Israel Scraps Gains Tax For Foreign Investors –

BOSTON – Hoping to spark the slumping Israeli high-tech sector, Finance Minister Silvan Shalom announced in late September that Israel had temporarily suspended a controversial capital gains tax levied against foreign investors in Israel-based venture capital funds. The move follows more than two years of intense lobbying efforts by Israeli venture capitalists, and increased geopolitical instability.

“I think they made a decision when they felt they had no other choice,” said Yair Safri, a general partner with Concord Ventures based in Herzelia, Israel. “We’ve waited a long time for this and were active participants in making it happen, but the right time to do it would have been two years ago or at least 10 months ago.”

Similar criticisms are easy to find among Israeli VCs, who feel foreign investment in their funds has long been discouraged by a short-sighted economic policy that taxes the businesses of today at the expense of building the businesses of tomorrow. Indeed, not only have some Israeli entrepreneurs fled Silicon Wadi for Silicon Valley, but most local VC fund managers have been forced to spend precious hours convincing foreign limited partners that the investment process is neither risky nor complicated, and then even more time securing necessary capital gains tax waivers from the local tax authority. “Of all the problems getting foreign investors to invest in Israel right now-and there are a number of them-the tax issue was certainly the one [those investors] were the most focused on,” said Erel Margalit, managing partner with Jerusalem Venture Partners.

And there were good reasons for such concerns. While almost every Israeli venture firm worth its salt was able to secure waivers that would protect its LPs from the capital gains taxes, and double-taxation in particular, the rules still proved sticky for many foreign LPs.

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One such case involved the California Public Employees Retirement System (CalPERS), which, through placement agent Grove Street Advisors, was poised to become the first U.S.-based pension fund to invest in an Israel-based VC vehicle. The deal, which involved a $5 million commitment to Apax Israel II, seemed fairly straightforward as the Israeli government was usually willing to grant waivers to investors deemed tax-exempt by their country of origin.

However, a problem arose when it was revealed that CalPERS had a standard agreement with Grove Street whereby the Wellesley, Mass.-based agent was to supply 0.5% of any relevant CalPERS commitment. In the Apax case, that would have come to just $25,000, but the Israeli tax authority declared that for-profit Grove Street’s involvement would preclude Apax from receiving a waiver for the entire CalPERS commitment. In the end, Grove Street spent nearly as much amending the CalPERS commitment agreement as it would have been required to invest on the Apax deal in the first place. Moreover, the reworked arrangement gave CalPERS newfound veto rights over Grove Street investment decisions.

“It was very complicated,” said Clint Harris, a partner with Grove Street.

Such complications have become so talked about among U.S.-based LPs that many have altogether avoided investing in Israel-based funds. It is hoped the September ruling will change that by massively simplifying the tax structure until at least 2004.

“There are certainly foreign investors who don’t want to deal with the tax issues involved here,” said Chemi Peres, managing partner of Pitango Venture Capital (formerly known as Polaris Venture Capital). “We haven’t seen all the details of the new decision yet, but I’m really hoping it will be clearer and fairer than what we have had.”

Another VC hoping to benefit from the decision is Eyal Kaplan, a general partner with Walden Israel. His firm was originally planning to hold a final close on its $120 million-targeted third fund last month, but may now extend the period so it can contact potential LPs who had previously shied away due to the tax complications.

“I think we’ll get at least some new investments out of this,” Kaplan said.

There are a handful of details surrounding the Israeli decision which, due in part to Yom Kippur, have not yet been spelled out.

One such issue is whether or not it will affect commitments like those $80 million Walden Israel III has already held a first close on. Also, since the ruling is only effective through 2004, it is unknown if it applies to all commitments made in that window, or possibly just to exits made. If the latter is the case, then funds like Walden and Concord would realistically be no better off than they were before the reversal.

The one thing that is certain is that at least a few countries will be closely monitoring the situation. Australia, in particular, will watch how Israel structures its new rules, as Aussie VCs have also complained that their country’s capital gains taxes on foreign investment have stunted entrepreneurial growth.