Israeli firms stage exodus to USA to avoid taxes

Israel’s prime minister has sounded warnings. His Cabinet has huddled in urgent sessions.

The situation is so dire, warns one of the country’s leading newspapers, some think it could threaten Israel’s economic survival.

The subject of all this angst? Not the four months of bloody hostilities that have brought Israelis and Palestinians to the brink of war.

No, it’s the mass exodus of Israeli technology start-ups to the state of Delaware, the USA’s most popular corporate domicile. Hundreds of high-tech firms from Israel have migrated to Delaware — on paper, at least — incorporating there for as little as $74 in about the time it takes to get a marriage license.

Delaware boasts friendly, flexible laws and courts, and makes comparatively few demands of companies registered there. Israeli executives say incorporating in Delaware helps them limit their tax liability and recruit U.S. management talent. Even more important, it gives them legitimacy in the eyes of a key audience — venture capitalists, underwriters and stock market investors.

“Nearly every Israeli (tech) company I know incorporates in the United States, most in Delaware,” says Lenny Roth, vice president of strategic planning for Airslide Systems, which was founded in Herzelia, Israel.

That’s precisely what Israeli officials find so alarming. Tiny Israel is the world’s leading technology incubator after the USA. More than 4,000 tech firms have sprung up there, most founded by veterans of elite technology units in the Israeli armed forces or brainy Jewish יmigrיs who left jobs as scientists in the former Soviet Union.

Overnight, technology has become one of the main drivers of Israel’s economy. Homegrown companies that shift their paper homes to Delaware are, in effect, exporting tax revenue, job opportunities and expertise to the USA, as well.

Israeli companies making the jump typically turn their Israeli research and development units into subsidiaries of the Delaware parent and open head offices in the USA. One example: Airslide, a pioneer in technology that lets cellular providers upgrade networks using their existing architecture, filed its papers in Delaware in 1999. It has moved its corporate headquarters from Israel to New York, leaving R&D and software engineering in Herzelia.

Little noticed in the USA, the stampede from the Holy Land to Delaware began in 1998 after Israel liberalized its currency-control laws and made it easier for Israeli citizens to set up offshore companies. Since then, more than 1,000 Israeli tech firms — anywhere from 60% to 90% of those believed to have formally restructured — have designated Delaware as their corporate home.

“That’s when the floodgates opened,” says David Chertok, a U.S.-born lawyer working in Tel Aviv.

What’s Delaware got?

Delaware is the domicile of choice for 323,000 companies. Half of the Fortune 500 are incorporated there. By registering in Delaware and becoming U.S. companies, Israeli firms benefit from:

• Capital. Like start-ups everywhere, most Israeli tech firms want financing from venture capital funds and ultimately plan to go public.

Israel’s technology prowess has spawned a vibrant venture capital industry, but Israeli funds are dwarfed in comparison with what’s available in the USA. The USA is home to the world’s largest pool of venture capital and most active group of private investors.

“There are venture capital funds that will simply not invest in non-U.S. companies,” says Ben Strauss, an Israeli-born lawyer specializing in corporation law at Pepper Hamilton in Wilmington, Del. “This enables them to seek funding from sources that wouldn’t have invested in non-Delaware entities. It gives them access to the U.S. capital markets, which is their strongest motivation.”

Roughly 130 Israeli companies have already held initial public offerings (IPOs) and listed on the tech-heavy Nasdaq stock market. These days, only U.S. and Canadian companies outnumber Israeli firms on the exchange.

There is debate about whether a Delaware-registered company commands a higher valuation in an IPO. But many Israeli tech executives clearly believe investors will pay a Delaware premium or, conversely, discount the shares of non-Delaware companies.

“Definitely,” says Eran Tirer, CEO and co-founder of Intercomp, an Israeli company specializing in software for banks, insurers and securities firms. Intercomp is 45%-owned by Formula group, a Nasdaq-listed company that is Israel’s largest software firm. Intercomp plans its own share offering, tentatively in early 2002. “U.S. investors look more favorably at U.S. companies,” Tirer says, explaining his motivation for filing in Delaware.

• Customers. “I tell clients to ask themselves who and where are their customers. Half the market is generally the United States,” says Yoram Tietz, an accountant with the Tel Aviv firm of Kost Forer & Gabbay.

For Intercomp, 80% of its business is in the USA. The company currently calls Southfield, Mich., its headquarters, but that’s only temporary, the result of a decision to hire several executives from nearby Compuware. In a few weeks, Tirer and other key executives will move to New York, which is to be the base for Intercomp’s management and support functions. The company’s research unit will stay in Israel.

“Israel is not the marketplace,” says Lance Boxer, newly named CEO of XOsoft, which got its start in Tel Aviv and recently settled on Somerset, N.J., as its corporate headquarters. “Israel is very isolated. It has excellent technology people with a very strong work ethic. But what you’ve got is an excellent incubation area.”

• Taxes and rules. Entrepreneurs who start businesses in Israel face capital gains taxes of 50% when their big payday arrives in the form of a buyout, venture capital investment or a share offering. That’s about twice what they pay if their businesses are incorporated in the USA.

Israeli Prime Minister Ehud Barak has campaigned unsuccessfully for rate cuts, arguing that the country’s high taxes are forcing businesses to flee.

The Israeli government “is simply asking for too much,” Tirer says. “Israel is losing something very vital. Brainpower is running out of the country and going to the U.S.”

Barak pushed through a new corporation law, which took effect last February. Even though it is modeled after Delaware’s law, it has serious shortcomings, experts say. The new law leaves shareholders and officers more vulnerable to creditors; and it makes corporate reorganizations involving mergers or stock swaps tougher to pull off. And because the law is untested, Israeli courts have not had a chance to set legal precedents, something that leaves companies jittery.

By contrast, not even the biggest Delaware-registered companies pay more than $150,000 a year in taxes. There, the law is interpreted by the Chancery Court, a panel of five appointed judges steeped in the state’s corporation-friendly code. There are no jury trials and generally few surprises for corporate litigants.

The Israel Democracy Institute (IDI), an independent think tank, has concluded that 90% of the Israeli tech firms that incorporated in 1999 did so in Delaware. Given the burdensome taxes and regulations they face at home, they’d be crazy not to leave, IDI said.

“There is no economic justification for establishing a company in Israel,” IDI’s report said. “A chief executive who establishes a company in Israel should be fired immediately for his irresponsibility.”

Delaware on the hunt

Delaware officials say they don’t know for sure how many Israeli companies have incorporated in the state. But the Israelis didn’t discover Delaware by accident. State officials have conducted two incorporation workshops there, drawing hundreds of lawyers, accountants and business people. In addition, the state maintains a representative in Israel to provide local companies with information and help make its sales pitch.

The state does everything it can to make the process painless: Applicants can file their forms online through agents who, among other services, act as mailing addresses for their clients; the state registration office is open from 7 a.m. to midnight most weekdays.

Israeli officials have reacted with alarm as companies have fled. In September, Israel’s deputy attorney general warned participants in a Delaware-organized conference in Tel Aviv to think twice before incorporating in the state. Delaware companies, she said, faced hidden liabilities and the potential of enormous legal costs and burdens if they became involved in litigation.

Her remarks have done little to slow the exodus, which is taking place among Palestinian companies, too.

“We would be in the final stages of incorporation there right now” if not for the current uprising, says Maan Bseiso, founder of Palnet, a Jerusalem-based Internet service provider.

The unrest forced Palnet to abort efforts to incorporate in Delaware. It will try again, once calm returns and venture capitalists and the stock markets are more comfortable with the idea of investing in the region. “You can’t convince anybody to invest here at the moment,” Bseiso says.

Some Israeli lawyers and accountants expect the tide of companies leaving for Delaware to slow as Israeli taxes come down and entrepreneurs there get more comfortable with the new corporation law.

Others, particularly those who hope to recruit U.S. management talent, aren’t so sure.

Boxer, a former top executive at Lucent and MCI, says there’s no way he’d have taken the job as CEO of XOsoft if the company had incorporated in Israel.

“I wanted to run an American company. It’s hard enough running an Israeli-founded company from America, especially with the unrest and with 75% of my software engineers being of Russian descent,” he says. “You not only deal with distance and concerns for safety, but with cultural and language and visa problems.”

Airslide’s Roth says the migration to Delaware and to the Nasdaq has made it almost impossible to tell anymore what’s an Israeli company and what’s not. The Israeli newspaper Ha’aretz also recently addressed the identity issue, throwing up its hands in frustration.

What does it mean to be an Israeli company these days, the newspaper wondered. “Are these companies operating here, or once operated here, or the founder’s surname is simply Cohen?”