Israel Cuts Tax On VC Gains: But Too Late For Many

by Lorys Charalambous, Tax-news.com, Cyprus

27 September 2001

Until 2000, Israel was the third-fastest growing venture capital market in the world. Then a combination of the dotcom crunch and a realisation by foreign (and particularly US) investors that gains realised in Israel were going to be double-taxed both there and in the US led to a dramatic fall in inward investment.

Israel ranked sixth in venture capital investment in 2000 with $3.2bn of investments in start-ups and $3.3bn in funds raised for investment. Most of this money came from the US.

Then came $12bn of gains from exits in 2000, and in particular the purchase of Chromatis by Lucent for $4.5bn, just before the bottom fell out of the market in general and Lucent's stock in particular. Negotiations between the venture capital fund, Jerusalem Venture Partners, and the income tax authorities, to reduce the massive tax bills US investors faced in both Israel and the US were conducted against a background of slumping share values which reduced capital profits for those who hadn't sold Lucent shares to below the level of the tax due on them. And the negotiations failed, with catastrophic consequences for future venture capital investment in Israel.

PwC expects a 50 per cent decline in investments during 2001. In the third quarter of 2000 investments in the high-tech sector totaled $463 million, but in the second quarter 2001, they slumped to a mere $106 million.

Now the Finance Ministry has belatedly scrapped taxation of foreign investments in local venture capital funds until January 1, 2004. Venture capitalists applauded the long-awaited elimination of dual-taxation ambiguities, but said it would not have an immediate impact on declining investment as the sector continued to be burdened by global market conditions.

The venture capital industry didn't quite know how to react yesterday to Finance Minister Silvan Shalom's announcement, said local newspaper Ha'aretz: 'Should they breathe a deep sigh of relief, or should they calculate the damage the industry has suffered in the last year-and-a-half? Should they ponder how much they lost over the long years the tax problem kept investors out of Israel?'

The tax problem has come up in almost every meeting between foreign investors and Israeli fund managers in the last year. Investors have been losing their appetite for investments in the high-tech industry worldwide, but in Israel, the tax problem and the intifada have meant that investors have been fleeing the sector even faster than elsewhere. The finance minister, said the newspaper, sounded like someone locking stable doors after all the horses have fled.

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