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The hi-tech industry is eagerly waiting the approval of the government budget in the Knesset. Not because of any special provision it will make for the industry, but rather because of Prime Minister Ariel Sharon's promise that within three months from the date of the budget approval a new tax reform committee will be set up, headed by Yair Rabinovich, chairman of the budgetary control authority, to discuss the various tax aspects of the industry.

In the last couple of months Sharon, at hi-tech conferences and personal conferences, said he will work to provide tax exemptions to Israeli investors in the industry, similar to the tax exemptions given in September 2001 to foreign investors on their profits from investments in Israeli VC funds.

If the exemptions go through, Israel will become the eighth country in the world to exempt its citizens from tax on investments they make in the local hi-tech industry. According to Leon Harris, International Tax Partner, Ernst & Young Israel, the seven countries to have already done so are Germany, the Netherlands, Belgium, Austria, Switzerland, Singapore and Taiwan. The tax exemption in Germany led to Munich becoming one of the most prominent European hi-tech and VC centers in the last 12 months.

Harris says local investors in many other countries pay reduced taxes on their investments in hi-tech. In Canada, for example, the tax never exceeds 25%, in France it is about 16% to 26% of the profit, in Britain 10% to 40%, and in Ireland, one of Israel's biggest competitors for foreign capital and local investments, it comes to 20%.

The industry is estimating the benefits to Israeli investors will be at the top of the Rabinovich committee's agenda. The tax rate on profits in the industry is currently 50%. Unlike the tax exemption to foreign investors, which has been legislated, the tax exemption to local investors does not yet have legal backing. It will require legislation, since it may arouse public objections to the idea of one kind of investment being preferred over another.

The tax division manager at Ernst & Young, Doron Kochavi, said the exemption to foreign investors is given only to foreign residents, thus it didn't create any internal preference compared with other sectors. Tax exemption for locals is another matter, Kochavi believes, considered unusual even in western countries.

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The tax issue has immediate influence on what is happening in the industry. The decrease in foreign investments in 2001, and the tax exemption that followed illustrate the depth of its impact on the industry.

Taxation on foreign investors' profits on their investments in Israeli VC funds became a hot issue at the end of 2000, when the sale of Chromatis Networks to Lucent Technologies (NYSE:LU) turned a theoretical debate into a raging discussion. The lack of regulation led to delays in transferring of the money to investors in Jerusalem Venture Partners, the VC fund that invested in Chromatis. The delay damaged investors' profits as the Lucent share plunged. The Chromatis deal had foreign investors fearing double taxation in their own countries, pushing them to freeze an estimated $1 billion in investments in Israel.

About 18 months ago the recommendations of the Ben-Bassat Commission for tax reforms were presented. The commission considered the hi-tech related tax deductions from 50% to 25%, and the reduced 25% tax on options to workers easy to execute. Its recommendations never materialized because of several controversial articles, such as the taxation on stock market taxation.

The hi-tech related issues discussed by the commission were considered those that would prevent Israeli startups hiding abroad. The dismissal of the commission's decisions was one of the factors that led to companies escaping to tax shelters or to the U.S. state of Delaware.

Since then some changes have occurred in the Israeli hi-tech industry. The crisis in the sector and the financing difficulties reduced the rate of escape from the country. A new trend began of companies listed abroad returning to Israel at the time of the crisis. Options to workers, one of the symbols of the boom 1997 to 2000, lost their centrality, and the Income Tax Authority rushed to ease the pain somewhat by reducing the tax from 50% to 42.5%, as a compromise until the bigger reform would be completed.

Sources in the industry said yesterday their hope was the new committee will try to create some sort of a mini-reform in the hi-tech sector, a reform that will lower taxation and make it more suitable for global competition.