The Israel Tax Authority recently published updated guidelines regarding the tax implications of investments made through SAFE agreements (Simple Agreement for Future Equity). This article addresses the classification of such transactions for tax purposes, their implications for investors and companies, and the conditions that must be met for a SAFE investment to be considered an equity investment rather than a loan or interest income or even in extreme cases having its profits classified as bearing income tax.

Given that one of the primary motivations for introducing the SAFE agreement format was tax-related and aimed at avoiding interest taxation—it is important to discuss the tax implications of such agreements and the guidelines that must be followed to achieve the desired tax treatment.

SAFE agreements have become a particularly popular tool among startup companies seeking rapid, simple, and flexible fundraising with very little legal and transaction work involved. Unlike a traditional loan or an immediate share issuance, a SAFE investment allows a company to receive capital from investors without determining the company's valuation at the time of investment (by setting a predefined discount and/or a valuation cap, which can be based on a current estimated valuation or a projected future valuation as may be negotiated). Under a SAFE agreement, the investor transfers funds to the company and, in return, receives a future right to convert the investment into shares, typically upon events such as an equity financing round, an IPO, or a company sale. Since no shares are issued immediately, the investor does not have voting or ownership rights until the investment is converted.

The key characteristic of a SAFE is that it is not considered debt for the company, meaning it does not bear interest, does not include a repayment schedule, and does not require a direct cash repayment. However, in certain cases, such as company liquidation or a change of control, the investor may be entitled to a return of the principal investment but without additional interest or returns.

The Israel Tax Authority states that a SAFE investment will be considered an equity investment rather than interest income or debt if the following criteria are met:

1. The recipient company must be a private company registered in Israel.
2. The company operates in the high-tech sector.
3. The majority of the company’s expenses, from its establishment until the agreement date or for three years prior to signing the SAFE, must be classified as research and development (R&D) activities, production, or marketing of products developed as part of R&D activities.
4. The R&D activities must continue at the time of closing the agreement.
5. The majority of the value of the company’s assets, directly or indirectly, must not be derived from real estate rights, real estate associations, real estate usage rights, or any asset attached to real estate in Israel, rights to exploit natural resources in Israel, or rights to income derived from real estate in Israel.
6. The total investment under a SAFE agreement for a single investor, directly or indirectly, must not exceed $20 million.
7. The company must not have conducted an equity financing round that determined a company valuation at least three months before signing the SAFE agreement.
8. The transfer or assignment of rights under the SAFE by the investor requires company approval, except where transferred to a permitted transferee as defined in the agreement.
9. The agreement must not be labeled as a loan or debt agreement.
10. The conversion of the SAFE into shares may occur only upon predefined trigger events, primarily including equity financing, an initial public offering, or a change of control in the company or the sale of most of its assets.
11. The investor has no contractual right to a cash repayment of the investment by the company, except in defined events such as a company sale or liquidation, in which case the investor’s standing within the SAFE will be subordinate to creditors but superior to ordinary shareholders (i.e., equivalent to preferred shares).
12. If the investor receives a repayment in any of the above cases, it will be limited to the principal amount only.
13. The discount rate at the time of share allocation must not change based on the time elapsed between the investment and allocation, but up to three discount levels may be set based on time or milestone achievements. The maximum discount must be granted no later than three years after signing.
14. Conversion must be based on a predetermined valuation if the share allocation date is set in advance within the agreement.
15. The agreement must not impose liens, pledges, or guarantees on the company's assets or those of subsidiaries or related entities in favor of the investor.
16. The company must not claim tax-deductible financing expenses or any other related expenses under the SAFE agreement, including direct or indirect financing costs, capitalization of financing costs, liability revaluation, or any other method.

The Israel Tax Authority guidelines state that if an investor receives shares upon SAFE conversion, a minimum holding period must be met for the transaction to be considered an equity investment. Generally, the shares must be held for at least 12 months from the SAFE signing date or 9 months from the share allocation date, whichever is earlier. However, there are two key exceptions where selling shares earlier will still be treated as equity income:

1. If the shares are sold as part of an exit transaction, where most of the company’s shares or significant assets are sold to a third party, the transaction will still be considered equity investment income even if the shares were sold before the required holding period.
2. If the company enters insolvency, liquidation, or receivership, the investor is entitled to liquidate their shares and receive their share of the proceeds according to the creditor hierarchy. In such cases, even if the shares are liquidated within a short time after allocation, the Israel Tax Authority will still classify the investment as equity rather than interest income.

Additionally, the guidelines specify that when an investor receives shares through a SAFE, the sale price must be identical to the price received by other shareholders in the transaction (excluding any predetermined discount). This ensures that the investor does not receive additional benefits that could indicate a guaranteed return resembling interest income.The practical effect of these exceptions is that an investor is not required to hold shares for the full minimum period if they are sold as part of a major liquidity event such as an exit or liquidation. This prevents tax complications for SAFE investors in cases where unforeseen events lead to early liquidation.When a SAFE qualifies as an equity investment, no taxable event occurs at the time of investment, share allocation, or SAFE conversion, and there is no withholding tax obligation at allocation. The taxable event occurs upon sale of the shares, at which point the proceeds will be classified as capital gains income subject to capital gains tax. This ensures that investors do not pay interest tax or expose the company to a tax liability due to imputed interest.There are also Implications for the company. If a SAFE is classified as an equity investment, the company does not need to withhold tax at source or recognize financing expenses. However, if the investment is classified as a loan or interest income, it may impact the company’s financial reports and result in changes to its tax liability.If, at the time of share allocation or sale, all required conditions are not met, the transaction may be classified as debt, and the proceeds may be taxed as interest income or commercial income, depending on the circumstances of the investor and the company.These guidelines apply to all SAFE agreements signed from January 1, 2025, through December 31, 2026, or until new guidelines are issued. Additionally, they may be relied upon for SAFE investments made since May 2023.