sometimes the consideration itself is uncertain / postponed / contingent on the continuation of the transaction or on milestones. In each of these cases, the question of the date and calculation of tax arises.
Moreover, the applicable tax rate to the sale of the shares, amounting to 30% (plus 3% surtax) by a shareholder who is deemed “substantial”, as opposed to 25% (plus 3% surtax) for one deemed an unsubstantial shareholder, depending on the question of its classification as “substantial” according to control indices, and the tax differences may be significant.
It emerges that failure or late examination of the tax aspects pertaining to a start-up may significantly impact the return therefrom, implicate on your cash flow (inter alia when a structure prevents optimal utilization of the foreign taxes paid or of the losses, resulting in “tax accidents” arising from improper incorporation and poor operation of the structure) that have the power to transfigure a successful idea into a dream that didn’t meet its potential. Appropriate tax decisions must be made in the early stages in conjunction with the technological and business decisions pertaining to the venture.