Israel Innovation Authority warns of economic woes from judicial reform

The Israel Innovation Authority has published a Position Paper (“Concern About Disintegration of Israeli Hi-Tech Due To World Developments And Possible Directions of Action, of April 30, 2023) commenting on challenges to the Israeli hi-tech sector. These range from inflation to the Ukraine war to….uncertainty in the Israeli judicial system. The position paper is couched in diplomatic language but it emits loud warnings about “uncertainty” stemming from the judicial reform proposals.

The Innovation Authority

The Innovation Authority (“the Authority”) used to be called the Office of the Chief Scientist. The Authority is famous for helping to fund R&D projects for a diverse range of Israeli businesses. These include first-time entrepreneurs, young start-ups, growth companies, industrial corporations and others.

R&D grants typically range up to 50% and even up to 100% in designated incubators. Companies operating in a development area may receive additional grants of 10% to 25%. Funding ranges up to 75% in the minority, ultra-Orthodox and female sectors.

What the paper says

Investments in Israeli hi-tech amounted to around $1.7 billion in the first quarter of 2023, the lowest input since 2019. And hi-tech stocks on the Tel-Aviv Stock Exchange have been static since the beginning of the year while the NASDAQ top 100 are up around 20%. Why?

According to the Authority, “Quarter 1 of 2023 was characterized by accelerated processes to make changes in the structure of the judicial system and the relationship between the three authorities in the State of Israel [presumably the legislature, executive and judicial authorities]. 

The expectation of these changes has created very high uncertainty about the status of the judicial authority regarding both civil and business aspects, which go together, and consequently, uncertainty, too, about the stability of institutional governance in Israel. Instability generates the impression of uncertainty and reduces the viability of investments in Israel. In light of these things, there is significant concern that Israel will soon be cut off from world capital flow trends and its share of venture capital may decrease.”

Incorporations abroad

The Authority points out that start-up founders must choose between: (1) forming (incorporating) an Israeli company, and (2) forming a foreign company with an Israeli R&D subsidiary in which case the IP (intellectual property) is usually abroad as well. 

Before 2023, most start-ups were formed in Israel. In February, because of the uncertainty and risks to the Israeli business environment and entrepreneurs, the trend changed and the default case in the first quarter of 2023 is now to form start-up companies abroad. The Authority estimates 50%-80% of start-ups were set up abroad by Israeli entrepreneurs in the first quarter of 2023. The Authority expects the “absolute majority” of start-up companies will very shortly be set up abroad – more than 80%.

Expected consequences

The Authority finds the trend to form companies abroad troubling because of its potential future impact on Israeli economic growth, employment, productivity and tax revenues. Hi-tech is a prime contributor to Israeli growth – around 25% of Israeli business output. Incorporating abroad may rapidly affect the location of: IP and resulting corporate tax payments, CEOs, financial and other services, marketing, operations and production.

Leading international economic bodies and rating agencies have surveyed the judicial proposals. 

Recommendations

The Authority says that uncertainty must be reduced by solving the political-judicial crisis, sooner rather than later. Also, the “Angels Law” giving tax credits to investors should be renewed and incentives updated for IP registered in Israel.

Deja Vu?

Twenty years ago, exactly the same thing happened, for tax reasons. In 2003, Israel taxed investors and VC funds at 50% on M&A “exit” gains, so it became standard practice to incorporate US parent corporations with Israeli R&D subsidiaries. Consequently, marketing activity, exit gains and taxes thereon all accrued to the US, and the economy slumped. 

As always, consult experienced advisers in each country at an early stage in specific cases.

leon@h2cat.com

The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.