---

---

# UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

# FORM 20-F

|o | REGISTRATION
STATEMENT PURSUANT TO SECTION 12(b) OR 12(g) OF THE SECURITIES EXCHANGE ACT OF
1934
|- | ------------------------------------------------------------------------------------------------

# OR

|x | ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------

# For the fiscal year
ended December 31, 2005

# OR

|o | TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

# For the transition
period from __________ to __________

# OR

|o | SHELL
COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | -------------------------------------------------------------------------------------------

Date of event requiring this shell company report _________

# Commission file number
0-49877



# On Track Innovations
Ltd.(Exact Name of
Registrant as Specified in Its Charter)

# ISRAEL(Jurisdiction of Incorporation or Organization)

# Z.H.R Industrial Zone,
Rosh-Pina 12000, Israel(Address of Principal
Executive Offices)

Securities registered or to be
registered pursuant to Section 12(b) of the Act:

|                    |                                          
|------------------- | -----------------------------------------
|
|
|
|
|Title of Each Class | Name of Each Exchange On Which Registered
|None                | None                                     

Securities registered or to be
registered pursuant to Section 12(g) of the Act:

# Ordinary Shares, NIS
0.1 nominal value(Title of Class)

Securities for which there is a
reporting obligation pursuant to Section 15(d) of the Act:

# None(Title of Class)

Indicate the number of outstanding shares
of each of the issuers classes of capital or common stock as of the close of the
period covered by the annual report: 11,932,074 Ordinary Shares, NIS 0.1 nominal value.

Indicate by check mark if the
registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

oYes   x No

If this report is an annual or
transition report, indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

oYes   x No

Note  Checking the box above
will not relieve any registrant required to file reports pursuant to Section 13
or 15(d) of the Securities Exchange Act of 1934 from their obligations under those
sections.



---

---



Indicate by check mark whether the
registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

xYes   o No

Indicate by check mark whether the
registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
See definition of accelerated filer and large accelerated filer in Rule 12b-2
of the Exchange Act.

Large Accelerated Filer o    Accelerated Filer o   Non-Accelerated Filer x

Indicate by check mark which
financial statement item the registrant has elected to follow:

Item 17 oItem 18 x

If this is an annual report, indicate
by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).

oYes   
x No

2

---

---



# INTRODUCTION

Unless
indicated otherwise by the context, all references in this Annual Report to:

| |  | we,
us, our, OTI, or the Company are to On Track Innovations Ltd. and its
subsidiaries;
| | - | -------------------------------------------------------------------------------------------------

| |  | dollars
or "$" are to United States dollars;
| | - | ----------------------------------------------

| |  | NIS
or shekel are to New Israeli Shekels;
| | - | ---------------------------------------------

| |  | the
Companies Law or the Israeli Companies Law are to the Israeli Companies Law,
5759-1999; and
| | - | ---------------------------------------------------------------------------------------------------

| |  | the
SEC is to the United States Securities and Exchange Commission.
| | - | ---------------------------------------------------------------------

# CAUTIONARY STATEMENT
REGARDING FORWARD-LOOKING STATEMENTS

Except
for the historical information contained in this Annual Report, the statements contained
in this Annual Report are forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities
Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of
1995, as amended, and other federal securities laws with respect to our business,
financial condition and results of operations. Such forward-looking statements reflect our
current view with respect to future events and financial results.

We
urge you to consider that statements which use the terms anticipate,
believe, expect, plan, intend,
estimate, anticipate and similar expressions are intended to
identify forward-looking statements. We remind readers that forward-looking statements are
merely predictions and therefore inherently subject to uncertainties and other factors and
involve known and unknown risks that could cause the actual results, performance, levels
of activity, or our achievements, or industry results, to be materially different from any
future results, performance, levels of activity, or our achievements, or industry results,
expressed or implied by such forward-looking statements. Such forward-looking statements
appear in Item 4  Information on the Company regarding, among other
things, our belief as to increased acceptance of smart-card technology, expansions of the
use of our technology, acquisitions, the impact of our relationship with technology
partners and business partners as well as to our revenue and the development of future
products, and Item 5  Operating and Financial Review and Prospects,
regarding, among other things, future sources of revenue, ongoing relationships with
current and future end-user customers and resellers, future costs and expenses and
adequacy of capital resources, as well as elsewhere in this Annual Report. Readers are
cautioned not to place undue reliance on these forward-looking statements, which speak
only as of the date hereof. Except as required by applicable law, including the securities
laws of the United States, we undertake no obligation to publicly release any update or
revision to any forward-looking statements to reflect new information, future events or
circumstances, or otherwise after the date hereof. We have attempted to identify
significant uncertainties and other factors affecting forward-looking statements in the
Risk Factors section that appears in Item 3.D. Key Information- Risk Factors,
and elsewhere in this Annual Report.

3

---

---



|         |                                                       |                                                                   |   
|-------- | ----------------------------------------------------- | ----------------------------------------------------------------- | --
|
|
|
|
|ITEM 1.  | IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS | 1                                                                
|ITEM 2.  | OFFER STATISTICS AND EXPECTED TIMETABLE               | 1                                                                
|ITEM 3.  | KEY INFORMATION                                       | 1                                                                
|         | A.                                                    | SELECTED FINANCIAL DATA                                           | 1 
|         | B.                                                    | CAPITALIZATION AND INDEBTEDNESS                                   | 2 
|         | C.                                                    | REASONS FOR THE OFFER AND USE OF PROCEEDS                         | 2 
|         | D.                                                    | RISK FACTORS                                                      | 2 
|ITEM 4.  | INFORMATION ON THE COMPANY                            | 14                                                               
|         | A.                                                    | HISTORY AND DEVELOPMENT OF THE COMPANY                            | 14
|         | B.                                                    | BUSINESS OVERVIEW                                                 | 15
|         | C.                                                    | ORGANIZATIONAL STRUCTURE                                          | 30
|         | D.                                                    | PROPERTY, PLANT AND EQUIPMENT                                     | 34
|ITEM 4A. | UNRESOLVED STAFF COMMENTS                             | 33                                                               
|ITEM 5.  | OPERATING AND FINANCIAL REVIEW AND PROSPECTS          | 35                                                               
|         | A.                                                    | OPERATING RESULTS                                                 | 35
|         | B.                                                    | LIQUIDITY AND CAPITAL RESOURCES                                   | 41
|         | C.                                                    | RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC               | 43
|         | D.                                                    | TREND INFORMATION                                                 | 43
|         | E.                                                    | OFF BALANCE SHEET ARRANGEMENTS                                    | 43
|         | F.                                                    | TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS                     | 43
|ITEM 6.  | DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES            | 44                                                               
|         | A.                                                    | DIRECTORS AND SENIOR MANAGEMENT                                   | 44
|         | B.                                                    | COMPENSATION                                                      | 46
|         | C.                                                    | BOARD PRACTICES                                                   | 47
|         | D.                                                    | EMPLOYEES                                                         | 53
|         | E.                                                    | SHARE OWNERSHIP                                                   | 54
|ITEM 7.  | MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS     | 57                                                               
|         | A.                                                    | MAJOR SHAREHOLDERS                                                | 57
|         | B.                                                    | RELATED PARTY TRANSACTIONS                                        | 59
|         | C.                                                    | INTERESTS OF EXPERTS AND COUNSEL                                  | 60
|ITEM 8.  | FINANCIAL INFORMATION                                 | 60                                                               
|         | A.                                                    | CONSOLIDATED FINANCIAL STATEMENTS AND OTHER FINANCIAL INFORMATION | 60
|         | B.                                                    | SIGNIFICANT CHANGES                                               | 61
|ITEM 9.  | THE OFFER AND LISTING                                 | 61                                                               
|         | A.                                                    | OFFER AND LISTING DETAILS                                         | 61
|         | B.                                                    | PLAN OF DISTRIBUTION                                              | 62
|         | C.                                                    | MARKETS                                                           | 62
|         | D.                                                    | SELLING SHAREHOLDERS                                              | 62
|         | E.                                                    | DILUTION                                                          | 62
|         | F.                                                    | EXPENSES OF THE ISSUE                                             | 62
|ITEM 10. | ADDITIONAL INFORMATION                                | 62                                                               
|         | A.                                                    | SHARE CAPITAL                                                     | 62
|         | B.                                                    | MEMORANDUM AND ARTICLES OF ASSOCIATION                            | 63
|         | C.                                                    | MATERIAL CONTRACTS                                                | 69
|         | D.                                                    | EXCHANGE CONTROLS                                                 | 69
|         | E.                                                    | TAXATION                                                          | 69
|         | F.                                                    | DIVIDENDS AND PAYING AGENTS                                       | 79
|         | G.                                                    | STATEMENT BY EXPERTS                                              | 79
|         | H.                                                    | DOCUMENTS ON DISPLAY                                              | 79
|         | I.                                                    | SUBSIDIARY INFORMATION                                            | 79
|         |                                                       |                                                                   |   



---

---



|          |                                                                              |   
|--------- | ---------------------------------------------------------------------------- | --
|
|
|
|
|ITEM 11.  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                   | 79
|ITEM 12.  | DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES                       | 80
|ITEM 13.  | DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES                              | 81
|ITEM 14.  | MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS | 81
|ITEM 15.  | CONTROLS AND PROCEDURES                                                      | 81
|ITEM 16A. | AUDIT COMMITTEE FINANCIAL EXPERT                                             | 81
|ITEM 16B. | CODE OF ETHICS                                                               | 81
|ITEM 16C. | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                       | 81
|ITEM 16D. | EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES                   | 82
|ITEM 16E. | PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS       | 82
|ITEM 17.  | FINANCIAL STATEMENTS                                                         | 83
|ITEM 18.  | FINANCIAL STATEMENTS                                                         | 83
|ITEM 19.  | EXHIBITS                                                                     | 83

2

---

---



# PART I

|ITEM 1. |  | IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS
|------- |  | -----------------------------------------------------

Not applicable.

|ITEM 2. |  | OFFER STATISTICS AND EXPECTED TIMETABLE
|------- |  | ---------------------------------------

Not applicable.

|ITEM 3. |  | KEY INFORMATION
|------- |  | ---------------

|A. | SELECTED
FINANCIAL DATA
|-- | -----------------------

The
following selected consolidated statements of operations data for the years ended December
31, 2003, 2004 and 2005, and the selected consolidated balance sheet data as of December
31, 2004 and 2005, have been derived from the audited consolidated financial statements of
On Track Innovations Ltd. (together with its subsidiaries, referred to as the Company or
OTI) set forth elsewhere in this annual report. These financial statements have been
prepared in accordance with generally accepted accounting principles in the United States,
or U.S. GAAP. The selected consolidated statements of operations data for the years ended
December 31, 2001 and 2002 and the selected consolidated balance sheet data as of December
31, 2001, 2002 and 2003 have been derived from our audited consolidated financial
statements not included in this annual report, which have also been prepared in accordance
with U.S. GAAP. The selected consolidated financial statements set forth below should be
read in conjunction with and are qualified by reference to our consolidated financial
statements and the related notes, as well as Item 5.  Operating and
Financial Review and Prospects, included elsewhere in this annual report.

Effective
as of June 17, 2002, we consummated a one to ten reverse share split of our ordinary
shares, such that each ten ordinary shares of NIS 0.01 par value became one ordinary share
of NIS 0.1 par value. All shares, per share, warrants and options amounts in the
consolidated financial statements have been adjusted to give retroactive effect to this
reverse share split for all periods presented.

|                                    | Year ended December 31
|----------------------------------- | ----------------------
|
|
|
|
|REVENUES                            |                       
|Sales                               |                       
|Licensing and transaction fees      |                       
|                                    |                       
|Total revenues                      |                       
|                                    |                       
|                                    |                       
|COST OF REVENUES                    |                       
|Sales                               |                       
|                                    |                       
|                                    |                       
|Total cost of revenues              |                       
|                                    |                       
|                                    |                       
|Gross profit                        |                       
|                                    |                       
|                                    |                       
|OPERATING EXPENSES                  |                       
|Research and development            |                       
|Less - participation by the         |                       
|Office of the Chief Scientist       |                       
|                                    |                       
|                                    |                       
|Research and development, net       |                       
|Selling and marketing               |                       
|General and administrative          |                       
|Amortization of goodwill            |                       
|and intangible assets               |                       
|                                    |                       
|Expenses relating to                |                       
|raising of  capital, exchange of    |                       
|subsidiary's employees equity       |                       
|interest in equity interests of     |                       
|the Company and new acquisitions    |                       
|in the Far East and other           |                       
|                                    |                       
|Gain from sale of subsidiary        |                       
|                                    |                       
|Total operating                     |                       
|expenses                            |                       
|                                    |                       
|                                    |                       
|Operating loss                      |                       
|                                    |                       
|Financial income (expenses), net    |                       
|Other income (expenses), net        |                       
|                                    |                       
|Loss before taxes                   |                       
|on income                           |                       
|Taxes on income                     |                       
|                                    |                       
|                                    |                       
|                                    |                       
|Minority share in income of         |                       
|subsidiary                          |                       
|                                    |                       
|Loss before                         |                       
|extraordinary item                  |                       
|                                    |                       
|Extraordinary item                  |                       
|                                    |                       
|Net loss                            |                       
|                                    |                       
|                                    |                       
|Basic and diluted net loss per      |                       
|ordinary share from:                |                       
|Loss before extraordinary item      |                       
|                                    |                       
|                                    |                       
|Extraordinary item                  |                       
|                                    |                       
|                                    |                       
|Net loss                            |                       
|                                    |                       
|                                    |                       
|Weighted average number of ordinary |                       
|shares used in computing net loss   |                       
|per ordinary share - basic and      |                       
|diluted                             |                       

1

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---



|                                           | As of December 31
|------------------------------------------ | -----------------
|
|
|
|
|Balance Sheet Data:                        |                  
|Cash and cash equivalents                  |                  
|Total current assets                       |                  
|Total assets                               |                  
|Total liabilities                          |                  
|Long term loans, net of current maturities |                  
|Total shareholders' equity                 |                  

|B. | CAPITALIZATION
AND INDEBTEDNESS
|-- | -------------------------------

Not applicable.

|C. | REASONS
FOR THE OFFER AND USE OF PROCEEDS
|-- | -----------------------------------------

Not applicable.

|D. | RISK
FACTORS
|-- | ------------

The
following risk factors, among others, could in the future affect our actual results of
operations and could cause our actual results to differ materially from those expressed in
forward-looking statements made by us. These forward-looking statements are based on
current expectations and we assume no obligation to update this information. Before you
decide to buy, hold, or sell our ordinary shares, you should carefully consider the risks
described below, in addition to the other information contained elsewhere in this Annual
Report. The following risk factors are not the only risk factors facing our company.
Additional risks and uncertainties not presently known to us or that we currently deem
immaterial may also affect our business. Our business, financial condition and results of
operations could be seriously harmed if any of the events underlying any of these risks or
uncertainties actually occurs. In that event, the market price for our ordinary shares
could decline, and you may lose all or part of your investment.

2

---

---



# RISKS RELATED TO OUR
BUSINESS

WE HAVE A HISTORY OF LOSSES AND
EXPECT TO CONTINUE TO INCUR FULL YEAR LOSSES AT LEAST THROUGH 2006.

We
have incurred losses in each year since we commenced operations in 1990. We reported net
losses of $11.7 million in 2001, $6.2 million in 2002, $3.6 million in 2003, $9.3 million
in 2004 and $9.1 million in 2005. We expect to incur full year losses at least through
2006, as we invest in the expansion of our global marketing network, reduce our product
prices in return for transaction fees based on the volume of transactions effected in
systems that contain our products, enhance our research and development capabilities and
expand our internal manufacturing capabilities.

IF THE MARKET FOR SMART CARDS IN
GENERAL, AND FOR CONTACTLESS MICROPROCESSOR-BASED SMART CARDS IN PARTICULAR, DOES NOT
GROW, SALES OF OUR PRODUCTS MAY NOT GROW AND MAY EVEN DECLINE.

The
success of our products depends on commercial enterprises, governmental authorities and
other potential card issuers adopting contactless microprocessor-based smart card
technologies. Other card technologies, such as magnetic strips or bar codes, are widely
used and could be viewed by potential customers as more cost effective alternatives to our
products. Additionally, potential customers in developed countries such as the United
States may already have installed systems that are based on technologies different from
ours and may therefore be less willing to incur the capital expenditures required to
install or upgrade to a contactless microprocessor-based smart card system. As a result,
we cannot assure you that there will be significant market opportunities for contactless
microprocessor-based smart card products. If demand for contactless microprocessor-based
smart card products such as ours does not develop or develops more slowly than we
anticipate, we may have fewer opportunities for growth than we expect.

IF WE FAIL TO DEVELOP NEW PRODUCTS OR
ADAPT OUR EXISTING PRODUCTS FOR USE IN NEW MARKETS, OUR REVENUE GROWTH MAY BE IMPEDED AND
WE MAY INCUR SIGNIFICANT LOSSES.

To
date, we have sold products incorporating our technology within a limited number of
markets. We are currently developing and marketing products such as medical cards for use
in hospitals and identity cards for use by governmental authorities. We are devoting
significant resources to developing and marketing these and other products and adapting
our existing products for use in new markets. If we fail to develop new products or adapt
our existing products for new markets, we may not recoup the expenses incurred in our
efforts to do so, our revenue growth may be impeded and we may incur significant losses.

WE HAVE HISTORICALLY DERIVED A
SIGNIFICANT PORTION OF OUR REVENUES FROM SALES TO SYSTEMS INTEGRATORS WHO ARE NOT THE
END-USERS OF OUR PRODUCTS. WE ARE TO A CERTAIN EXTENT DEPENDENT ON THE ABILITY OF THESE
INTEGRATORS TO MAINTAIN THEIR EXISTING BUSINESS AND SECURE NEW BUSINESS.

In
2003, 2004 and 2005, 28%, 16% and 9%, respectively, of our revenues were derived from
sales to systems integrators, who incorporate our products into systems which they supply
and install for use in a specific project. To the extent our revenues depend on the
ability of systems integrators to successfully market, sell, install and provide technical
support for systems in which our products are integrated or to sell our products on a
stand-alone basis, our revenues may decline if the efforts of these systems integrators
fail. Further, the faulty or negligent implementation and installation of our products by
systems integrators may harm our reputation and dilute our brand name. Because we are one
step removed from the end-users of our products, it may be more difficult for us to
rectify damage to our reputation caused by systems integrators who have direct contact
with end-users. In addition, termination of agreements with systems integrators or
revocation of exclusive distribution rights within a certain area can be difficult. If we
are unable to maintain our current relationships with systems integrators or develop
relationships with new systems integrators, we may not be able to sell our products and
our results of operations could be impaired.

3

---

---



Unless
we continue to expand our direct sales, our future success will depend upon the timing and
size of future purchases by systems integrators and the success of the projects and
services for which they use our products.

OUR REVENUE GROWTH MAY BE IMPAIRED IF
WE ARE UNABLE TO MAINTAIN OUR CURRENT, AND ESTABLISH NEW, STRATEGIC RELATIONSHIPS.

The
markets for our products are usually highly specialized and require us to enter into
strategic relationships in order to facilitate or accelerate our penetration into new
markets. We consider a relationship to be strategic when we integrate our technology into
some of the product offerings of a manufacturer or systems integrator that has a
significant position in a specified market, and then we cooperate in marketing the
resulting product. The termination of any of our strategic relationships or our failure to
develop additional relationships in the future may limit our ability to expand the markets
in which our products are deployed or to sell particular products.

ONE OF OUR CUSTOMERS ACCOUNTED FOR
APPROXIMATELY 30% OF OUR REVENUES. A LOSS OF THIS CUSTOMER OR A REDUCTION OR DELAY IN
ORDERS FROM SUCH CUSTOMER COULD HARM OUR BUSINESS.

In
2005, one of our customers accounted for approximately 30% of our consolidated revenues.
There can be no assurance that such customer will continue to use our products and
services. A termination, reduction, delay or cancellation of orders from such customer,
including reductions or delays due to market, economic or competitive conditions, could
have a material adverse effect on our business, operating results and financial condition.

SOME OF OUR AGREEMENTS MAY IN THE
FUTURE RESTRICT OUR ABILITY TO TAKE ACTIONS THAT WE THEN BELIEVE TO BE DESIRABLE.

In
some of our agreements with suppliers, distributors and joint venture partners, we have
agreed to restrict ourselves in some areas of business for different time periods ranging
from several months to several years. In addition, in some markets we sell our products
through distributors who, in general, have exclusive distribution rights in that market if
sales quotas are met.

WE FACE INTENSE COMPETITION. IF WE ARE UNABLE TO COMPETE SUCCESSFULLY, OUR BUSINESS PROSPECTS WILL BE IMPAIRED.

We
face intense competition from developers of contact and contactless microprocessor-based
technologies and products, developers of contactless products that use other types of
technologies that are not microprocessor-based, and non-smart card technologies. We
compete on the basis of a range of competitive factors including price, compatibility with
the products of other manufacturers, and the ability to support new industry standards and
introduce new reliable technologies. Many of our competitors, including Philips
Semiconductors, a division of Philips Electronics N.V., and Infineon Technologies AG, have
greater market recognition, larger customer bases, and substantially greater financial,
technical, marketing, distribution, and other resources than we possess. As a result, they
may be able to introduce new products, respond to customer requirements and adapt to
evolving industry standards more quickly than we can. In addition, we may not be able to
differentiate our products sufficiently from those of our competitors.

From
time to time, we or one or more of our present or future competitors may announce new or
enhanced products or technologies that have the potential to replace or shorten the life
cycles of our existing products. The announcement of new or enhanced products may cause
customers to delay or alter their purchasing decisions in anticipation of such products,
and new products developed by our competitors may render our products obsolete or achieve
greater market acceptance than our products.

4

---

---



If
we cannot compete successfully with our existing and future competitors, we could
experience lower sales, price reductions, loss of revenues, reduced gross margins and
reduced market share.

IF THERE IS A SUSTAINED INCREASE IN
DEMAND FOR MICROPROCESSORS, AVAILABILITY MIGHT BE LIMITED AND PRICES MIGHT INCREASE.

Our
products require microprocessors. The microprocessor industry periodically experiences
increased demand and limited availability due to production capacity constraints.
Increased demand for, or limited availability of, microprocessors could substantially
increase the cost of producing our products. Because some of our customer contracts have
fixed prices, we may not be able to pass on any increases in costs to these customers, and
consequently our profit margin could be reduced.

In
addition, as a result of a shortage, we may be compelled to delay shipments of our
products, or devote additional resources to maintaining higher levels of microprocessor
inventory. Consequently, we may experience substantial period-to-period fluctuations in
our cost of revenues and, therefore, in our future results of operations.

OUR PRODUCTS HAVE LONG DEVELOPMENT
CYCLES AND WE MAY EXPEND SIGNIFICANT RESOURCES IN RELATION TO A SPECIFIC PROJECT WITHOUT
REALIZING ANY REVENUES.

The
development cycle for our products varies from project to project. Typically, the projects
in which we are involved are complex and require that we customize our products to our
customers needs and specifications in return for payment of a fixed amount. We then
conduct evaluation, testing, implementation and acceptance procedures of the customized
products with the customer. Only after successful completion of these procedures will
customers place orders for our products in commercial quantities. In addition, our
contracts do not typically include minimum purchase requirements. We, therefore, cannot
assure you that contracts into which we enter will result in commercial sales. Our average
development cycle is typically between 18 and 24 months from initial contact with a
potential customer until we deliver commercial quantities to the customer and recognize
significant revenues. As a result, we may expend financial, management and other resources
to develop customer relationships before we recognize any revenues.

FLUCTUATIONS IN OUR QUARTERLY
FINANCIAL PERFORMANCE MAY CREATE VOLATILITY IN THE MARKET PRICE OF OUR SHARES AND MAY MAKE
IT DIFFICULT TO PREDICT OUR FUTURE PERFORMANCE.

Our
quarterly revenues and operating results have varied substantially in the past and are
likely to do so in the future. These fluctuations may be driven by various factors which
are beyond our control, are difficult to predict and may not meet the expectations of
analysts and investors. These factors include:

| |  | the
size and timing of orders placed by our customers, particularly in government projects.
Government projects typically involve a protracted competitive procurement process and in
some circumstances litigation following the award of a contract. As a result, it is
difficult to predict the timing and size of orders under such contracts. For example, we
started to prepare our offer for the Israeli national electronic parking system project
in 1992, we were awarded the contract in May 1998 and deployment began in January 2000.
We started recognizing revenues in the second half of 2000.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
fact that our rental expenses are fixed and we may not be able to reduce them in the
event of a reduction in revenues in a particular quarter. In addition, our payroll
expenses are relatively fixed and we would not expect to reduce our workforce due to a
reduction in revenues in any particular quarter.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
tendency of our clients to place orders for products toward the last quarter of their
financial year.
| | - | ---------------------------------------------------------------------------------------------------------

5

---

---



Because
of these factors, our revenues and operating results in any quarter may not be indicative
of our future performance, and it may be difficult for you to evaluate our prospects.

DELAYS OR DISCONTINUANCE OF THE
SUPPLY OF COMPONENTS MAY HAMPER OUR ABILITY TO PRODUCE OUR PRODUCTS ON A TIMELY BASIS AND
CAUSE SHORT-TERM ADVERSE EFFECTS.

The
components we use in our products, including microprocessors and cards, are supplied by
third party suppliers and manufacturers. Except for Samsung, currently the sole supplier
of the chip that integrates our antenna interface into Samsungs microprocessor, none
of these suppliers is a sole supplier. Nevertheless, we sometimes experience short-term
adverse effects due to delayed shipments that have in the past interrupted and delayed,
and could in the future interrupt and delay, the supply of our products to our customers,
and may result in cancellation of orders for our products. In addition, we do not
generally have long term supply contracts under which our suppliers are committed to
supply us with components at a fixed price. Suppliers could increase component prices
significantly without warning or could discontinue the manufacture or supply of components
used in our products. We may not be able to develop alternative sources for product
components if and as required in the future. Even if we are able to identify alternative
sources of supply, we may need to modify our products to render them compatible with other
components. This may cause delays in product shipments, increase manufacturing costs and
increase product prices.

Because
some of our suppliers are located in Europe and the Far East, we may experience logistical
problems in our supply chain, including long lead times for receipt of products or
components and shipping delays. In addition, our subcontractors located in Israel and the
Far East may, on occasion, feel the impact of potential economic or political instability
in their regions, which could affect their ability to supply us with components for our
products in a timely manner.

IF WE FAIL TO HIRE, TRAIN AND RETAIN
QUALIFIED RESEARCH AND DEVELOPMENT PERSONNEL, OUR ABILITY TO ENHANCE OUR EXISTING
PRODUCTS, DEVELOP NEW PRODUCTS AND COMPETE SUCCESSFULLY MAY BE MATERIALLY AND ADVERSELY
AFFECTED.

Our
success depends in part on our ability to hire, train and retain qualified research and
development personnel. Individuals who have expertise in research and development in our
industry are scarce. Competition for such personnel in the electronics industry is
intense, particularly in Israel. Consequently, hiring, training and retaining such
personnel is both time consuming and expensive. In addition, it may be difficult to
attract qualified personnel to Rosh Pina, which is in the North of Israel. If we fail to
hire, train and retain employees with skills in research and development, we may not be
able to enhance our existing products or develop new products.

OUR ABILITY TO COMPETE DEPENDS ON OUR
CONTINUING RIGHT TO USE, AND OUR ABILITY TO PROTECT, OUR INTELLECTUAL PROPERTY RIGHTS.

Our
success and ability to compete depend in large part on using our intellectual property and
proprietary rights to protect our technology and products. We rely on a combination of
patent, trademark, design, copyright and trade secret law, as well as confidentiality
agreements and other contractual relationships with our employees, customers, affiliates,
distributors and others. While substantially all of our employees are subject to
non-compete agreements, these agreements may be difficult to enforce as a result of
Israeli law limiting the scope of employee non-competition undertakings.

We
currently have patents registered in the United States, Israel and other countries
covering some of our technology and have pending applications in the United States,
Europe, Far East, Israel and elsewhere which have not yet resulted in granted patents. We
cannot be certain that patents will be issued with respect to any of our pending or future
patent applications or that the scope of our existing patents, or any future patents that
are issued to us, will provide us with adequate protection for our technology and
products. Others may challenge our patents or registered trademarks. We do not know
whether any of them will be upheld as valid or will be enforceable against alleged
infringers. Thus we do not know whether they will enable us to prevent or hinder the
development of competing products or technologies. Moreover, patents provide legal
protection only in the countries where they are registered and the extent of the
protection granted by patents varies from country to country.

6

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The
measures we have taken to protect our technology and products may not be sufficient to
prevent their misappropriation by third parties or independent development by others of
similar technologies or products. Competitors may also develop competing technology by
designing around our patents and thereafter manufacturing and selling products that
compete directly with ours.

In
order to protect our technology and products and enforce our patents and other proprietary
rights, we may need to initiate, prosecute or defend litigation and other proceedings
before courts and patent and trademark offices in numerous countries. These legal and
administrative proceedings could be expensive and could occupy significant management time
and resources.

OUR PRODUCTS MAY INFRINGE THE
INTELLECTUAL PROPERTY RIGHTS OF OTHERS.

It
is not always possible to know with certainty whether or not the manufacture and sale of
our products does or will infringe patents or other intellectual property rights owned by
third parties. For example, patent applications may be pending at any time which, if
granted, cover products that we developed or are developing. In certain jurisdictions, the
subject matter of patents is not published until the patents are issued. Third parties may
from time to time claim that our products infringe their patent or other intellectual
property rights. In addition, if third parties claim that our customers are violating
their intellectual property rights, our customers may seek indemnification from us (which
could be costly), or may terminate their relationships with us. Our products depend on
operating systems licensed to us and we may also be subject to claims by third parties
that our use of these operating systems infringes their intellectual property rights. Any
intellectual property claim could involve time-consuming and disruptive litigation that,
if determined adversely to us, could prevent us from making or selling our products,
subject us to substantial monetary damages or require us to seek licenses.

Intellectual
property rights litigation is complex and costly, and we cannot be sure of the outcome of
any litigation. Even if we prevail, the cost of litigation could harm our results of
operations. In addition, litigation is time consuming and could divert our
managements attention and resources away from our business. If we do not prevail in
any litigation, in addition to any damages we might have to pay, we might be required to
discontinue the use of certain processes, cease the manufacture, use and sale of
infringing products and solutions, expend significant resources to develop non-infringing
technology or obtain licenses on unfavorable terms. Licenses may not be available to us on
acceptable terms or at all. In addition, some licenses are non-exclusive and, therefore,
our competitors may have access to the same technology licensed to us. If we fail to
obtain a required license or cannot design around any third party patents or otherwise
avoid infringements, we may be unable to sell some of our products.

THE LOSS OF THE SERVICES OF OUR
CHAIRMAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER, ODED BASHAN, COULD SERIOUSLY HARM OUR
BUSINESS.

Our
success depends, in part, on the continued service of Oded Bashan, our Chairman, President
and Chief Executive Officer. Mr. Bashan is one of our founders and has developed our
business and technology strategy since our inception. The loss of services of Mr. Bashan
could disrupt our operations and harm our business.

IN THE PAST SIX YEARS WE HAVE
ACQUIRED SEVERAL COMPANIES OR GROUPS OF COMPANIES AND WE INTEND TO CONTINUE TO PURSUE
STRATEGIC ACQUISITIONS IN THE FUTURE. THE FAILURE TO SUCCESSFULLY INTEGRATE ACQUIRED
COMPANIES AND BUSINESSES OR TO ACQUIRE NEW COMPANIES AND BUSINESSES MAY HARM OUR FINANCIAL
PERFORMANCE AND GROWTH.

In
the past six years we have acquired the SoftChip group, an Israeli designer of
microprocessors and operating systems for smart cards, InterCard Systemelectronic GmbH, or
InterCard Systemelectronic, a German company that provides OEM and electronics
manufacturing services, ASEC Spolka Akcyjna, or ASEC, a Polish company that develops,
manufactures and markets card readers and reader modules based on radio frequency
identification technologies, 71.5% of e-Pilot, a Hong Kong-based company that develops,
manufactures and markets smart card inlays for smart cards and other products, Pioneer
Oriental International, Ltd., or POI, an engineering company that develops and
manufactures machinery used to create smart cards inlays for smart cards and other
products, and that also manufactures contact and contactless smart cards themselves and
inlay for contact and contactless smart cards, and substantially all of the assets of
Pioneer Oriental Engineering Ltd., or POE, relating to the design and manufacture of
machinery for the manufacture of smart cards, and InSeal, a French company providing an
operating system for contactless applications to a variety of customers in the payments
market. We paid for all seven of these acquisitions through the issuance of our ordinary
shares. These and future acquisitions could result in:

7

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| |  | difficulties
in integrating our operations, technologies, products and services with those of the
              acquired companies;
| | - | -----------------------------------------------------------------------------------------------------------------------------------

| |  | difficulty
in integrating operations that are spread across significant geographic distances;
| | - | ---------------------------------------------------------------------------------------------

| |  | diversion
of our capital and our management's attention away from other business issues;
| | - | ----------------------------------------------------------------------------------------

| |  | potential
loss of key employees and customers of companies we acquire;
| | - | ----------------------------------------------------------------------

| |  | increased
liabilities as a result of liabilities of the companies we acquire; and
| | - | ---------------------------------------------------------------------------------

| |  | dilution
of shareholdings in the event we acquire companies in exchange for our shares.
| | - | ---------------------------------------------------------------------------------------

We
may not successfully integrate any technologies, manufacturing facilities or distribution
channels that we have or may acquire and we cannot assure you that any of our recent
acquisitions will be successful. In addition, if we do not acquire new companies and
businesses in the future, our business may not grow as expected. If any of our recent or
future acquisitions are not successful, our financial performance and business may be
adversely affected.

WE ARE SUSCEPTIBLE TO CHANGES IN
INTERNATIONAL MARKETS AND DIFFICULTIES WITH INTERNATIONAL OPERATIONS COULD HARM OUR
BUSINESS.

Over the last five years, we have
derived revenues from different geographical areas. The following table sets forth our
sales in different geographical areas as a percentage of revenues:

|     | Africa | Europe | Far East | Americas | Israel
|---- | ------ | ------ | -------- | -------- | ------
|
|
|
|
|2001 |        |        |          | 6        |       
|2002 |        |        |          | 13       |       
|2003 |        |        |          | 15       |       
|2004 |        |        |          | 11       |       
|2005 |        |        |          | 11       |       

Our
ability to maintain our position in existing markets and to penetrate new, regional and
local markets, is dependent, in part, on the stability of regional and local economies.
Our regional sales may continue to fluctuate widely and may be adversely impacted by
future political or economic instability in these or other foreign countries or regions.

In
addition, there are inherent risks in these international operations which include:

| |  | changes
in regulatory requirements and communications standards;
| | - | ----------------------------------------------------------------

| |  | required
licenses, tariffs and other trade barriers;
| | - | ----------------------------------------------------

| |  | difficulties
in enforcing intellectual property rights across, or having to litigate disputes in,
              various jurisdictions;
| | - | --------------------------------------------------------------------------------------------------------------------------------------

| |  | difficulties
in staffing and managing international operations;
| | - | ---------------------------------------------------------------

8

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| |  | potentially
adverse tax consequences; and
| | - | -----------------------------------------

| |  | the
burden of complying with a wide variety of complex laws and treaties in various
jurisdictions.
| | - | --------------------------------------------------------------------------------------------------

If
we are unable to manage the risks associated with our focus on international sales, our
business may be harmed.

BECAUSE WE REPORT IN DOLLARS WHILE A
PORTION OF OUR REVENUES AND EXPENSES ARE INCURRED IN OTHER CURRENCIES, CURRENCY
FLUCTUATIONS COULD ADVERSELY AFFECT OUR RESULTS OF OPERATIONS.

Our
functional and reporting currency is the U.S. dollar. We generate a significant portion of
our revenues in U.S. dollars but we incur a large portion of our expenses in other
currencies, principally some employees salaries in New Israeli Shekels, or NIS, and
the majority of the expenses of our German and Polish subsidiaries, InterCard
Systemelectronic and ASEC Spolka Akcyjna, in euros and of our subsidiaries Pioneer
Oriental International Ltd. and e-Pilot in Chinese Yuan Renminbi. To the extent that we
and our subsidiaries based in Israel, Europe and the Far-East conduct our business in
different currencies, our revenues and expenses and, as a result, our assets and
liabilities, are not necessarily accounted for in the same currency. We are, therefore,
exposed to foreign exchange rate fluctuations. These fluctuations may negatively affect
our results of operations. Our operations could also be adversely affected if we are
unable to limit our exposure to currency fluctuations in the future. Accordingly, we may
enter into currency hedging transactions to decrease the risk of financial exposure to
fluctuations in the exchange rate of the U.S. dollar against the NIS or other currencies.

However,
these measures may not adequately protect us from material adverse effects resulting from
currency fluctuations. In addition, if we wish to maintain the dollar-denominated value of
sales made in other currencies, any devaluation of the other currencies relative to the
U.S. dollar would require us to increase our other currency denominated sales price. That
could cause our customers to cancel or decrease orders.

WE MAY HAVE TO ADAPT OUR PRODUCTS IN
ORDER TO INTEGRATE THEM INTO OUR CUSTOMERS SYSTEMS OR IF NEW GOVERNMENT REGULATIONS
OR INDUSTRY STANDARDS ARE ADOPTED OR CURRENT REGULATIONS OR STANDARDS ARE CHANGED.

Some
of our products are subject to government regulation in the countries in which they are
used. For example, card readers that are used in the United States and in Europe require
certification of compliance with regulations of the Federal Communications Commission and
the European Telecommunications Standards Institute, respectively, regarding emission
limits of radio frequency devices. In addition, governmental certification for the systems
into which our products are integrated may be required. The International Standards
Organization is in the process of approving industry standards regulating the transfer of
data between contactless smart cards and a reader. If there is a change in government
regulations or industry standards, we may have to make significant modifications to our
products and, as a result, could incur significant costs and may be unable to deploy our
products in a timely manner.

In
addition, prior to purchasing our products, some customers may require us to receive or
obtain a third party certification, or occasionally certify ourselves, that our products
can be integrated successfully into their systems or comply with applicable regulations.
Receipt of third party certifications may not occur in a timely manner or at all. In some
cases, in order for our products, or for the system into which they are integrated, to be
certified, we may have to make significant product modifications. Failure to receive third
party certifications could render us unable to deploy our products in a timely manner or
at all.

9

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OUR PRODUCTS MAY CONTAIN DEFECTS THAT
ARE ONLY DISCOVERED AFTER THE PRODUCTS HAVE BEEN DEPLOYED. THIS COULD HARM OUR REPUTATION,
RESULT IN LOSS OF CUSTOMERS AND REVENUES AND SUBJECT US TO PRODUCT LIABILITY CLAIMS.

Our
products are highly technical and deployed as part of large and complex projects. Because
of the nature of our products, they can only be fully tested when fully deployed. For
example, the testing of our parking payment product required the distribution of sample
parking payment cards to drivers, installation of electronic kiosks at which a card holder
can increase the balance on his or her card, linking of kiosks to financial and parking
databases, collection of data through handheld terminals, processing of data that is
collected by the system, compilation of reports and clearing of parking transactions. Any
defects in our products could result in:

| |  | harm
to our reputation;
| | - | -----------------------

| |  | loss
of, or delay in, revenues;
| | - | -------------------------------

| |  | loss
of customers and market share;
| | - | -----------------------------------

| |  | failure
to attract new customers or achieve market acceptance for our products; and
| | - | -----------------------------------------------------------------------------------

| |  | unexpected
expenses to remedy errors.
| | - | -------------------------------------

In
addition, we could be exposed to potential product liability claims. While we currently
maintain product liability insurance, we cannot assure you that this insurance will be
sufficient to cover any successful product liability claim. Any product liability claim
could result in changes to our insurance policies, including premium increases or the
imposition of a large deductible or co-insurance requirements. Any product liability claim
in excess of our insurance coverage would have to be paid out of our cash reserves.
Furthermore, the assertion of product liability claims, regardless of the merits
underlying the claim, could result in substantial costs to us, divert managements
attention away from our operations and damage our reputation.

TERRORIST ATTACKS MAY HAVE A MATERIAL
ADVERSE EFFECT ON OUR OPERATING RESULTS.

Terrorist
attacks and other acts of violence or war may affect the financial markets on which our
ordinary shares trade, the markets in which we operate, our operations and profitability
and your investment. These attacks or subsequent armed conflicts resulting from or
connected to them may directly impact our physical facilities or those of our suppliers or
customers. Furthermore, these terrorist attacks may make travel and the transportation of
our supplies and products more difficult and/or expensive and ultimately affect the
results of our operations.

# RISKS RELATED TO OUR
ORDINARY SHARES

OUR SHARE PRICE HAS FLUCTUATED IN THE
PAST AND MAY CONTINUE TO FLUCTUATE IN THE FUTURE.

The
market price of our ordinary shares has experienced significant fluctuations and may
continue to fluctuate significantly. The market price of our ordinary shares may be
significantly affected by factors such as the announcements of new products or product
enhancements by us or our competitors, technological innovations by us or our competitors
or quarterly variations in our results of operations. In addition, any statements or
changes in estimates by analysts covering our shares or relating to the smart card
industry could result in an immediate effect, that may be adverse to the market price of
our shares.

Trading
in shares of companies listed on the NASDAQ National Market in general and trading in
shares of technology companies in particular has been subject to extreme price and volume
fluctuations that have been unrelated or disproportionate to operating performance. These
factors may depress the market price of our ordinary shares, regardless of our actual
operating performance.

Securities
litigation has also often been brought against companies following periods of volatility
in the market price of its securities. In the future, we may be the target of similar
litigation that could result in substantial costs and diversion of our managements
attention and resources.

10

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OUR SHARE PRICE COULD BE ADVERSELY
AFFECTED BY FUTURE SALES OF OUR ORDINARY SHARES.

As
of May 22, 2006, we have outstanding 15,251,367 ordinary shares, warrants to purchase
2,165,073 additional ordinary shares at a weighted average exercise price of $14.02 per
share and options to purchase 967,462 additional ordinary shares at a weighted average
exercise price of $9.48 per share. During 2005, we filed several registration statements
registering the resale of a total of 5,926,467 ordinary shares, including ordinary shares
issuable upon exercise of options and warrants. We may in the future sell or issue
additional ordinary shares. The market price of our ordinary shares could drop as a result
of sales of substantial amounts of our ordinary shares in the public market or the
perception that such sales may occur, including sales or perceived sales by our directors,
officers or principal shareholders. These factors could also make it more difficult to
raise additional funds through future offerings of our ordinary shares or other
securities.

IF OUR ORDINARY SHARES ARE EVER
CONSIDERED A PENNY STOCK, ANY INVESTMENT IN OUR ORDINARY SHARES WILL BE CONSIDERED A
HIGH-RISK INVESTMENT AND BECOME SUBJECT TO RESTRICTIONS ON MARKETABILITY.

If
the bid price of our ordinary shares falls below $5.00 and we fail to maintain our NASDAQ
listing, our ordinary shares may be deemed a penny stock for the purposes of
the Exchange Act. The bid price of our ordinary shares as of MAY 18, 2006 was $10.28 but
was less than $5.00 from February 26, 2003 until October 22, 2003. We continue to maintain
our NASDAQ listing. Brokers effecting transactions in a penny stock are subject to
additional customer disclosure and record keeping obligations. The additional obligations
include disclosure of the risks associated with low price stocks, stock quote information
and broker compensation. In addition, brokers making transactions in penny stocks are
subject to additional sales practice requirements under the Exchange Act. These additional
requirements include making inquiries into the suitability of penny stock investments for
each customer or obtaining the prior written agreement of the customer for the penny stock
purchase. Because of these additional obligations, some brokers will not effect
transactions in penny stocks. If our shares are deemed a penny stock in the
future, this designation could have an adverse effect on the liquidity of our ordinary
shares and your ability to sell our ordinary shares.

OUR SHAREHOLDERS COULD EXPERIENCE
DILUTION OF THEIR OWNERSHIP INTEREST BY REASON OF OUR ISSUING MORE SHARES THAT ARE
PURCHASED BY THIRD PARTIES.

Under
Israeli law, shareholders in public companies do not have preemptive rights. This means
that our shareholders do not have the legal right to purchase shares in a new issue before
they are offered to third parties. In addition, our board of directors may approve the
issuance of shares in many instances without shareholders approval. As a result, our
shareholders could experience dilution of their ownership interest by reason of our
raising additional funds through the issuance of more shares that are purchased by third
parties. The weighted average price per share at which we sold shares during 2004 and
during 2005 was $11.64 and $11.62, respectively. In addition, we may continue to acquire
companies or businesses in exchange for our shares, resulting in dilution of your
shareholding.

WE DO NOT ANTICIPATE PAYING CASH
DIVIDENDS IN THE FORESEEABLE FUTURE.

We
have never declared or paid cash dividends and we do not anticipate paying cash dividends
in the foreseeable future. We intend to retain all future earnings to fund the development
of our business. In addition, if we would receive benefits under Israeli law for our
Approved Enterprises, payment of a cash dividend may create additional tax
liabilities for us.

OUR CONCENTRATION OF VOTING POWER
WILL LIMIT YOUR ABILITY TO INFLUENCE OR CONTROL CORPORATE ACTIONS.

Oded
Bashan currently has the right to vote approximately 19.9% of our outstanding shares by
reason of his ownership of 813,171 of our outstanding shares and his holding proxies to
vote 2,212,891 additional ordinary shares that are owned by others. He therefore has
substantial voting power in comparison to our other shareholders and, accordingly, his
vote in the shareholders meetings may influence the outcome of such meetings.

11

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WE HAVE NOT YET EVALUATED OUR
INTERNAL CONTROL OVER FINANCIAL REPORTING IN COMPLIANCE WITH SARBANES-OXLEY ACT.

We
are required to comply with the internal control evaluation and certification requirements
of Section 404 of the Sarbanes-Oxley Act by no later than the end of our 2006 fiscal year.
We have begunthe process of determining whether our existing internal controls
over financial reporting systems are in compliance with Section 404. This process may
divert internal resources and will take a significant amount of time and effort to
complete. If it is determined that we are not in compliance with Section 404, we may be
required to implement new internal control procedures and reevaluate our financial
reporting. We may experience higher than anticipated operating expenses as well as higher
consulting fees during the implementation of these changes and thereafter. Further, we may
need to hire additional qualified personnel in order for us to be compliant with Section
404. If we are unable to implement these changes effectively or efficiently, it could harm
our operations, financial reporting or financial results and could result in our being
unable to obtain an unqualified report on internal controls from our independent
registered public accounting firm.

FOLLOWING THE IMPLEMENTATION OF SFAS
NO. 123R, WE ARE REQUIRED TO RECORD A COMPENSATION EXPENSE IN CONNECTION WITH SHARE-BASED
COMPENSATION, AND, AS A RESULT, OUR PROFITABILITY MAY BE REDUCED SIGNIFICANTLY.

On
December 16, 2004, the Financial Accounting Standards Board, or FASB, issued Statement No.
123 (revised 2004), Share-Based Payment, or SFAS No. 123(R), which is a revision of SFAS
No. 123. Generally, the approach in SFAS No. 123(R) is similar to the approach described
in SFAS No. 123. However, SFAS No. 123 permitted, but did not require, share-based
payments to employees to be recognized based on their fair values while SFAS No. 123(R)
requires, as of the first quarter of 2006, all share-based payments to employees to be
recognized as a compensation expense based on their fair values. SFAS No. 123(R) also
revises, clarifies and expands guidance in several areas, including measuring fair value,
classifying an award as equity or as a liability and attributing compensation cost to
reporting periods. The impact of the adoption of SFAS No. 123(R) cannot be predicted at
this time because it will depend also on levels of share-based compensation granted in the
future. Had we adopted this standard in prior periods, however, we would have recorded a
material amount as compensation expense, which would have had a material adverse effect on
our results of operations. The adoption of this standard could have a significant adverse
impact on our results of operations, although we do not expect it will have any impact on
our overall financial position. In addition, if as a result of SFAS No. 123(R) we would
stop or limit the use of stock options as an incentive and retention tool, it could have
an adverse effect on our ability to recruit and retain employees.

# RISKS RELATED TO ISRAEL

CONDITIONS IN ISRAEL MAY HARM OUR
ABILITY TO PRODUCE AND SELL OUR PRODUCTS AND SERVICES AND MAY ADVERSELY AFFECT OUR SHARE
PRICE.

We
are incorporated under the laws of the State of Israel, our principal executive offices
and research and development facilities, as well as some of our suppliers, are located in
Israel. Political, economic and military conditions in Israel directly affect our
operations. Since the establishment of the State of Israel in 1948, a number of armed
conflicts have taken place between Israel and its Arab neighbors. A state of hostility,
varying in degree and intensity, has led to security and economic problems for Israel.
Despite the progress towards peace between Israel and its Arab neighbors, the future of
these peace efforts remains uncertain. Since October 2000, there has been a substantial
deterioration in the relationship between Israel and the Palestinian Authority and a
significant increase in violence, primarily in the West Bank and Gaza Strip. The ongoing
violence between Israel and the Palestinians or any future armed conflicts, political
instability or continued violence in the region would likely have a negative effect on our
business condition, harm our results of operations and adversely affect the share price of
publicly traded Israeli companies such as us. In addition, Israels economy has been
subject to numerous destabilizing factors, including a period of rampant inflation in the
early to mid-1980s, low foreign exchange reserves, fluctuations in world commodity prices,
military conflicts and civil unrest. Furthermore, several countries still restrict
business with Israel and Israeli companies, which may limit our ability to make sales in
those countries. These restrictions may have an adverse impact on our operating results,
financial condition or the expansion of our business.

12

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OUR OPERATIONS COULD BE DISRUPTED AS
A RESULT OF THE OBLIGATION OF KEY PERSONNEL TO PERFORM ISRAELI MILITARY SERVICE.

Some
of our executive officers and employees must perform annual military reserve duty in
Israel and may be called to active duty at any time under emergency circumstances. Our
operations could be disrupted by the absence for a significant period of one or more of
our executive officers or other key employees due to military service. Any disruption to
our operations would harm our business.

THE ISRAELI GOVERNMENT PROGRAMS AND TAX BENEFITS IN WHICH WE CURRENTLY PARTICIPATE OR WHICH WE CURRENTLY
RECEIVE REQUIRE US TO MEET SEVERAL CONDITIONS AND MAY BE TERMINATED OR REDUCED IN THE
FUTURE. THIS COULD INCREASE OUR COSTS OR TAXES.

We
are entitled to certain tax benefits under Israeli government programs, largely as a
result of the Approved Enterprise status granted to some of our capital
investment programs by the Israeli Ministry of Industry and Trade. Taxable income derived
from each program is tax exempt for a period of ten years beginning in the year in which
the program first generates taxable income, up to 14 years from the date of approval or 12
years from the date of the beginning of production. Without such benefits our taxable
income from such programs would be taxed at the regular corporate tax rate (31% in 2006,
29% in 2007, 27% in 2008, 26% in 2009 and 25% in 2010 and thereafter). To maintain our
eligibility for these tax benefits, we must continue to meet conditions, including making
specified investments in property, plants and equipment, 30% of which must be from paid-in
capital. We cannot assure you that we will continue to receive these tax benefits at the
same rate or at all. From time to time, we submit requests for expansion of our approved
enterprise programs. These requests might not be approved. The termination or reduction of
these programs and tax benefits could increase our taxes and could have a material adverse
effect on our business.

BECAUSE WE RECEIVED GRANTS FROM THE
ISRAELI OFFICE OF THE CHIEF SCIENTIST, WE ARE SUBJECT TO ONGOING RESTRICTIONS.

We
received royalty-bearing grants from the Office of the Chief Scientist of the Israeli
Ministry of Industry, Trade and Labor, or the OCS, for research and development programs
that meet specified criteria. We are obligated to pay royalties with respect to the grants
received. In addition, the terms of the OCS grants limit our ability to manufacture
products or transfer technologies outside of Israel if such products or technologies were
developed using know-how developed with or based upon OCS grants. Pursuant to the Israeli
Encouragement of Research and Development in the Industry Law, we and any non-Israeli who
becomes a holder of 5% or more of our share capital are generally required to notify the
OCS and such non Israeli shareholder is required to undertake to observe the law governing
the grant programs of the Chief Scientist, the principal restrictions of which are the
transferability limits described above.

IT MAY BE DIFFICULT TO ENFORCE A
UNITED STATES JUDGMENT AGAINST US, OUR OFFICERS AND DIRECTORS OR TO ASSERT UNITED STATES
SECURITIES LAW CLAIMS IN ISRAEL.

We
are incorporated in Israel. Most of our executive officers and directors are non residents
of the United States and a substantial portion of our assets and the assets of these
persons are located outside of the United States. Therefore, it may be difficult for an
investor, or any other person or entity, to enforce a United States court judgment based
upon the civil liability provisions of the United States federal securities laws in an
Israeli court against us or any of these persons or to effect service of process upon
these persons in the United States. Additionally, it may be difficult for an investor, or
any other person or entity, to enforce civil liabilities under United States federal
securities laws in original actions instituted in Israel.

13

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PROVISIONS OF ISRAELI LAW MAY DELAY,
PREVENT OR MAKE UNDESIRABLE AN ACQUISITION OF ALL OR A SIGNIFICANT PORTION OF OUR SHARES
OR ASSETS.

Israeli
Companies Law regulates acquisitions of shares through tender offers, requires special
approvals for transactions involving shareholders holding 5 percent or more of the
Companys capital, and regulates other matters that may be relevant to these types of
transactions. These provisions of Israeli law could have the effect of delaying or
preventing a change in control and may make it more difficult for a third party to acquire
us, even if doing so would be beneficial to our shareholders. These provisions may limit
the price that investors may be willing to pay in the future for our ordinary shares.
Furthermore, Israeli tax considerations may make potential transactions undesirable to us
or to some of our shareholders.

|ITEM 4. |  | INFORMATION ON THE COMPANY
|------- |  | --------------------------

|A. | HISTORY
AND DEVELOPMENT OF THE COMPANY
|-- | --------------------------------------

We
were incorporated under the laws of the State of Israel on February 15, 1990, under the
name of De-Bug Innovations Ltd. Our name was changed to On Track Innovations Ltd. on July
8, 1991.

Our
address is Z.H.R Industrial Zone, Rosh-Pina 12000, Israel. Our telephone number is
011-972-4-686-8000. In 1998 we established a wholly-owned subsidiary in the United States,
OTI America, Inc., a New Jersey corporation. OTI America, Inc. is located at 2 Executive
Drive Suite 740, Fort Lee, New Jersey 07024, and its telephone number is (201) 944-3233.
Copies of this annual report and certain other documents referred to herein can be
obtained on our website, www.otiglobal.com, or upon request from our Director of Corporate
Communication, Ms. Galit Mendelson, at the following telephone number: (201) 944-5200
(#111). The information on our website is not incorporated into this annual report.

On
December 30, 1999, we acquired all of the outstanding shares of City Smart Ltd., a
Hong-Kong based systems integrator in exchange for 6,686 of our ordinary shares (which, as
of that date, had an aggregate market value of approximately $451,300). On January 28,
2000, we acquired all of the outstanding shares of SoftChip Israel Ltd. and SoftChip
Technologies (3000) Ltd., each an Israel-based developer and designer of microprocessors
and operating systems for smart cards, in exchange for 12,119 of our ordinary shares
(which, as of that date, had an aggregate market value of approximately $1.3 million). On
February 2, 2000, we entered into an agreement with an indirect wholly-owned subsidiary of
Cheung Kong Infrastructure Ltd., a Hong Kong-based infrastructure company, to establish
the e-Smart System joint venture in Hong Kong to, among other things, be the exclusive
distributor for our products in Greater China. In connection therewith, we contributed
$3.1 million to the joint venture. This joint venture acquired the assets of City Smart
Ltd. in 2001. On June 15, 2000 and in January 2001, we acquired 51% and the remaining 49%,
respectively, of the nominal share capital of two related German companies, Intercard
Kartensysteme GmbH and InterCard Systemelectronic GmbH, the former of which is a systems
integrator for smart card systems and the latter of which is a manufacturer of electronic
devices, for an aggregate purchase price of $5.8 million. In June 2004, we sold our 50%
stake in our e-Smart System joint venture to our partner. On October 1, 2004 we completed
the acquisition of ASEC, a Polish company that develops, manufactures and markets card
readers and reader modules, for a purchase price of approximately $1.6 million, which was
paid through the issuance of 186,264 of our ordinary shares. In addition, the ASEC share
purchase agreement provides for the payment of up to an additional $350,000 to Nextel in
the event that specified performance criteria are met by ASEC for the years ended December
31, 2004 and 2005. In June 2005, we issued 14,298 of our ordinary shares in consideration
for $175,000 to be paid to Nextel based on the said performance criteria. Based on
ASECs 2005 results, the Company did not incur any further liability in connection
with the earn-out formula. In October 2004, we sold our InterCard Kartensysteme subsidiary
for approximately $2.5 million. In July 2005, we completed the acquisition of POI, a Hong
Kong company that develops and manufactures machinery used to create smart cards inlays
for smart cards and other products, as well as to manufactures contact and contactless
smart cards themselves, and substantially the assets of POE relating to the design and
manufacture of machinery for the manufacture of smart cards, for an aggregate purchase
price of approximately $1 million, which was paid through the issuance of 82,229 of our
ordinary shares. In July 2005, we also completed the acquisition of 71.5% of e-Pilot, a
Hong Kong-based company that develops, manufactures and markets smart card inlays for
smart cards and other products, for a purchase price of $661,000, which was paid through
the issuance of 52,572 of our ordinary shares. During 2005, we also established an
affiliated company together with an Asian government entity, in the form of joint venture,
for the manufacture and sale of OTI-based travel document inlays for such government. The
appropriate foreign governments entities approved the establishment of the joint
venture. As of December 31, 2005, the affiliated company as not yet commenced its
operations. In May 2006, we completed the acquisition of InSeal SAS, a French Company
that provides an operating system for contactless applications to a variety of customers
in the payments market, for a total of 243,800 of our ordinary shares and 180,000
warrants. The warrants, which have a nominal exercise price, become exercisable in four
equal annual installments.

14

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For
additional information concerning these transactions, see
C.  Organizational Structure below, and Note 5 to our consolidated
financial statements included elsewhere in this annual report.

|B. | BUSINESS
OVERVIEW
|-- | -----------------

# General

Since
our incorporation in 1990, we have designed, developed and sold contactless
microprocessor-based smart card products. Because our cards contain a microprocessor, they
can store and process information and run multiple applications. Our cards are referred to
as contactless because they do not require physical contact with a card
reader, as power and data are transferred to a card through a magnetic field generated by
a card reader. Our products combine the benefits of both microprocessors and contactless
cards. We believe that we are one of the first companies to deploy contactless
microprocessor-based smart card products for commercial use. In addition to contactless
microprocessor-based smart cards, we also sell products that are based on other card
technologies.

Since
our incorporation in 1990, we have focused on the development of our core technologies and
our OTI Platform-based products. We currently offer three lines of products, each of which
constitutes a complete system, as well as components (such as smart cards and readers)
that we sell to original equipment manufacturers, or OEMs, for incorporation into their
own products. Our three complete system product lines include:

| |  | Micropayments
Solutions, offers financial institutions a cashless system and loyalty
program to replace cash; including the PayPass system that we are installing for
MasterCard, our EasyPark system and our mass transit payment system;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Petroleum
Systems, OTIs EasyFuel is a wireless, cashless, cardless, and
paperless fuel management and petroleum solution; including both our gasoline management
system, or GMS, and our EasyFuel systems; and
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Smart
ID Solutions, for credentialing, identification and verification of
individuals combine the capability to support biometric identification with the
portability of smart cards.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Substantially
all of our contactless microprocessor-based products are based on a common platform which
we refer to as the OTI Platform. The OTI Platform combines our patented technologies and
consists of our smart cards, our smart card readers, software that enables the development
of applications for the smart card and a communications technology that ensures that the
transmission of data to and from the card is secure and reliable. The OTI Platform can be
customized to support a large number of applications, such as credit and debit card
functions, identification and loyalty programs. The OTI Platform has been deployed in
different markets, such as petroleum, mass transit and e-passport/national ID, and is
being developed for other markers, such as medical services. For some markets, we have
developed extensively customized hardware and software systems based on our OTI Platform,
such as the petroleum payment and management solution for fleet managers and an electronic
parking payment system.

Our
products offer the following benefits:

| |  | The
information stored on a card and transferred between the card and the reader is secure.
| | - | -------------------------------------------------------------------------------------------

| |  | Our
products provide for a reliable transfer of information to and from a card.
| | - | -------------------------------------------------------------------------------

| |  | Our
cards are durable, easy to use and take a variety of forms, including credit card size
solutions, key chains, tags, stickers and wristwatches.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Our
products are easy to install and maintain.
| | - | ----------------------------------------------

15

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| |  | Our
products enable the transition from other card technologies to our contactless
microprocessor-based technology.
| | - | -------------------------------------------------------------------------------------------------------------------

| |  | Our
products support multiple, independent applications on the same card.
| | - | -------------------------------------------------------------------------

We
intend to enhance our position in the design and development of contactless
microprocessor-based smart card products by developing new applications for our
technology. We also intend to enter new markets, either alone or through relationships
with other parties, such as MasterCard International and BP (formerly known as British
Petroleum), and we aim to generate additional revenues from transaction fees and ongoing
payments for customer support.

We
market our technologically advanced products through our global network of subsidiaries
and strategic relationships. Our sales and marketing efforts are directed from our U.S.
subsidiary, OTI America, Inc., located in Fort Lee, New Jersey, and carried out through
our subsidiaries in Israel, America, Europe, Africa and the Far-East.

Industry Background

# What is a smart card?

Plastic
cards that contain a semiconductor chip are generally referred to as smart
cards. Smart card technologies were first developed in response to the limitations
of the magnetic strip commonly used in most credit and debit cards, telephone cards and
hotel room access cards. Smart cards store larger amounts of information than magnetic
strip cards. They can also update this information and store it more securely than a
magnetic strip card can. Depending on the complexity of the chip that a smart card
contains, some smart cards can process the stored information and support more than one
application. For example, smart cards can act as a substitute for cash by storing a cash
balance on the card that may later be reduced or increased. The same card can also store
information identifying its holder.

# What is a smart card
system?



A
smart card system is comprised of a smart card, a reader that transmits and receives data
from the smart card, and a computer that processes data received from the reader. A reader
housed in a protective casing is known as a terminal. Many terminals today are designed
for contact smart cards. These terminals rely on physical contact between the
card and the reader and contain a slot into which the smart cards are inserted or through
which they are swiped. Most smart cards today are credit card-sized plastic cards.
However, with the introduction of contactless smart cards that do not need any
physical contact with a reader, and the form which smart cards and readers take can vary
widely.

16

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# Types of smart card chips

The
type of semiconductor chip on a smart card determines the amount of information and the
number and complexity of applications that can be provided by the card, or how
smart the card is. In todays market, there are three primary types of
chips. From the least technologically advanced to the most technologically advanced, they
are as follows:

Memory
chip. The most basic type of chip used in smart cards is the memory chip. Smart cards
containing memory chips are more advanced than magnetic strip cards because they can store
larger amounts of data. Like magnetic strip cards, however, memory chips are not capable
of processing the stored information. An external reader extracts the data stored on a
memory chip card which is then transferred to an external computer system where it is
processed. Updated information is then transferred back to the reader and then to the
card. The most common memory card application is a disposable prepaid telephone card.

Application
Specific Integrated Circuit, or ASIC, chip. An ASIC chip can store data and perform
limited pre-determined data processing tasks. It cannot be reprogrammed once created.
ASIC-based chips are primarily used for applications that require limited processing
capabilities and lower levels of security, such as premises access control and mass
transit.

Microprocessor
chip. Unlike ASIC chips, microprocessor chips can be reprogrammed after being
manufactured. Microprocessor chips can also run more applications and perform more complex
calculations than ASIC chips. The difference between an ASIC-based smart card and a
microprocessor-based smart card can be analogized to the difference between a calculator
and a personal computer. A calculator is typically programmed at the time of manufacture
to perform only a limited number of functions, and like an ASIC-based smart card, these
functions cannot subsequently be changed. A personal computer has an operating system that
can run many different applications, and like a microprocessor-based smart card, these
applications can be modified and added to a personal computer.

Microprocessors
can process information using a formula, or algorithm, with a great number of variables,
whereas ASIC chips can only repeat a fixed algorithm with a limited number of variables.
Therefore, data stored on a microprocessor chip can be encrypted using a random code that
is difficult to break. As a result, data stored on a microprocessor chip benefits from a
higher level of security than data stored on an ASIC chip. At the same time,
microprocessors require more power than ASIC chips for their operations and are typically
more expensive.

# Contact vs. Contactless

Another
primary distinction between types of smart cards is whether they are contact
or contactless, that is, whether physical contact between the card and the
reader is required in order to transfer data and power between them. When using a contact
card, the cardholder swipes or inserts the card into a slot in the card reader. When
inserted properly, a metallic pad, or contact plate, on the smart card aligns with the
electronic contacts inside the reader, and data and power are transferred across this
connection. By contrast, in contactless smart card systems, power and data are transmitted
through antennas located on the smart card and the reader without making physical contact.

The
developers of contactless microprocessor-based smart cards face the following significant
challenges:

| |  | Support
of ISO standards. The International Standard Organization, or ISO, established standards
regulating the transfer of data between a contactless smart card and its reader, under
the name ISO 14443. Currently, two separate types of standards  Type A and Type B
 have been approved by ISO. Because both standards are currently being used, only
readers that can support both standards offer users the flexibility to use smart cards
based on either standard.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Transfer
of power to the card. Most providers of contactless smart card systems use a technology
called resonant circuitry to create a magnetic field between the card and reader through
which power is transferred to the card. Current limitations of resonant circuitry
technology make this technology impractical for providing sufficient power to a
microprocessor-based smart card in a contactless system.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

17

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| |  | Support
of existing card-based infrastructure. Because of the large existing base of
contact-based systems, there is demand for technologies that can support both contact and
contactless applications with the same equipment. However, combined contact and
contactless cards have traditionally contained two chips, one for use by contact-based
systems and one for use by contactless-based systems. The use of two chips increases the
cost of the card and the likelihood of discrepancies between the information stored on
each chip by different applications. The use of two chips also limits the level of
security to the level offered by the ASIC chip. We believe that the shortcomings of these
dual contact/contactless cards create a need for a single chip that can work with both
contact and contactless systems. There have been attempts, principally by some of the
larger chip manufacturers, to develop a technology that uses a single chip, but we are
unaware of any successful commercial implementation of this technology by anyone other
than us.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Despite
the challenges discussed above, contactless smart cards offer considerable advantages over
traditional contact-based smart cards including:

| |  | Speed.
Transaction time in contactless systems is shorter than in contact systems because it is
not necessary to insert the card in, or swipe it through, a reader or otherwise position
it in any specific direction. As a result, for systems that need to handle a large number
of users over a short period of time, such as mass transit systems, contactless systems
provide considerable time savings when aggregated over a large number of users while
users save time on each of their transactions.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Convenience.
Contactless systems simplify the way transactions are executed. For example, a shopper
can pay for goods in a retail outlet simply by positioning a wallet containing a
contactless smart card in close proximity to a reader positioned at the check-out,
without the need to withdraw the card from the wallet.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Variety
of forms. Because contactless smart cards do not need to fit into a slot in a reader,
they can take a wider array of forms desired by smart card users and providers, such as
key chains, tags, wristwatches and other forms.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Maintenance
costs of contactless smart card systems are lower than maintenance costs for contact
systems since the components can be shielded in a protective casing, and the readers and
the cards are not subject to friction caused by inserting the card into, or swiping it
through, a reader. Moreover, contactless smart card readers do not contain moving parts
such as the contact plates in contact-based systems that are subject to wear and tear. As
a result, contactless systems can operate under harsher conditions and have longer lives
than contact systems. However, because contactless smart card systems require additional
components, such as antennas in the reader and on the card and other transmission
components at the level of the reader, the up-front costs associated with a contactless
system are higher than the costs associated with a contact-based system.

# The OTI Solution

Our
technology enables microprocessor-based smart card systems to operate in a contactless
environment. This technology is not only available for new systems, but can be integrated
with and upgrade existing contact systems and other contactless systems. Our products have
the benefits discussed below.

| |  | Combining
the advantages of contactless systems and microprocessor-based systems. Our technology
successfully combines the features of microprocessor-based cards and contactless cards
and provides the following benefits to card users and card issuers:
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Features                                                     | Advantages to card users                     | Advantages to card issuers                     
|------------------------------------------------------------ | -------------------------------------------- | -----------------------------------------------
|
|
|
|
|Benefits of contactless cards compared to contact cards      |                                              |                                                
|                                                            
|Faster transaction time                                      | Shorter time to complete a transaction       | More transactions per minute                   
|                                                            
|Cards do not need to be inserted or put into readers         | Easier to use and come in a variety of forms | Lower maintenance costs                        
|                                                            
|Durability                                                   | The card lasts longer                        | Reduce card replacement cost                   
|
|                                                            
|Benefits of microprocessors compared to ASIC or memory chips
|                                                            
|Multiple applications                                        | The card has multiple uses                   | Generates revenues from additional applications
|                                                            
|Enhanced security                                            | Information on the card is more secure       | System is less vulnerable to fraud             

| |  | Ease
of transition from other card systems to contactless microprocessor-based systems. We
provide our customers with an easy upgrade of their existing systems by allowing card
issuers who currently utilize magnetic strip card systems or other contact-based systems
to switch to a contactless system without forcing them to replace their existing
infrastructure. For example, as part of a project for MasterCard PayPass, we upgraded
regular standard point-of-sales and that supported only magnetic stripe to support
contactless microprocessor-based smart cards. We followed by integrating our inlay
solution with plastic card manufacturers to allow quick upgrade from regular credit cards
to contactless operations.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Ease
of transition from contact-based microprocessors to contactless microprocessors. Chip
manufacturers and operating system providers can use our technology to upgrade their off
the- shelf products to support both contact and contactless operations. This can be done
by combining our technology with our customers microprocessor, enabling the
microprocessor to support contact and contactless operations. By applying our patented
hardware, customers can save months of development time and reduce the time to market for
their products.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Support
of multiple standards. Our readers are capable of supporting ISO 14443 Type A and Type B
standards. Because both of these standards are currently being used, we offer users the
flexibility to adopt either standard.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Strategy

Our
goal is to be the leading provider of contactless microprocessor-based smart card
products. Key elements of our strategy for achieving this goal include:

| |  | Enhance
technological position. We intend to continue to invest in research and development in
order to enhance our technological position, develop new technologies, extend the
functionality of our products and services, and offer innovative products to our
customers.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Expand
global market presence. Our sales and marketing effort is currently directed from our
U.S. subsidiary, OTI America, located in Fort Lee, New Jersey. We market our products
through a global network of marketing subsidiaries in Israel, America, Europe, Africa and
the Far-East. We intend to use these entities to strengthen our presence in existing
markets, penetrate new markets, provide local customer service and technical support, and
adapt our products to our local customers specific needs.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Increase
focus on generating high-margin, recurring revenues. We currently derive most of our
revenues from one-time payments for our products and technologies. We intend to generate
additional revenues by receiving service fees for ongoing customer services and technical
support and transaction fees from our customers based on the volume of transactions
effected in systems that contain our products. For example, we have entered into such fee
arrangements with respect to our parking systems in Israel and our gasoline management
systems in South Africa. By reducing customers up-front payments for our products
in return for receiving on-going participation in the revenue they generate for the
customer, we are able to build and maintain long-term relationships with our customers
and generate a constant stream of high-margin, recurring revenues and, at the same time,
provide cost-effective turnkey solutions to our customers.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| |  | Leverage
existing relationships and seek new relationships. We have entered into relationships
with BP (formerly known as British Petroleum), to cover the South African petroleum
market. Recently, the relationship was extended and expanded so that OTI granted BP a
worldwide license for its petroleum payment solution. We have entered into these
relationships in order to facilitate or accelerate our penetration into new markets, as
well as assist us in defining and pursuing new applications for our products. We are
continuously seeking additional relationships to complement our marketing strategy and
promote our brand worldwide.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Leverage
presence in existing industries to enter into new industries. We offer our customers the
ability to add new applications to their smart cards, thereby expanding the number of
industries in which our products are used. For example, users of the gasoline management
system we have sold to BP in South Africa will have in the future the option to add a
payment application to their card. The application will allow them to pay with the card
at convenience stores that install the system and to earn loyalty points every time they
do so. We plan to generate additional revenues through the sale of products required to
add and operate these applications.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Pursue
strategic acquisitions. We plan to pursue acquisitions of companies that enhance our
manufacturing, sales, marketing and research and development capabilities. In this way,
we plan to expand our product offerings and provide more comprehensive service to our
customers. Since our initial public offering in 1999, we have acquired the SoftChip
Group, an Israeli based developer and designer of microprocessors and operating systems
for smart cards, InterCard Systemelectronic, a German company that provides OEM and
electronics manufacturing services, ASEC, a Polish company that develops, manufactures
and markets card readers and reader modules based on radio frequency identification
technologies, 71.5% of e-Pilot, a Hong Kong-based company that develops, manufactures and
markets smart card inlays for smart cards and other products, POI, an engineering company
that develops and manufactures machinery used to create smart cards inlays for smart
cards and other products, and that also manufactures contact and contactless smart cards
themselves, substantially the assets of POE relating to the design and manufacture of
machinery for the manufacture of smart cards, InSeal, a French company providing an operating system for contactless applications for a variety
of customers in the payments market.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Core technologies

Since
our inception in 1990, we have developed technologies that facilitate the transmission of
data and power between a contactless microprocessor-based smart card and a reader. Our
products are based on a number of core technologies, which are discussed below.

Power and data
transmission technology

We
refer to our power and data transmission technology as matched antenna
technology. The power, as well as the data, is transmitted to the microprocessor installed
on the smart card through an electro-magnetic field generated by the reader. Our
technology offers a number of key advantages:

| |  | Contactless
smart cards can be based on microprocessors. In contrast to resonant circuitry
technology, which is the predominant technology used for ASIC-based contactless smart
cards, our matched antenna technology enables a reader to power a standard microprocessor
embedded in the contactless card.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Replacing
one of the components of the smart card system does not require re-tuning the system. In
smart card systems based on resonant circuitry, once a component of the system is
replaced the whole system needs to be re-tuned in order to function properly. This
increases maintenance time and costs. Our technology allows components of the system to
be replaced without any need for re-tuning, providing for easy, cost effective
installation and maintenance of our products.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| |  | The
reader does not need to be installed in close proximity to its antenna. The reader can be
installed at a distance of up to 33 meters, or 100 feet, from the antenna, providing the
ability to install smart card systems in harsh conditions, including potentially
explosive environments such as gasoline stations. In addition, the customer can install
the reader where there is easy access, facilitating installation and maintenance of the
reader.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Antenna interface

Our
antenna interface technology enables a single microprocessor to connect, or interface,
with both contact and contactless readers. We refer to this as a dual
interface feature. This enables customers with existing contact systems to gradually
transition to contactless cards, rather than incurring up-front all the costs of replacing
the contact system with a contactless system. We have developed the following two methods
of implementing our dual interface feature:

| |  | Adding
our antenna interface chip. The chip can be added to standard microprocessor-based
contact cards, allowing the card to operate as a contactless smart card, in addition to
being a contact card. This can be implemented within a relatively short period of up to
three months, which reduces our customers time to market.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Integrating
an antenna interface into the microprocessor. The antenna interface can be integrated
into a microprocessor, which reduces the cost of manufacturing dual interface cards once
manufacturing levels reach significant volumes of chips. At that point, the additional
upfront cost of engineering work required in order to successfully integrate the two
components  the microprocessor and the antenna interface  into one chip, is
offset by the fact that only a single component is required. This is referred to as a
monochip.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

In
1998, our antenna interface, which enables any contact-based microprocessor with any
operating system to work in a contactless environment, was awarded the annual prize of the
European Smart Card Applications and Technology organization for the most innovative
achievement for smart cards in 1997.

21

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Antenna module

Contactless
smart cards require an antenna as a conduit for ingoing and outgoing transmissions of
power and data. Traditional contactless smart cards contain an antenna coil that is
embedded around the edge of the card. The technology for embedding the antenna coil into
the card is complex, creating a barrier for contact smart card manufacturers to transition
to manufacturing contactless smart cards. Our technology eliminates the need to embed the
antenna coil around the edge of the smart card by mounting the antenna on a standard size
platform, or module, into which the microprocessor is embedded. Our technology allows
contactless cards to be produced using existing contact card production processes without
the need for new machinery. This significantly reduces manufacturing costs. In addition,
when a manufacturing infrastructure exists in the local market, shipping costs to the
local market and possibly duties can be reduced.

In
2000, our antenna module was awarded the annual prize of the European Smart Card
Applications and Technology organization for the most innovative achievement for smart
cards in 1999.

Communications technology

We
have developed a unique communications technology that includes:

| |  | a
set of rules, or a protocol, that is designed to ensure that information is properly
transmitted               from the reader to the card, and vice versa;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | an
additional layer of coding that makes the transmission of information more difficult to
intercept               and read; and
| | - | --------------------------------------------------------------------------------------------------------------------------------

| |  | a
technique that reduces the effect of background interference on the quality of the
transmission.
| | - | --------------------------------------------------------------------------------------------------

Microprocessor chip and
operating system design know-how

Through our acquisition of the
SoftChip Group, we have employed personnel skilled in the design of microprocessors and
development of operating systems for smart cards. SoftChip acquired its know-how through
its involvement in the design of microprocessors for smart cards on behalf of leading
microprocessor manufacturers.

# Products

The OTI Platform

Substantially
all of our products are based on a common platform, which we refer to as the OTI Platform.
The OTI Platform combines our patented technologies and consists of:

| |  | smart
cards, which can take a variety of forms including tags, stickers, wristwatches, key
chains               and plastic credit card-sized cards;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------

| |  | smart
card readers;
| | - | -------------------

| |  | software
that enables the development of applications on contactless microprocessor-based smart
              cards; and
| | - | ------------------------------------------------------------------------------------------------------------------------

| |  | a
method of communications that regulates the transmission of data between a contactless
smart card               and a reader.
| | - | -------------------------------------------------------------------------------------------------------------------------------

The
following is a graphical representation of a contactless microprocessor-based smart card
based on the OTI Platform:

22

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All
of these elements work together to provide a foundation, upon which we or our customers
build applications. The transmission of information between the card and the reader in an
OTI Platform-based product is secure and reliable. For example, if communications are
interrupted in the course of a transmission, the information transferred is incomplete,
and the OTI Platform will reject the impaired transmission and require that the
information be re-transmitted. In addition, our OTI Platform ensures that information is
transmitted from the card in an encrypted form only to readers that are authorized to
receive and able to decipher the transmission.

The
OTI Platform supports several types of payment methods including debit and credit
applications, loyalty points and an electronic cash substitute that increases or reduces
the balance on the users card. We refer to these as e-purse applications.

Our Products

Our products consist of:

Payment Solutions.

We
typically design our payment solutions while teaming up with financial institutions and
back office providers. These solutions offer a cashless system and loyalty program for
small purchases, such as fast food, gasoline and movie tickets. Our payment solutions
include the following:

| |  | PayPass.
OTI is supplying key components of the technology for multiple contactless payment
programs, driven by major financial institutions: MasterCard Internationals PayPass program,
Visa contactless program and ExpressPay from American Express.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | E-purse
(Stored Value Cards). We have developed a product that enables a person to load pre-paid
value on a card, which provides float for issuers, while enabling cardholders to pay for
small purchases in environments such as phone booths, vending machines and fast food
restaurants, without the need for exact change.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | As
of the date of this annual report, we have not derived revenues from sales of our E-purse
product.
| | - | -----------------------------------------------------------------------------------------------------

| |  | Parking
payment system. Our electronic parking payment system, which we refer to as EasyPark,
enables drivers to be charged for the exact period of time they are parked and simplifies
the monitoring and collection of parking fees. Drivers are issued contactless
microprocessor-based smart cards, or EasyPark cards, to replace existing parking payment
methods, including parking meters. The EasyPark card stores the amount of money, or the
balance that is available for payment of parking fees. A driver can increase the balance
at special self-service kiosks placed at convenient locations. Compliance with parking
regulations is monitored by inspectors using specially designed hand-held terminals.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

23

---

---



| | In
May 1999, the EasyPark system was selected as the national parking system for Israel.
During 2000, the system was widely implemented throughout Israel. In 2005, The Union of
Local Authorities in Israel extended EasyParks contract for an additional five
years term. The program currently has more than 250,000 subscribers, and is currently in
use in 26 cities across the country. We are currently marketing the EasyPark system
through our global network of subsidiaries.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Mass
transit. We have designed a product that enables efficient fare collection from a large
volume of passengers in various types of mass transportation systems, such as buses and
trains. The smart card serves as the passengers ticket. The chip in the smart card
stores the passengers fare balance and is debited with the fare when the passenger
boards or disembarks. The balance on the smart card can be increased repeatedly. OTI is
marketing this product to system integrators that specialize in mass transit solutions.
For example, we have announced that we are working with Scheidt & Bachmann.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Petroleum Systems.

Our
petroleum systems include EasyFuel and GMS (gasoline management system):

| |  | EasyFuel.
Our wireless petroleum solution is named EasyFuel. EasyFuel incorporates options for
retail and private fleets as well as a pay-at-the-pump solution. The system monitors and
expedites the fueling and payment process through a completely wireless detection and
authorization system. This system is also ideally positioned for the retail petroleum
market by enabling drivers to pay for gasoline at the pump, pay for other services and
products at the gas station and earn loyalty points for these purchases.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | GMS.
GMS records and monitors the identity of the driver and the vehicle, the drivers or
fleets credit status, the vehicles fuel consumption and other information
determined by the customer, such as periodic vehicle maintenance. By processing and
managing this information, GMS allows oil companies and fleet managers to receive billing
information automatically, simplify payment processes, track the use of each vehicle and
reduce the risk of theft or fraud. GMS also enhances the loyalty of fleet drivers and
managers to oil companies operating participating gas stations.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
information is communicated via an antenna in the vehicles gas tank to an antenna
mounted on the fuel nozzle when the fuel nozzle is inserted into the vehicles gas
tank, and is then transferred to the gas station computer. Disengaging the nozzle from
the gas tank will immediately turn off the pump.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
following diagram illustrates a typical GMS system:
| | -------------------------------------------------------



| | We
commenced sales of GMS in 1995. GMS is being used by a number of petroleum companies,
such as BP South Africa in Africa, Turcas in Turkey and Mobil in Ecuador. As of December
31, 2005, a total of approximately 900 gas stations have been equipped with GMS,
including in South Africa, Turkey and Ecuador, and we have delivered GMS equipment for
approximately 105,000 vehicles.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

24

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Smart ID Solutions.

Our
smart identification products combine the portability of smart cards with the capability
to support advanced identification and authentication technology and manage significant
amounts of information. Our smart identification products include the following:

| |  | e-passport/National
ID. We have developed a product that supports advanced authentication methods developed
by other companies. Authentication methods are required by governments for identification
documentation. Biometric identification involves inputting data regarding the physical
characteristics of the smart card holder, such as his fingerprints or facial impression,
into the smart card. This data is stored in the smart card and compared with the actual
characteristics of the smart card holder when the card is presented for identity
validation. This enables governments to transition from paper-based national
documentation systems to a more cost-effective paperless identification system,
encompassing multiple forms of government identification such as passports, national
identification cards, drivers licenses and national health cards. In addition, we
have incorporated our antenna module into a sticker. The sticker can be attached to
existing paper documentation, thus converting it into a contactless smart card.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Israeli government selected our technology and products for use in a system controlling
passage between Israel and areas governed by the Palestinian Authority which will be
supplied by Electronic Data Systems.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Recently,
we announced that we established together with a government entity of a major Asian
country, a joint venture for the manufacture and sale of OTI-based travel document inlays
for such government.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | MediSmart.
Our MediSmart product is designed to secure, process and manage medical information by
providing doctors and hospital administrators with information regarding the patients
identity, medical history, insurance coverage and payment history. This information can
be automatically updated after each treatment. Treatment information can be automatically
transferred to the insurance providers computer system. This product reduces costs
to medical providers, provides increased security for a patients medical history
and improves the quality and speed of service to patients. We began field tests of the
product in South Africa in 2003 and the product was successfully deployed in June 2004 by
CareCross Health, the leading primary healthcare provider in South Africa.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Technology licensing

In
2003, we entered into an agreement with Atmel Corporation for the purpose of collaborating
on the development of Mastercards PayPass contactless payment program.
Atmel was selected by MasterCard to supply the secure contactless microcontroller. Under
the agreement, Atmel has partnered with us to provide contactless solution expertise for
PayPass, including the operating system, application support and inlay
technology. The agreement may be terminated by either party in the event of a breach of
the agreement by, or the commencement of a bankruptcy, receivership or liquidation
proceeding involving, the other party.

In
2005, we partnered with STMicroelectronics to supply Visa International with a contactless
payment solution. Under the agreement, STMicroelectronics provides the contactless
microcontroller and OTI provides the operating system and application, the contactless
card technology including the inlay technology,

# Customer service and
technical support

We
provide our customers with training and installation support and ongoing customer service
and technical support through our global network of subsidiaries. We have a support team
of twenty one employees consisting of ten employees located in our corporate headquarters
in Rosh Pina, Israel, four employees in Africa, three employees in the United States and
four employees in Europe. Our customer service team in Rosh Pina, Israel provides central
services to our network of local subsidiaries. The subsidiaries, in turn, provide 24-hour
customer support to our customers, through telephone and email for an ongoing fee. On-site
technical support is provided to customers for a fee.

25

---

---



# Customers

We
sell our products to systems integrators and service providers. Our customers can be
divided into the following groups:

| |  | Systems
integrators. Systems integrators incorporate our products into their systems, which
theythen sell to service providers and install for use in a specific project.
Some of thesesystems integrators also market and distribute our products. We
derived $3.6 million (or 18%)of our revenues in 2001, $3.9 million (or 22%) of
our revenues in 2002, $5.5 million (or 28%)of our revenues in 2003, $3.7 million
(or 16%) of our revenues in 2004, and $3.1 million (or9%) of our revenues in 2005
from sales to systems integrators.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Service
providers. Service providers include companies and government agencies that offer
smartcard services to end-users who are their customers. We derived $16.3 million
(or 82%) of ourrevenues in 2001, $14.1 million (or 78%) of our revenues in 2002,
$14.1 million (or 72%) of ourrevenues in 2003, $19.4 million (or 84%) of our
revenues in 2004 and $32.6 million (or 91%) ofour revenues in 2005 from sales to
service providers.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Sales and marketing

We
have built a global network of subsidiaries through which we sell and market our products.
As of December 31, 2005, we had a total sales and marketing staff of 31 employees in five
locations. We market our products in the Americas through OTI America, which employs four
people in sales and marketing. In Africa we sell and market through OTI Africa, which
employs eight people in sales and marketing. In Europe, we sell and market through
InterCard Systemelectronic and ASEC, which together employ nine people in sales and
marketing. In Israel, we sell and market through our headquarters in Rosh Pina, which
employs four people in sales and marketing. In the Far-East, we sell and market through
POI and e-Pilot Group, which together employ six people in sales and marketing. Our sales
and marketing staff implements marketing programs to promote our products and services and
enhance our global brand recognition. Our current marketing efforts include participation
in trade shows and conferences, press releases, updating our web site, conducting speaking
engagements and advertising in industry publications. We also conduct technical seminars
to inform customers, distributors and other industry participants of the benefits of our
products and technologies.

Some
of the independent systems integrators to which, for their own use, we sell our products
also act as distributors for our products. We have granted some of our systems integrators
exclusive distribution rights within a particular country or region. We generally
guarantee exclusivity only if certain sales targets are met.

# Seasonality

Our
revenues are subject to seasonal fluctuations related to the slowdown in spending
activities and the increased activity related to the year-end purchasing cycles of many
end-users of our products. Hence, our sales and profits in the fourth quarter of every
year tend to be higher than in other quarters, particularly the first and second quarters
of each year. We anticipate that we will continue to experience quarter-to-quarter
seasonal fluctuations.

# Manufacturing

External manufacturers
and suppliers

We
currently purchase substantially all of the hardware and software components of our
products from third-party suppliers and outsource substantially all of the manufacturing
and assembling of our products to manufacturing subcontractors. This allows us to focus
our resources on the design, development and marketing of our products. We have not
entered into long-term supply contracts. Instead, we purchase components on a purchase
order basis. Our policy is to use more than one supplier and manufacturing subcontractor
for each part of our production process in order to limit over-dependence on any one
supplier or manufacturer.

26

---

---



Smart cards.

| |  | Microprocessors.
The current suppliers of microprocessors for our smart cards areSTMicroelectronics
and Atmel. In addition, we have jointly developed with Samsung a monochipthat
integrates our antenna interface with Samsungs microprocessor.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Modules.
A module is a silicon plate into which the components of a microprocessor are embedded.The microprocessor module and the antenna module on which the microprocessor and
antennainterface are mounted are manufactured in Europe and South East Asia.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Packaging.
We package the components for our smart cards in a variety of forms, including keychains,
tags, stickers and cards. The key chains, tags and stickers containing ourmicroprocessor
and antenna modules are manufactured in China and in Europe. Our creditcard-sized
smart cards are manufactured in Korea, China, Thailand and the United States.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Readers.
We purchase off-the-shelf components for our readers from various suppliers includingInfineon,
Motorola, AMD and National Semiconductor. The readers are assembled for us inGermany,
mainly by our wholly-owned subsidiary InterCard Systemelectronic.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Operating
systems.

We
have developed the Hercules Operating System, a scaleable multi-application operating
system. The design of OTIs Hercules Operating System is a reflection of high demands
with regard to functionality, security, flexibility, maintenance and performance.

Quality
control.

We
maintain strict internal and external quality control processes. We require that the
facilities of our suppliers and manufacturing subcontractors be ISO 9001:2000 certified.
ISO 9001:2000 refers to a quality assurance model established by ISO for companies that
design, produce, install, inspect and test products.

Internal
manufacturing capabilities.

We
currently package, test and encode our readers at our production facility in Rosh Pina,
Israel. Our packaging and testing facilities are ISO 9001:2000 certified. In Rosh Pina, we
also incorporate modules into credit card-sized contactless smart cards.

InterCard
Systemelectronic, our wholly-owned German subsidiary, owns a manufacturing facility in
Germany for electronic devices primarily for the transportation industry and card
terminals. We also manufacture card readers at the facilities of InterCard
Systemelectronic.

We
have granted our former joint venture, e-Smart, an option to manufacture smart cards using
our technology for sale in Greater China. We will retain exclusive rights to our
technology and any smart cards manufactured by e-Smart will be required to contain modules
manufactured by us. We are entitled to receive royalties at the rates described in the
amendment to the distribution agreement, for smart cards manufactured by e-Smart.

# Government regulation

Some
of our products are subject to government regulation in the countries in which they are
used. For example, card readers that are used in the United States require certification
of compliance with regulations of the Federal Communications Commission and those used in
Europe require certification of compliance with regulations of the European
Telecommunications Standards Institute regarding emission limits of radio frequency
devices. In the United States, our GMS and retail petroleum products are subject to
compliance with regulations of Underwriters Laboratories Inc., a public safety and testing
certification organization, and in Europe to regulations of the European Union. Our
products are currently in compliance with these regulations.

27

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# Research and development

We
believe that our future success depends on our ability to maintain our technological
leadership, enhance our existing products and develop new products and technologies.
Accordingly, we intend to continue devoting substantial resources to research and
development. We are paying royalties to the Government of Israel at a rate of 3%-5% of
sales of the products in which the Government of Israel has participated in financing
through grants, up to the amounts granted, linked to the U.S. dollar with annual interest
at LIBOR as of the date of the approval. The following table describes our research and
development activities during each of the past five years:

|                                                        | 2001 | 2002 | 2003 | 2004 | 2005
|------------------------------------------------------- | ---- | ---- | ---- | ---- | ----
|
|
|
|
|Our expenditures net of grants from the OCS             |      |      | $    | 6.2  |     
|Our net expenditures as a percentage of annual revenues |      |      |      | 31   | %   
|OCS grants                                              |      |      | $    | 0.6  |     

Our
research and development activities focus on three areas:

| |  | implementing
our core technologies in microprocessors and readers;
| | - | ------------------------------------------------------------------

| |  | enhancing
the functionality of our components and expanding the range of our products to serve new
              markets; and
| | - | -----------------------------------------------------------------------------------------------------------------------------

| |  | developing
new innovative technologies related to the operation of contactless microprocessor based
              smart cards.
| | - | ------------------------------------------------------------------------------------------------------------------------------

At
December 31, 2005, we employed 86 persons in our research and development department. Our
main research and development facilities are located at our headquarters in Rosh Pina,
Israel. We believe that our success is based on our experienced team of senior engineers
and technicians who have on average 13 years of experience in their respective fields. Our
research and development facilities are ISO 9001:2000 certified.

# Proprietary technologies

Our
success and ability to compete depend in large part upon protecting our proprietary
technology.  We rely on a combination of patent, trademark, copyright and trade
secret law, as well as know-how, confidentiality agreements and other contractual
relationships with our employees, affiliates, distributors and others.  We have a
number of issued patents in various jurisdictions with respect to our technologies, as
well as a number of pending patent applications.  The more significant of these are
as follows:

Patents

|Technology                                                                                          | Status                                                                                                                                                                                                             
|--------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|System and Method For The Non-Contact
Transmission of Data.                                         | Patents granted in the United States, Israel, Canada,
Singapore, Australia, South Africa and Hong Kong.  The U.S.
patent expires in 2010 and the other patents expire in 2011.                                     
|                                                                                                    |                                                                                                                                                                                                                    
|Contact/Contactless Data Transaction Card.                                                          | Patents granted in the United States, Israel, Australia,
Hong Kong, The Netherlands, Germany, France, Italy, Spain
and the United Kingdom. The Israeli patent expires in 2016
and the other patents expire in 2017.
|                                                                                                    |                                                                                                                                                                                                                    
|Smart card amenable to assembly using two
manufacturing stages and a method of
manufacture thereof. | Patents granted in the United States and Israel. The Israeli
patent expires in 2017 and the U.S. patent expires in 2018.                                                                                           
|                                                                                                    |                                                                                                                                                                                                                    
|Contact/Contactless Smart Card having
Customizable Antenna Interface                                | Patents granted in the United States, Hong Kong, Israel,
Belgium, Germany, France, Ireland, Italy, The Netherlands,
United Kingdom, Canada and Australia. These patents expire
in 2018.                            

28

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|Technology                                                                                | Status                                                                                                                                                                                                             
|----------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Data transaction system for process
monitoring and event tracking                         | Patents granted in the United States, Hong Kong, Israel,
Germany, France, Italy, Spain, United Kingdom, Canada and
Australia. The Israeli and the U.S. patents expire in 2018
and the other patents expire in 2019.
|                                                                                          |                                                                                                                                                                                                                    
|Contactless data transaction tag having a
coil antenna mounted in association with a
band | Patent granted in Israel. The patent expires in 2018.                                                                                                                                                              
|                                                                                          |                                                                                                                                                                                                                    
|Self-closing cap for the filling neck of a
container                                      | Patents granted in the United States, Hong Kong, Israel,
Germany, France, Italy, Spain, United Kingdom and Australia.
The Israeli patent expires in 2018 and the other patents
expire in 2019.                     
|                                                                                          |                                                                                                                                                                                                                    
|System that uses contactless smart card for
parking systems.                              | Patents granted to Easy Park in Israel, the United States,
Europe, Hong Kong and South Africa.  These patents expire in
2012.                                                                                      
|                                                                                          |                                                                                                                                                                                                                    
|Apparatus and process for producing
Document Core Inlays for smart cards travel
documents | PCT application in the national phase for was filed during
January 2006.                                                                                                                                           
|                                                                                          |                                                                                                                                                                                                                    
|Designs                                                                                   |                                                                                                                                                                                                                    
|                                                                                          |                                                                                                                                                                                                                    
|Design for unique Key Chain                                                               | Design in the United States pending.                                                                                                                                                                               
|                                                                                          |                                                                                                                                                                                                                    
|Smart Card Reader                                                                         | Pending in Israel                                                                                                                                                                                                  

29

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|Trademarks            |                                                                                  
|--------------------- | ---------------------------------------------------------------------------------
|                      |                                                                                  
|MEDISMART             | Trademarks pending in the United States, South Africa and the European Community.
|                      |                                                                                  
|MEDISMART & DEVICE    | Trademarks pending in the United States, South Africa and the European Community.
|                      |                                                                                  
|OTI                   | Trademarks granted in the United States, Israel and European Community.          
|                      |                                                                                  
|OTI INSIGHT           | Trademarks granted in the United States, Israel and European Community.          
|                      |                                                                                  
|OTI INSIGHT & DEVICE  | Trademarks granted in the United States, Israel and European Community.          
|                      |                                                                                  
|SCIENCE - NON FICTION | Trademarks granted in the United States, Israel and European Community.          

We
cannot be certain that patents will be issued with respect to any of our pending or future
patent applications.  In addition, we do not know whether any issued patents will be
enforceable against alleged infringers or will be upheld if their validity is challenged.

# Competition

Contactless
microprocessor-based products and technologies. We anticipate competition in sales of
our products, systems and technologies from other providers of contactless
microprocessor-based smart card technologies. We expect competition to intensify as our
competitors commit greater resources to the development of contactless
microprocessor-based smart cards. Some of the larger chip manufacturers that operate in
the smart card market, including Atmel, STM, Infineon and Philips Semiconductors, have
announced that they are developing contactless microprocessor-based smart cards. However,
we are not aware of any other company that has deployed contactless microprocessor-based
smart card products for commercial use.

Contactless
ASIC-based products and technologies. We compete with contactless ASIC-based
technologies developed primarily by Philips Semiconductors, which comply with ISO 14443
and which are used by some of the largest manufacturers of smart cards, including Gemplus,
Axalto and Giesecke & Devrient, and Sonys contactless ASIC-based technology,
that is not ISO compliant. Other companies offer contactless ASIC-based systems for
specific applications. In addition, Orpak Industries, Ltd. and Roisman Engineering Ltd.,
both based in Israel, also offer gasoline management systems, which use simple ASIC-based
devices powered by batteries and that do not comply with the standards set by ISO.

Other
contact-based technologies. We compete with contact-based products such as
microprocessor-based contact cards, ASIC-based contact cards, memory chip cards and
magnetic strip cards. We believe that these cards offer inferior functionality compared to
contactless microprocessor-based smart cards. Nevertheless, some of our potential
customers have in the past, and may in the future, consider these alternatives sufficient
for their needs.

30

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|C. | ORGANIZATIONAL
STRUCTURE
|-- | ------------------------

# ITEM 1.

The
chart below describes the corporate structure of our principal subsidiaries and major
affiliates.



| | (1) | The
remaining shares of Easy Park Ltd. are held by two investors.
| | --- | -----------------------------------------------------------------

| | (2) | Including
10% of the shares of Easy Park Israel Ltd. that we hold directly.
| | --- | ---------------------------------------------------------------------------

| | (3) | We
acquired a 51% interest in our existing InterCard Systemelectronic and our
          former InterCard Kartensysteme subsidiaries in June 2000. We acquired the
          remaining 49% interest in these subsidiaries in January 2001. We sold InterCard
          Kartensysteme in October 2004.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (4) | We
acquired ASEC in October 2004.
| | --- | ---------------------------------

| | (5) | We
acquired e-Pilot Group and Pioneer Oriental International Ltd in July 2005.
| | --- | ------------------------------------------------------------------------------

| | (6) | We
have established the joint venture during 2005.
| | --- | --------------------------------------------------

| | (7) | We
have established Millennium Cards Technology Limited during 2006.
| | --- | ---------------------------------------------------------------------

| | (8) | We
acquired InSeal SAS in May 2006.
| | --- | -----------------------------------

Easy Park Ltd.

Easy
Park Ltd. developed our EasyPark system. Easy Park is incorporated under the laws of the
State of Israel, uses office space in our headquarters in Rosh Pina, Israel and rents
additional office space in Tel Aviv. Each holder or holders, individually or in the
aggregate, of 10.5% of Easy Parks issued share capital may appoint one member to
Easy Parks board of directors. By reason of our ownership of 91.8% of Easy
Parks outstanding shares, we currently have the right to appoint all of the members
of its board of directors.

Our
Easy Park system was selected as the a national parking system for Israel.

31

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The SoftChip Group

On
January 28, 2000, we acquired from Michael and Yael Cohen all of the shares of SoftChip
Israel Ltd. and SoftChip Technologies (3000) Ltd., which we refer to collectively as the
SoftChip group, in exchange for 12,119 of our ordinary shares. The closing price of our
ordinary shares on this date was EUR103.30 per share (equivalent to $100.90 per share). It
was agreed that Michael Cohen would continue as chief executive officer of SoftChip
Technologies (3000) Ltd. pursuant to an employment agreement with a six year term. Michael
Cohens employment agreement was terminated on March 31, 2003 and instead we have
hired Michael Cohen to provide services as a consultant. We also granted Michael Cohen
options to purchase 10,000 of our ordinary shares at an exercise price of $30.00 per
share.

The
SoftChip group designs microprocessors and operating systems for smart cards. Under the
share purchase agreement, Michael and Yael Cohen agreed not to develop, promote or sell
competing or similar products to our products or the SoftChip groups products for a
period of two years after the termination of his employment with Softchip, without our or
the SoftChip companies prior approval.

OTI America, Inc.

OTI
America, Inc., our U.S. subsidiary, is headquartered in Fort Lee, New Jersey and incorporated in Delaware, and provides marketing and customer support services for our products in North and
South America. In addition, our global marketing and strategy development is headed from
OTI America.

OTI Africa Ltd.

OTI
Africa Ltd. is headquartered and incorporated in South Africa and provides marketing,
distribution and customer support services for our products in Africa.

The InterCard group

On
June 15, 2000 and in January 2001, we acquired 51% and the remaining 49%, respectively, of
the nominal share capital of two related German companies, one of which, InterCard
Kartensysteme GmbH, is a systems integrator for smart card systems and the other of which,
InterCard Systemelectronic GmbH, is a manufacturer of electronic devices, for an aggregate
purchase price of $5.8 million. InterCard Kartensysteme primarily supplied smart card
systems for over 80 university campuses in Germany. InterCard Kartensysteme also sold copy
machine payment systems to universities, libraries and corporations.

In
October 2004, we sold our InterCard Kartensysteme subsidiary. The purchase price for our
shares in InterCard Kartensysteme is $2.5 million, to be paid in two installments. The
first installment in the amount of $1.25 million, which was paid in January 2005,
consisted of $685,000 in cash, a euro 325,000 interest-free promissory note ($432,000),
payable in 32 monthly installments of euro 10,000 and a final installment of euro 5,000,
beginning on February 1, 2005, and a euro 100,000 promissory note ($133,000), payable in
12 monthly installments of euro 9,000, beginning on February 1, 2005. The second
installment in the amount of $1.25 million shall be paid in 25 quarterly payments
beginning on April 1, 2005. In October 2005, we entered into a settlement agreement
according to which the outstanding balances of the two loans were reduced by euro 165,000
and combined to one loan which is payable in 24 monthly installments of euro 10,000 each
and a final installment of euro 5,000. The gain from the sale, in the amount of $374,000,
was recognized in the consolidated financial statements in 2005.

e-Smart System Inc.

On
February 2, 2000, we entered into a shareholders agreement to establish e-Smart System
Inc., a joint venture in Hong Kong owned 50% by us and 50% by Ocean Wonder Limited, an
indirect wholly-owned subsidiary of Cheung Kong Infrastructure Ltd., or CKI, a Hong
Kong-based infrastructure company, which in turn is a subsidiary of Cheung Kong (Holdings)
Ltd. Cheung Kong (Holdings) has significant stakes in Hutchison Wampoa, a Hong Kong based
telecommunications company, and Hong Kong Electric. As part of the joint venture, we
appointed e-Smart as exclusive distributor for our products in Greater China (the
Peoples Republic of China, Taiwan, Hong Kong and Macau). The joint venture is using
the established distribution network of Cheung Kong (Holdings) and will also undertake
marketing activities in Greater China.

32

---

---



In
exchange for its interest in the venture, CKI contributed $3.6 million in cash. We
contributed $3.1 million in cash and undertook to contribute an additional $500,000 on
February 2, 2001. In January 2001, e-Smart exercised an option that we had granted to it
to acquire the assets of our subsidiary, City Smart Ltd., a Hong Kong based systems
integrator, in lieu of the additional $500,000 we had undertaken to contribute to e-Smart.
City Smart supplied smart card systems to residential housing complexes in Hong Kong using
identification cards for security. City Smart ceased all operations following the
acquisition of its assets by e-Smart. We have agreed to indemnify e-Smart and CKI against
any losses they incur in connection with City Smart as a result of any event occurring
prior to February 2, 2000 or arising out of any City Smart customer contract entered into
prior to the exercise of the option, provided we are notified of the claim prior to
February 2, 2002. We have received no notice of any claim under the indemnification. As of
December 31, 2003 the Companys investment in e-Smart was zero.

In
June 2004, we signed an agreement with CKI for the sale of our 50% interest in the issued
share capital of e-Smart and the transfer of e-Smarts exclusive distribution rights
in Greater China. Under the agreement, we received $10,000 in consideration for the
acquisition of the shares by CKI and $40,000 and $20,000 for the transfer of
e-Smarts exclusive distribution rights and for management services provided by CKI
to e-Smart, respectively. In addition, we agreed to pay e-Smart royalties equivalent to a
certain percentage of our net revenues generating from e-Smarts activities in
Greater China up to $300,000.

ASEC Spolka Akcyjna

On
October 22, 2004, we completed the acquisition of ASEC, which is headquartered in Krakow,
Poland, from Nextel Spolka Akcyjna, or Nextel. ASEC develops, manufactures and markets
card readers and reader modules based on radio frequency identification technologies,
including high-end programmable smart card as well as economically priced readers.
Pursuant to the Preliminary Share Purchase Agreement, dated as of September 14, 2004, as
amended in October 2004, between us and Nextel, or the Agreement, the aggregate purchase
price for the acquisition was $1.6 million, which was paid to Nextel through the issuance
of 186,264 of our ordinary shares, calculated by dividing the purchase price by the
average price of our ordinary shares during the ten trading days prior to, but excluding,
the closing date of the acquisition ($8.59 per share). In addition, the Agreement provides
for additional consideration of up to $350,000 to be paid to Nextel in the form of our
ordinary shares, subject to ASEC meeting specified performance criteria for the years
ended December 31, 2004 and 2005, referred to as the earn-out formula. ASEC met the
performance criteria for the year ended December 31, 2004. Accordingly, as of December 31,
2004 we recognized a liability of $175,000 in connection with the earn-out formula, which
was settled by 14,298 ordinary shares that were issued by us to Nextel in June 2005.

Based
on ASECs 2005 performance, we did not incur any further liability in connection with
the earn-out formula. The results of operations of ASEC have been included in the
consolidated financial statements as from October 1, 2004.

Pioneer Oriental
International Ltd.

In
July 2005, we completed the acquisition of POI, a Hong Kong company, a subsidiary of POE,
a Hong Kong company. POI is an engineering company that develops and manufactures
machinery used to create smart card inlays for smart cards and other products, and also
manufactures contact and contactless smart cards themselves. Pursuant to the Asset
Purchase Agreement dated June 16, 2005, between us, POE, and its shareholders (together,
referred to as the Sellers), as amended, the aggregate purchase price for the acquisition
was paid to the Sellers through the issuance of an aggregate 40,441 of our ordinary
shares.

In
July 2005, POI completed the acquisition of substantially all of the assets of POE
relating to the design and manufacture of machinery for the manufacture of smart cards,
including certain proprietary technologies related to the manufacturing process. Pursuant
to the Asset Purchase Agreement dated June 16, 2005 between POI and POE, POI also agreed
to make offers of employment to each of the employees of POE. The aggregate purchase price
for the acquisition was paid to POE through the issuance of an aggregate of 41,788 of our
ordinary shares.

33

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e-Pilot Ltd.

In
July 2005, we completed the acquisition of a 71.5% interest in e-Pilot Ltd, a British
Virgin Islands company, from three of e-Pilots shareholders (collectively, referred
to as the e-Pilot Shareholders). e-Pilot, which is headquartered in Hong Kong, develops,
manufactures and markets smart card inlays for smart cards and other products. Pursuant to
share purchase agreements entered into with each of the e-Pilot Shareholders, the
aggregate purchase price for the acquisition was paid to the e-Pilot Shareholders through
the issuance of an aggregate of 52,572 of our ordinary shares.

InSeal SAS

In
May 2006, we completed the acquisition of InSeal SAS, for an aggregate of 243,800 of our
ordinary shares and 180,000 warrants. The warrants, which have a nominal exercise price,
become exercisable in four equal annual installments. InSeal SAS is a Marseille, France
based company currently providing an operating system for contactless applications to a
variety of customers in the payments market. InSeals JayCOS® is currently in use
in contactless payments programs in the US.

|D. | PROPERTY,
PLANT AND EQUIPMENT
|-- | -----------------------------

We
lease an aggregate of 10,639 square meters of land in Rosh Pina, Israel from the Israel
Lands Authority. Of the 10,639 square meters, 2,377 meters are leased under a 49 year
lease which expires on November 16, 2041, with an option to extend for a further period of
49 years. Our principal management, administration and marketing activities occupy a 1,188
square meter facility on the site. The remaining 8,262 square meters of land are leased
under a 49 year lease with the Israel Lands Authority which expires on September 14, 2047,
with an option to extend for a further period of 49 years. Our principal engineering,
research and development and part of our manufacturing activities occupy a 4,000 square
meter facility on this site. The rent for the initial 49-year term of each of these leases
was prepaid in its entirety at the beginning of the lease terms as is customary in Israel
for leases of property for industrial purposes from the Israel Lands Authority.

Our
rights under these leases, including the facilities built on the site, are pledged for the
benefit of Bank Hapoalim. Our majority owned subsidiary, Easy Park Ltd., leases office
space in this complex from us. Easy Park also leases an aggregate of 137 meters in Tel
Aviv pursuant to a lease that expires on April 14, 2008, with an option to extend for a
further period of 6 years.

OTI America, Inc. leases an aggregate
of 4,375 square feet of office space in Fort Lee, New Jersey pursuant to a lease that
expires on August 31, 2009. OTI Africa Ltd. leases an aggregate of 2,500 square meters of
office space in Cape Town, South Africa, pursuant to a lease that expires on December 31,
2008. ASEC leases an aggregate of 495 square meters of office space in Krakow, Poland
pursuant to a lease that expires on July 31, 2007, with an option to extend the lease for
additional two years, and 169 square meters of office space in Warsaw , Poland, pursuant
to a lease that expires on March 15, 2008.

InterCard
Systemelectronic owns an aggregate of 5,201 square meters of land in Bad Durrheim,
Germany. Of this land, 3,000 square meters can be used commercially and the remainder is
currently designated as farmland. The commercially usable land is currently being used by
InterCard Systemelectronic for its manufacturing facility.

e-Pilot
leases an aggregate of 1,459 square meters of office space in BaoOn, Shenzhen pursuant to
a lease that expires on July 31, 2006. The office space is currently being used for
its manufacturing facility.

POI
owns an aggregate of 91 square meters of office space in Fo Tan, Hong Kong. The office
space is commercially usable and is currently being used by administration department. An
aggregate of 1,464 square meters of office space was leased by POI in BaoOn, Shenzhen
pursuant to a lease that expires on July 31, 2006 for its manufacturing facility. An
aggregate of 864 square meters of space was leased by POI in BaoOn, Shenzhen pursuant
to a lease that expires on July 31, 2006 for its staff dormitory.

|ITEM 4A. |  | UNRESOLVED STAFF COMMENTS
|-------- |  | -------------------------

None.

34

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|ITEM 5. |  | OPERATING AND FINANCIAL REVIEW AND PROSPECTS
|------- |  | --------------------------------------------

|A. | OPERATING
RESULTS
|-- | -----------------

The
following discussion and analysis is based on and should be read in conjunction with our
consolidated financial statements contained in Item 18.  Financial
Statements.

# Overview

We
design, develop and sell contactless microprocessor-based smart card systems. Our
headquarters and main research and development activities are in Israel. Our sales and
marketing efforts are directed from our U.S. subsidiary, OTI America, located in Fort Lee,
New Jersey, with additional sales and support offices located in Israel, Europe, South
Africa and the Far East. Our packaging, assembly and manufacturing facilities are located
in Israel, Germany and Far East.

Since
our incorporation in 1990, we have focused on the development of our core technologies and
our OTI Platform-based products. We currently offer three lines of products, each of which
constitutes a complete system, as well as components (such as smart cards and readers)
that we sell to original equipment manufacturers, or OEMs, for incorporation into their
own products. Our three complete system product lines include:

| |  | Micropayments
Solutions, including the PayPass system that we are installing for
MasterCard International, our EasyPark system and our mass transit payment system;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Petroleum
Systems, including both our gasoline management system, or GMS, and our
EasyFuel systems; and
| | - | -------------------------------------------------------------------------------------------------------

| |  | Smart
ID Solutions,for both personal identification and credentialing purposes.
| | - | -------------------------------------------------------------------------------

We
began selling campus systems, our first product line, in 1993. Over time, our customer
base for campus systems increased and, in 1995, we began selling our second product line,
GMS. In 2003, we introduced and began to realize revenues from EasyFuel, our contactless
petroleum system, which we expect to account for an increasing proportion of our petroleum
system sales. In 1998, we were awarded a contract for the first of our micropayments
systems, an electronic parking payment system which we refer to as EasyPark. We began to
deploy EasyPark in 2000 and completed deployment of the first system in June 2001. We
deployed our first mass transit micropayments system in China during 2000 and in the
United States in 2003. In 2002, we began to realize nonrecurring engineering revenues from
the PayPass micropayments system that we are installing for MasterCard International
and we began to recognize product sale revenues from that system in 2004.

We
began to market components for incorporation into the products of OEMs with our
acquisition of InterCard Systemelectronic in June 2000. During 2003, 2004 and 2005,
product sales to OEMs accounted for $6.3 million, $8.9 million and $6.9 million,
respectively, of our total revenues.

We
have reported net losses for each year that we have been in business. Our business tends
to be seasonal, with greater sales in the third and the fourth quarters of every year, we
do not anticipate having net earnings for either of the first two quarters of 2006 and we
also cannot assure you that we will be profitable in either of the last two quarters of
2006, or afterwards.

# Sources of Revenue

We
have historically derived a substantial majority of our revenues from the sale of our
products, including both complete systems and OEM components. Asubstantial
majority of our revenues has been, and is likely to continue to be, from the sale of
complete systems. We anticipate that revenues from sales will continue to represent the
substantial majority of our revenues in the future. In addition, we generate revenues from
licensing and transaction fees, and also, less significantly, from non-recurring
engineering, customer services and technical support. We anticipate that revenues from
licensing and transaction fees will make a proportional greater contribution to our total
revenues and that revenues from sales will make a proportionally smaller contribution to
our revenues in the future.

35

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During
the past three years, the revenues that we have derived from sales and licensing and
transaction fees have been as follows (dollar amounts in thousands):

|                               | 2003 | 2004 | 2005
|------------------------------ | ---- | ---- | ----
|
|
|
|
|Sales                          |      |      | $   
|Licensing and transaction fees |      |      |     
|                               |      |      |     
|                               |      |      | $   
|                               |      |      |     

Sales
increased by $2.1 million and $11.4 million in 2004 and 2005, respectively, due to an
increase in sales of contactless payment products.

Licensing
and transaction fees include one-time and periodic payments for manufacturing or
distribution rights for our products. Transaction fees are paid by customers based on the
volume of transactions processed by systems that contain our products. We expect to
generate additional revenues from transaction fees in the future as the installation and
usage of systems that contain our products become more widespread, and accordingly
anticipate that these fees will make a proportionally greater contribution to our total
revenues in the future.

We
have historically derived revenues from different geographical areas. The following table
sets forth our revenues, by dollar amount (in thousands) and as a percentage of revenues
in different geographical areas, during the past three years:

|     | Africa | Europe | Far East
|---- | ------ | ------ | --------
|
|
|
|
|2003 |        |        | $       
|2004 |        |        | $       
|2005 |        |        | $       

|     | America | Israel
|---- | ------- | ------
|
|
|
|
|2003 |         |       
|2004 |         |       
|2005 |         |       

We
anticipate that, over time, the revenues that we derive from America will grow both in
absolute amounts and as a percentage of our total revenues. Our revenues derived from
outside the U.S., which are primarily received in currencies other than the U.S. dollar,
will have a varying impact upon our total revenues, as a result of fluctuations in such
currencies exchange rates against the U.S. dollar. In addition, and regardless of
these fluctuations, as the proportionate contribution of America to our total revenues
grows, the proportionate contribution of Europe is likely to decline.

39

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# Cost of revenues and
gross margin

Our
costs of revenues, by revenue source, and gross profit, for each of the past three years
were as follows (dollar amounts in thousands):

|                               | Year ended December 31
|------------------------------ | ----------------------
|
|
|
|
|Cost of revenues               |                       
|Sales                          |                       
|                               |                       
|Licensing and transaction fees |                       
|                               |                       
|                               |                       
|Total cost of revenues         |                       
|                               |                       
|                               |                       
|Gross profit                   |                       

Sales.           Cost
of revenues relating to sales consists primarily of materials, as well as           the
salary, fees payable to subcontractors and related costs for our technical
          staff who assemble our products. The increase in 2005 is primarily the result
of           increased sales which generated corresponding increased costs during the
years           covered by the table, and dueto execution of the initial stages of
new           projects which are characterized by lower margins in their early stages.

Licensing
and transaction fees. Licensing and transaction fees revenues do not have directly
attributable cost of revenues. The only costs incurred to initiate the project represent
selling and marketing expenses and are classified as such in the consolidated statement of
operations.

# Operating expenses

Our
operating expenses and operating loss for each of the past three years were as follows
(dollar amounts in thousands):

|                                          | Year ended December 31
|----------------------------------------- | ----------------------
|
|
|
|
|Operating expenses                        |                       
|Research and development                  |                       
|Less - participation by the Office of the |                       
|Chief Scientist                           |                       
|                                          |                       
|                                          |                       
|Research and development, net             |                       
|Selling and marketing                     |                       
|General and administrative                |                       
|Amortization of intangible assets         |                       
|Expenses relating to raising of capital,  |                       
|exchange of subsidiary's employees        |                       
|equity interest in equity interest of     |                       
|the Company and acquisitions in the Far   |                       
|East*                                     |                       
|Gain from sale of subsidiary              |                       
|                                          |                       
|                                          |                       
|Total operating expenses                  |                       
|                                          |                       
|                                          |                       
|Operating loss                            |                       
|                                          |                       
|* Consist of:                             |                       
|Research and development                  |                       
|Selling and marketing                     |                       
|General and administrative                |                       
|                                          |                       

37

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Research
and development. Our research and development expenses consist primarily of salaries
and related expenses of our research and development staff, as well as subcontracting
expenses. All research and development costs are expensed as incurred. The increase in our
research and development expenses in 2004 as compared to 2003 was primarily due to a
decrease in the participation of the Office of the Chief Scientist and also due to costs
associated with regulatory compliance and our involvement with standard institutions. The
increase in 2005 as compared to 2004 was primarily due to increase in expenses related to
salaries that resulted from an increase of the number of employees and from an increase of
expenses related to options granted to employees. We expect that our research and
development expenses might increase in the future as we continue to develop new products
and new applications for our existing products and as a result of designing our own
microprocessors and smart card operating system.

Selling
and marketing. Our selling and marketing expenses consist primarily of salaries and
substantially all of the expenses of our sales and marketing subsidiaries and offices in
the United States, South Africa, the Far East and Europe, as well as expenses related to
advertising, professional expenses, participation in exhibitions and tradeshows. The
increase in 2004 as compared to 2003 was primarily due to an increase in marketing and
advertising efforts associated with (i) our successful bid to participate in the first
phase of the U.S. Governments e-passport project, (ii) our various micropayments
solutions projects, (iii) increasing our presence in the petroleum systems market,
specifically in the Far East and (iv) our continuing efforts to promote a number of
significant projects in the U.S. The increase in 2005 as compared to 2004 was primarily
due to increase in expenses related to salaries that resulted mainly from an increase of
expenses related to options granted to employees.

We
expect that our selling and marketing expenses might increase in the future as we continue
to expand our local sales and marketing subsidiaries, open new offices and hire additional
personnel.

General
and administrative. Our general and administrative expenses consist primarily of
salaries and related expenses of our executive management, such as management fees and
travel expenses, as well as financial and administrative staff. These expenses also
include costs of our professional advisors such as lawyers and accountants, office
expenses, insurance and vehicle expenses, which have collectively grown with the scope,
magnitude and complexity of our business. The increase in 2005 as compared to 2004 was
primarily due to increase in expenses related to salaries that resulted mainly from an
increase of expenses related to options granted to employees. We expect that general
corporate and administrative expenses will increase in the future as we continue to expand
our operations.

Expenses
relating to raising of capital and exchange of subsidiarys employees equity interest
in equity interest of the Company and acquisitions in the Far East. In 2004 these expenses
consisted primarily of $1.1 million of options granted to employees of our South African
subsidiary in exchange for their existing shares and options in that subsidiary, $661,000
of options granted and $550,000 of bonuses paid to our employees and $904,000 of expenses
related to the repricing of employee options. In 2005, the expenses in the amount of $1.8
million resulted from our activity in connection with the acquisitions in the Far East.

# Financing income
(expenses), net

Financing
income consists primarily of interest earned on our investments in U.S. treasury
securities and foreign exchange gains. Financing expenses consist primarily of interest
payable on bank loans and foreign exchange losses. The increase in 2005 financing income
as compared to 2004 was primarily due to new investments in U.S. treasury securities made
through funds raised in private placements and exercise of options and warrants.

Our
financing income (expenses), net for each of the past three years, has been as follows
(dollar amounts in thousands):

|                                | Year ended December 31
|------------------------------- | ----------------------
|
|
|
|
|Financing income                |                       
|Financing expenses              |                       
|                                |                       
|Financing income (expense), net |                       
|                                |                       

38

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# Critical Accounting
Policies and Estimates

We
prepare our consolidated financial statements in conformity with accounting principles
generally accepted in the U.S. Accordingly, we are required to make certain estimates,
judgments and assumptions that we believe are reasonable based upon the information
available. These estimates and assumptions affect the reported amounts of assets and
liabilities at the date of the financial statements and results of operations. To fully
understand and evaluate our reported financial results, we believe it is important to
understand our revenue recognition policy, our policy with respect to the impairment of
goodwill and other intangible assets and our policy with respect to stock compensation.

Revenue
recognition. We recognize product sale revenues upon delivery, provided there is
persuasive evidence of an agreement, delivery has occurred, the fee is fixed or
determinable and collection is probable and no further obligation exists. In the case of
nonrecurring engineering, revenue is recognized on completion of testing and approval of
the customization of the product by the customer and provided that no further obligation
exists.

Technology
license revenues are recognized at the time the technology and license is delivered to the
customer, collection is probable, the fee is fixed and determinable, persuasive evidence
of an arrangement exists, no significant obligation remains under the sale or licensing
agreement and no significant customer acceptance requirements exist after delivery of the
technology.

We
recognize revenues from customer services and technical support as the services are
rendered ratably over the period of the related contract.

We
recognize transaction fees as they are earned based on usage.

Our
revenue recognition policies are consistently applied for all revenues recognized.

Goodwill
and other intangible assets.We follow Statement of Financial Accounting Standard No.
141, or SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill
and Other Intangible Assets. Under SFAS No. 142, goodwill is not amortized but is
subject to periodic impairment tests in accordance with this statement. Goodwill
impairment is deemed to exist if the net book value of a reporting unit exceeds its
estimated fair value. Under SFAS No. 141, the total purchase price of business
acquisitions accounted for using the purchase method is allocated first to identifiable
assets and liabilities based on estimated fair values. The excess of the purchase price
over the fair value of net assets of purchased businesses is recorded as goodwill.

We
perform an annual impairment test during the fourth quarter of each fiscal year or more
frequently if impairment indicators are presents. Goodwill and other intangible assets,
net, amounted to approximately $6.1 million as of December 31, 2005. If these estimates
change in the future, we may be required to record impairment charges for our goodwill. As
of December 31, 2005 no impairment charges were required.

Stock
option plans. For the year ended December 31, 2005, we continued to apply the
provisions of Accounting Principles Board Opinion No. 25, or APB No. 25, including
Financial Accounting Standards Board or FASB Interpretation No. 44 Accounting for
Certain Transactions Involving Stock Compensation  and Interpretation of APB
No.25 and provide pro forma disclosures required by SFAS No. 123, as amended by SFAS
No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure,
an amendment of Statement 123". Under APB No. 25, when the exercise price of an
employee share option is equivalent to or above the market price of the underlying stock
on the date of grant, no compensation expense is recognized. SFAS No. 123 defines a fair
value based method of accounting for an employee stock option. As required by SFAS No.
123, the Company has determined the fair value of stock-based arrangement grants. The fair
values of stock-based compensation awards granted were estimated using the
Black-Scholes option pricing model with certain assumptions that are
significant inputs.

39

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The
critical assumptions relate to determining the expected life of the option, considering
the outcome of service-related conditions (i.e., vesting requirements and forfeitures),
expected volatility of the underlying stock as an estimate of the future price fluctuation
for a term commensurate with the expected life of the option, expected dividend yield on
the underlying stock, commensurate with the expected life of the option, and risk-free
interest rate commensurate with the expected term of the option.

SFAS
No. 123 requires that the option pricing model used consider managements
expectations about the life of the option, future dividends, and stock price volatility.
Both the volatility and dividend yield components should reflect reasonable expectations
commensurate with the expected life of the option. To determine the expected volatility,
we generally begin with calculating historical volatility over the most recent period
equal to the expected life of the options. The expected dividend yield on the underlying
stock for all relevant periods is zero since there is no history of paying dividends. The
expected life of an employee stock option award was estimated based on reasonable facts
and assumptions on the grant date.

These
estimates introduce significant judgment into determining the fair value of stock-based
compensation awards.

# Recently issued
accounting guidance

In
November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment to ARB
43, Chapter 4". The amendment made by SFAS No. 151 clarifies that abnormal amounts of
idle facility expense, freight, handling costs, and wasted material (spoilage) should be
recognized as current-period charges, and also require the allocation of fixed production
overhead to inventory based on the normal capacity of the production facilities. The
guidance is effective for inventory costs incurred during fiscal years beginning after
June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal
years beginning after November 23, 2004. The provision of SFAS No. 151 should be applied
prospectively.

The
implementation of SFAS No. 151 is not expected to have a material impact on our
consolidated financial statements.

In
December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based
Payment. SFAS No. 123(R) will require that the compensation cost relating to
share-based payment transactions be recognized in financial statements. That cost will be
measured based on the fair value of the equity or liability instruments issued, SFAS No.
123(R) covers a wide range of share-based compensation arrangements including share
options, restricted share plans, performance-based awards, share appreciation rights and
employee share purchase plans. SFAS No. 123(R) replaces SFAS No. 123, Accounting for
Stock-Based Compensation, and supersedes APB No. 25, Accounting for Stock
Issued to Employees. SFAS No. 123, as originally issued in 1995, established as
preferable a fair-value- based method of accounting for share-based payment transactions
with employees. However, that Statement permitted entities the option of continuing to
apply the guidance in APB No. 25, as long as the footnotes to financial statements
disclosed what net income would have been had the preferable fair-value-based method been
used. Public entities will be required to apply SFAS No. 123(R) as of the first interim or
annual reporting period of the first fiscal year that begins after June 15, 2005. As
permitted by SFAS No. 123, until December 31, 2005, we accounted for share-based payments
to employees using APB No. 25s intrinsic value method. Accordingly, the adoption of
SFAS No. 123(R)s fair value method will have a significant impact on the our result
of operations, although it will have no impact on our overall financial position or cash
flows. We have adopted SFAS No. 123(R) using the modified prospective method.
The modified prospective method requires compensation cost to be recognized
beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for all
share-based payments granted after the effective date and (b) based on the requirements of
SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No.
123(R) that remain unvested on the effective date. The impact of adoption of SFAS No.
123(R) cannot be predicted at this time because it will depend on levels of share-based
payments granted in the future. However, had we adopted SFAS No. 123(R) in prior periods,
the impact of that standard would have approximated the impact of SFAS No. 123 as
described in the disclosure of pro forma net income (loss) and earnings (loss) per share
in Note 2(N) to our financial statements set forth elsewhere in this annual report. The
Company is currently considering the possible implications of adopting SFAS No. 123(R).

40

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In
June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections. SFAS No. 154 replaces APB Opinion No. 20, Accounting
Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial
Statements. SFAS No. 154 requires that a voluntary change in accounting principle be
applied retrospectively with all prior period financial statements presented on the new
accounting principle. SFAS No. 154 also requires that a change in method of depreciating
or amortizing a long-lived nonfinancial asset be accounted for prospectively as a change
in estimate, and correction of errors in previously issued financial statements should be
termed a restatement. SFAS No. 154 is effective for accounting changes and
correction of errors made in fiscal years beginning after December 15, 2005. The
implementation of SFAS No. 154 is not expected to have an impact on our consolidated
financial statements.

|B. | LIQUIDITY
AND CAPITAL RESOURCES
|-- | -------------------------------

Our
principal sources of liquidity since our inception have been sales of equity securities,
borrowings from banks, convertible loans, cash from the exercise of options and grants
from the Office of the Chief Scientist. We had cash and cash equivalents of $29.7 million
as of December 31, 2005 and $23.9 million as of December 31, 2004. In addition, we had
short-term investments of $20.0 million (representing U.S. treasury securities) as of
December 31, 2005 and $4.6 million as of December 31, 2004. We believe that our working
capital is sufficient to meet our present requirements.

Operating
activities. For the year ended December 31, 2005 we have used $940,000 of cash in
operating activities primarily due to our net loss of $9.1 million, $1.2 million increase
in other receivables and prepaid expenses, $1.1 million decrease in trade payables, $1.0
million increase in inventories as a result of anticipated higher sales in the coming
quarters, $587,000 increase in trade receivables, $444,000 of extraordinary gain in
business combination and due to a $374,000 gain from sale of a subsidiary, partially
offset by $8.9 million amortization of deferred stock compensation in respect to stock
options granted to employees, $981,000 charge for depreciation of our property and
equipment, $895,000 increase in other current liabilities, $893,000 in connection with
stock options granted to consultants, $700,000 amortization of intangible assets and
$560,000 increase in accrued severance pay, net. For the year ended December 31, 2004 we
have used $330,000 of cash in operating activities primary to our net loss of $9.3
million, from an increase of $1.2 million in inventories, a $1.1 million increase in trade
receivables and from a $792,000 increase in other receivables and prepaid expenses,
partially offset by $4.9 million amortization of deferred stock compensation in respect to
stock options granted to employees, $2.1 million increase in trade payables that are the
result of the increase in the amount of payables that were associated to suppliers, $1.9
million due to stock options granted to consultants, $999,000 decrease in short-term
investments due to the maturity of the bonds of the Israeli government in which we
invested and $543 increase in other current liabilities .

Investing
and financing activities. For the year ended December 31, 2005, net cash used in
investing activities was $18.8 million, mainly due to an $17.9 million investment in
available-for-sale securities, $2.4 million investment in an affiliated company in the
Far-East and to $1.9 million investment in equipment purchases, partially offset by $2.4
million proceeds from maturity of available-for-sale securities and $909,000 receipts on
account of loans and receivables related to our disposition of a German subsidiary in
2004. For the year ended December 31, 2004 net cash used in investing activities was $5.1
million mainly due to a $4.5 million investment in available-for-sale securities and due
to $449,000 investment in equipment purchases.

For
the year ended December 31, 2005, net cash provided by financing activities was $25.4
million, mainly due to $20.1 million proceeds from issuance of shares and detachable
warrants (net of issuance costs), and to $6.7 million due to exercise of options and
warrants, partially offset by $721,000 repayment of long-term bank loans and by $630,000
decrease in short term credit. For the year ended December 31, 2004, net cash provided by
financing activities was $19.5 million, mainly due to $12.8 million proceeds from issuance
of shares and detachable warrants (net of issuance costs), $6.8 million due to exercise of
options and warrants and $437,000 increase in short-term bank credit, net, partially
offset by $475,000 repayment of long-term bank loans

41

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Market Risk

Market
risks relating to our operations result primarily from changes in interest rates and
currency fluctuations. In order to limit our exposure, we may enter, from time to time,
into various derivative transactions. Our objective is to reduce exposure and fluctuations
in earnings and cash flows associated with changes in interest rates and foreign currency
rates. We do not use financial instruments for trading purposes. It is our policy and
practice from time to time to use derivative financial instruments only to limit exposure.

Interest Rate Risks

We
are exposed to market risks resulting from changes in interest rates, relating primarily
to our loan obligations to banks. We do not currently use derivative financial instruments
to limit exposure to interest rate risk. As of December 31, 2005, we had fixed interest
rate loan obligations of $239,000. Of this amount, $119,000 was denominated in South
African Rand, $79,000 was denominated in Polish Zloty and $41,000 was denominated in NIS.
These loans will be repaid during the next 4 years. At the same time, we had variable
interest rate loan obligations of $1.8 million in dollars. These loans will be repaid
during the next 7 years. We believe that the potential loss that would result from an
increase or decrease in the interest rate is immaterial to our business and consolidated
net assets.

The
carrying value of the loans are equivalent to or approximate their fair market value as
they bear interest at approximate market rates.

Impact of Inflation and
Currency Fluctuations.

Our
functional and reporting currency is the U.S. dollar. We generate a significant portion of
our revenues and we incur some of our expenses in other currencies. As a result, we are
exposed to the risk that the rate of inflation in countries in which we are active other
than the U.S. will exceed the rate of devaluation of such countries currencies in
relation to the dollar or that the timing of this devaluation will lag behind inflation in
such countries. To date, we have not been materially affected by changes in the rate of
inflation or the exchange rates of other countries currencies compared to the
dollar, but we cannot assure you that we will not be adversely affected in the future.

The
annual rate of inflation in Israel was 2.4% in 2005, 1.21% in 2004 and (1.89)% in 2003 .
The NIS devalued by approximately 6.8% in 2005 and increased in value by approximately
1.6% and 7.6% in 2004 and 2003, respectively, against the U.S. dollar.

The
functional currency of InterCard Systemelectronic is the euro and of ASEC Spolka Akcyjna
is the Polish Zloty and the functional currency of POI and e-Pilot is the Chinese Yuan
Renminbi. Significantly, all of these subsidiaries revenues are earned, and
significantly all of their expenses are incurred, in their functional currencies . To the
extent that there are fluctuations between the euro, the Polish Zloty and/or the Chinese
Yuan Renminbi against the U.S. dollar, the translation adjustment will be included in our
consolidated changes in shareholders equity and will not impact the consolidated
statement of operations. We do not expect our exposure to these fluctuations to be
material.

Corporate Tax Rate

On
July 25, 2005 the Knesset, The Israeli Parliament, passed the Law for the
Amendment of the Income Tax Ordinance (No.147 and Temporary Order)  2005, or the
Amendment. The Amendment provides for a gradual reduction in the company tax rate in the
following manner: in 2006 the tax rate will be 31%, in 2007 the tax rate will be 29%, in
2008 the tax rate will be 27%, in 2009 the tax rate will be 26% and from 2010 onward the
tax rate will be 25%. Furthermore, as from 2010, upon reduction of the company tax rate to
25%, real capital gains will be subject to tax of 25%. As of December 31, 2005, our net
operating loss carry-forwards for Israeli tax purposes amounted to approximately $44
million. Under Israeli law, net operating losses can be carried forward indefinitely and
offset against certain future taxable income. Since we have incurred tax losses through
December 31, 2005, we have not yet utilized the tax benefits for which we are eligible
under the Approved Enterprise status. $4.5 million of our investment programs
in buildings, equipment and production facilities have been granted Approved
Enterprise status and we are, therefore, eligible for a tax exemption under the Law
for the Encouragement of Capital Investments, 1959. Subject to compliance with applicable
requirements, the portion of our income derived from the Approved Enterprise
programs is tax-exempt for a period of the earliest of (1) ten years commencing in the
first year in which it generates taxable income, (2) 14 years from the date of approval or
(3) 12 years from the date of beginning of production. If we do not comply with these
requirements, the tax benefits may be cancelled and we may be required to refund the
amount of benefits received, in whole or in part, with the addition of linkage differences
to the Israeli consumer price index and interest. As of the date of this annual report, we
believe that we are in compliance with these conditions.

42

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Government of Israel
Support Programs

We
participate in programs offered by the Office of the Chief Scientist of the Ministry of
Industry and Trade that support research and development activities. We received and
obtained grants of $853,000 in 2003, $394,000 in 2004 and $618,000 in 2005 from the Office
of the Chief Scientist. Under the terms of these grants, a royalty of 3% to 3.5% of the
sales of products must be paid to the Office of the Chief Scientist, beginning with the
commencement of sales of products developed with grant funds and ending when the dollar
value of the grant is repaid.

Royalties
payable with respect to grants received under programs approved after January 1, 1999,
however, will be subject to interest on the dollar-linked value of the total grants
received at an annual rate of LIBOR applicable to dollar deposits. As of December 31,
2005, we have received a total of $5.8 million from the Office of the Chief Scientist net
of royalties paid to it (or accrued for). The terms of Israeli government participation
also require that the manufacturing of products developed with government grants be
performed in Israel, unless the Office of the Chief Scientist has granted special
approval. If the Office of the Chief Scientist consents to the manufacture of the products
outside Israel, we may be required to pay increased royalties, ranging from 120% to 300%
of the amount of the Office of the Chief Scientist grant, depending on the percentage of
foreign manufacture. These restrictions continue to apply even after we have paid the full
amount of royalties payable in respect of the grants. Based upon the aggregate grants
received to date, we expect that we will continue to pay royalties to the Office of the
Chief Scientist to the extent of our sales of our products and related services for the
foreseeable future. Separate Office of the Chief Scientist consent is required to transfer
to third parties technologies developed through projects in which the government
participates. These restrictions do not apply to exports from Israel of products developed
with these technologies.

|C. | RESEARCH
AND DEVELOPMENT, PATENTS AND LICENSES, ETC.
|-- | ----------------------------------------------------

Discussed
above in "Item 5.A. Overview."

|D. | TREND
INFORMATION
|-- | -----------------

Discussed
above in "Item 5.A.  Overview."

|E. | OFF
BALANCE SHEET ARRANGEMENTS
|-- | ------------------------------

None.

|F. | TABULAR
DISCLOSURE OF CONTRACTUAL OBLIGATIONS
|-- | ---------------------------------------------

As
of December 31, 2005, we and our subsidiaries had contractual obligations which are
expected to affect our consolidated cash flow in future periods as follows:

|                            | 2006 | 2007 | 2008 | 2009 | 2010 and
thereafter | Total
|--------------------------- | ---- | ---- | ---- | ---- | ------------------- | -----
|
|
|
|
|Operating lease obligations |      |      | $    | 386  |                     | $    
|Long-term debt obligations  |      |      | $    | 507  |                     | $    
|Total                       |      |      | $    | 893  |                     | $    

43

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We
shall also pay royalties to the Office of the Chief Scientist as discussed above in
Item 5B. Liquidity and Capital Resources.

For
an additional information on our contractual obligations as of December 31, 2005, under
long-term bank loans and operating leases, see Notes 8 and 9 to our consolidated financial
statements. For a description of liens on our assets see Note 9C to our consolidated
financial statements.

|ITEM 6. | DIRECTORS,
SENIOR MANAGEMENT AND EMPLOYEES
|------- | ------------------------------------------

|A. | DIRECTORS
AND SENIOR MANAGEMENT
|-- | -------------------------------

# Management

The
following table sets forth certain information concerning our current directors and
executive officers, including officers of certain of our subsidiaries:

|Name                          | Age | Position                                                                                      
|----------------------------- | --- | ----------------------------------------------------------------------------------------------
|
|
|
|
|Oded Bashan (1)               | 59  | President, Chief Executive Officer, Chairman and Director                                     
|Ronnie Gilboa                 | 49  | Vice President-Projects and Director                                                          
|Guy Shafran                   | 33  | Chief Financial Officer                                                                       
|Moshe Aduk                    | 49  | Vice President-Gasoline Management System                                                     
|Nehemya Itay                  | 56  | Vice President-Hardware Engineering                                                           
|Ohad Bashan                   | 34  | Chief Marketing Officer; President and Chief Executive Officer, OTI America, Inc. and Director
|Eliezr Manor (1)(2)(3)        | 58  | Director                                                                                      
|Liora Katzenstein (2)(3)      | 50  | Director                                                                                      
|Eli Akavia (1)(2)             | 58  | Director                                                                                      
|Shlomo Tussia-Cohen (1)(2)(3) | 34  | Director                                                                                      

---

(1)
          Compensation committee member 
(2)
          Audit committee member 
(3)
          External director

Oded
Bashanco-founded the Company in 1990 and has continued to serve as our President,
Chief Executive Officer and Chairman since that time. Prior to founding us, he served as
the president of Electo-Galil, an Israeli manufacturer of radio frequency identification
cards, from 1984 to 1990. Mr. Bashan is Chairman of OTI America, Inc., OTI Africa Ltd.,
SoftChip Technologies (3000) Ltd., Easy Park Ltd. and Easy Park Israel Ltd. and a director
of ASEC, Millennium Cards Technology Ltd., e-Pilot Group Limited, Oriental Power
Technology Ltd. and Z.H.R. Industrial Park Company Ltd. In 1997, Mr. Bashan was awarded
the Leading Businessman Award in Management, Business and Economics by the Israeli
Institute of Public Opinion. He is currently a member of the trustee committee of the
Tel-Chai College and a member of the consulting committee for the Executive MBA program at
Bar Ilan University. Mr. Bashan holds both a B.A. and an M.A. in economics and business
management from the Hebrew University of Jerusalem.

Ronnie
Gilboaco-founded the Company in 1990 and has continued to serve as a director since
that time. From 1990 to the end of 2001 he served as Vice President R&D and since that
date serves as our Vice President-Projects. He serves on the board of directors of OTI
America, Inc., ASEC S.A, OTI Africa Ltd., Easy Park Ltd., Easy Park Israel Ltd. and
Softchip Technologies (3000) Ltd. Prior to founding us, Mr. Gilboa was the manager of
research and development at Electo-Galil, an Israeli manufacturer of radio frequency-based
identification cards, from 1984 to 1990. Mr. Gilboa holds a B.Sc. in electrical
engineering from The Technion (Israeli Institute of Technology).

44

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Guy
Shafranserves as our Chief Financial Officer, having served in that position since
June, 2000, and has served as a director of Easy Park Ltd. since June 2000 and as a
director of Easy Park (Israel) Ltd. since March 2002. Since 2005 Mr. Shafran also serves
as the President and Chairman of Millennium Cards Technology Ltd. Mr. Shafran is a
director in Easy Park Ltd., e-PilotGroup Limited, Oriental Power Technology Ltd. and
Millennium Cards Technology Ltd. Prior to joining us, Mr. Shafran was chief
financial officer at the Israel Cold Storage and Supply Company Ltd., an Israeli public
company engaged in the distribution of soft drinks and cold storage, from June 1996 to
March 2000. From July 1995 to February 1996, Mr. Shafran was assistant to the chairman of
the Baran Group Ltd., an Israeli engineering company. Mr. Shafran holds a B.A. in
economics with a specialization in business administration from Ben Gurion University,
Beer Sheba, and a MEI Graduate Degree in Management specializing in International
Management and Entrepreneurship from Swinburne University of Technology.

Moshe
Adukserves as our Vice PresidentGasoline Management System, having served in
that position since July 1995. From 1990 to July 1995, he was employed by us as a research
and development engineer. He served as a director from 1995 to July 1999. Prior to joining
us, Mr. Aduk was a hardware and software development engineer at Electo-Galil, an Israeli
manufacturer of radio frequency-based identification cards, from 1985 to 1990. From 1984
to 1985, he was employed as a technical support engineer at Motorola Israel. Mr. Aduk
holds a B.Sc. in electrical engineering from The Technion (Israeli Institute of
Technology).

Nehemya
Itayserves as our Vice PresidentHardware Engineering, having served in that
position since July 1995. From 1990 to July 1995, he was employed by us as a research and
development engineer. He served as a director from 1991 to July 1999. Mr. Itay is a member
of the Joint Task Committee of the International Standards Organisation on standards for
contactless smart cards. Prior to joining us, Mr. Itay was a hardware development engineer
at Electo-Galil, an Israeli manufacturer of radio frequency-based identification cards,
from 1986 to 1990. From 1982 to 1985, he was an hardware electronic engineer at Elscint,
an Israeli technology company. Mr. Itay holds a B.Sc. in electrical engineering from The
Technion (Israeli Institute of Technology) and an M.A. in electronics from Drexel
University, Philadelphia.

Ohad
Bashanhas served as Chief Marketing Officer and prior to thatas our Head of
Global Marketing and Strategy Development since June 2000. Mr. Bashan also serves as
President, Chief Executive Officer and a director of OTI America, Inc., since 1998, and as
a director of our board, e-Pilot Group Limited, Oriental power Technology Ltd. and
Millennium Cards Technology Ltd. since 2005. From 1996 to August 1998, he was our
business development manager. Mr. Bashan holds a B.A. in business from the College of
Business Management, Tel Aviv, with specializations in marketing and finance, and an
M.B.A. from Pepperdine University, California.  Ohad Bashan is the son of Oded
Bashan.

Eliezer
Manor serves as a director, having served in that position since July 2003. He serves
as a managing partner and co-founder of Global Catalyst Partners (GCP) VC Fund, a managing
partner and co-founder of Global Catalyst Partners II VC Fund, as a director of Trans
Balkan Fund (a private equity fund active in Romania, Bulgaria and Croatia), a director on
several portfolio companies of GCP, a member of the Executive Steering Committee of China
VC Research Institute and as a lecturer and consultant in Israel and abroad on Hi-Tech and
Venture Capital. Mr. Manor holds a B.Sc. Physics from the Tel Aviv University and a M.Sc.
Applied Physics from the Weizmann Institute of Science, Israel.

Prof.
          Liora Katzenstein serves as a director, having served in that position
since           July 2003. Prof. Katzenstein serves as the President of ISEMI  the
          Institute for the Study of Entrepreneurship Management and Innovation, Managing
          Director of the Consulta Associates, an international business development
          consulting firm, a partner and Joint Managing Director of Palafric Investment,
a           real estate investment company, an owner and President of Forum
International,           an Israeli business development consulting firm, and a program
manager of MIL            Israel Management Center. Prof. Katzenstein serves as a
director in           Amanet Ltd., Palafric Investment Ltd. and in several companies of
the RAD group           which are traded on NASDAQ. Prof. Katzenstein holds a License as
Sciences           Politiques from the Graduate Institute of International Studies,
University of           Geneva, Switzerland, a MALD in Law and Diplomacy from the
Fletcher School of Law           and Diplomacy, Tufts University, Boston, MA and a Ph.D.
in International           Economics from the Graduate Institute of International
Studies, University of           Geneva, Switzerland.

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Eli
Akavia,serves as a director, having served in that position since December 2003. Mr.
Akavia is an independent consultant. Until recently, Mr. Akavia worked for Luboshitz
Kasierer, an Israeli auditing firm (formerly a member firm of Arthur Andersen and
currently merged with Ernst & Young, Israel) for 30 years, first as an employee and
later as a senior partner. Mr. Akavias roles at Luboshitz Kasierer included: Head of
Audit Department, Head of Hi Tech Division and Partner in charge of the Firm Professional
Standards Group. He specialized in hi-tech companies and accumulated invaluable experience
in US GAAP and SEC rules. Mr. Akavia has participated in a large number of companies
initial public offerings in the United States.

Shlomo
Toussia-Cohen serves as a director, having served in that position since June 2005.
From 2002 to 2005 Mr. Toussia-Cohen worked as senior assistant to Director General of the
Israeli Broadcasting Authority  the Israeli Public TV and Radio. Until recently he
worked as chief executive officer and member of the investment committee in the Education
Fund for Journalists (1977) Ltd. Holding a Master degree in Law (L.L.M.) with
specialization in private law from the Hebrew University of Jerusalem and a bachelor
degree in Business (B.A.) with specialization in finance from the Interdisciplinary Center
of Herzelia, Mr. Toussia-Cohen works as a Lawyer and is a member of both the Israeli Bar
and the of New York State bar.

|B. | COMPENSATION
|-- | ------------

# Executive Compensation

The
aggregate compensation paid by us and our subsidiaries to our executive directors and
executive officers listed above under Management, in the year ended December
31, 2005 was $770,000. This amount includes approximately $145,000 set aside or accrued to
provide pension, severance, retirement or similar benefits or expenses, but does not
include business travel, relocation, professional and business association dues and
expenses reimbursed to officers, and other benefits commonly reimbursed or paid by
companies in Israel.

Non-executive
directors are reimbursed for their expenses for each board meeting attended and in
addition receive compensation for their service on the board. Our executive directors do
not receive compensation for their service on the board of directors or any committee of
the board of directors. The aggregate amount paid by us and our subsidiaries to our
non-executive directors listed above under Management, in the year ended
December 31, 2005 was $68,000.

See
Item 6.  E.  Share Ownership for information on beneficial
ownership of our shares by our directors and executive officers. We have no outstanding
loans to any of our directors or executive officers.

# Employment Agreements

We
maintain written employment and related agreements with all of our office holders. These
agreements provide for monthly salaries and contributions by us to executive insurance and
vocational studies funds. The employment agreements of certain of our office holders
further provide that we may give the employee an annual bonus in accordance with targets
to be determined by the compensation committee by December 31 of each calendar year in
respect of the following year. In determining the amount of the bonus, the compensation
committee must relate it to our revenues or profits, as applicable to the employee. We
approved bonus plan principles for our senior management on a shareholders general
meeting held on January 31, 2003. If justifiable in light of our quarterly financial
results, we may make advances on bonus payments pursuant to a resolution of our board of
directors. All of our office holders employment and related agreements contain
provisions regarding noncompetition, confidentiality of information and assignment of
inventions. The enforceability of covenants not to compete in Israel is unclear.

Agreement
with Oded Bashan. The employment agreement of Oded Bashan, dated July 1, 2004,
provides for a five-year term ending on June 30, 2009. Mr. Bashan may terminate his
employment, and we may terminate his employment for reasonable and justifiable cause, in
either case on six months notice. In the event of termination, Mr. Bashan is
entitled to receive severance pay equal to twice the rate of one months current
salary multiplied by the number of years of employment. In the event we terminate his
employment prior to June 30, 2009, unless the termination occurred as a result of
circumstances depriving him of the right to severance pay at law or as a result of a
breach of fiduciary duty or a material breach of confidentiality or noncompetition
undertakings, we are required to continue paying Mr. Bashan a monthly salary, including
benefits but excluding bonuses, until June 30, 2009, and in any event, for a period that
shall not be less than six months following the notice period described above. In addition
to the salary, contributions and bonus described above, Mr. Bashan is entitled under his
contract of employment to an additional bonus of $15,000 for every one percent increase in
our average share price quoted for the last two months of any year over the average share
price quoted for the last two months of the preceding year.

46

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Agreement
with Ronnie Gilboa. The employment agreement of Ronnie Gilboa, dated July 1, 1999,
provides for a five-year term ended on June 30, 2004, and was extended automatically for a
non-determined period. Mr. Gilboa may terminate his employment, and we may terminate his
employment for reasonable and justifiable cause, in either case on six months
notice. In the event of termination, Mr. Gilboa is entitled to receive severance pay equal
to twice the statutory rate of one months current salary multiplied by the number of
years of employment.

Agreement
with Guy Shafran.  The employment agreement of Guy Shafran, dated January 1,
2006, provides for a three-year term ended on December 31, 2009, with an option for
additional two years and is automatically extended unless terminated as described
below.  In the event of termination, Mr. Shafran is entitled to receive severance pay
equal to twice the rate of one months current salary multiplied by the number of
years of employment in OTI or one of its subsidiaries.  Mr. Shafran is expected to
work in Hong-Kong for three years with option for an additional two years and in the event
that the employment abroad or in connection to it will be terminated before such period,
Mr. Shafran will be paid in full and will be entitled to all terms as if such a
termination did not exist. Mr. Shafran may terminate his employment on six months notice,
and we may terminate his employment for reasonable or justifiable cause on one years
notice.  In the event of termination of employment, unless the termination occurred
as a result of circumstances depriving Mr. Shafran of the right to severance pay at law or
as a result of a breach of fiduciary duty or a material breach of his confidentiality or
noncompetition undertakings, Mr. Shafran shall be entitled to additional six months
severance payments with full terms and benefits.

Agreements
with Moshe Aduk and Nehemya Itay. The employment agreements of Moshe Aduk and Nehemya
Itay, each dated July 1, 1999, provide for a five-year term ending on June 30, 2004, and
were extended automatically for a non-determined period. These individuals may terminate
their employment, and we may terminate their employment for reasonable and justifiable
cause, in either case on six months notice. In the event of termination, these
individuals are entitled to receive severance pay equal to twice the rate of one
months current salary multiplied by the number of years of employment. In the event
we terminate the employment of either Mr. Aduk or Mr. Itay, unless the termination
occurred as a result of circumstances depriving them of the right to severance pay at law
or as a result of a breach of fiduciary duty or a material breach of his confidentiality
or noncompetition undertakings, we are required to continue paying each of them a monthly
salary for three months following the notice period described above.

Agreement
with Ohad Bashan.  The employment agreement of Ohad Bashan with OTI America,
Inc., dated October 6, 2005, was approved by OTI America, OTI and our General Meeting of
shareholders on November 12, 2005. Mr. Bashan may terminate his employment on six months
notice and we may terminate his employment on six months notice.  In the event we
terminate his employment, Mr. Bashan shall be entitled to six months severance payments
with full terms and benefits, and shall be entitled to severance payment in an amount
equal to two monthly salaries for each year Mr. Bashan was employed with the Company or
OTI America, in addition to all benefits and salary Mr. Bashan is entitled to during the
six month period. In the event that the notice of termination is within the school period
of Mr. Bashans children, Mr. Bashan will be entitled to full compensation until the
end of such school year, provided, however, that such year started on or before the  notice
of termination.  In addition to his monthly salary, Mr. Bashan shall be entitled to
receive a special annual bonus of 0.5% of the annual sales in Americas markets. The bonus
will be paid during the month of April of the following year of the actual sales, as
recognized in OTIs financial statements.    In addition, OTI America
has the right to assign Mr. Bashans employment agreement to us, and require Mr.
Bashan to relocate to Israel.

47

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|C. | BOARD
PRACTICES
|-- | ---------------

# Election of Directors;
Appointment of Officers

Our
current board of directors consists of seven directors. Under our articles of association,
our board of directors may not consist at any time of more than nine members. A majority
of these directors must be non-executive directors, who are directors that are neither
office holders nor our employees. Directors are appointed, removed or replaced, by a
majority vote of our shareholders present in person or by proxy at a general meeting of
shareholders.

Once
elected at a shareholders meeting, our directors, except our external directors,
hold office until the first general meeting of shareholders held at least thirty six
months after their election, except for Mr. Oded Bashan and Mr. Ronnie Gilboa who may not
be replaced or removed unless by an affirmative vote of 75% of the Companys
shareholders entitled to vote and voting in person or by proxy at a general meeting of
shareholders. Incumbent directors may be reelected at that meeting. Unless contrary to the
law, a director may be elected for consecutive terms.

Under
the new Israeli Companies Law, which took effect on February 1, 2000 (the Companies
Law), the chief executive officer of a public company may not serve as a chairman of
the board of directors unless authorized by a general meeting of the shareholders and then
only for a period of time that does not exceed three years. On July 11, 2003, our
shareholders authorized our CEO, Oded Bashan, to act as our chairman for an additional
three-year period ending May 25, 2006, after such date, we plan to recommend to our
shareholders to authorize Mr. Bashan to act as our CEO for an additional 3-year period.

Our
board of directors appoints our chief executive officer. Each of our executive officers
serves at the discretion of the board of directors, subject to the terms of any employment
agreement, and holds office until his or her successor is elected or until his or her
earlier resignation or removal. Except for Ohad Bashan, our Chief Marketing Officer, and
President and Chief Executive Officer of OTI America, who is the son of Oded Bashan, our
co-founder and chairman of our board of directors, none of our directors or executive
officers has any family relationship with any other director or executive officer.

# External Directors

The
Israeli Companies Law requires Israeli companies with shares that have been offered to the
public in or outside of Israel to appoint at least two external directors. No person may
be appointed as an external director of a company if the person, or the persons
relative, partner, employer or any entity under the persons control, has, or had
within the two years preceding the persons appointment as an external director, any
affiliation with the company or with any entity controlling, controlled by or under common
control with the company. The term affiliation includes control, an employment
relationship, a business or professional relationship maintained on a regular basis, or
service as an office holder, excluding service as a director appointed to serve as an
external director in a company that intends to make an initial offering of its shares to
the public. The term office holder is defined as a director, general manager,
chief business manager, deputy general manager, vice general manager, executive vice
president, vice president, other manager directly subordinate to the general manager or
any other person assuming the responsibilities of any of the foregoing positions, without
regard to such persons title. Each person listed in the table above is an office
holder. The external directors were not office holders until elected.

In
addition, no person may serve as an external director if that persons other
positions or business activities create, or may create, a conflict of interest with the
persons service as an external director or may otherwise interfere with the
persons ability to serve as an external director. If, at the time an external
director is appointed, all current members of the board of directors are of the same
gender, then that external director must be of the other gender. Regulations promulgated
under the Companies Law provide that the requirement of Israeli residency does not apply
to the external directors of companies whose shares are listed for trading outside of
Israel.

External
directors are elected by a majority vote at a shareholders meeting at which either
the majority of shares voted at the meeting, including at least one-third of the shares
held by non-controlling shareholders voted at the meeting, vote in favor of the election
of the external director, or the total number of shares held by non-controlling
shareholders voted against the election of the external director does not exceed one
percent of the aggregate voting rights in the company.

48

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The
initial term of an external director is three years and may be extended for one additional
three year period. External directors may only be removed by the same percentage of
shareholders as is required for their election, or by a court, and then only if the
external directors cease to meet the statutory qualifications for their appointment or if
they violate their duty of loyalty to the company. If an external directorship becomes
vacant, our board of directors is required under the Companies Law to call a
shareholders meeting immediately to appoint a new external director.

A
company may not appoint an external director as an office holder and may not employ or
receive services from an external director, directly or indirectly, including through a
corporation controlled by that person, for two years following the termination of his or
her service as an external director of that company.

Each
committee of our board of directors must include at least one external director and the
audit committee must include all of the external directors. An external director is
entitled to compensation as provided in regulations adopted under the Companies Law and is
otherwise prohibited from receiving any other compensation, directly or indirectly, in
connection with services provided as an external director.

In
addition, the audit committee of our board of directors must include at least three
independent directors within the meaning of the NASDAQ National Market listing
requirements. Our directors Shlomo Toussia-Cohen, Eliezer Manor and Prof. Liora
Katenstein, qualify as external directors under the Companies Law and independent
directors under the NASDAQ National Market listing requirements. In addition, our director
Eli Akavia, CPA, qualifies as an independent director under the NASDAQ National Market
listing requirements.

# Alternate Directors

Under
our articles of association, each of our directors, other than our external directors, may
appoint, by written notice to us, any person to serve as an alternate director. Under the
Companies Law, a current director cannot be appointed as an alternate director nor can a
currently-serving alternate director be appointed as an alternate director. An alternate
director has all the rights and duties of the director appointing him, unless the
appointment of the alternate provides otherwise, and the right to remuneration. The
alternate director may not act at any meeting at which the appointing director is present.
Unless the time period or scope of the appointment is limited by the appointing director,
the appointment is effective for all purposes, but expires upon the expiration of the
appointing directors term. Currently, none of our directors has appointed any
alternate directors.

# Directors Service
Contracts

Except
directors who are also officers of the Company, none of our directors have any services
contracts either with us, or with any of our subsidiaries, which provide for benefits upon
termination of employment or service.

# Exculpation,
Indemnification and Insurance of Office Holders

Under
the Companies Law, an Israeli company may only exculpate an office holder in advance, in
whole or in part, for breach of duty of care and only if a provision authorizing such
exculpation is included in its articles of association. Our articles of association
include such a provision. A company may not exculpate an office holder in advance from his
liability towards the company which is caused by a breach of duty of care in case of
distribution (as defined in the Companies Law). A company may not exculpate an office
holder for breach of duty of loyalty. However, the company may approve an act performed in
breach of the duty of loyalty of an office holder provided that the office holder acted in
good faith, the act or its approval does not harm the company, and the office holder
discloses the nature of his or her personal interest in the act and all material facts and
documents a reasonable time before discussion of the approval.

A
company may indemnify an office holder in respect of certain liabilities either in advance
of an event or following an event provided a provision authorizing such indemnification is
inserted in its articles of association. Advance indemnification of an office holder must
be limited to the following:

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| | a
financial liability imposed on him in favor of another person pursuant to a judgment,
settlement or arbitrators award approved by court provided that the indemnification
shall be limited to events which are determined by the board of directors, are
foreseeable in light of the companys activities at the time when the obligation for
indemnification is granted, and to amounts and standards which are determined by the
board of directors as reasonable in such event, and provided that the obligation for
indemnification will specify the said events and amounts or standards;
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | reasonable
litigation expenses, including attorneys fees, incurred by the office holder or
imposed by a court in proceedings instituted against him by the company, on its behalf or
by a third party, in connection with criminal proceedings in which the officer holder was
acquitted or as a result of a conviction for a crime that does not require proof of
criminal intent; and
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | reasonable
litigation expenses, including attorneys fees, incurred by the office holder due to
investigation or proceedings instituted against the office holder by an authority
authorized to conduct such investigation or proceedings and ended without filing an
indictment against him and without imposing monetary liability as an alternative to
criminal proceedings or ended without filing an indictment against him but in imposing
monetary liability as an alternative to criminal proceedings for a crime that does not
require proof of criminal intent.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

A company may insure an office holder
against the following liabilities incurred for acts performed as an office holder:

| | a
breach of duty of loyalty to the company, to the extent that the office holder acted in
good faith and had a reasonable basis to believe that the act would not prejudice the
company;
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | a
breach of duty of care to the company or to a third party; and
|- | ----------------------------------------------------------------

| | a
financial liability imposed on the office holder in favor of a third party.
|- | -----------------------------------------------------------------------------

An Israeli company may not indemnify
or insure an office holder against any of the following:

| | a
breach of duty of loyalty, except to the extent that the office holder acted in good
faith and had a reasonable basis to believe that the act would not prejudice the company;
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | a
breach of duty of care committed intentionally or recklessly except that such
recklessness is made solely negligently;
|- | ------------------------------------------------------------------------------------------------------------------------

| | an
act or omission committed with intent to derive illegal personal benefit; or
|- | -------------------------------------------------------------------------------

| | a
fine levied against the office holder.
|- | ----------------------------------------

Under
the Companies Law, indemnification and insurance of office holders must be approved by our
audit committee and our board of directors and, in specified circumstances, by our
shareholders.

Our
articles of association allow us to indemnify and insure our office holders to the fullest
extent permitted by the Companies Law. Our office holders are currently covered by a
directors and officers liability insurance policy with an aggregate claim limit of
$5 million. As of the date of this annual report, no claims for directors and
officers liability insurance have been filed under this policy.

Our
U.S. subsidiary has also entered into indemnification agreements with certain of its key
employees. These agreements provide, independent of the indemnification these individuals
are entitled to by law and under the provisions of the subsidiarys charter,
indemnification for certain acts while employed by the subsidiary. These indemnification
agreements contain exclusions, such as limiting indemnification that would be unlawful or
that is covered by other liability insurance. Moreover, employees are not indemnified
against liability to the extent that the employee gained a personal profit to which he or
she is not legally entitled, including proceeds obtained from the illegal trading of our
equity securities. The performance of these agreements is guaranteed by us as parent of
the U.S. subsidiary, to the extent permitted by Israeli law.

# Compensation Committee

Our
board of directors established our compensation committee in July 1999. The duties of the
compensation committee are to review the terms of employment of our senior management, to
review and recommend to our board of directors the issuance and the allocation of options
under our share option plans and to perform any other task delegated by our board of
directors.

50

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The
current members of our compensation committee are Oded Bashan, Eliezer Manor, Shlomo
Toussia-Cohen and Eli Akavia.

# Steering Committee

Our
board of directors established our Steering Committee in November 2004. The duties of the
Steering Committee are to review the deployment of our company towards the implementation
of the Sarbanes-Oxley Act.

The
current members of our Steering Committee are our CFO, Controller, General Counsel and in
addition Oded Bashan and Eli Akavia.

# Audit Committee

Our
board of directors established our audit committee in July 1999. The Companies Law
requires public companies to appoint an audit committee consisting of at least three
directors, including all the external directors. The audit committees
responsibilities are governed by a written charter. The responsibilities of the audit
committee include appointing our independent registered accounting firm (subject to the
shareholders approval under the Companies Law) and identifying irregularities in the
management of our business in consultation with our independent accountants and the
internal auditor and suggesting appropriate responses. The audit committees
responsibilities also include approving related party transactions as required by the
Companies Law. Neither the chairman of the board of directors, nor any director employed
by or otherwise providing services on a regular basis to us, a controlling shareholder, or
relative of a controlling shareholder may be a member of the audit committee. The audit
committee may not approve an action or a transaction with a controlling shareholder, or
with an office holder, unless at least two external directors are serving on the audit
committee at the time of the approval, one of whom is present at the meeting at which the
approval is granted. In addition, pursuant to the listing requirements of the NASDAQ
National Market, we are required to maintain an audit committee including at least three
independent directors. In accordance with the provisions of the Sarbanes-Oxley Act, our
Audit Committee is required to pre-approve all audit and permitted non-audit services
provided by our external auditors.

The
current members of our audit committee are Shlomo Toussia-Cohen, Liora Katzenstein Eliezer
Manor and Eli Akavia, all of which are independent directors. Eli Akavia is
the Audit Committees Chairman, and our board has determined that he is an
Audit Committee Financial Expert.

# Internal Auditor

Under
the Companies Law, the board of directors must appoint an internal auditor that is
recommended by the audit committee. The role of the internal auditor is to examine, among
other things, whether the companys actions comply with the law and orderly business
procedure. Under the Companies Law, the internal auditor may not be an office holder or an
interested party, as defined below, or a relative of an office holder or an interested
party, and he or she may not be the companys independent accountant or the
independent accountants representative. The Companies Law defines an
interested party as a holder of 5% or more of the issued shares or voting
rights of a company, a person or entity who has the right to designate at least one
director or the general manager of the company, and a person who serves as a director or
general manager. In August 2000, our audit committee recommended and our board of
directors appointed Brightman Almagor & Co., the Israeli practice of Deloitte &
Touche LLP, as our internal auditors.

# Fiduciary Duties;
Approval of Certain Transactions

The
Companies Law codifies the fiduciary duties that office holders owe to a company. An
office holders fiduciary duties consist of a duty of care and a duty of loyalty. The
duty of care requires an office holder to act with the degree of care with which a
reasonable office holder in the same position would act under the same circumstances. The
duty of care includes using reasonable means to obtain information as to the advisability
of a given action submitted for his or her approval or performed by virtue of his or her
position, as well as all other information pertaining to such actions.

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The
duty of loyalty requires an office holder to act in good faith and for the benefit of the
company, and includes avoiding any conflict of interest between the office holders
other positions or personal affairs and the performance of his or her position in the
company, avoiding any competition with the company, avoiding exploiting any business
opportunity of the company in order to receive a personal benefit for himself or herself
or others, and revealing to the company any information or documents relating to the
companys affairs which come into the office holders possession as a result of
his or her position as an office holder.

The
Companies Law further requires that an office holder disclose to the company any personal
interest that he or she may have and all related material information known to him or her
in connection with any existing or proposed transaction by the company. The disclosure
must be made promptly and in no event later than the board of directors meeting at which
the transaction is first discussed. In addition, if the transaction is an extraordinary
transaction, as defined below, the office holder must also disclose any personal interest
held by the office holders spouse, siblings, parents, grandparents, descendants,
spouses descendants and the spouses of any of the foregoing and by any corporation
in which the office holder is a 5% or greater shareholder, director or general manager or
in which he or she has the right to appoint the general manager or at least one director.
The Companies Law defines an extraordinary transaction as a transaction that
is not in the ordinary course of business, that is not on market terms, or that is likely
to have a material impact on a companys profitability, assets or liabilities. In the
case of a transaction between the company and an office holder, or a third party in which
an office holder has a personal interest, but that is not an extraordinary transaction and
is not adverse to the companys interest, once the office holder complies with the
above disclosure requirements only board approval is required unless the articles of
association of the company provide otherwise. In the case of an extraordinary transaction
between the company and an office holder, or a third party in which an office holder has a
personal interest, in addition to any approval required by the articles of association,
the transaction must be approved first by the audit committee, then by the board of
directors and, in certain cases, by the shareholders. A director who has a personal
interest in a matter that is considered at a meeting of the board of directors or the
audit committee may in general not be present at this meeting or vote on this matter. If a
majority of the directors have a personal interest in an extraordinary transaction, these
directors are permitted to be present and vote on the transaction, but shareholder
approval is also required. Under NASDAQ Rule 4350(h), the Company should conduct an
appropriate review of all related party transactions for potential conflict of interest
situations on an ongoing basis and all such transactions should be approved by the
companys audit committee or another independent body of the Board of Directors.

Under
the Companies Law, all arrangements as to compensation of office holders who are not
directors require approval by the board of directors, and undertakings to indemnify or
insure an office holder who is not a director require both board and audit committee
approval. In general, arrangements regarding the compensation, indemnification and
insurance of directors require audit committee and shareholder approval in addition to
board approval. Under NASDAQ Rule 4350(c)(3)(A), compensation of the Chief Excutive
Officer must be determined, or recommended to the Board for determination, either by: (i)
a majority of the independent directors, or (ii) a compensation committee comprised solely
of independent directors. The Chief Executive Officer may not be present during voting or
deliberations. Under NASDAQ Rule 4350(c)(3)(B) compensation of all executive officers,
except the Chief Executive Officer, must be determined, or recommended to the Board for
determination, either by (i) a majority of the independent directors, or (ii) a
compensation committee comprised solely of independent directors.

The
Companies Law applies the same disclosure requirements to a controlling party of a public
company that it applies, as described above, to an office holder. For these purposes a
controlling party is any person possessing the ability to direct the
activities of the company, including a shareholder which holds 25% or more of the voting
rights of the company if no other shareholder owns more than 50% of the voting rights in
the company, but excluding a person whose power is derived solely from his or her position
on the board of directors or from another position with the company. Two or more
shareholders with a personal interest in the approval of the same transaction are deemed
to be joint shareholders. Extraordinary transactions with a controlling party or in which
a controlling party has a personal interest, and the engagement and terms of compensation
of a controlling party as an office holder, require the approval of the audit committee,
the board of directors and the shareholders. Shareholder approval must be by a majority of
shares voted at the meeting, including at least one-third of the shares of the
disinterested shareholders who are present, in person or by proxy, at the meeting, or,
alternatively, the total shareholdings of the disinterested shareholders who vote against
the transaction must not represent more than 1% of the aggregate voting rights in the
company.

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Under
the Companies Law, a shareholder has a duty to refrain from abusing his or her power in
the company and to act in good faith in exercising its rights and performing its
obligations to the company and other shareholders, including, among other things, voting
at a general meeting of shareholders on the following matters:

| |  | an
amendment to the articles of association;
| | - | --------------------------------------------

| |  | an
increase in the company's authorized share capital;
| | - | ------------------------------------------------------

| |  | a
merger; and
| | - | -------------

| |  | approval
of a related-party transaction requiring shareholder approval.
| | - | -----------------------------------------------------------------------

In
addition, any controlling shareholder, any shareholder who knows that its vote can
determine the outcome of a shareholder vote and any shareholder who, under a
companys articles of association, can appoint or prevent the appointment of an
office holder, is under a duty to act with fairness towards the company. The Companies Law
does not describe the substance of this duty.

# Compensation Committee
Interlocks and Insider Participation

Other
than Oded Bashan, who serves as a member of our compensation committee, none of the
members of our compensation committee or audit committee is currently, or has ever been at
any time since our formation, an officer or employee of our company. None of our executive
officers serves as a member of the board of directors or compensation committee of any
entity that has one or more executive officers serving on our compensation committee.

|D. | EMPLOYEES
|-- | ---------

The
breakdown of the number of our employees, including employees in our subsidiaries, by
department, is as follows:

|                                         | Number of employees as of December 31
|---------------------------------------- | -------------------------------------
|
|
|
|
|Sales and marketing                      |                                      
|Research and development and engineering |                                      
|Manufacturing and operations             |                                      
|Customer support                         |                                      
|Management and administration            |                                      
|                                         |                                      
|                                         |                                      
|Total                                    |                                      

The
substantial increase in the number of our employees in 2005 compared to 2004, was mainly
due to the acquisitions of e-Pilot and POI. Of these employees, on December 31, 2005, 104
were based in Israel, 12 in the United States, 99 in Europe, 31 in South Africa and 379 in
the Far East.

Under
applicable law and by order of the Israeli Ministry of Labor and Welfare, we and our
Israeli employees are subject to certain provisions of the collective bargaining
agreements between the Histadrut, the General Federation of Labor in Israel and the
Coordination Bureau of Economic Organizations, including the Industrialists Association.
These provisions principally concern cost of living increases, length of the working day,
minimum daily wages for professional employees, contributions to pension funds, insurance
for work-related accidents, procedures for dismissing employees, determination of
severance pay, annual and other vacation, sick pay and other conditions of employment. We
provide our employees with benefits and working conditions above the required minimum and
which we believe are competitive with benefits and working conditions provided by similar
companies in Israel. Our employees are not represented by a labor union. We have written
employment agreements with substantially all of our employees. Competition for qualified
personnel in our industry is intense and it may be difficult to attract or maintain
qualified personnel to our offices. We dedicate significant resources to employee
retention and have never experienced work stoppages and we believe that our relations with
our employees are good.

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|E. | SHARE
OWNERSHIP
|-- | ---------------

The
following table sets forth certain information as of May 22, 2006 regarding the beneficial
ownership of our ordinary shares by each of our directors and executive officers:

|                                                | Shares beneficially owned
|----------------------------------------------- | -------------------------
|
|
|
|
|Oded Bashan (1)                                 |                          
|Ronnie Gilboa                                   |                          
|Guy Shafran                                     |                          
|Moshe Aduk                                      |                          
|Nehemya Itay                                    |                          
|Ohad Bashan                                     |                          
|Shlomo Tussia-Cohen (2)                         |                          
|Eliezer Manor (3)                               |                          
|Liora Katzenstein (4)                           |                          
|Eli Akavia (5)                                  |                          
|All executive officers and directors as a group |                          

*** Less than 1%

|(1) | Includes
813,171 ordinary shares held by Mr. Bashan. Also includes 15,450                ordinary
shares held by Mr. Bashans wife. Mr. Bashan disclaims beneficial
               ownership of the share held by his wife. Also includes 2,212,891 ordinary
shares                as to which Mr. Bashan has voting power pursuant to irrevocable
proxy granted to                him.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Consists
of options held by Mr. Tussia-Cohen to purchase 40,000 ordinary shares.
|--- | --------------------------------------------------------------------------------

|(3) | Consists
of options held by Mr. Manor to purchase 78,500 ordinary shares.
|--- | -------------------------------------------------------------------------

|(4) | Consists
of options held by Ms. Katzenstein to purchase 69,500 ordinary shares.
|--- | -------------------------------------------------------------------------------

|(5) | Consists
of options held by Mr. Akavia to purchase 65,000 ordinary shares.
|--- | --------------------------------------------------------------------------

# Share Option Plans

The
following is a description of the share option plans that we and our subsidiaries
maintain. In addition to the discussion below, please see Notes 10B and 10C to our
consolidated financial statements. Under Israeli law, except for issuances of options to
directors, or their families, share option plans and revisions to these plans are not
subject to shareholder approval. Under Nasdaq rules, however, absent an exemption, most
new share option plans and material revisions are subject to shareholders approval.

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# 2006 Alternative Option
Exercise Mechanism

On
April 11, 2006, we offered to each of our and our subsidiaries employees, and the
our directors and office holders (other than External Directors, as such term
is defined in the Israeli Companies Law of 1999) who held outstanding options to purchase
an aggregate of 4,485,017 of our ordinary shares, which were issued by us pursuant to the
terms of the our 2001 Share Option Plan or the Companys 1995 Share Option Plan,
which was superseded by the 2001 Share Option Plan, as amended, which we collectively
refer to as the Share Option Plan, to exercise all of his or her outstanding options into
a new number of ordinary shares, based on the Black-Scholes pricing model according to the
following principles. We refer to this offer as the Alternative Option Exercise Mechanism
or AOEM. Our Board of Directors approved the AOEM, on February 12, 2006. Further, our
shareholders approved the AOEM at an extraordinary meeting of the shareholders on March
21, 2006.

| |  | Each
option exercised in accordance with the terms of the AOEM was exercised without a cash
payment into the number of ordinary shares equal to a fraction, the numerator of which
was the economic value of the option on March 21, 2006, the date the AOEM was approved by
our shareholders,(based on the Black-Scholes model) and the denominator was $15.04, the
closing market price of our ordinary shares on NASDAQ on such date.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Each
person holding vested options could, pursuant to the AOEM, exercise such vested options,
provided, that such holder entered into a 33 month lock-up arrangement with respect to
82.5% of the shares received, with 7.5% of such shares to be released from the lock-up at
the end of each calendar quarter commencing with the first quarter ending after the May
16, 2006.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Each
person holding unvested options could, pursuant to the AOEM, exercise such unvested
options, provided, that such holder entered into a lock-up arrangement wherein the shares
received are restricted or locked-up in accordance with the vesting period provided for
in the original terms of the applicable option agreement, provided, however, that if the
vesting of the unvested options is subject to the holders continued employment or
relationship with us or the general terms of the unvested options expire as a result of
termination of the holders employment for cause, or due to the holders death
or disability, such provisions apply to the shares issued pursuant to the AOEM. Holders
could be required to forfeit shares if, in accordance with the terms of the applicable
option agreement, the occurrence of any events covered by those provisions would require
the holder to forfeit his or her options.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Each
person who chose to exercise his or her options pursuant to the AOEM was required to sign
an irrevocable proxy pursuant to which the voting rights associated with the shares
received were granted to our Chairman, Oded Bashan, on behalf of the Board of Directors,
or to whom our Board of Directors may choose, until the sale or transfer of the shares to
an unaffiliated third party.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Each
Holder had a period of 25 business days to accept the AOEM. The AOEM terminated at
midnight, U.S. Eastern time, on the evening of May 16, 2006. As a result of the AOEM, we
issued a total of 2,448,816 ordinary shares in exchange for options to acquire a total of
3,771,436 ordinary shares. If a holder of options did not participate in the AOEM, the
original terms of his or her option agreement and the Share Option Plan continue to apply
and such option may be exercised in accordance with its terms.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

2001 Share Option Plan

We
established our 2001 Share Option Plan in February 2001. The plan provides for the grant
of options to our employees, directors and consultants, and those of our subsidiaries and
affiliates. Upon establishment of the plan, we reserved 75,000 ordinary shares for
issuance. On February 26, 2002, on July 12, 2002, on March 28, 2003, on July 16, 2003, on
September 2, 2003, on November 17, 2003, on April 20, 2004, on March 25, 2005, and on
September 25, 2005, our board of directors adopted certain resolutions with regard to the
2001 Share Option Plan that increased the number of available options under the plan by a
total of 9,675,000 so that the aggregate number of options available under the plan is now
9,750,000, of which, 4,500,000 options are subject to shareholders approval or NASDAQ
exemption as set forth below. The increase of the number of available options under the
plan pursuant to the Board of Directors resolutions dated March 28, 2003, July 16, 2003
and September 2, 2003 were subject to either our shareholders approval or an
exemption granted pursuant to NASDAQ Market Place Rules that such approval is not
required. We applied for an exemption in connection with such increases approved by the
board of directors and such exemption has been granted by NASDAQ due to differences
between the Israeli law and NASDAQ rules. On November 17, 2003, our board of directors
approved a further increase of 500,000 options subject to either shareholders
approval or additional exemption from NASDAQ. On April 20, 2004, our board of directors
approved a further increase of 2,500,000 options subject to either shareholders
approval or additional exemption from NASDAQ. On March 25, 2005, our board of directors
approved a further increase of 2,500,000 options subject to either shareholders
approval or additional exemption from NASDAQ. As of December 31, 2005, the Company did not
obtain an exemption from NASDAQ with regard to this increase. On September 25, 2005, our
board of directors approved a further increase of 2,000,000 options subject to either
shareholders approval or additional exemption from NASDAQ. As of December 31, 2005,
the Company did not obtain an exemption from NASDAQ with regard to this increase. Under
this plan, as of May 22, 2006, 3,823,778 options had been exercised and 967,462 are
outstanding and exercisable. Of the options that are outstanding, as of May 22, 2006,
253,000 are held by our directors and officers listed above under Item
6.A  Directors and Senior Management, and have a weighted average exercise
price of $7.45.

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On
February 26, 2002, our board of directors resolved to approve a grant by which, inter
alia, we may pay, during a 12-month period, the salaries of certain of its employees who
agree to participate in the grant, by way of grant of options. All such options are to be
held by a trustee, for the benefit of each such employee. At the direction of and in
accordance with instructions given by an employee who has received options, the trustee
shall exercise such options and sell the shares issued upon such exercise. The proceeds
mentioned above will be released on a monthly basis by the trustee (net of deductions
required by law) to the maximum extent necessary for payment of such monthly salary to
such employee. We undertook to pay from our own sources any and all differences between
the relevant monthly salary and such proceeds. On March 28, 2003, our board of directors
approved the extension of the arrangement for an additional period of six months
commencing May 2003 and on October 28, 2003 our board of directors approved the extension
of the arrangement for the employees of InterCard Systemelectronic for the period
commencing November 2003 and ending July 2004. On August 26, 2004, our board of directors
approved the extension of the arrangement for an additional period of six months
commencing July 2004 and on November 26, 2004 our board of directors approved the
extension of the arrangement for an additional period of twelve months commencing January
2005. The principal purpose of this arrangement is to enable us to use our available cash
for other proper corporate purposes, including payment of sales expenses and research and
development costs.

Our
2001 Share Option Plan is administered by our compensation committee which makes
recommendations to our board of directors regarding the grantees of options and the terms
of the grant, including exercise prices, grant dates, vesting schedules, acceleration of
vesting and forfeiture. Under the Companies Law the allocation of options is solely within
the authority of our board of directors. Under the plan, the terms and conditions of
options are set forth in individual option agreements with the grantee.

Under
the plan, if the employment of a grantee is terminated for cause, all of his or her
options expire immediately. A grantee whose employment is terminated without cause may
exercise his or her vested options within three months of termination. If the termination
is due to the death or disability of the grantee, the options may be exercised within 18
months of the date of termination in the case of death and 12 months in the case of
disability.

In
accordance with the terms and conditions imposed by Section 102 of the Israel Income
Tax Ordinance, or the Ordinance, grantees that receive options under the 2001 Share
Option Plan (excluding grantees who previously received options that were incorporated
upon the commencement of Amendment No. 132 of the Income Tax ordinance, or the Tax Reform,
that was approved on July 24, 2002 and became effective on January 1, 2003, and those who
are not employees or office holders and those who are our controlling shareholders) are
afforded certain tax benefits. We elected the benefits available under the capital
gains alternative. There are various conditions that must be met in order to qualify
for these benefits, including registration of the options in the name of a trustee, or the
Trustee, for each of the employees who is granted options. Each option, and any ordinary
shares acquired upon the exercise of the option, must be held by the Trustee for a period
commencing on the date of grant and ending no earlier than 24 months after the end of the
tax year in which the option was granted and deposited in trust with the Trustee. In the
capital gains track a company may not recognize expenses pertaining to the options for tax
purposes. We also granted our employees options pursuant to Section 102(c) of the
Ordinance that are not held in trust by a trustee, which while enabling the immediate
exercising and selling of options granted under the 2001 Share Option Plan, will be
subject to the marginal tax rate up to 50% plus payments to the National Insurance
Institute and health tax on the date of the sale of the shares or options. As of January
1, 2003, Section 3(i) of the Ordinance was partially replaced by Section 102(c) and no
longer applies to allocations of options to employees (including directors and office
holders). Section 3(i) still applies and imposes taxes on those who are not employees
(such as consultants and service providers) and to employees who are considered
controlling shareholders.

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1995 Share Option Plan

We
established our 1995 Share Option Plan in December 1995. The plan provides for the grant
of options to our employees. Our 1995 Share Option Plan has been superseded by our 2001
Share Option Plan and we have ceased to grant options under our 1995 Share Option Plan. On
July 12, 2002 our board of directors adopted certain resolutions with regard to the 1995
Share Option Plan that increased the number of available options under the plan by 30,300
so that the aggregate number of options available under this plan is 130,300. Under this
plan, as of May 22, 2006, 79,007 options to purchase shares had been exercised and none of
the options are outstanding.

Generally,
options issued under the plan vest over a period of three to five years in equal annual
installments commencing immediately following the grant date. Under the plan, if the
employment of a grantee is terminated for cause, all of his or her options expire
immediately. Generally, a grantee whose employment is terminated without cause after a
trial period of no less than six months may exercise his or her vested options. If the
termination is due to the death of the grantee, the options may be exercised within twelve
months of the date of termination. In the event of disability or retirement of the
grantee, the compensation committee determines the treatment of options held by the
grantee.

Our
1995 Share Option Plan is subject to the same provisions of the Israeli Income Tax
Ordinance as our 2001 Share Option Plan.

2001 Employee Share
Purchase Plan

In
June 2001, we approved the establishment of an employee share purchase plan. No shares
have been issued under the plan. Under the plan, we have reserved 67,500 ordinary shares
for purchase by our employees and those of our subsidiaries who have been employed for at
least six months. Eligible employees may purchase our ordinary shares at 85% of the lesser
of the fair market value of our ordinary shares of the first day of the applicable
offering period or the first day of the applicable offering period.

|ITEM 7. | MAJOR
SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
|------- | -------------------------------------------------

|A. | MAJOR
SHAREHOLDERS
|-- | ------------------

The
following table provides summary information regarding the beneficial ownership by the
following persons of our outstanding ordinary shares as of May 22, 2006:

| |  | each
person or entity known to beneficially own more than 5% of our ordinary shares;
| | - | ------------------------------------------------------------------------------------

| |  | all
of our executive officers and directors as a group.
| | - | -------------------------------------------------------

Beneficial
ownership of shares is determined under the rules of the Securities and Exchange
Commission and generally includes any shares over which a person exercises sole or shared
voting or investment power. To our knowledge and except as indicated by footnote, each
person identified in the table below possesses sole voting and investment power with
respect to all ordinary shares held by them.

The
table also includes the number of shares underlying options and warrants that are
exercisable within 60 days of May 22, 2006. Ordinary shares subject to these options and
warrants are deemed to be outstanding for the purpose of computing the ownership
percentage of the person holding these options and warrants, but are not deemed to be
outstanding for the purpose of computing the ownership percentage of any other person. The
table reflects a total of 15,251,367 ordinary shares outstanding as of May 22, 2006.
Unless otherwise indicated below, the address of each director, executive officer or
listed shareholder is care of On Track Innovations Ltd., Z.H.R. Industrial Zone, P.O. Box
32, Rosh Pina, Israel 12000.

57

---

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|                                                | Shares beneficially owned
|----------------------------------------------- | -------------------------
|
|
|
|
|Oded Bashan (1)                                 |                          
|All executive officers and directors as a group |                          
|Palo Alto Investors (2)                         |                          
|William Leland Edwards (3)                      |                          

---

|(1) | Includes
813,171 ordinary shares held by Mr. Bashan. Also includes 15,450                ordinary
shares held by Mr. Bashans wife. Mr. Bashan disclaims beneficial
               ownership of the share held by his wife. Also includes 2,212,891 ordinary
shares                as to which Mr. Bashan has voting power pursuant to irrevocable
proxy granted to                him.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | This
information is based solely on a Schedule 13G filed with the SEC on May 8,
               2006 by Palo Alto Investors. Based on the information provided in such
Schedule                13G, the address of Palo Alto Investors is: 470 University
Avenue, Palo Alto, CA                94301. Palo Alto Investors reports sole voting power
over 2,114,808 shares.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | This
information is as of December 31, 2005 and is based solely on a Schedule
               13G filed with the SEC on November 1, 2005, by William Leland Edwards.
Based on                the information provided in such Schedule 13G, the address of
William Leland                Edwards is: 470 University Avenue, Palo Alto, CA 94301.
William Leland Edwards                reports shared voting power over 1,292,368 shares,
and shared dispositive power                over 1,292,368 shares.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Significant Changes in
the Ownership of Major Shareholders.

2005 Financing

On
November 1, 2005 we completed an approximately $22.2 million private placement, or the
Private Placement, of new equity financing with institutional investors from the US,
Switzerland and England. We intend to use the net proceeds from the private placement to
support large-scale implementation of projects in the ID and payments markets. The
transaction involved the sale of 1,828,026 units, of which (i) 1,544,568 consist of one
ordinary share and a warrant to purchase three-fifths (3/5) of an ordinary share and (ii)
283,458 consist of one ordinary share and a warrant to purchase one-half (1/2) of an
ordinary share. The purchase price for each of the 1,828,026 units was $12.15 per unit,
which equaled the average closing price of our ordinary shares on the NASDAQ National
Market during the last five trading days before pricing.

The
1,196,431 warrants, which are exercisable as of May 1, 2006, are for the purchase of an
aggregate of up to 1,068,470 ordinary shares, they have terms of five years and an
exercise price of $14.58 per share, and may be redeemed by OTI after two years if the
market price of the underlying ordinary shares reaches $26.25 and certain other conditions
are met. Purchasers of 1,544,568 of the ordinary shares included in the units, and
purchasers of all of the warrants included in the units, have agreed to
lock-up such shares and warrants until May 1, 2006.

58

---

---



2006 Warrants Tender Offer

On
April 23, 2006, we offered to the holders of warrants to purchase an aggregate of 820,800
ordinary shares, or the 2004 Warrants, which were sold by us on April 29, 2004 pursuant to
a private placement transaction, and to the holders of 1,196,431 warrants to purchase an
aggregate of 1,068,470 ordinary shares, or the 2005 Warrants, which were sold by us on
November 1, 2005 pursuant to a separate private placement transaction, referred to
collectively with the 2004 Warrants as the Warrants, for a period of 60 days, (1) to
reduce the exercise price of the 2004 Warrants from $13.97 to $12.29 per share; and (2) to
reduce the exercise price of the 2005 Warrants from $14.58 to $12.39 per share. The
warrant offer expires at midnight, U.S. Eastern time, on June 22, 2006. Our Board of
Directors approved the warrant offer on February 12, 2006. Further, our shareholders
approved the warrant offer at an extraordinary meeting of the shareholders on March 21,
2006.

# Major Shareholders
Voting Rights

Our
major shareholders do not have different voting rights.

# Record Holders

Based
on a review of the information  provided to us by our transfer agent, as of May 22, 2006,  there
were 38 holders of record of our ordinary  shares,  of which 19 record holders holding  approximately  13.5% of
our ordinary  shares had registered  addresses in the United States.  These numbers are not  representative  of
the  number of  beneficial  holders of our shares nor is it  representative  of where such  beneficial  holders
reside since many of these  ordinary  shares were held of record by brokers or other  nominees  (including  one
U.S. nominee company,  CEDE & Co., which held  approximately 80% of our outstanding  ordinary shares as of said
date).

|B. | RELATED
PARTY TRANSACTIONS
|-- | --------------------------

Our
policy is to enter into transactions with related parties on terms that are on the whole
no less favorable to us than those that would be available from unaffiliated parties.
Based on our experience in the business sectors in which we operate and the terms of our
transactions with unaffiliated third parties, we believe that all of the transactions
described below met this policy standard at the time they occurred.

# Agreement with HolyTech
Ltd.

In
January 1996, we entered into an agreement with HolyTech Ltd., a company owned by Varda
Bashan, Ora Gilboa and certain other of our shareholders, which formalized an arrangement
that had existed since 1992. Varda Bashan is the spouse of Oded Bashan, our co-founder and
chairman of our board of directors, and Ora Gilboa is the spouse of Ronnie Gilboa, our
co-founder and a director. Under the agreement, HolyTech provides us with management and
engineering services as needed. Mrs. Bashan provides administration services, Mrs. Gilboa
provides sales operation services and a number of other shareholders of HolyTech, who are
also our employees, provide engineering and warehouse services. HolyTech has no activities
other than the provision of these services to us. The cost of these services is intended
to equal the cost of these services if performed by unrelated parties. The aggregate
consideration for the services that HolyTech provided to us was $76,000 in 2003, $44,000
in 2004 and $45,000 in 2005. On August 25, 2000, our audit committee reviewed and
reapproved the terms of this agreement.

# Agreements with
Directors and Officers

We have entered into employment
agreements with all of our officers. In addition, we have granted options to purchase our
ordinary shares to our officers and directors. On January 31, 2003 the shareholders of OTI
approved a bonus plan for our senior management and on July 11, 2003 our general meeting
approved a plan to issue options to our non-executive directors.

59

---

---



# Agreement Relating to
Insurance Services

We
have been receiving insurance agency services from a family member of one of our officers.
On August 22, 2003, our board of directors ratified and approved such engagement in
accordance with the applicable Israeli Companies Law provisions.

|C. | INTERESTS
OF EXPERTS AND COUNSEL
|-- | --------------------------------

Not
applicable.

|ITEM 8. | FINANCIAL
INFORMATION
|------- | ---------------------

|A. | CONSOLIDATED
FINANCIAL STATEMENTS AND OTHER FINANCIAL INFORMATION
|-- | -----------------------------------------------------------------

The
financial statements required by this item are found in Item 18 of this annual report,
beginning on page F-1.

# Legal Proceedings

We
are currently not a party to any material legal proceedings and are not aware of any
pending or threatened litigation against us that we believe would have a material adverse
effect on our business and the business of our subsidiaries taken as a whole. During the
last two fiscal years, we have not been a party to any legal proceedings that have had a
material adverse effect on our business and the business of our subsidiaries taken as a
whole.

On
September 3, 2003, Edi Wuhl, a former employee of the Company, filed a suit against the
Company to the District Labor Court in Nazareth in the amount of NIS 3,953 (approximately
$900). The suit is based on Mr. Wuhls claims that the Company has breached the
employment agreement with him, and that the Company owes him commission payment for
certain sales. On December 17, 2003, the Company filed a statement of defense. On May 23,
2004, a preliminary hearing was conducted, which did not lead to any settlement. The proof
hearing that was scheduled to September 25, 2005 was postponed for April 23, 2006. The
Company is required to file its answers in May 2006. In the opinion of the Company, based
on advice of its legal advisor, the plaintiffs chances of prevailing against the
Company are remote. No provision in respect thereof has been included in the financial
statements.

On
October 15, 2005, Sinocard Technology Limited, or Sincord, filed a suit against e-Pilot
Group Limited and Oriental Power Technology Limited, two subsidiaries of the Company, and
certain directors of the subsidiaries, in the High Court of The Hong Kong SAR. The action
is based, inter alia, on Sinocards claims that it is entitled to one third of the
issued and outstanding shares of Oriental Power Technology Limited, pursuant to a certain
agreement that allegedly exists between the parties. Sinocard demands that the
subsidiaries shall cause the issuance of such shares. In addition, Sinocard seeks to be
compensated for damages and for alleged unjustified enrichment of the defendants
(including the subsidiaries). The subsidiaries and the other defendants filed their
statement of defense. Pursuant to the rules of Hong Kong Court, Sinocard must lodge an
application at Court seeking instructions for further conduct of the matter. By March 24,
2006 such application has not been made. This case is in a preliminary stage so it is not
possible to asses the likelihood of an unfavorable outcome or the magnitude of any
potential loss. No provision in respect thereof has been included in the financial
statements.

# Dividend Policy

We
have never declared or paid any cash dividends on our ordinary shares or other securities.

We currently
expect to retain all future earnings, if any, to finance the development of our business,
and do not anticipate paying any cash dividends in the foreseeable future. Any future
determination relating to dividend policy will be made by our board of directors and will
depend on a number of factors, including future earnings, capital requirements, financial
condition and future prospects and other factors the board of directors may deem relevant.
In the event of a distribution of a cash dividend out of tax exempt income, we will be
liable for corporate tax at a rate of 25% in respect of the amount distributed.

60

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|B. | SIGNIFICANT
CHANGES
|-- | -------------------

Except
as otherwise disclosed in this annual report, no significant change has occurred since
December 31, 2005.

|ITEM 9. | THE
OFFER AND LISTING
|------- | ---------------------

|A. | OFFER
AND LISTING DETAILS
|-- | -------------------------

Our
ordinary shares were quoted on the Neuer Market of the Frankfurt Stock Exchange since
August 31, 1999 until January 31, 2003. Since January 31, 2003, the shares have been
listed on the new Prime Standard Segment of the Frankfurt Stock Exchange. Following the
approval of our General shareholders meeting, our Board of Directors applied for the
delisting of our shares from the Frankfurt Stock Exchange, which has been approved. The
last day of trading of our ordinary shares on Frankfurt Stock Exchange was December 20,
2005. Our shares were quoted on the NASDAQ SmallCap Market from November 12, 2002 until
December 20, 2004. On December 16, 2004, we were approved for listing on the NASDAQ
National Market, and our shares commenced trading on NASDAQ National Market on December
20, 2004.

The
following table shows, for the periods indicated, the high and low closing prices of our
ordinary shares in Euros giving effect to the reverse split as reported on the Neuer
Market of the Frankfurt Stock Exchange. The closing prices that are indicated below
commencing January 31, 2003 were as reported in the Prime Standard Market of the Frankfurt
Stock Exchange. It also shows, for the periods indicated, the high and low closing prices
of our ordinary shares expressed in U.S. dollars based on the noon buying rate in New York
City for cable transfers in foreign currencies, as certified for customs purposes by the
Federal Reserve Bank of New York on the relevant dates. See the discussion below for the
exchange rates applicable during the periods set forth below. The following table also
shows, for the periods indicated since November 2002 until December 2004, the high and low
closing prices of our ordinary shares in U.S. dollars as reported on NASDAQ SmallCap, and
for the periods indicated since December 2004, the high and low closing prices of our
ordinary shares in U.S. dollars as reported on NASDAQ National Market.

|               | Frankfurt Stock
Exchange (1)(3)
per
Share  | Frankfurt Stock
Exchange (1)(3)
per
Share $ | Nasdaq National
Market (2)
per
Share $
|-------------- | ------------------------------------------- | ------------------------------------------- | --------------------------------------
|
|
|
|
|Year           |                                             |                                             |                                       
|2001           |                                             |                                             |                                       
|2002           |                                             |                                             |                                       
|2003           |                                             |                                             |                                       
|2004           |                                             |                                             |                                       
|2005           |                                             |                                             |                                       
|               |                                             |                                            
|2004           |                                             |                                            
|First quarter  |                                             |                                             |                                       
|Second quarter |                                             |                                             |                                       
|Third quarter  |                                             |                                             |                                       
|Fourth quarter |                                             |                                             |                                       
|2005           |                                             |                                            
|First quarter  |                                             |                                             |                                       
|Second quarter |                                             |                                             |                                       
|Third quarter  |                                             |                                             |                                       
|Fourth quarter |                                             |                                             |                                       
|2006           |                                             |                                            
|First quarter  |                                             |                                             |                                       

61

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|              | Frankfurt Stock
Exchange (1)(3)
per
Share  | Frankfurt Stock
Exchange (1)(3)
per
Share $ | Nasdaq National
Market (2)
per
Share $
|------------- | ------------------------------------------- | ------------------------------------------- | --------------------------------------
|
|              |                                             |                                            
|Month         |                                             |                                            
|November 2005 |                                             |                                             |                                       
|December 2005 |                                             |                                             |                                       
|January 2006  |                                             |                                             |                                       
|February 2006 |                                             |                                             |                                       
|March 2006    |                                             |                                             |                                       
|April 2006    |                                             |                                             |                                       
|May 2006      |                                             |                                             |                                       

|(1) | Our
ordinary shares were quoted on the Neuer Market of the Frankfurt Stock           Exchange
from August 31, 1999 until January 31, 2003, after which, until           December 20,
2005, the shares have been listed on the new Prime Standard Segment           of the
Frankfurt Stock Exchange. To the extent required, shares prices are           adjusted to
give effect to our 10-for-1 reverse share split effective as of June           17, 2002.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Our
ordinary shares were quoted on the NASDAQ SmallCap Market from November 12,
          2002 until December 20, 2004. On December 16, 2004, we were approved for
listing           on the NASDAQ National Market, and our ordinary shares commenced
trading on the           National Market on December 20, 2004.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Until
December 20, 2005
|--- | -----------------------

|B. | PLAN
OF DISTRIBUTION
|-- | --------------------

Not
applicable.

|C. | MARKETS
|-- | -------

Our
ordinary shares are traded publicly on the NASDAQ National Market under the symbol
OTIV since December 20, 2004, and were traded on the NASDAQ Small Cap Market
from November 12, 2002 until December 20, 2004. Until December 20, 2005, our ordinary
shares were traded publicly on the Prime Standard Market of the Frankfurt Stock Exchange
under the symbol OT5.

|D. | SELLING
SHAREHOLDERS
|-- | --------------------

Not
applicable.

|E. | DILUTION
|-- | --------

Not
applicable.

|F. | EXPENSES
OF THE ISSUE
|-- | ---------------------

Not
applicable.

|ITEM 10. | ADDITIONAL
INFORMATION
|-------- | ----------------------

|A. | SHARE
CAPITAL
|-- | -------------

Not
applicable.

62

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|B. | MEMORANDUM
AND ARTICLES OF ASSOCIATION
|-- | --------------------------------------

We
were incorporated under the laws of the State of Israel on February 15, 1990, under the
name of De-Bug Innovations Ltd., with unlimited duration. We are registered with the
Israeli registrar of companies in Jerusalem. Our founders were Oded Bashan and Ronnie
Gilboa and our registration number is 52-004286-2. Our name was changed to On Track
Innovations on July 8, 1991. Our objectives under our memorandum of association are to
engage in any activity related to innovation and inventions in the fields of science and
technology.

The
following is a summary of the material provisions of our Articles of Association and
related provisions of Israeli corporate law. This summary is qualified in its entirety by
reference to the complete text of the Articles of Association; see Item
4.  Information on the Company.  General and Item
19.  Exhibits.

# Description of Shares

Our
authorized share capital consists of 30,000,000 ordinary shares, NIS 0.1 nominal value.

The
following table sets out changes in our authorized share capital that occurred during the
last three years:

|Date              | Nature of Action               | State of Authorized Share Capital After
the Action
|----------------- | ------------------------------ | --------------------------------------------------
|
|
|
|
|June 17, 2002     | Consolidation of share capital | NIS 500,000 divided into 5,000,000                
|                  | (10-to-1 reverse stock split)  | ordinary shares of nominal value NIS 0.1.         
|November 14, 2003 | Increase in share capital by   | NIS 1,000,000 divided into 10,000,000             
|                  | additional 5,000,000 shares    | ordinary shares of nominal value NIS 0.1          
|April 6, 2004     | Increase in share capital by   | NIS 3,000,000 divided into 30,000,000             
|                  | additional 20,000,000 shares   | ordinary shares of nominal value NIS 0.1.         

Description of Ordinary
Shares

As
of May 22, 2006, our authorized share capital consists of 30,000,000 ordinary shares,
nominal value of NIS 0.1 per share, of which 15,251,367 were issued and outstanding.

The
ownership or voting of ordinary shares by non-residents of Israel is not restricted in any
way by our articles of association or the laws of the State of Israel, except that
nationals of countries which are in a state of war with Israel might not be recognized as
owners of ordinary shares.

# Dividend and Liquidation
Rights

We
are permitted to declare a dividend to be paid to the holders of ordinary shares, but we
have never declared a dividend and we do not anticipate any dividend declaration in the
foreseeable future. Dividends may only be paid out of our profits and other surplus funds,
as defined in the Companies Law, as of the end of the most recent fiscal year or as
accrued over a period of two years, whichever is higher, provided that there is no
reasonable concern that payment of a dividend will prevent us from satisfying our existing
and foreseeable obligations as they become due. In the event of our liquidation, after
satisfaction of liabilities to creditors, our assets will be distributed to the holders of
ordinary shares in proportion to the nominal value of their holdings. This right may be
affected by the grant of preferential dividend or distribution rights to the holders of a
class of shares with preferential rights that may be authorized in the future by our
shareholders. Under the Companies Law, the declaration of a dividend does not require the
approval of the shareholders of a company unless the companys articles of
association require otherwise. Our articles of association provide that our board of
directors may declare and pay dividends without the approval of our shareholders.

63

---

---



# Preemptive Rights

Under
Israeli law, shareholders in public companies such as ours do not have preemptive rights.

This
means that our shareholders do not have the legal right to purchase shares in a new issue
before they are offered to third parties. As a result, our shareholders could experience
dilution of their ownership interest if we decide to raise additional funds by issuing
more shares and these shares are purchased by third parties.

# Voting,
Shareholders Meetings and Resolutions

Holders
of our ordinary shares have, for each ordinary share held, one vote on all matters
submitted to a vote of shareholders. These voting rights may be affected by the grant of
any special voting rights to the holders of a class of shares with preferential rights
that may be authorized in the future by our shareholders. The quorum required for a
general meeting of shareholders consists of at least two shareholders present, in person
or by proxy, who hold or represent together at least 25% of our issued and outstanding
ordinary shares, provided, however that as long as we are listed on NASDAQ, the quorum at
a general meeting shall be two members present in person or by proxy holding at least
33-1/3% of our issued and outstanding ordinary shares or such higher percentage as NASDAQ
may impose on listed companies from time to time so long as such higher percentage is in
effect. A meeting adjourned for lack of a quorum is generally adjourned to the same day in
the following week at the same time and place. If a quorum is not present within half an
hour following the time appointed for the reconvened meeting, the shareholders then
present, in person or by proxy, shall constitute a quorum.

Under
the Companies Law, unless otherwise provided in the articles of association or by
applicable law, shareholders resolutions require the approval of holders of a simple
majority of our ordinary shares voting, in person or by proxy on the matter. A
shareholders resolution to amend our articles requires the approval of a simple
majority of our shareholders present in person or by proxy.

Under
the Companies Law, a shareholder has certain duties of good faith and fairness towards the
company.

# Transfer of Shares and
Notices

Fully
paid ordinary shares are issued in registered form and may be freely transferred under our
articles of association unless the transfer is restricted or prohibited by Israeli law or
the rules of a stock exchange on which the shares are traded. Under the Companies Law,
unless otherwise provided in the articles of association or by applicable law,
shareholders of record are entitled to receive at least 21 days prior notice of meetings
of shareholders. Our articles of association provide that each shareholder of record is
entitled to receive at least 14 days prior notice of any annual or extraordinary
shareholders meeting and at least 21 days prior notice of any shareholders
meeting at which a special resolution is proposed.

# Special Notification
Duties

Our
articles of association provide that any shareholder whose shareholding increases above
1%, 5%, 10%, 15%, 20%, 25%, 30%, and so on, of our then outstanding share capital, is
obliged to notify us in writing of such change within ten days. A shareholder who fails to
comply with this requirement will be denied his or her voting rights, in respect of shares
in excess of the particular threshold the crossing of which was not reported, for a six-
to 24-month period to be determined in light of relevant circumstances by the board of
directors in its sole discretion. Shareholders complying with the filing requirements of
Sections 13(d) and 13(g) of the Exchange Act and the regulations promulgated thereunder
will not be subject to this requirement.

64

---

---



# Anti-Takeover Provisions
under Israeli Law

Tender
Offer. A person wishing to acquire shares of a publicly traded Israeli company and who
would as a result hold over 90% of the companys issued and outstanding share capital
is required by the Companies Law to make a tender offer to all of the companys
shareholders for the purchase of all of the issued and outstanding shares of the company.
If the shareholders who refuse to sell their shares hold less than 5% of the issued share
capital of the company, all of the shares held by such shareholders that the acquirer
offered to purchase will be transferred to the acquirer by operation of law. However, the
shareholders may petition the court to alter the consideration for the acquisition. If the
dissenting shareholders hold more than 5% of the issued and outstanding share capital of
the company, the acquirer may not acquire additional shares of the company from
shareholders who accepted the tender offer if following such acquisition the acquirer
would then own over 90% of the companys issued and outstanding share capital.

The
Companies Law provides that an acquisition of shares of a public company must be made by
means of a tender offer if as a result of the acquisition the purchaser would become a 25%
or greater shareholder of the company. This rule does not apply if there is already
another 25% shareholder of the company. As of the date of this annual report, we are not
aware of any single shareholder which holds 25% or more of our shares. Similarly, the
Companies Law provides that an acquisition of shares in a public company must be made by
means of a tender offer if as a result of the acquisition the purchaser would become a 45%
or greater shareholder of the company, if there is no 50% or greater shareholder of the
company. Regulations promulgated under the Companies Law provide that the tender offer
requirements described in this paragraph do not apply to companies whose shares are listed
for trading outside of Israel if, according to the law in the country in which the shares
are traded, including the rules and regulations of the stock exchange on which the shares
are traded, either:

| |  | there
is a limitation on the acquisition of any level of control of the company; or
| | - | -----------------------------------------------------------------------------------

| |  | the
acquisition of any level of control must be by means of a tender offer to the public.
| | - | -----------------------------------------------------------------------------------------

Merger.
          The Companies Law permits merger transactions if approved by each partys
          board of directors and the majority of each partys shares voted on the
          proposed merger at a shareholders meeting called on at least 21 days
prior           notice. Our articles of association provide that merger transactions may
be           approved by a simple majority of the shareholders present, in person or by
          proxy, at a general meeting of our shareholders. Under the Companies Law, in
          determining whether the required majority has approved the merger, shares held
          by the other party to the merger, any person holding at least 25% of the
          outstanding voting shares or holding at least 25% of the means of appointing
          directors of the other party to the merger, or anyone acting on their behalf,
          including their relatives or companies controlled by them, are excluded from
the           vote. If a majority of shareholders of one of the parties do not approve
the           transaction because the votes of certain shareholders are excluded from the
          vote, a court may still approve the merger upon the request of holders of at
          least 25% of the voting rights of a company, if the court holds that the merger
          is fair and reasonable, taking into account the value of the parties to the
          merger and the consideration offered to the shareholders. Upon the request of a
          creditor of either party to the proposed merger, the court may delay or prevent
          the merger if it concludes that there exists a reasonable concern that, as a
          result of the merger, the surviving company will be unable to satisfy the
          obligations of any of the parties to the merger. In addition, a merger may not
          be executed unless at least 50 days have passed from the time that a proposal
          for approval of the merger has been filed with the Israeli Registrar of
          Companies.

Tax
Law. Israeli tax law treats specified acquisitions, including a share-for-share swap
between an Israeli company and a foreign company, less favorably than does United States
tax law. For example, Israeli tax law may subject a shareholder who exchanges ordinary
shares in an Israeli company for shares in a foreign company to immediate taxation.

# Other Anti-Takeover
Provisions

We
are also subject to the tender offer provisions of the Exchange Act, as amended.

65

---

---



# Transfer Agent,
Registrar and Paying Agent

The
transfer agent and registrar for our ordinary shares in the United States is Continental
Stock Transfer & Trust Company. Its address is 17 Battery Place, New York, New York
10004, and its telephone number at this location is 212-509-4000. Our paying agent in
Germany is Dresdner Bank AG.

# Election of Directors;
Appointment of Officers

Our
current board of directors consists of seven directors. Under our articles of association,
our board of directors may not consist at any time of more than nine members. A majority
of these directors must be non-executive directors, who are directors that are neither
office holders nor our employees. Directors are appointed, removed or replaced, by a
majority vote of our shareholders present in person or by proxy at a general meeting of
shareholders.

Once
elected at a shareholders meeting, our directors, except our external directors,
hold office until the first general meeting of shareholders held at least thirty six
months after their election except for Mr. Oded Bashan and Mr, Ronnie Gilboa who may not
be replaced or removed unless by an affirmative vote of 75% of the Companys
shareholders entitled to vote and voting in person or by proxy at a general meeting of
shareholders. Incumbent directors may be reelected at that meeting. Under the new Israeli
Companies Law, which took effect on February 1, 2000, the chief executive officer of a
public company may not serve as a chairman of the board of directors unless authorized by
a general meeting of the shareholders and then only for a period of time that does not
exceed three years. As a result, on July 11, 2003, our shareholders authorized our CEO,
Oded Bashan, to act as our chairman for an additional three-year period ending May 25,
2006.

Our
board of directors appoints our chief executive officer. Each of our executive officers
serves at the discretion of the board of directors, subject to the terms of any employment
agreement, and holds office until his or her successor is elected or until his or her
earlier resignation or removal. Except for Ohad Bashan, our Chief Marketing Officer, and
President and Chief Executive Officer of OTI America, who is the son of Oded Bashan, our
co-founder and chairman of our board of directors, none of our directors or executive
officers has any family relationship with any other director or executive officer.

# Fiduciary Duties;
Approval of Certain Transactions

The
Companies Law codifies the fiduciary duties that office holders owe to a company. An
office holders fiduciary duties consist of a duty of care and a duty of loyalty. The
duty of care requires an office holder to act with the degree of care with which a
reasonable office holder in the same position would act under the same circumstances. The
duty of care includes using reasonable means to obtain information as to the advisability
of a given action submitted for his or her approval or performed by virtue of his or her
position, as well as all other information pertaining to such actions. The duty of loyalty
requires an office holder to act in good faith and for the benefit of the company, and
includes avoiding any conflict of interest between the office holders other
positions or personal affairs and the performance of his or her position in the company,
avoiding any competition with the company, avoiding exploiting any business opportunity of
the company in order to receive a personal benefit for himself or herself or others, and
revealing to the company any information or documents relating to the companys
affairs which come into the office holders possession as a result of his or her
position as an office holder.

The
Companies Law further requires that an office holder disclose to the company any personal
interest that he or she may have and all related material information known to him or her
in connection with any existing or proposed transaction by the company. The disclosure
must be made promptly and in no event later than the board of directors meeting at which
the transaction is first discussed. In addition, if the transaction is an extraordinary
transaction, as defined below, the office holder must also disclose any personal interest
held by the office holders spouse, siblings, parents, grandparents, descendants,
spouses descendants and the spouses of any of the foregoing and by any corporation
in which the office holder is a 5% or greater shareholder, director or general manager or
in which he or she has the right to appoint the general manager or at least one director.
The Companies Law defines an extraordinary transaction as a transaction that
is not in the ordinary course of business, that is not on market terms, or that is likely
to have a material impact on a companys profitability, assets or liabilities. In the
case of a transaction between the company and an office holder, or a third party in which
an office holder has a personal interest, but that is not an extraordinary transaction and
is not adverse to the companys interest, once the office holder complies with the
above disclosure requirements only board approval is required unless the articles of
association of the company provide otherwise. In the case of an extraordinary transaction
between the company and an office holder, or a third party in which an office holder has a
personal interest, in addition to any approval required by the articles of association,
the transaction must be approved first by the audit committee, then by the board of
directors and, in certain cases, by the shareholders. A director who has a personal
interest in a matter that is considered at a meeting of the board of directors or the
audit committee may in general not be present at this meeting or vote on this matter. If a
majority of the directors have a personal interest in an extraordinary transaction, these
directors are permitted to be present and vote on the transaction, but shareholder
approval is also required.

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Under
the Companies Law, all arrangements as to compensation of office holders who are not
directors require approval by the board of directors, and undertakings to indemnify or
insure an office holder who is not a director require both board and audit committee
approval. In general, arrangements regarding the compensation, indemnification and
insurance of directors require audit committee and shareholder approval in addition to
board approval.

The
Companies Law applies the same disclosure requirements to a controlling party of a public
company that it applies, as described above, to an office holder. For these purposes a
controlling party is any person possessing the ability to direct the
activities of the company, including a shareholder which holds 25% or more of the voting
rights of the company if no other shareholder owns more than 50% of the voting rights in
the company, but excluding a person whose power is derived solely from his or her position
on the board of directors or from another position with the company. Two or more
shareholders with a personal interest in the approval of the same transaction are deemed
to be joint shareholders. Extraordinary transactions with a controlling party or in which
a controlling party has a personal interest, and the engagement and terms of compensation
of a controlling party as an office holder, require the approval of the audit committee,
the board of directors and the shareholders. Shareholder approval must be by a majority of
shares voted at the meeting, including at least one-third of the shares of the
disinterested shareholders who are present, in person or by proxy, at the meeting, or,
alternatively, the total shareholdings of the disinterested shareholders who vote against
the transaction must not represent more than 1% of the aggregate voting rights in the
company.

Under
the Companies Law, a shareholder has a duty to refrain from abusing his or her power in
the company and to act in good faith in exercising its rights and performing its
obligations to the company and other shareholders, including, among other things, voting
at a general meeting of shareholders on the following matters:

| |  | an
amendment to the articles of association;
| | - | --------------------------------------------

| |  | an
increase in the company's authorized share capital;
| | - | ------------------------------------------------------

| |  | a
merger; and
| | - | -------------

| |  | approval
of a related-party transaction requiring shareholder approval.
| | - | -----------------------------------------------------------------------

In
addition, any controlling shareholder, any shareholder who knows that its vote can
determine the outcome of a shareholder vote and any shareholder who, under a
companys articles of association, can appoint or prevent the appointment of an
office holder, is under a duty to act with fairness towards the company. The Companies Law
does not describe the substance of this duty.

# Exculpation,
Indemnification and Insurance of Office Holders

Under
the Companies Law, an Israeli company may only exculpate an office holder in advance, in
whole or in part, for breach of duty of care and only if a provision authorizing such
exculpation is included in its articles of association. Our articles of association
include such a provision. A company may not exculpate an office holder in advance from his
liability towards the company which is caused by a breach of duty of care in case of
distribution (as defined in the Companies Law). A company may not exculpate an office
holder for breach of duty of loyalty. However, the company may approve an act performed in
breach of the duty of loyalty of an office holder provided that the office holder acted in
good faith, the act or its approval does not harm the company, and the office holder
discloses the nature of his or her personal interest in the act and all material facts and
documents a reasonable time before discussion of the approval.

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A
company may indemnify an office holder in respect of certain liabilities either in advance
of an event or following an event provided a provision authorizing such indemnification is
inserted in its articles of association. Advance indemnification of an office holder must
be limited to the following:

| | a
financial liability imposed on him in favor of another person pursuant to a judgment,
settlement or arbitrators award approved by court provided that the indemnification
shall be limited to events which are determined by the board of directors, are
foreseeable in light of the companys activities at the time when the obligation for
indemnification is granted, and to amounts and standards which are determined by the
board of directors as reasonable in such event, and provided that the obligation for
indemnification will specify the said events and amounts or standards;
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | reasonable
litigation expenses, including attorneys fees, incurred by the office holder or
imposed by a court in proceedings instituted against him by the company, on its behalf or
by a third party, in connection with criminal proceedings in which the officer holder was
acquitted or as a result of a conviction for a crime that does not require proof of
criminal intent; and
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | reasonable
litigation expenses, including attorneys fees, incurred by the office holder due to
investigation or proceedings instituted against the office holder by an authority
authorized to conduct such investigation or proceedings and ended without filing an
indictment against him and without imposing monetary liability as an alternative to
criminal proceedings or ended without filing an indictment against him but in imposing
monetary liability as an alternative to criminal proceedings for a crime that does not
require proof of criminal intent.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

A
company may insure an office holder against the following liabilities incurred for acts
performed as an office holder:

| | a
breach of duty of loyalty to the company, to the extent that the office holder acted in
good faith and had a reasonable basis to believe that the act would not prejudice the
company;
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | a
breach of duty of care to the company or to a third party; and
|- | ----------------------------------------------------------------

| | a
financial liability imposed on the office holder in favor of a third party.
|- | -----------------------------------------------------------------------------

An Israeli company may not indemnify
or insure an office holder against any of the following:

| | a
breach of duty of loyalty, except to the extent that the office holder acted in good
faith and had a reasonable basis to believe that the act would not prejudice the company;
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | a
breach of duty of care committed intentionally or recklessly except that such
recklessness is made solely negligently;
|- | ------------------------------------------------------------------------------------------------------------------------

| | an
act or omission committed with intent to derive illegal personal benefit; or
|- | -------------------------------------------------------------------------------

| | a
fine levied against the office holder.
|- | ----------------------------------------

Under
the Companies Law, indemnification and insurance of office holders must be approved by our
audit committee and our board of directors and, in specified circumstances, by our
shareholders.

Our
articles of association allow us to indemnify and insure our office holders to the fullest
extent permitted by the Companies Law. Our office holders are currently covered by a
directors and officers liability insurance policy with an aggregate claim limit of
$5 million. As of the date of this annual report, no claims for directors and
officers liability insurance have been filed under this policy.

Our
U.S. subsidiary has also entered into indemnification agreements with certain of its key
employees. These agreements provide, independent of the indemnification these individuals
are entitled to by law and under the provisions of the subsidiarys charter,
indemnification for certain acts while employed by the subsidiary. These indemnification
agreements contain exclusions, such as limiting indemnification that would be unlawful or
that is covered by other liability insurance. Moreover, employees are not indemnified
against liability to the extent that the employee gained a personal profit to which he or
she is not legally entitled, including proceeds obtained from the illegal trading of our
equity securities. The performance of these agreements is guaranteed by us as parent of
the U.S. subsidiary, to the extent permitted by Israeli law.

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|C. | MATERIAL
CONTRACTS
|-- | ------------------

Other
than in the ordinary course of business, we did not enter into any material contracts in
the past two years.

|D. | EXCHANGE
CONTROLS
|-- | -----------------

There
are currently no Israeli currency control restrictions on payments of dividends or other
distributions with respect to our ordinary shares or the proceeds from sales of the
shares, except for the obligation of Israeli residents to file reports with the Bank of
Israel regarding some transactions. However, legislation remains in effect under which
currency controls can be imposed by administrative action at any time.

The
ownership or voting of our ordinary shares by non-residents of Israel, except with respect
to citizens of countries which are in a state of war with Israel, is not restricted in any
way by our memorandum of association or articles of association or by the laws of the
State of Israel.

|E. | TAXATION
|-- | --------

# Israeli Taxation,
Foreign Exchange Regulation and Investment Programs

THE FOLLOWING IS A SUMMARY OF THE
MATERIAL ASPECTS OF THE CURRENT TAX STRUCTURE APPLICABLE TO COMPANIES IN ISRAEL AND THEIR
EFFECT ON US. THE SUMMARY ALSO CONTAINS A DISCUSSION OF ISRAELI TAX CONSEQUENCES TO
PERSONS PURCHASING OUR ORDINARY SHARES NOT BY WAY OF ISSUANCE OF BONUS SHARES AND ISRAEL
GOVERNMENT PROGRAMS BENEFITING US. PORTIONS OF THIS DISCUSSION ARE BASED ON TAX
LEGISLATION THAT HAS NOT YET BEEN SUBJECT TO JUDICIAL OR ADMINISTRATIVE INTERPRETATION,
AND WE CANNOT ASSURE YOU THAT THE VIEWS EXPRESSED IN THIS DISCUSSION WILL BE ACCEPTED BY
THE TAX AUTHORITIES IN QUESTION. THE DISCUSSION SHOULD NOT BE RELIED ON AS LEGAL OR
PROFESSIONAL TAX ADVICE AND IS NOT EXHAUSTIVE OF ALL POSSIBLE TAX CONSIDERATIONS.

WE URGE INVESTORS IN OUR ORDINARY
SHARES TO CONSULT THEIR OWN TAX ADVISORS AS TO THE ISRAELI OR OTHER TAX CONSEQUENCES OF
THE PURCHASE, OWNERSHIP AND DISPOSITION OF ORDINARY SHARES, INCLUDING, IN PARTICULAR, THE
EFFECT OF ANY FOREIGN, STATE OR LOCAL TAXES.

# Tax Reform

Effective
as of January 1, 2003 a comprehensive tax reform took effect in Israel. Pursuant to the
reform, resident companies are subject to Israeli tax on income accrued or derived in
Israel or abroad. In addition, the concept of controlled foreign corporation
was introduced according to which an Israeli company or an individual may become subject
to Israeli taxes on certain income of a non-Israeli subsidiary if the subsidiarys
primary source of income is passive income (such as interest, dividends, linkage
differences royalties, rental income or capital gains). The tax reform also substantially
changed the system of taxation of capital gains.

# Taxation of companies

General
Corporate Tax Structure. Israeli companies are subject to corporate tax at the rate of
34% of taxable income in the 2005 tax year, 31% in the 2006 tax year, 29% in the 2007 tax
year, 27% in the 2008 tax year, 26% in the 2009 tax year and 25% in the 2010 tax year and
thereafter. However, the effective tax rate payable by a company which derives income from
certain approved enterprises may be considerably lower, as discussed further below.

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Tax
Benefits Under the Law for the Encouragement of Capital Investments, 1959. The Law for
the Encouragement of Capital Investment, 1959, commonly referred to as the Investment Law,
provides that a proposed capital investment in eligible facilities may, upon application
to the Investment Center of the Ministry of Industry and Trade of the State of Israel, be
designated as an approved enterprise. Each certificate of approval for an approved
enterprise relates to a specific investment program delineated both by its financial
scope, including its capital sources, and by its physical characteristics, e.g., the
equipment to be purchased and utilized under the program. The tax benefits derived from
any certificate of approval relate only to taxable income attributable to the specific
approved enterprise. If a company has more than one approval or only a portion of its
capital investments is approved, its effective tax rate is the result of a weighted
combination of the applicable rates. Income derived from activity which is not integral to
the activity of the enterprise should not be divided between the different approved
enterprises and should not enjoy tax benefits.

Taxable
income of a company derived from an approved enterprise is subject to a reduced corporate
tax rate of 25%. The tax rate is subject to additional reductions depending on the
percentage of foreign investment in the relevant company until the earlier of:

| |  | Seven
consecutive years, or ten years in the case of a foreign investors company as
defined below, starting in the year in which the approved enterprise first generates
taxable income;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Twelve
years from the start of production; or
| | - | ---------------------------------------------

Fourteen
years from the date of approval of the approved enterprise status.

A
company owning an approved enterprise may elect to forego entitlement to grants otherwise
available as a result of an approved enterprise in return for an alternative package of
benefits. Under the alternative package of benefits, a companys undistributed income
derived from an approved enterprise will be exempt from company tax for a period of
between two and ten years from the first year of taxable income, depending on the
geographic location of the approved enterprise within Israel, and the company will be
eligible for a reduced tax rate for the remainder of the benefits period.

We
elected to adopt the Alternative Benefits Program status for our investment
programs. A company that has elected to receive the alternative package of benefits and
that subsequently pays a dividend out of income derived from the approved enterprise
during the tax exemption period will be subject to tax in respect of the amount
distributed, including any company tax on these amounts, at the rate which would have been
applicable had it not elected the alternative package of benefits, generally 10%-25%,
depending on the percentage of the investment in the companys shares held by foreign
shareholders. The dividend recipient is taxed at the reduced rate applicable to dividends
from approved enterprises, which is 15%, if the dividend is distributed during the tax
exemption period or within 12 years after this period. The company must withhold this tax
at source. If classified as a foreign investors company there is no limit on the
period during which a dividend may be distributed from approved enterprise profits and it
should always enjoy the benefits of the law.

Subject
to the provisions of the law concerning income under the alternative package of benefits,
all dividends are considered to be attributable to the entire enterprise and their
effective tax rate is the result of a weighted combination of the various applicable tax
rates. Under the Investment Law, a company that has elected the alternative package of
benefits is not obliged to distribute exempt retained profits, and may generally decide
from which years profits to declare dividends. We currently intend to reinvest any
amount derived from our approved enterprise programs and not to distribute the income as a
dividend.

A
company that has an approved enterprise program is eligible for further tax benefits if it
qualifies as a foreign investors company. A foreign investors company is a
company whose investees, comprising non-Israeli residents, directly or indirectly hold
more than 25% of the companys share capital and combined share and loan capital. A
company that qualifies as a foreign investors company and has an approved enterprise
program is eligible for tax benefits for a ten-year benefit period. The company tax rate
applicable to income earned from approved enterprise programs (currently, for programs on
which an application for an approved enterprise status was submitted before 31, December,
2003) in the benefit period (following the period, if any, of no tax) by a company meeting
these qualifications is as follows:

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|For a company with foreign investment of | Tax Rate
|---------------------------------------- | --------
|
|
|
|
|Over 25% but less than 49%               | 25%     
|49% or more but less than 74%            | 20%     
|74% or more but less than 90%            | 15%     
|90% or more                              | 10%     

The
Investment Center bases its decision as to whether or not to approve an application on the
criteria set forth in the Investment Law and regulations, the then prevailing policy of
the Investment Center, and the specific objectives and financial criteria of the
applicant. Accordingly, there can be no assurance that any such applications will be
approved. In addition, the benefits available to an approved enterprise are conditional
upon the fulfillment of conditions stipulated in the Investment Law and its regulations
and upon the criteria in the specific certificate of approval, as described above. In the
event that a company does not meet these conditions, it would be required to refund the
amount of tax benefits, with the addition of consumer price index linkage adjustment and
interest.

The
Investment Center has granted approved enterprise status to three of our investment
programs under the alternative benefits option. Taxable income derived from these programs
is tax exempt for a period of ten years beginning with the year in which we first generate
taxable income. We have derived, and expect to continue to derive, a substantial portion
of our revenues from our approved enterprise programs at our manufacturing facility. The
Investment Law also provides that an approved enterprise is entitled to accelerated
depreciation on its property and equipment that are included in an approved investment
program. There is no certainty that the Israeli government will continue to provide the
same or similar tax benefits in the future.

On
March 30, 2005, the Knesset approved a reform of the Encouragement of Capital Investments
Law  1959. The primary changes are as follows:

| |  | Companies
that meet the criteria of the Alternate Path of tax benefits will receive those benefits
without prior approval. In addition there will be no requirement to file reports with the
Investment Center. Audit will take place via the Income Tax Authorities as part of the
tax audits. Request for pre-ruling is possible.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Tax
benefits of the Alternate Path include lower tax rates or no tax depending on area and
the path chosen, lower tax rates on dividends and accelerated depreciation.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | In
order to receive benefits in the Grant Path or the Alternate Path, the Industrial
Enterprise must contribute to the economic independence of the Countrys economy in
one of the following ways:
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Grants under the Law for the
Encouragement of Industrial Research and Development, 1984.

Under
the law for the Encouragement of Industrial Research and Development, 1984, commonly
referred to as the Research Law, research and development programs which meet specified
criteria and are approved by a governmental committee of the Office of the Chief Scientist
are eligible for grants of up to 50% of the projects expenditure, as determined by
the research committee, in exchange for the payment of royalties from the sale of products
developed under the program. Regulations under the Research Law generally provide for the
payment of royalties to the Chief Scientist of 3 to 3.5% on sales of products and services
derived from our technology developed using these grants until 100% of the dollar-linked
grant is repaid. For programs approved from 1999 and thereafter, the amount of the grant
to be repaid will include annual interest at LIBOR from the date of approval.

The
terms of the Israeli government participation also require that the manufacture of
products developed with government grants be performed in Israel. However, under the
regulations of the Research Law, if any of the manufacturing is performed outside Israel
by any entity other than us, assuming we receive approval from the Chief Scientist for the
foreign manufacturing, we may be required to pay increased royalties. The increase in
royalties depends upon the manufacturing volume that is performed outside of Israel
follows:

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|Manufacturing Volume Outside of Israel | Royalties to the Chief Scientist
as a Percentage of Grant
|-------------------------------------- | ---------------------------------------------------------
|
|
|
|
|less than 50%                          | 120%                                                     
|between 50% and less than 90%          | 150%                                                     
|90% and more                           | 300%                                                     

If
the manufacturing is performed outside of Israel by us, the rate of royalties payable by
us on revenues from the sale of products manufactured outside of Israel will increase by
1% over the regular rates. If the manufacturing is performed outside of Israel by a third
party, the rate of royalties payable by us on those revenues will be a percentage equal to
the percentage of our total investment in the given system that was funded by grants. In
addition, in recent years the government of Israel has accelerated the rate of royalty
rates for repayment of Chief Scientist grants, and may further accelerate them in the
future.

The
technology developed with Chief Scientist grants may not be transferred to third parties
without the prior approval of a governmental committee under the Research Law, and may not
be transferred to non-residents of Israel (Beginning April 1, 2005, governmental committee
under the Research Law may approve a transfer of technology to non-residents of Israel
under restricted conditions and in accordance with the Research Law). Approval, however,
is not required for the export of products developed using the grants. Approval of the
transfer of technology to residents of Israel may be granted in specific circumstances,
only if the recipient abides by the provisions of the Research Law and related
Regulations, including the restrictions on transfer of know-how and the obligation to pay
royalties in an amount that may be increased. We cannot provide any assurance that
consent, if requested, will be granted.

The
funds available for grants from the Chief Scientist depend on several criteria and
prevailing government policy and budget, and may be reduced or eliminated in the future.
Even if these grants are maintained, there is no assurance that we will receive Chief
Scientist grants in the future. In addition, each application to the Chief Scientist is
reviewed separately, and grants are based on the program approved by the research
committee. Expenditures supported under other incentive programs of the State of Israel
are not eligible for grants from the Chief Scientist. We cannot provide any assurance that
applications to the Chief Scientist will be approved and, until approved, the amounts of
any grants are not determinable.

Tax
Benefits for Research and Development. Israeli tax law allows, under specific
conditions, a tax deduction in the year incurred for expenditures, including capital
expenditures, relating to scientific research and development projects, if the
expenditures are approved by the relevant Israeli government ministry, determined by the
field of research, and the research and development is for the promotion of the enterprise
and is carried out by or on behalf of the company seeking the deduction. Expenditures not
so approved are deductible over a three-year period. However, expenditures made out of
proceeds made available to us through government grants are not deductible according to
Israeli law.

Tax
Benefits Under the Law for the Encouragement of Industry (Taxes), 1969. The Law for
the Encouragement of Industry (Taxes), 1969, generally referred to as the Industry
Encouragement Law, provides several tax benefits for industrial companies. An
Industrial Company is defined as a company resident in Israel, at least 90% of
whose income in a given tax year exclusive of income from specified sources, is derived
from an industrial enterprise owned by it. An industrial enterprise is defined
as an enterprise whose major activity in a given tax year is industrial production
activity.

Under
the Industry Encouragement Law, industrial companies are entitled to the following
preferred corporate tax benefits:

| |  | deduction
of purchase of know-how and patents utilized in the development of the company over an
              eight-year period;
| | - | ---------------------------------------------------------------------------------------------------------------------------------

| |  | deduction
of expenses incurred in connection with a public stock issuance over a three-year period;
              and
| | - | ---------------------------------------------------------------------------------------------------------------------

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| |  | right
to elect, under certain conditions, to file a consolidated tax return with additional
related Israeli industrial companies operating a common production line.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------

Under
some tax laws and regulations, an industrial enterprise may be eligible for special
depreciation rates for machinery, equipment and buildings. These rates differ based on
various factors including the date operations begin and the number of work shifts. An
industrial company owning an approved enterprise may choose between the depreciation rates
for an industrial company provided for in the Income Tax Regulations (Inflationary
Adjustments) (depreciation rates), 1986 or the regular depreciation rates determined in
the above Regulations.

Eligibility
for benefits under the Industry Encouragement Law is not subject to receipt of prior
approval from any governmental authority. We cannot assure you that we will continue to
qualify as an industrial company or that the benefits described above will be available to
us in the future.

Special
Provisions Relating to Taxation under Inflationary Conditions. The Income Tax Law
(Inflationary Adjustments), 1985, referred to as the Inflationary Adjustments Law,
represents an attempt to overcome the problems presented to a traditional tax system by an
economy undergoing rapid inflation. The Inflationary Adjustments Law is highly complex.
These are some of its important features:

| |  | There
is a special tax adjustment for the preservation of equity whereby certain corporate
assets are classified broadly into fixed (inflation resistant) assets and non-fixed
assets. Where a companys equity, as defined in the law, exceeds the depreciated
cost of fixed assets, a deduction from taxable income that takes into account the effect
of the applicable annual rate of inflation on the excess is allowed up to a ceiling of
70% of taxable income in any single tax year, with the unused portion permitted to be
carried forward on a linked basis. If the depreciated cost of fixed assets exceeds a
companys equity, then the excess multiplied by the applicable annual rate of
inflation is added to taxable income.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Subject
to certain limitations, depreciation deductions on fixed assets and losses carried
forward are adjusted for inflation based on the increase in the Israeli consumer price
index.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Gains
on traded securities, are taxable in certain circumstances determined under the
Inflationary Adjustments Law. However, dealers in securities are subject to the regular
tax rules applicable to business income in Israel.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

One
of the net effects of the Inflationary Adjustments Law is that our taxable income for
Israeli corporate tax purposes will be different from our dollar income reflected in our
financial statements, which are based on changes in the Shekel exchange rate with respect
to the dollar.

# Taxation of our
shareholders

Reform
in Taxation of Capital Market. As mentioned above, on July 24, 2002, the Israeli
parliament, the Knesset, approved an extensive amendment to the Income Tax Ordinance. The
amendment substantially changed the taxation in several areas, including taxation of the
capital market. Generally, the amendment shall become effective regarding taxation of the
capital market on January 1, 2003.

Capital
Gains Tax on Sales of Our Ordinary Shares. Israeli law imposes a capital gains tax on
the sale of capital assets. The law distinguishes between real gain and inflationary
surplus. The inflationary surplus is a portion of the total capital gain that is
equivalent to the increase of the relevant assets purchase price that is
attributable to the increase in the Israeli consumer price index between the date of
purchase and the date of sale. The real gain is the excess of the total capital gain over
the inflationary surplus. The inflationary surplus accumulated from and after December 31,
1993 is exempt from any capital gains tax in Israel. The real gain is added to ordinary
income, which effective until December 31, 2002 was taxed at ordinary rates of up to 50%
for individuals and 36% for corporations.

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Effective
January 1, 2003, the capital gains tax rate imposed upon sale of capital assets acquired
after that date has been reduced to 25%; capital gains accrued from assets acquired before
that date are subject to a blended tax rate based on the relative periods of time before
and after that date that the asset was held.

Capital
Gains Tax on Sales of Our Ordinary Shares Effective January 1, 2003. Payers of Israeli
tax who are not subject to the Inflationary Adjustments Law or are not entitle to maintain
books in foreign currency shall be subject to 15% tax on the real capital gain in case the
shares were purchased after December 31, 2002, and in case the shares were purchased
before that date the sale will be subject to a blended tax in which the portion of the
gain accrued until December 31, 2002 will be exempt from Israeli capital gains tax and the
portion of the real gain accrued from January 1, 2003 until the date of sale will be
subject to 15% tax. The taxable real gain will be based on the difference between the
adjusted average value of the shares during the last three trading days before January 1,
2003 (or the adjusted original cost if it is higher than the adjusted average value) and
the value of the shares at the date of sale. In the event the above calculation create a
loss; such loss can only be offset against capital gain from other traded securities
according to the provisions of the Israeli law. The amount of the loss is limited to the
difference between the adjusted average value and the value of the shares at the date of
sale. However, such payers of Israeli tax shall be subject to 25% tax on the real capital
gain in the case that they deduct interest expenses and linkage differences.

Notwithstanding
the foregoing, dealers in securities in Israel and companies taxed under the Inflationary
Adjustment Law or are entitled to maintain books in foreign currency are taxed at regular
tax rates applicable to business income.

Notwithstanding
the above, securities that are defined as foreign securities that are sold prior to
January 1, 2007 shall be subject to 35% tax on the real capital gain. Foreign securities
that are bought prior to January 1, 2007 and sold after January 1, 2007 shall be subject
to 35% capital gains tax on the real gains accrued until January 1, 2007 and 15% capital
gains tax on the real gains accrued thereafter. With regards to individuals and companies,
which are not subject to the Inflationary Adjustments Law and to bookkeeping in foreign
currency provisions, capital gains from sale of foreign securities are subject to 15% tax
beginning January 1, 2005. However, according to new tax legislation our ordinary shares
are not considered foreign traded securities.

Generally
under the amendment losses from tradable shares by payers of Israeli tax who are not
subject to the Inflationary Adjustments Law or have the right to maintain books in foreign
currency can be offset with gains from the same source (e.g., sales of foreign securities,
sales of securities that are not foreign securities). Such losses can be carried forward
indefinitely.

In
addition, since our ordinary shares are traded on a Stock Exchange outside of Israel,
gains on the sale of ordinary shares held by non-Israeli tax resident investors will be
exempt from Israeli capital gains tax, provided, inter alia, that such capital gains are
not by a permanent establishment in Israel, that such shareholders did not acquire their
shares prior to the public offering and that the shareholders are not subject to the
Inflationary Adjustment law or are entitle to maintain books in foreign currency all
subject to the provision of the Israeli tax legislation.

Under
the convention between the government of the United States of America and the government
of Israel with respect to taxes on income, the sale, exchange or disposition of ordinary
shares by a person who qualifies as a resident of the United States within the meaning of
the U.S.- Israel tax treaty and who is entitled to claim the benefits afforded to the
person by the U.S.-Israel tax treaty generally will not be subject to the Israeli capital
gains tax unless certain exceptions apply, including where the U.S. resident holds,
directly or indirectly, shares representing 10% or more of our voting power during any
part of the 12-month period preceding the sale, exchange or disposition of the shares
subject to certain conditions. A sale, exchange or disposition of ordinary shares by a
treaty U.S. resident who holds, directly or indirectly, shares representing 10% or more of
our voting power at any time during the preceding 12-month period would be subject to
Israeli tax, to the extent applicable unless the aforementioned exemption from capital
gains tax for shares listed on a Stock Exchange outside of Israel applies. However, in any
case, under the U.S.-Israel tax treaty and the Israeli tax law a treaty U.S. resident will
be subject to capital gains tax in Israel, the U.S. resident would be permitted to claim a
credit for the taxes against the U.S. federal income tax imposed with respect to the sale,
exchange or disposition, subject to the limitations in U.S. laws applicable to foreign tax
credits. The U.S.-Israel tax treaty does not relate to U.S. state or local taxes.

74

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Taxation
of Non-Resident Holders of Shares. Non-residents of Israel are subject to income tax
on income accrued or derived from sources in Israel. Under the amendment, capital gain is
deemed to accrue or derive in Israel in the case of sale of shares of an Israeli company
(see above in Section Capital Gains Tax on Sales of Our Ordinary Shares).

Non-residents
of Israel are subject to tax on income accrued or derived from sources in Israel. These
sources of income include passive income such as dividends, royalties and interest, as
well as non-passive income, such as income received for services rendered in Israel. On
distribution of dividends other than bonus shares, income tax is withheld at source, at
the rate of 25%, (or 12.5% for dividends not generated by an approved enterprise if the
non-resident is a U.S. corporation and holds at least 10% of our voting power throughout a
certain period, and 15% for dividends generated by an approved enterprise), unless in each
case a different rate is provided in a treaty between Israel and shareholders
country of residence. Under the U.S.-Israel tax treaty, the maximum tax on dividends paid
to a holder of ordinary shares who is a U.S. resident will be 25%. However, under the
Investment Law, dividends generated by an approved enterprise are taxed at the rate of
15%.

Foreign
Exchange Regulations. We are permitted to pay in Israeli and non-Israeli currency:

| |  | dividends
to holders of our ordinary shares; and
| | - | ------------------------------------------------

| |  | any
amounts payable with respect to our ordinary shares upon our dissolution, liquidation or
winding               up.
| | - | ----------------------------------------------------------------------------------------------------------------------

If
we make any payments in Israeli currency, the payments may be converted into freely
repatriable dollars at the rate of exchange prevailing at the time of conversion.

# Material United States
Federal Income Consequences

The
following is a summary of the material United States federal income tax consequences of
the acquisition, ownership and disposition of our ordinary shares by United States holders
(as defined below). This summary is based upon the United States Internal Revenue Code of
1986, as amended, applicable Treasury regulations promulgated and proposed under the
Internal Revenue Code, judicial authority and current administrative rulings and
practices, all of which are subject to change, possibly with retroactive effect or
different interpretations. We have not sought any ruling from the United States Internal
Revenue Service with respect to the matters discussed below, and we cannot provide any
assurance that the IRS or a court will agree with our conclusions. The discussion below
assumes that you will hold the ordinary shares as capital assets.

THE
FOLLOWING SUMMARY IS INCLUDED HEREIN FOR GENERAL INFORMATION AND IS NOT INTENDED TO BE,
AND SHOULD NOT BE CONSTRUED TO BE, LEGAL OR TAX ADVICE. ACCORDINGLY, EACH UNITED STATES
HOLDER IS URGED TO CONSULT A TAX ADVISOR WITH RESPECT TO THE U.S. FEDERAL, STATE, LOCAL OR
NON-U.S. TAX CONSEQUENCES OF HOLDING AND DISPOSING OF ORDINARY SHARES.

This
discussion is not a comprehensive description of all of the tax consequences that may be
relevant to United States holders of ordinary shares, and you should consult your
professional advisor as to the tax consequences of the acquisition, ownership and
disposition of our ordinary shares. In particular, this discussion does not address your
tax treatment if you are subject to special tax rules under United States federal income
tax law, for example, if you are:

| |  | a
bank, insurance company or other financial institution, or "financial services entity",
| | - | -----------------------------------------------------------------------------------------

| |  | a
regulated investment company, real estate investment trust or grantor trust,
| | - | ------------------------------------------------------------------------------

| |  | a
broker or dealer in securities or foreign currency,
| | - | -----------------------------------------------------

| |  | a
United States holder who has a functional currency other than the United States dollar,
| | - | -----------------------------------------------------------------------------------------

75

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| |  | a United States holder who acquires ordinary shares in connection with employment or other
performance of services, or who acquires ordinary shares in the form of bonus shares from
us,
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
United States holder subject to the alternative minimum tax,
| | - | --------------------------------------------------------------

| |  | a
United States holder who owns, or is deemed to own, at least 10% or more, by voting power
or               value, of our shares,
| | - | ----------------------------------------------------------------------------------------------------------------------------------

| |  | a
United States holder who owns ordinary shares as part of a hedge or as part of a hedging
transaction straddle, conversion transaction, constructive sale transaction or other
risk-reduction transaction for United States federal income tax purposes,
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
tax-exempt entity, or
| | - | -----------------------

| |  | a
United States holder that expatriates out of the United States, or a former long-term
resident of the United States.
| | - | ----------------------------------------------------------------------------------------------------------------------

Further,
this description does not address any United States federal estate and gift tax
consequences, nor any state, local or foreign tax consequences relating to the
acquisition, ownership and disposition of our ordinary shares. If a partnership or other
entity taxable as a partnership for U.S. federal income tax purposes holds our ordinary
shares, the U.S. federal income tax treatment of a partner will generally depend on the
status of the partner and the activities of the partnership. Such partners are urged to
consult their tax advisors.

For
purposes of this discussion, you are a United States holder if you are:

(i)       
          an individual citizen or resident of the United States, including an alien
          individual who is a lawful permanent resident of the United States or meets the
          substantial presence residency test under United States federal income tax laws,

(ii)       
          a corporation (or other entity treated as a corporation for United States
          federal tax purposes), or a partnership (other than a partnership that is not
          treated as a United States person under any applicable U.S. Treasury
          Regulations), created or organized in or under the laws of the United States,
          any of its states or the District of Columbia,

(iii)       
          an estate the income of which is subject to United States federal income
          taxation regardless of its source,

(iv)       
          a trust if a court within the United States is able to exercise primary
          supervision over the administration of the trusts and one or more United States
          persons have the authority to control all substantial decisions of the trust, or
          a trust that has valid election in effect to be treated as a U.S. person, or

(v)       
          any person otherwise subject to United States federal income tax on a net income
          basis in respect of ordinary shares, if such status as a United States holder is
          not overridden pursuant to the provisions of an applicable tax treaty.

# Distributions on
Ordinary Shares

We
do not at this time anticipate paying any dividends. But, if we do distribute property to
you in the future, then subject to the discussion below under Passive Foreign
Investment Company Considerations, the following rules regarding distributions will
generally apply.

Distributions
you receive from us with respect to your ordinary shares, including any related tax
withheld by Israel, will constitute dividends for United States federal income tax
purposes to the extent paid out of our current or accumulated earnings and profits as
determined for United States federal income tax purposes. To the extent that a
distribution exceeds our available earnings and profits, it will be treated as a
nontaxable return of capital to the extent of your adjusted tax basis in the ordinary
shares (reducing such adjusted tax basis dollar for dollar), and thereafter as capital
gain.

76

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Dividends
you receive generally will be treated as foreign source dividend income and will not be
eligible for the dividends-received deduction allowed to corporate shareholders under the
Internal Revenue Code.

For
a temporary period beginning with taxable years beginning in 2003 and ending with taxable
years beginning after December 31, 2008, qualified dividend income will
generally be subject to a maximum U.S. federal income tax rate of 15% for non-corporate
United States holders. For this purpose, qualified dividend income means
dividends received from a qualified foreign corporation. A qualified
foreign corporation is a corporation that: (i) is entitled to the benefits of a
comprehensive tax treaty with the United States (which includes an exchange of information
program), or (ii) is readily tradeable on an established securities market in the United
States. However, dividends will not qualify for the preferential rate if we are treated,
in the year the dividend is paid or in a prior year, as passive foreign investment
company, or PFIC (described below under Passive Foreign Investment Company
Considerations.). Because our shares trade on the NASDAQ National Market, any
dividends we pay on shares traded on the NASDAQ National Market during that period should
generally constitute qualified dividend income, unless, in the year we pay a
dividend or in the prior year, we are a PFIC. If we are not a PFIC in the year the
dividend is paid or in a prior year, dividend distributions with respect to our ordinary
shares should be treated as qualified dividend income, subject to the United States holder
satisfying holding period and other requirements described below. A United States holder
will not be entitled to the preferential rate: (a) if the U.S. holder has not held the
ordinary shares or ADRs for at least 61 days of the 121-day period beginning on the date
which is 60 days before the ex-dividend date, or (b) to the extent the U.S. holder is
under an obligation to make related payments on substantially similar property. Any days
during which the U.S. holder has diminished its risk of loss on our shares are not counted
towards meeting the 61-day holding period. Finally, U.S. holders who elect to treat the
dividend income as investment income pursuant to section 163(d)(4) of the Code
will not be eligible for the preferential rate of taxation.

The
amount of any distribution we make to you will equal the fair market value in United
States dollars of the Israeli Shekels or other property you receive, including the amount
of any related withheld tax, on the date of distribution, which, in the case of a
distribution paid in Israeli Shekels will be based on the exchange rate on the date of
your receipt. For United States federal income tax purposes, you will have a basis in any
Israeli Shekels you receive equal to the dollar value of the Israeli Shekels on the date
of payment. Any gain or loss that you recognize upon a subsequent disposition of these
Israeli Shekels will generally be ordinary income or loss.

Subject
to the limitations set forth in the Internal Revenue Code, U.S. holders may elect to claim
a foreign tax credit against their U.S. income tax liability for Israeli income tax
withheld from distributions received in respect of ordinary shares. In general, these
rules limit the amount allowable as a foreign tax credit in any year to the amount of
regular U.S. tax for the year attributable to foreign taxable income. This limitation on
the use of foreign tax credits generally will not apply to an electing individual U.S.
holder whose creditable foreign taxes during the year do not exceed $300, or $600 for
joint filers, if such individuals gross income for the tax year from non-U.S.
sources consists solely of certain passive income. A U.S. holder will be denied a foreign
tax credit with respect to Israeli income tax withheld from dividends received with
respect to the ordinary shares if such U.S. holder has not held the ordinary shares for at
least 16 days out of the 30-day period beginning on the date that is 15 days before the
ex-dividend date or to the extent that such U.S. holder is under an obligation to make
certain related payments with respect to substantially similar or related property. Any
day during which a U.S. holder has substantially diminished its risk of loss with respect
to the ordinary shares will not count toward meeting the 16-day holding period referred to
above. A U.S. holder will also be denied a foreign tax credit if the U.S. holder holds
ordinary shares in an arrangement in which the U.S. holders reasonably expected
economic profit is insubstantial compared to the foreign taxes expected to be paid or
accrued. The rules relating to the determination of the foreign tax credit are complex,
and U.S. holders should consult their own tax advisors to determine whether and to what
extent they would be entitled to such credit. U.S. holders that do not elect to claim a
foreign tax credit may instead claim a deduction for Israeli income tax withheld, provided
such holders itemize their deductions.

77

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# Sale, Exchange, or Other
Taxable Disposition of Our Ordinary Shares

Subject
to the discussion below under Passive Foreign Investment Company
Considerations, the following rules will generally apply to the sale, exchange or
other disposition of our ordinary shares by a United States holder.

In
general, a United States holder will recognize gain or loss upon the sale, exchange or
other disposition of an ordinary share equal to his amount realized in the disposition
less the adjusted income tax basis in the ordinary share. A United States holders
initial income tax basis in any ordinary shares, will be the U.S. dollar amount paid for
the ordinary shares, or the U.S. dollar equivalent of the fair market value of any
property, including foreign currency, you exchanged for the ordinary shares as of the date
of exchange. The amount realized is the amount of cash and the fair market value of
property received, including or the United States dollar value on the date of the
disposition of the amount realized in Israeli Shekels.

Gain
or loss recognized upon the sale, exchange or other disposition of an ordinary share will
generally be capital gain or loss, and will generally be long-term capital gain or loss if
the holding period in the disposed of ordinary shares exceeds one year. Special rates of
tax apply to long-term capital gains recognized by non-corporate United States holders.
Under most circumstances, the gain or loss will be treated as United States source income
for United States foreign tax credit purposes. However, U.S. Treasury Regulations
generally require a loss to be allocated to foreign source income to the extent certain
dividends were received by the taxpayer within a 24-month period preceding the date on
which the taxpayer recognized the loss. The deductibility of the loss realized on the
sale, exchange or other disposition of ordinary shares is subject to limitations.

# Passive Foreign
Investment Company Considerations

Special
United States federal income tax rules apply to a United States holder who owns shares of
a corporation that was at any time during the United States holders holding period a
passive foreign investment company, or a PFIC. A non-United States corporation will be
classified as a PFIC for United States federal income tax purposes in any taxable year in
which, after applying look-through rules for lower tier affiliates, either (1) at least
75% of its gross income (including the pro-rata share of gross income at any U.S. or
foreign company which the NON-United States corporation owns, or is considered to own, 25%
or more of the shares by value) is passive income, or (2) at least 50% of the
gross value of its assets (including the pro-rata share of the assets of any U.S. or
foreign company which the non-United States corporation owns (or is considered to own) 25%
or more of the shares by value) is attributable to assets that produce passive income or
are held for the production of passive income. Passive income for this purpose generally
includes dividends, interest, royalties, rents and gains from commodities and securities
transactions.

Based
on our estimated gross income, the average value of our gross assets (assuming that we are
entitled to value our intangible assets using the methods suggested for publicly traded
corporations) and the nature of our business, we believe that we will not be considered
PFIC for our current taxable year, and there is only a small chance that we will be a PFIC
in the foreseeable future. Since PFIC status is a factual determination that must be made
annually and is therefore subject to change, our status in current and future years
depends on our assets and activities in those years. Because the market price of our
ordinary shares is likely to fluctuate and because the market price of the shares of
technology companies has been especially volatile, we cannot assure you whether or not we
will be considered a PFIC for any taxable year. Also, because PFIC status is in part based
on facts on and through December 31 of each year, it is not possible to determine whether
we will have become a PFIC for a calendar year until after the close of the year, when we
finalize our financial information on and through December 31. In addition, we cannot
provide any assurance that the applicable tax law will not change in a manner which
adversely affects our PFIC determination. If we were a PFIC for a taxable year, a United
States holder could be subject to interest charges and higher tax rates with respect to
any gain from the sale or exchange of, and certain distributions with respect to our
ordinary shares.

If
we are or become a PFIC, a United States holder of our ordinary shares could make a
variety of elections that may alleviate the tax consequences referred to above. However,
it is expected that the conditions necessary for making an election to treat us as a
qualified electing fund under the PFIC rules will not be available. You should consult
your tax advisor regarding our potential status as a PFIC and the tax consequences to you
that would arise if we were treated as a PFIC.

78

---

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# Backup Withholding and
Information Reporting

If
you hold ordinary shares, you may be subject to information reporting and backup
withholding of United States federal income tax with respect to cash payments in respect
of dividends or the gross proceeds from dispositions. The backup withholding rate is
currently 28%. However, you will not be subject to backup withholding if you properly
execute, under penalties of perjury, an IRS Form W-9 or a substantially similar form in
which you provide your correct taxpayer identification number, certify that it is correct,
certify that you are a United States person, and certify as to one of the following
conditions: (1) you are not subject to backup withholding because you are a corporation or
come within another enumerated exempt category, (2) you have not been notified by the IRS
that you are subject to backup withholding, or (3) you have been notified by the IRS that
you are no longer subject to backup withholding. Backup withholding will not apply with
respect to payments made to certain exempted participants, such as corporations and
tax-exempt organizations. Backup withholding is not an additional tax and may be claimed
as a credit against the U.S. federal income tax liabilities of a United States holder,
provided that the required information is timely furnished to the IRS.

The
above description is not intended to constitute a complete analysis of all tax
consequences relating to the ownership or disposition of our ordinary shares by a United
States holder. You should consult your own tax advisor concerning the tax consequences of
your particular situation, as well as any tax consequences that may arise under the laws
of any state, local, foreign, or other taxing jurisdiction.

|F. | DIVIDENDS
AND PAYING AGENTS
|-- | ---------------------------

Not
applicable.

|G. | STATEMENT
BY EXPERTS
|-- | --------------------

Not
applicable.

|H. | DOCUMENTS
ON DISPLAY
|-- | --------------------

We
are subject to the informational requirements of the Securities Exchange Act of 1934, as
amended, applicable to foreign private issuers and fulfill the obligation with respect to
such requirements by filing reports with the Securities and Exchange Commission. As a
foreign private issuer, we are exempt from the rules under the Exchange Act prescribing
the furnishing and content of proxy statements, and our officers, directors and principal
shareholders are exempt from the reporting and short-swing profit recovery
provisions contained in Section 16 of the Exchange Act. In addition, we are not required
under the Exchange Act to file periodic reports and financial statements with the
Securities and Exchange Commission as frequently or as promptly as United States companies
whose securities are registered under the Exchange Act. You may read and copy any document
we file with the Securities and Exchange Commission without charge at the Securities and
Exchange Commissions public reference room at 100 F Street, N.E., Washington D.C.
20549. Copies of such material may be obtained by mail from the Public Reference Branch of
the Securities and Exchange Commission at such address, at prescribed rates. Please call
the Securities and Exchange Commission at 1-800-SEC-0330 for further information on the
public reference room. A copy of each report submitted in accordance with applicable
United States law is also available for public review at our principal executive offices.

In
addition, the Securities and Exchange Commission maintains an Internet website at
http://www.sec.gov that contains reports, proxy statements, information statements and
other material that are filed through the Securities and Exchange Commissions
Electronic Data Gathering, Analysis and Retrieval, or EDGAR, system.

|I. | SUBSIDIARY
INFORMATION
|-- | ----------------------

Not
applicable.

79

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|ITEM 11. | QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- | ----------------------------------------------------------

For
disclosure regarding our market risk exposure, see Item 5.  Operating and
Financial Review and Prospects above.

|ITEM 12. | DESCRIPTION
OF SECURITIES OTHER THAN EQUITY SECURITIES
|-------- | ------------------------------------------------------

Not
applicable.

80

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# PART II

|ITEM 13. | DEFAULTS,
DIVIDEND ARREARAGES AND DELINQUENCIES
|-------- | -----------------------------------------------

There
are no defaults, dividend arrearages or delinquencies that are required to be disclosed.

|ITEM 14. | MATERIAL
MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS
|-------- | ----------------------------------------------------------------------------

There
are no material modifications to, or qualifications of, the rights of security holders
that are required to be disclosed.

|ITEM 15. | CONTROLS
AND PROCEDURES
|-------- | -----------------------

Our
management, including our chief executive officer, or CEO, and chief financial officer, or
CFO, are responsible for establishing and maintaining our disclosure controls and
procedures (within the meaning of Rule 13a-15(e) of the Securities Exchange Act of
1934). These controls and procedures were designed to ensure that information required to
be disclosed in the reports that we file under the Exchange Act, is recorded, processed,
summarized and reported within the time periods specified in the rules and forms of the
SEC and that such information was made known to our management, including our CEO and CFO,
by others within the Company, as appropriate to allow timely decisions regarding required
disclosure. We evaluated these disclosure controls and procedures under the supervision of
our CEO and CFO as of December 31, 2005. Based upon that evaluation, our management,
including our CEO and CFO, concluded that our disclosure controls and procedures are
effective.

There
has been no change in our internal control over financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during our fiscal year ended
December 31, 2005, that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.

|ITEM 16A. | AUDIT
COMMITTEE FINANCIAL EXPERT
|--------- | --------------------------------

Our
board of directors has determined that Eli Akavia, a member of its audit committee, is an
audit committee financial expert, as defined in Item 401 of Regulation S-K. Mr. Akavia
qualifies as an independent director under the NASDAQ rules.

|ITEM 16B. | CODE
OF ETHICS
|--------- | --------------

We
have adopted a Code of Business Conduct and Ethics that applies to our directors,
executive and financial officers and all of our employees. The Code of Business Conduct
and Ethics is publicly available on our website at www.otiglobal.com and we will provide
shareholders with a written copy upon request. If we make any substantive amendments to
the Code of Business Conduct and Ethics or grant any waivers, including any implicit
waiver, from a provision of these codes to our chief executive officer, chief financial
officer or corporate controller, we will disclose the nature of such amendment or waiver
on our website.

|ITEM 16C. | PRINCIPAL
ACCOUNTANT FEES AND SERVICES
|--------- | --------------------------------------

Policy on Pre-Approval of Audit
and Non-Audit Services of Independent Auditors

Our
audit committee is responsible for the oversight of our independent auditors work.
The audit committees policy is to pre-approve all audit and non-audit services
provided by Somekh Chaikin (a member of KPMG International). These services may include
audit services, audit-related services, tax services and other services, as further
described below. The audit committee sets forth the basis for its pre-approval in detail,
listing the particular services or categories of services which are pre-approved, and
setting forth a specific budget for such services. Additional services may be pre-approved
by the audit committee on an individual basis. Once services have been pre-approved,
Somekh Chaikin and our management then report to the audit committee on a periodic basis
regarding the extent of services actually provided in accordance with the applicable
pre-approval, and regarding the fees for the services performed.

81

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# Principal Accountant
Fees and Services

We
paid the following fees for professional services rendered by KPMG International for the
years ended December 31:

|                       | 2005 | 2004
|---------------------- | ---- | ----
|
|
|
|
|Audit fees (1)         |      |     
|                       |      |     
|Audit-related fees (2) |      |     
|                       |      |     
|Tax fees (3)           |      |     
|                       |      |     
|All other fees (4)     |      |     
|                       |      |     
|                       |      |     
|                       |      |     

(1)
          The audit fees for the years ended December 31, 2005 and 2004, are the
aggregate           fees billed (for the year) for the professional services rendered for
the audits           of our 2005 and 2004 annual consolidated financial statements,
review of           consolidated quarterly financial statements of 2005 and 2004,
statutory audits           of us and our subsidiaries, consents and assistance with
review of documents           filed with the SEC. [TO BE UPDATED BY KPMG]

(2)
          The audit-related fees are the aggregate fees billed (for the year) for
          assurance and related services that are reasonably related to the performance
of           the audit or review of our financial statements and are not reported under
Audit           Fees.

(3)
          Tax fees are the aggregate fees billed (in the year) for professional services
          rendered for tax compliance, tax advice on actual or contemplated transactions
          and tax planning.

(4)
All other fees are the aggregate fees billed (in the year) for professional
          services mainly in connection with the due diligence concerning the acquisition
          of Asec S.A., e-Pilot and POI, and compliance with Sarbanes-Oxley Act
          requirements.

# Pre-Approval Policies
and Procedures

Our
audit committee pre-approved all audit and non-audit services provided to us and to our
subsidiaries during the periods listed above. The committee approves discrete projects on
a case-by-case basis that may have a material effect on our operations and also considers
whether proposed services are compatible with the independence of the public accountants.

|ITEM 16D. | EXEMPTIONS
FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
|--------- | ----------------------------------------------------------

Not
applicable.

|ITEM 16E. | PURCHASES
OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS
|--------- | ----------------------------------------------------------------------

None.

82

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# PART III

|ITEM 17 | FINANCIAL
STATEMENTS
|------- | --------------------

The
Company has elected to furnish financial statements and related information specified in
Item 18.

|ITEM 18. | FINANCIAL
STATEMENTS
|-------- | --------------------

# Index to the Financial
Statements of the Registrant

|                                                                                  | 
|--------------------------------------------------------------------------------- | 
|
|
|
|
|Report of Independent Registered Public Accounting Firm                           | 
|Consolidated Balance Sheets                                                       | 
|Consolidated Statements of Operations                                             | 
|Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Loss | 
|Consolidated Statements of Cash Flows                                             | 
|Notes to the Consolidated Financial Statements                                    | 

|ITEM 19 | EXHIBITS
|------- | --------

|Exhibit No. | Description
|----------- | -----------

|1 |  | Articles
of Association, as amended and restated on June 3, 2005. (Filed herewith)
|- |  | ----------------------------------------------------------------------------------

|2 |  | Specimen
share certificate (1).
|- |  | -------------------------------

|4.1 |  | Original
Section 102 Share Option Plan of the Registrant.(2)
|--- |  | ------------------------------------------------------------

|4.2 |  | Stock
Compensation Program and Stock Award Agreement of OTI America, Inc.(1)
|--- |  | ----------------------------------------------------------------------------

|4.3 |  | 2001
Employee Share Purchase Plan of the Registrant.(1)
|--- |  | -------------------------------------------------------

|4.4 |  | 2001
Share Option Plan of the Registrant.(1)
|--- |  | --------------------------------------------

|4.5 |  | Application
to Approve a Trustee for an Option Plan pursuant to Section 102 of the Income Tax
                 Ordinance; and Deed of Trust. (2)
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|4.6 |  | Long
Term Lease Agreement, dated as of March 6, 2002 by and between the Israel Lands Authority
and                  the Registrant.(1)
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------

|4.7 |  | Irrevocable
Proxy, dated as of June 27, 2003, for the benefit of Oded Bashan. (3)
|--- |  | ---------------------------------------------------------------------------------

|4.8 |  | Form
of Securities Purchase Agreement between the Registrant and various investors, dated as
of                  April 29, 2004, incorporated by reference to the Company's  6-K form
furnished to the SEC on April                  29, 2004.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.9 |  | Form
of Securities Purchase Agreement between the Registrant and various investors, dated as
of                  October 27, 2005, incorporated by reference to the Company's  6-K form
furnished to the SEC on                  November 8, 2005.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|8 |  | List
of subsidiaries (Filed herewith).
|- |  | --------------------------------------

|12.1 |  | Certification
of Chief Executive Officer, pursuant to Rule 13a-14(a) under the Securities Exchange
                 Act of 1934.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------

|12.2 |  | Certification
of Chief Financial Officer, pursuant to Rule 13a-14(a) under the Securities Exchange
                 Act of 1934.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------

|13.1 |  | Certification
of Chief Executive Officer, pursuant Rule 13a-14(b) under the Securities Exchange Act
                 of 1934, and 18 U.S.C. Section 1350.
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------

|13.2 |  | Certification
of Chief Financial Officer, pursuant Rule 13a-14(b) under the Securities Exchange Act
                 of 1934, and 18 U.S.C. Section 1350.
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------

|15 |  | Consent
of Somekh Chaikin, a member firm of KPMG International
|-- |  | --------------------------------------------------------------

83

---

---



|(1) | Previously
filed with the Companys Registration Statement on Form F-1,           filed on June
14, 2002.
|--- | ---------------------------------------------------------------------------------------------------------

|(2) | Previously
filed with an amendment to the Companys  Registration           Statement on
Form F-1, filed on September 11, 2002.
|--- | -------------------------------------------------------------------------------------------------------------------------------

|(3) | Previously
filed with the Companys Registration Statement on Form F-1,           filed on
September 12, 2003.
|--- | --------------------------------------------------------------------------------------------------------------

84

---

---



# On Track Innovations Ltd. and
its Subsidiaries

# Consolidated Financial
Statements As of December 31, 2005



---

---



On Track Innovations
Ltd.and its subsidiaries

# Consolidated Financial
Statements as of December 31, 2005

---

# Contents

|                                                                       | Page      
|---------------------------------------------------------------------- | ----------
|
|
|
|
|Report of Independent Registered Public Accounting Firm                | F-2       
|Consolidated Balance Sheets                                            | F-3 - F-4 
|Consolidated Statements of Operations                                  | F-5       
|Consolidated Statements of Shareholders' Equity and Comprehensive Loss | F-6       
|Consolidated Statements of Cash Flows                                  | F-7 - F-8 
|Notes to the Consolidated Financial Statements                         | F-9 - F-38



---

---



# Report of Independent
Registered Public Accounting Firm

# To the Board of
Directors and ShareholdersOn Track Innovations Ltd.

We have audited the accompanying consolidated
balance sheets of On Track Innovations Ltd. (the Company) and its subsidiaries
as of December 31, 2005 and 2004 and the related consolidated statements of operations,
shareholders equity and comprehensive loss and cash flows for each of the years in
the three year period ended December 31, 2005. These consolidated financial statements are
the responsibility of the Companys management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance
with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial
statements presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects, the
financial position of the Company and its subsidiaries as of December 31, 2005 and 2004
and the results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2005, in conformity with U.S. generally accepted
accounting principles.

/s/ Somekh ChaikinCertified Public Accountants (Isr.)Member Firm of KPMG International

Tel Aviv, IsraelMarch 24, 2006

F - 2

---

---



|On Track Innovations Ltd.                              
|-------------------------------------------------------
|and its subsidiaries                                   
|                                                       
|Consolidated Balance Sheets                            
|                                                       
|US dollars in thousands except share and per share data

|                                                    | December 31
|--------------------------------------------------- | -----------
|
|
|
|
|Assets                                              |            
|                                                    |            
|Current assets                                      |            
|Cash and cash equivalents                           |            
|Short-term investments                              |            
|Trade receivables (net of allowance for doubtful    |            
|accounts of $ 329 and $ 785 as of December 31, 2004 |            
|and 2005, respectively)                             |            
|Other receivables and prepaid expenses              |            
|Inventories                                         |            
|                                                    |            
|                                                    |            
|Total current assets                                |            
|                                                    |            
|                                                    |            
|Severance pay deposits fund                         |            
|                                                    |            
|Long-term receivables                               |            
|                                                    |            
|Investment in an affiliated company                 |            
|                                                    |            
|Property, plant and equipment, net                  |            
|                                                    |            
|Intangible assets, net                              |            
|                                                    |            
|Goodwill                                            |            
|                                                    |            
|                                                    |            
|Total assets                                        |            
|                                                    |            

F - 3

---

---



|On Track Innovations Ltd.                              
|-------------------------------------------------------
|and its subsidiaries                                   
|                                                       
|Consolidated Balance Sheets                            
|                                                       
|US dollars in thousands except share and per share data

|                                                         | December 31
|-------------------------------------------------------- | -----------
|
|
|
|
|Liabilities and Shareholders' Equity                     |            
|                                                         |            
|Current Liabilities                                      |            
|Short-term bank credit and current maturities            |            
|of long-term bank loans                                  |            
|Trade payables                                           |            
|Other current liabilities                                |            
|                                                         |            
|Total current liabilities                                |            
|                                                         |            
|                                                         |            
|Long-Term Liabilities                                    |            
|Long-term loans, net of current maturities               |            
|Accrued severance pay                                    |            
|Deferred tax liabilities                                 |            
|                                                         |            
|Total long-term liabilities                              |            
|                                                         |            
|                                                         |            
|Total liabilities                                        |            
|                                                         |            
|                                                         |            
|Commitments and Contingencies                            |            
|                                                         |            
|Minority interests                                       |            
|                                                         |            
|Shareholders' Equity                                     |            
|Ordinary shares of NIS 0.1 par value: Authorized -       |            
|30,000,000 shares as of December 31, 2004 and 2005;      |            
|issued and outstanding - 8,422,175 and 11,932,074 shares |            
|as of December 31, 2004 and 2005, respectively           |            
|Additional paid-in capital                               |            
|Deferred compensation                                    |            
|Accumulated other comprehensive income                   |            
|Accumulated deficit                                      |            
|                                                         |            
|                                                         |            
|Total shareholders' equity                               |            
|                                                         |            
|                                                         |            
|Total liabilities and shareholders' equity               |            
|                                                         |            

The accompanying notes are an
integral part of the consolidated financial statements.

F - 4

---

---



|On Track Innovations Ltd.                              
|-------------------------------------------------------
|and its subsidiaries                                   
|                                                       
|Consolidated Statements of Operations                  
|                                                       
|US dollars in thousands except share and per share data

|                                                                  | Year ended December 31
|----------------------------------------------------------------- | ----------------------
|
|
|
|
|Revenues                                                          |                       
|Sales                                                             |                       
|Licensing and transaction fees                                    |                       
|                                                                  |                       
|Total revenues                                                    |                       
|                                                                  |                       
|Cost of Revenues                                                  |                       
|Sales                                                             |                       
|                                                                  |                       
|Total cost of revenues                                            |                       
|                                                                  |                       
|Gross profit                                                      |                       
|                                                                  |                       
|Operating Expenses                                                |                       
|Research and development                                          |                       
|Less - participation by the Office of the Chief Scientist         |                       
|                                                                  |                       
|Research and development, net                                     |                       
|Selling and marketing                                             |                       
|General and administrative                                        |                       
|Amortization of intangible assets                                 |                       
|Expenses relating to raising of Capital, exchange of subsidiary's |                       
|employees equity interests in equity interest of the Company      |                       
|and acquisitions in the Far East.*                                |                       
|Gain from sale of subsidiary                                      |                       
|                                                                  |                       
|Total operating expenses                                          |                       
|                                                                  |                       
|                                                                  |                       
|Operating loss                                                    |                       
|Financial income                                                  |                       
|Financial expenses                                                |                       
|                                                                  |                       
|Financial income (expenses), net                                  |                       
|Other income (expenses), net                                      |                       
|                                                                  |                       
|Loss before taxes on income                                       |                       
|Taxes on income                                                   |                       
|Minority share in income of subsidiary                            |                       
|                                                                  |                       
|Loss before extraordinary item                                    |                       
|                                                                  |                       
|Extraordinary item                                                |                       
|                                                                  |                       
|Net loss                                                          |                       
|                                                                  |                       
|                                                                  |                       
|Basic and diluted net loss per ordinary                           |                       
|share from:                                                       |                       
|                                                                  |                       
|Loss before extraordinary item                                    |                       
|Extraordinary item                                                |                       
|                                                                  |                       
|Net loss                                                          |                       
|                                                                  |                       
|Weighted average number of ordinary                               |                       
|shares used in computing basic and                                |                       
|diluted net loss per ordinary share                               |                       
|                                                                  |                       
|* Consist of:                                                     |                       
|Research and development                                          |                       
|Selling and marketing                                             |                       
|General and administrative                                        |                       
|                                                                  |                       
|                                                                  |                       
|                                                                  |                       

The accompanying notes are an integral
part of the consolidated financial statements.

F - 5

---

---



|On Track Innovations Ltd.                                             
|----------------------------------------------------------------------
|and its subsidiaries                                                  
|                                                                      
|Consolidated Statements of Shareholders' Equity and Comprehensive Loss
|                                                                      
|US dollars in thousands, except share and per share data              

|                                              | Number of
Shares | Share
capital | Additional
paid-in
capital | Deferred
compensation | Accumulated
other
comprehensive
income | Accumulated
deficit | Total
shareholders'
equity
|--------------------------------------------- | ---------------- | ------------- | -------------------------- | --------------------- | -------------------------------------- | ------------------- | --------------------------
|
|
|
|
|Balance as of December 31, 2002               |                  |               |                            | 1,817,156             |                                        | $                   | 52                        
|                                              |                  |              
|Changes during the year                       |                  |              
|ended December 31, 2003:                      |                  |              
|                                              |                  |              
|Deferred stock compensation, net              |                  |               |                            | -                     |                                        |                     | -                         
|Amortization of deferred compensation         |                  |               |                            | -                     |                                        |                     | -                         
|Stock options and warrants granted to         |                  |              
|consultants                                   |                  |               |                            | -                     |                                        |                     | -                         
|Exercise of options and warrants              |                  |               |                            | 864,856               |                                        |                     | 19                        
|Conversion of a loan to options               |                  |               |                            | -                     |                                        |                     | -                         
|Conversion of convertible promissory note     |                  |               |                            | 52,000                |                                        |                     | 1                         
|Issuance of shares and detachable             |                  |              
|warrants, net of issuance                     |                  |              
|expenses of $1,204                            |                  |               |                            | 2,044,703             |                                        |                     | 47                        
|Foreign currency translation adjustments      |                  |               |                            | -                     |                                        |                     | -                         
|Net loss                                      |                  |               |                            | -                     |                                        |                     | -                         
|                                              |                  |               |                            |                       |                                        |                     |                           
|Balance as of December 31, 2003               |                  |               |                            | 4,778,715             |                                        | $                   | 119                       
|                                              |                  |              
|Changes during the year ended                 |                  |              
|December 31, 2004:                            |                  |              
|                                              |                  |              
|Deferred stock compensation, net              |                  |               |                            | -                     |                                        |                     | -                         
|Amortization of deferred compensation         |                  |               |                            | -                     |                                        |                     | -                         
|Stock options granted to consultants          |                  |               |                            | -                     |                                        |                     | -                         
|Exercise of options and warrants              |                  |               |                            | 2,057,196             |                                        |                     | 45                        
|Issuance of shares and detachable             |                  |              
|warrants, net of issuance expenses of $ 2,260 |                  |               |                            | 1,400,000             |                                        |                     | 31                        
|Shares issued in connection with the          |                  |              
|purchase of a subsidiary                      |                  |               |                            | 186,264               |                                        |                     | 4                         
|Foreign currency translation adjustments      |                  |               |                            | -                     |                                        |                     | -                         
|Net unrealized loss on                        |                  |              
|available-for-sale securities                 |                  |               |                            | -                     |                                        |                     | -                         
|Net loss                                      |                  |               |                            | -                     |                                        |                     | -                         
|                                              |                  |               |                            |                       |                                        |                     |                           
|Balance as of December 31, 2004               |                  |               |                            | 8,422,175             |                                        | $                   | 199                       
|                                              |                  |              
|Changes during the year ended                 |                  |              
|December 31 2005:                             |                  |              
|                                              |                  |              
|Deferred stock compensation                   |                  |               |                            | -                     |                                        |                     | -                         
|Amortization of deferred compensation         |                  |               |                            | -                     |                                        |                     | -                         
|Stock options and warrants granted to         |                  |              
|consultants                                   |                  |               |                            | -                     |                                        |                     | -                         
|Exercise of options and warrants              |                  |               |                            | 1,395,566             |                                        |                     | 31                        
|Issuance of shares in respect to              |                  |              
|investments                                   |                  |               |                            | 286,307               |                                        |                     | 3                         
|Issuance of shares and detachable warrants,   |                  |              
|net of issuance expenses of $ 4,153           |                  |               |                            | 1,828,026             |                                        |                     | 41                        
|Foreign currency translation adjustments      |                  |               |                            | -                     |                                        |                     | -                         
|Net loss                                      |                  |               |                            | -                     |                                        |                     | -                         
|                                              |                  |               |                            |                       |                                        |                     |                           
|Balance as of December 31, 2005               |                  |               |                            | 11,932,074            |                                        | $                   | 274                       
|                                              |                  |               |                            |                       |                                        |                     |                           

|                                                                      | Year ended December 31
|--------------------------------------------------------------------- | ----------------------
|
|
|
|
|Total comprehensive loss:                                             |                       
|Net loss                                                              |                       
|Foreign currency translation adjustments                              |                       
|Net unrealized gain (loss) on available- for- sale securities         |                       
|Reclassification adjustment for loss on available-for-sale securities |                       
|                                                                      |                       
|Total comprehensive loss                                              |                       
|                                                                      |                       

The accompanying notes are an integral part of the consolidated financial statements.

F - 6

---

---



|On Track Innovations Ltd.                              
|-------------------------------------------------------
|and its subsidiaries                                   
|                                                       
|Consolidated Statements of Cash Flows                  
|                                                       
|US dollars in thousands except share and per share data

|                                                                              | Year ended December 31
|----------------------------------------------------------------------------- | ----------------------
|
|
|
|
|Cash flows from operating activities                                          |                       
|Net loss                                                                      |                       
|Adjustments required to reconcile net loss to                                 |                       
|net cash provided by (used in) operating activities:                          |                       
|Amortization of deferred stock compensation                                   |                       
|Stock compensation to services and good providers                             |                       
|Extraordinary item                                                            |                       
|Gain from sale of subsidiary                                                  |                       
|Loss (gain) on sale of property and equipment                                 |                       
|Amortization of intangible assets                                             |                       
|Depreciation                                                                  |                       
|Amortization of beneficial conversion feature on convertible notes            |                       
|Accrued severance pay, net                                                    |                       
|Minority share in income of subsidiaries                                      |                       
|Accrued interest and linkage differences on long-term loans                   |                       
|Increase (decrease) in deferred tax liabilities                               |                       
|Decrease in short-term investments                                            |                       
|Increase in trade receivables                                                 |                       
|Decrease (increase) in other receivables and prepaid expenses                 |                       
|Decrease (increase) in inventories                                            |                       
|Increase (decrease) in trade payables                                         |                       
|Increase in other current liabilities                                         |                       
|Decrease in long-term deferred revenues                                       |                       
|                                                                              |                       
|Net cash provided by (used in) operating activities                           |                       
|                                                                              |                       
|Cash flows from investing activities                                          |                       
|Sale of a consolidated subsidiary, net of cash disposed of                    |                       
|Receipts on account of loans and receivables                                  |                       
|Acquisition of consolidated subsidiaries, net of cash acquired (Supplement C) |                       
|Investment in an affiliated company                                           |                       
|Proceeds from sale of property and equipment                                  |                       
|Purchase of property and equipment                                            |                       
|Purchase of available-for-sale securities                                     |                       
|Proceeds from maturity of available-for-sale securities                       |                       
|                                                                              |                       
|Net cash used in investing activities                                         |                       
|                                                                              |                       
|                                                                              |                       
|Cash flows form financing activities                                          |                       
|Increase (decrease) in short-term bank credit, net                            |                       
|Proceeds from issuance of shares and detachable warrants,                     |                       
|net of issuance expenses                                                      |                       
|Proceeds from long-term bank loans                                            |                       
|Repayment of long-term bank loans                                             |                       
|Exercise of options and warrants                                              |                       
|                                                                              |                       
|Net cash provided by financing activities                                     |                       
|                                                                              |                       
|                                                                              |                       
|Effect of exchange rate changes on cash                                       |                       
|                                                                              |                       
|                                                                              |                       
|Increase in cash and cash equivalents                                         |                       
|Cash and cash equivalents at the beginning of the year                        |                       
|                                                                              |                       
|                                                                              |                       
|Cash and cash equivalents at the end of the year                              |                       
|                                                                              |                       

The accompanying notes are an
integral part of the consolidated financial statements.

F - 7

---

---



|On Track Innovations Ltd.                              
|-------------------------------------------------------
|and its subsidiaries                                   
|                                                       
|Consolidated Statements of Cash Flows (cont'd)         
|                                                       
|US dollars in thousands except share and per share data

|                                                        | Year ended December 31
|------------------------------------------------------- | ----------------------
|
|
|
|
|Supplementary cash flows activities:                    |                       
|                                                        |                       
|A. Cash paid during the period for:                     |                       
|Interest                                                |                       
|                                                        |                       
|Income taxes                                            |                       
|                                                        |                       
|                                                        |                       
|B. Non-cash transactions:                               |                       
|Purchase of property and equipment                      |                       
|                                                        |                       
|Issuance expenses                                       |                       
|                                                        |                       
|                                                        |                       
|C. Acquisition of consolidated subsidiaries:            |                       
|Assets acquired and liabilities assumed of the          |                       
|subsidiaries at date of acquisition:                    |                       
|Working capital surplus, excluding cash                 |                       
|and cash equivalents                                    |                       
|Property and equipment                                  |                       
|Long-term liabilities                                   |                       
|Goodwill                                                |                       
|Know-how                                                |                       
|Brand                                                   |                       
|Customer contracts                                      |                       
|Customer relationships                                  |                       
|Deferred tax liabilities                                |                       
|Minority interests                                      |                       
|Issuance of shares in consideration for the acquisition |                       
|Liability in respect with the acquisition of            |                       
|subsidiaries                                            |                       
|Direct costs of acquisitions paid via grant of options  |                       
|Extraordinary item                                      |                       
|                                                        |                       
|                                                        |                       
|                                                        |                       

The accompanying notes are an integral
part of the consolidated financial statements.

F - 8

---

---



|On Track Innovations Ltd.                              
|-------------------------------------------------------
|and its subsidiaries                                   
|                                                       
|Consolidated Statements of Cash Flows (cont'd)         
|                                                       
|US dollars in thousands except share and per share data

|Note 1 |  | General
|------ | - | -------

| | On
Track Innovations Ltd. (the Company) was founded in 1990, in Israel. The
Company and its subsidiaries (together the Group) are principally engaged in
the field of design and development of contactless microprocessor-based smart card
systems. The Companys ordinary shares were traded on the Neuer Markt in Germany
until February 3, 2002 after which, the shares were listed on the new Prime Standard
Market of the Frankfurt Stock Exchange. Following the approval of the General shareholders meeting,
the Board of Directors of the Company applied for the delisting of the Companys
shares from the Frankfurt Stock Exchange, which has been approved. The last day of
trading of the shares on Frankfurt Stock Exchange was December 20, 2005. Commencing
November 2002, the Companys shares were also listed for trading on NASDAQ.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 2 |  | Significant Accounting Policies
|------ | - | -------------------------------

| | The
consolidated financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America (US GAAP). The
significant accounting policies followed in the preparation of the financial statements,
applied on a consistent basis, are as follows:
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | A. | Principles
of consolidation
| | -- | ---------------------------

| | The
consolidated financial statements include the financial statements of the Company and its
subsidiaries. Intercompany transactions and balances have been eliminated upon
consolidation.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Estimates
and assumptions
| | -- | -------------------------

| | The
preparation of the consolidated financial statements requires management of the Company
to make a number of estimates and assumptions relating to the reported amounts of assets
and liabilities and the disclosure of contingent assets and liabilities at the date of
the consolidated financial statements and the reported amounts of revenues and expenses
during the period. Actual results could differ from those estimates.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | Financial
statements in U.S. dollars
| | -- | ------------------------------------

| | Substantially
all of the Companys and certain of its subsidiaries revenues are in U.S.
dollars. A significant portion of purchases of materials and components and most
marketing costs are denominated in U.S. dollars. Therefore, the functional and reporting
currency of the Company and certain of its subsidiaries is the U.S. dollar.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Transactions
and balances denominated in U.S. dollars are presented at their original amounts.
Transactions and balances in other currencies are remeasured into U.S. dollars in
accordance with the principles set forth in Statement of Financial Accounting Standards (SFAS)
No. 52, Foreign Currency Translation. All exchange gains and losses from
remeasurement of balance sheet items denominated in non U.S. dollar currencies are
reflected in the consolidated statements of operations.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 9

---

---



|Note 2 |  | Significant Accounting Policies (contd)
|------ | - | ----------------------------------------

| | C. | Financial
statements in U.S. dollars (contd)
| | -- | ---------------------------------------------

| | The
functional currency of the remaining subsidiaries are their local currencies. The
financial statements of those companies are translated into U.S. dollars in accordance
with SFAS No. 52, using the exchange rate at the balance sheet date for assets and
liabilities, and weighted average exchange rates for revenues and expenses. Translation
adjustments resulting from the process of the aforesaid translation are included as a
separate component of shareholders equity (accumulated other comprehensive income).
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | D. | Cash
equivalents
| | -- | ----------------

| | Cash
equivalents are short-term highly liquid investments and debt instruments that are
readily convertible to cash with original maturities of three months or less from the
date of deposit.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | E. | Short-term
investments
| | -- | ----------------------

| | The
Company accounts for investments in U.S. treasury securities in accordance with SFAS No.
115, Accounting for Certain Investments in Debt and Equity Securities.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Management
determines the appropriate classification of its investments in debt securities at the
time of purchase and reevaluates such determinations at each balance sheet date. At
December 31, 2004 and 2005, the Companys investments were classified as
available-for-sale and are stated at market value. Unrealized gains and losses are
reported as a separate component of shareholders equity (accumulated other
comprehensive income). Interest income is included in financial income. Realized gains
and losses are included in financial income or expenses.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | At
December 31, 2005, there was an unrealized loss on the Companys investment in fixed
rate treasury securities in the amount of $ 27. The contractual maturity of all debt
securities is within one year.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | F. | Inventories
| | -- | -----------

| | Inventories
are stated at the lower of cost or market value. Inventory write-offs are provided to
cover risks arising from slow moving items or technological obsolescence. Such
write-offs, which were not material for 2003, 2004 and 2005, have been included in cost
of revenues.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Cost
is determined by calculating raw materials, work in process and finished products on a
moving average basis.
| | -------------------------------------------------------------------------------------------------------------------

F - 10

---

---



|Note 2 |  | Significant Accounting Policies (contd)
|------ | - | ----------------------------------------

| | G. | Investment
in an affiliated company
| | -- | -----------------------------------

| | In
these financial statements, affiliated company is a company held to the extent of 20% or
more (which is not a subsidiary). The investment in affiliated company is accounted for
by the equity method. Profits on intercompany sales, not realized outside the Group, were
eliminated.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | H. | Property,
plant and equipment, net
| | -- | ----------------------------------

| | Property,
plant and equipment are stated at cost less accumulated depreciation. Depreciation is
calculated by the straight-line method over the estimated useful lives of the assets as
follows:
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                | Years
|----------------------------------------------- | -----
|
|
|
|
|Leasehold land                                  | 49   
|Buildings                                       | 25   
|Computers, software and manufacturing equipment | 3-5  
|Office furniture and equipment                  | 5-16 
|Motor vehicles                                  | 6    

| | I. | Impairment
of long-lived assets
| | -- | -------------------------------

| | The
Companys long-lived assets (including intangible assets) to be held and used are
reviewed for impairment in accordance with SFAS No. 144 Accounting for the
Impairment or Disposal of Long- Lived Assets, whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be recoverable. No
impairment losses have been identified for each of the years ended December 31, 2003,
2004 and 2005.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | J. | Goodwill
and purchased intangible assets
| | -- | ----------------------------------------

| | Goodwill
is tested for impairment at least on an annual basis and written down when impaired.
Based on the impairment tests performed, there was no impairment of goodwill in fiscal
2003, 2004 or 2005. Purchased intangible assets other than goodwill are amortized over
their useful lives unless these lives are determined to be indefinite. Purchased
intangible assets are carried at cost, less accumulated amortization. Amortization is
computed over the estimated useful lives of the respective assets, generally three to
seven years.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 11

---

---



|Note 2 |  | Significant Accounting Policies (contd)
|------ | - | ----------------------------------------

| | K. | Reclassification
| | -- | ----------------

| | Certain
prior year amounts have been reclassified to conform to current year presentation. Such
reclassifications did not have any impact on the Companys shareholders equity
or net income (loss).
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | L. | Revenue
recognition
| | -- | -------------------

| | The
Group generates revenues from product sales, licensing and transaction fees. Revenues are
also generated from non-recurring engineering, customer services and technical support.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Revenues
from products sales and non-recurring engineering are recognized in accordance with Staff
Accounting Bulletin (SAB) No. 104 Revenue Recognition, when
delivery has occurred provided there is persuasive evidence of an agreement, the fee is
fixed or determinable and collection of the related receivable is probable and no further
obligations exist. In the case of non-recurring engineering, revenue is recognized on
completion of testing and approval of the customization of the product by the customer
and provided that no further obligation exits.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Technology
license revenues are recognized at the time the technology and license is delivered to
the customer, collection is probable, the fee is fixed and determinable, a persuasive
evidence of an agreement exists, no significant obligation remains under the sale or
licensing agreement and no significant customer acceptance requirements exist after
delivery of the technology.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Transaction
fees are recognized as earned based on usage. Usage is determined by receiving
confirmation from the users.
| | -----------------------------------------------------------------------------------------------------------------------

| | Revenues
relating to customer services and technical support are recognized as the services are
rendered ratably over the term of the related contract.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------

| | M. | Research
and development costs
| | -- | ------------------------------

| | Research
and development costs are charged to operations as incurred.
| | ---------------------------------------------------------------------

| | Participation
and grants from the Government of Israel (Office of the Chief Scientist  OCS)
in approved programs for research and development are recognized as a reduction of
expense as the related costs are incurred.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 12

---

---



|Note 2 |  | Significant Accounting Policies (contd)
|------ | - | ----------------------------------------

| | N. | Stock-based
compensation
| | -- | ------------------------

| | Employees
| | ---------

| | The
Company has elected to follow Accounting Principles Board Opinion (APB) No.
25, Accounting for Stock Issued to Employees, and FASB Interpretation (FIN)
No. 44 Accounting for Certain Transactions Involving Stock Compensation, in
accounting for its employee share option plan. Under APB No. 25, when the exercise price
of an employee share option is equivalent to or above the market price of the underlying
stock on the date of grant, no compensation expense is recognized
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Pro
forma information regarding the Companys net loss and net loss per share is
required by SFAS No. 123, Accounting for Stock-Based Compensation, and SFAS
No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure,
and has been determined as if the Company had accounted for its employee share options
under the fair value method prescribed by SFAS No. 123.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Pro
forma information under SFAS No. 123 is as follows:
| | -------------------------------------------------------

|                                                | Year ended December 31
|----------------------------------------------- | ----------------------
|
|
|
|
|Net loss as reported                            |                       
|Deduct: Compensation expense according to       |                       
|APB 25 included in reported net loss            |                       
|Add:       Application of compensation expenses |                       
|according to SFAS No. 123                       |                       
|                                                |                       
|Pro forma net loss                              |                       
|                                                |                       
|                                                |                       
|Basic and diluted net loss per ordinary share   |                       
|as reported from:                               |                       
|Loss before extraordinary item                  |                       
|Extraordinary item                              |                       
|                                                |                       
|Net loss                                        |                       
|                                                |                       
|                                                |                       
|Pro forma basic and diluted net loss per share  |                       
|From:                                           |                       
|Loss before extraordinary item                  |                       
|Extraordinary item                              |                       
|                                                |                       
|Net loss                                        |                       
|                                                |                       

F - 13

---

---



|Note 2 |  | Significant Accounting Policies (contd)
|------ | - | ----------------------------------------

| | N. | Stock-based
compensation (contd)
| | -- | ---------------------------------

| | The
fair value of each option granted is estimated on the date of grant, using the
Black-Scholes model using the following assumptions:
| | ---------------------------------------------------------------------------------------------------------------------------------------

| | 1. | Dividend
yield of zero percent for all periods.
| | -- | -----------------------------------------------

| | 2. | Risk-free
interest rate of 2.5%, 3.29% and 4.1% for December 31, 2003, 2004 and
               2005, respectively.
| | -- | ------------------------------------------------------------------------------------------------------------------

| | 3. | Estimated
expected lives of 3.37-5 years for all periods.
| | -- | ---------------------------------------------------------

| | 4. | Expected
average volatility of 82%  86%, 78%  85% and 70%  76%
               for December 31, 2003, 2004 and 2005, respectively which represents a
weighted                average standard deviation rate for the price of the Companys
Ordinary                Shares in the NASDAQ National Market.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | For
additional information see Note 10C.
| | ----------------------------------------

| | Non-Employees
| | -------------

| | The
Company applies SFAS No. 123 and EITF 96-18 Accounting for Equity Instruments that
are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods
or Services with respect to options issued to non-employees. SFAS No. 123 requires
use of an option valuation model to measure the fair value of these options at the grant
date.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | O. | Basic
and diluted net loss per share
| | -- | ------------------------------------

| | Basic
and diluted net loss per ordinary share is computed based on the weighted average number
of ordinary shares outstanding during each year.
| | -----------------------------------------------------------------------------------------------------------------------------------------------

| | All
outstanding stock options and convertible notes have been excluded from the calculation
of the diluted net loss per ordinary share because all such securities are anti-dilutive
for all periods presented.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | P. | Fair
value of financial instruments
| | -- | -----------------------------------

| | The
Company in estimating fair value disclosures for financial instruments used the following
methods and assumptions:
| | ----------------------------------------------------------------------------------------------------------------------

| | The
carrying amount of cash and cash equivalents, trade receivables, short-term bank credit
and trade payables are equivalent to, or approximate their fair value due to the
short-term maturity of these instruments.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
fair value of marketable securities are based on quoted market prices.
| | --------------------------------------------------------------------------

| | Long-term
receivables are presented at the present value of expected future cash flows discounted
at the interest rate of 10%.
| | ------------------------------------------------------------------------------------------------------------------------------

| | The
carrying amounts of long-term loans are equivalent to or approximate their fair value as
they bear interest at approximate market rates.
| | --------------------------------------------------------------------------------------------------------------------------------------------

F - 14

---

---



|Note 2 |  | Significant Accounting Policies (contd)
|------ | - | ----------------------------------------

| | Q. | Taxes
on income
| | -- | ---------------

| | The
Company accounts for taxes on income in accordance with SFAS No. 109, Accounting
for Income Taxes. Deferred tax asset and liability account balances are recognized
for the future tax consequences attributable to differences between the financial
statements carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable income in
the years in which those temporary differences are expected to be recovered or settled.
The effect on deferred tax assets and liabilities of a change in tax rates is recognized
in the consolidated statement of operations in the period that includes the enactment
date. The Company provides a valuation allowance to reduce deferred tax assets to the amount deemed more likely than not to be realizable.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | R. | Severance
pay
| | -- | -------------

| | The
Companys liability for severance pay for its Israeli employees is calculated
pursuant to Israeli severance pay law based on the most recent salary of the employees
multiplied by the number of years of employment, as of the balance sheet date. Employees
are entitled to one months salary for each year of employment or a portion thereof.
Certain senior executives are entitled to receive additional severance pay. The Companys
liability for all of its Israeli employees is partly provided by monthly deposits for
insurance policies and by an accrual. The value of these policies is recorded as an asset
in the Companys balance sheet.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Severance
pay deposits fund represent contributions to severance pay funds and cash surrender value
of life insurance policies that are recorded at their current redemption value.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Severance
pay expenses for the years ended December 31, 2003, 2004 and 2005 amounted to
approximately $ 246, $ 596 and $ 557, respectively.
| | -------------------------------------------------------------------------------------------------------------------------------------------

| | S. | Advertising
expenses
| | -- | --------------------

| | Advertising
expenses are charged to the statements of operations as incurred.
| | -----------------------------------------------------------------------------

F - 15

---

---



|Note 2 |  | Significant Accounting Policies (contd)
|------ | - | ----------------------------------------

| | T. | Concentrations
of credit risk
| | -- | -----------------------------

| | Financial
instruments that potentially subject the Company to concentrations of credit risk consist
principally of cash and cash equivalents, U.S. treasury securities, long-term receivables
and trade receivables.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Cash
and cash equivalents are invested mainly in U.S. dollars with major banks in Israel and
the United States. Management believes that the financial institutions that hold the Groups
investments are financially sound and, accordingly, minimal credit risk exists with
respect to these investments.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | U.S.
                     treasury securities are denominated in U.S. dollars. Management
believes that                     minimal credit risk exists with respect to these
securities.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Long-term
receivables represent amounts to be received in consideration of the sale of InterCard
GmbH (see Note 5D). Management believes that the Company received satisfactory guarantees
and pledge which may assure the receipts of the aforesaid amounts.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Companys trade receivables are derived from sales to large and financially secure
organizations located mainly in the United States, Far East, Africa and Europe. The
Company performs ongoing credit evaluations of its customers and to date has not
experienced any material losses. An allowance for doubtful accounts is determined on the
basis of specific identification of balances, the collection of which, in managements
opinion, is doubtful. In determining the adequacy of the provision, management bases its
opinion, inter alia, on the estimated risks, in reliance on available information with
respect to the debtors financial position. As for major customers, see Note 13.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
activity in the allowance for doubtful accounts for the years ended December 31, 2003,
2004 and 2005 is as follows:
| | -----------------------------------------------------------------------------------------------------------------------

|                                                     | 2003 | 2004 | 2005
|---------------------------------------------------- | ---- | ---- | ----
|
|
|
|
|Allowance for doubtful accounts at beginning of year |      |      | $   
|Additions charged to provision doubtful accounts     |      |      |     
|Write-downs charged against the allowance            |      |      |     
|Translation differences                              |      |      |     
|Increase (decrease) from acquisition/disposal of     |      |     
|subsidiaries                                         |      |      |     
|                                                     |      |      |     
|                                                     |      |     
|Allowance for doubtful accounts at end of year       |      |      | $   
|                                                     |      |      |     

F - 16

---

---



|Note 2 |  | Significant Accounting Policies (contd)
|------ | - | ----------------------------------------

| | U. | New
accounting standards
| | -- | ------------------------

| | 1. | In
June 2005, the Financial Accounting Standards Board (FASB),
               issued SFAS No. 154, Accounting Changes and Error Corrections.
SFAS                No. 154 replaces APB Opinion No. 20, Accounting Changes and
SFAS No.                3, Reporting Accounting Changes in Interim Financial
Statements.                SFAS No. 154 requires that a voluntary change in
accounting principle be applied                retrospectively with all prior period
financial statements presented on the new                accounting principle. SFAS No.
154 also requires that a change in method of                depreciating or amortizing a
long-lived non-financial asset be accounted for                prospectively as a change
in estimate, and correction of errors in previously                issued financial
statements should be termed a restatement. SFAS No.                154 is
effective for accounting changes and correction of errors made in fiscal
               years beginning after December 15, 2005. The implementation of SFAS No.
154 is                not expected to have a material impact on the Companys
consolidated                financial statements.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | In December 2004, the
FASB issued SFAS No. 123 (revised 2004), Share-Based
Payment. SFAS No. 123(R) will require that the compensation cost relating to
share-based payment transactions be recognized in financial statements. That cost will be
measured based on the fair value of the equity or liability instruments issued.
SFAS No. 123(R) covers a wide range of share-based compensation arrangements including
share options, restricted share plans, performance-based awards, share appreciation rights
and employee share purchase plans. SFAS No. 123(R) replaces SFAS No. 123, Accounting
for Stock-Based Compensation, and supersedes APB No. 25, Accounting for Stock
Issued to Employees. SFAS No. 123, as originally issued in 1995, established as
preferable a fair-value based method of accounting for share-based payment transactions
with employees. However, that Statement permitted entities the option of continuing to
apply the guidance in APB No. 25, as long as the footnotes to financial statements
disclosed what net income would have been had the preferable fair-value based method been
used. Public entities will be required to apply SFAS No. 123(R) as of the first interim
or annual reporting period of the first fiscal year that begins after June 15,
2005. As permitted by SFAS No. 123, the Company currently accounts for share-based
payments to employees using APB No. 25s intrinsic value method. Accordingly, the
adoption of SFAS No. 123(R)s fair value method will have a significant impact on the
Companys result of operations, although it will have no impact on its overall
financial position or cash flows. The Company plans to adopt SFAS No. 123(R) using the
modified prospective method.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 17

---

---



|Note 2 |  | Significant Accounting Policies (contd)
|------ | - | ----------------------------------------

| | U. | New
accounting standards (contd)
| | -- | ---------------------------------

| | 2. | (contd)
| | -- | --------

| | The
modified prospective method requires compensation cost to be recognized
beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for
all share-based payments granted after the effective date and (b) based on the
requirements of SFAS No. 123 for all awards granted to employees prior to the effective
date of SFAS No. 123(R) that remain unvested on the effective date. The impact of
adoption of Statement 123(R) cannot be predicted at this time because it will depend on
levels of share-based payments granted in the future. However, had the Company adopted
SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the
impact of SFAS No. 123 as described in the disclosure of pro forma net income (loss) and
earnings (loss) per share in Note 2(N) to the financial statements.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | In
November 2004, the FASB issued SFAS No. 151, Inventory Costs                an
amendment ofAccounting Research Bulletin No. 43, Chapter 4               (SFAS
151). The amendments made by SFAS 151 clarify that abnormal                amounts
of idle facility expense, freight, handling costs and wasted materials
               (spoilage) should be recognized as current-period charges and require the
               allocation of fixed production overheads to inventory based on the normal
               capacity of the production facilities. The guidance is effective for
inventory                costs incurred during fiscal years beginning after June 15,
2005. The Company                has not yet assessed the impact, if any, the adoption of
this standard will have                on its consolidated financial position or results
of operations.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 3 |  | Other Receivables and Prepaid Expenses
|------ | - | --------------------------------------

|                                              | December 31
|--------------------------------------------- | -----------
|
|
|
|
|Government institutions                       |            
|Prepaid expenses                              |            
|Receivable in respect of sale of a subsidiary |            
|(see Note 5D)                                 |            
|Other receivables                             |            
|                                              |            
|                                              |            
|                                              |            
|                                              |            

|Note 4 |  | Inventories
|------ | - | -----------

|                  | December 31
|----------------- | -----------
|
|
|
|
|Raw materials     |            
|Work in progress  |            
|Finished products |            
|                  |            
|                  |            
|                  |            
|                  |            

F - 18

---

---



|Note 5 |  | Investments
|------ | - | -----------

| | A. | Pioneer
Oriental International Ltd.
| | -- | -----------------------------------

| | In
July 2005, the Company completed the acquisition of Pioneer Oriental International Ltd. (POI),
a Hong Kong company, a subsidiary of Pioneer Oriental Engineering Ltd., a Hong Kong
company (POE). POI is an engineering company that develops and manufactures
machinery used to create smart card inlays for smart cards and other products, as well as
to manufacture contact and/or contactless smart cards themselves. Pursuant to the Asset
Purchase Agreement dated June 16, 2005, between POE, and its shareholders (together the
Sellers) and OTI (as amended, the POI Purchase Agreement), the aggregate
purchase price for the acquisition was paid to the Sellers through the issuance of an
aggregate 40, 441 of the Companys ordinary shares.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
July 2005, the Companys new, wholly-owned subsidiary, POI, completed the
acquisition of substantially all of the assets of POE relating to the design and
manufacture of machinery for the manufacture of smart cards, including certain
proprietary technologies related to the manufacturing process. Pursuant to the Asset
Purchase Agreement dated June 16, 2005 between POI and POE, (as amended, the POE Purchase
Agreement), POI also agreed to make offers of employment to each of the employees of POE.
The aggregate purchase price for the acquisition was paid to POE through the issuance of
an aggregate of 41,788 of the Companys ordinary shares.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
acquisitions were accounted for as a purchase and the Company allocated the purchase
price according to the fair value of the tangible assets and intangible assets acquired
and liabilities assumed. The purchase price was calculated in accordance with EITF No.
99-12 Determination of the Measurement Date for the Market Price of Acquirer
Securities issues in purchase business combination (EITF No. 99.12),
and was $ 1,041. The sum of the fair values of the assets acquired less liabilities
assumed exceeded the acquisition cost. Accordingly, the Company reduced the purchase
price allocated to the acquired non-current assets to zero. After the above allocation,
negative goodwill in the amount of $ 444 remained. In accordance with SFAS No. 141 Business
combinations, this amount was recognized as an extraordinary gain.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | e-Pilot
Group Ltd.
| | -- | ------------------

| | In
July 2005, the Company completed the acquisition of a 71.5% interest in e-Pilot Group Ltd
(e-Pilot), a British Virgin Island company, from three of e-Pilot s
shareholders (collectively, the e-Pilot Shareholders). e-Pilot, which is
headquartered in Hong Kong, develops, manufactures and markets smart card inlays for
smart cards and other products. Pursuant to share purchase agreements (as amended, the
e-Pilot Purchase Agreements), entered into with each of the e-Pilot Shareholders, the
aggregate purchase price for the acquisition was paid to the e-Pilot Shareholders through
the issuance of an aggregate of 52,572 of the Companys ordinary shares.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 19

---

---



|Note 5 |  | Investments (contd)
|------ | - | --------------------

| | B. | e-Pilot
Group Ltd. (contd)
| | -- | ---------------------------

| | The
acquisition was accounted for as a purchase and the Company allocated the purchase price
according to the fair value of the tangible assets and intangible assets acquired and
liabilities assumed. The purchase price in the amount of $ 661 was calculated in
accordance with EITF No. 99-12.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
connection with the acquisition, the Company recognized an intangible asset in the amount
of $ 1,183, which was assigned to customer relationships and is being amortized over
five years.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | ASEC
Spolka Akcyjna
| | -- | -------------------

| | In
October 2004, the Company completed the acquisition of ASEC Spolka Akcyjna (ASEC)
from Nextel Spolka Akcyjna (Nextel), headquartered in Karkow, Poland. ASEC
develops, manufactures and markets card readers and reader modules based on radio
frequency identification technologies, including high-end programmable smart card as well
as economically priced readers. Pursuant to the Preliminary Share Purchase Agreement,
dated September 2004, as amended in October 2004, between Nextel and the Company (the
Agreement), the aggregate purchase price for the acquisition was $ 1,600,
which was paid to Nextel through the issuance of 186,264 of the Companys ordinary
shares, based on a market price of US $ 8.59 per share, which was the average closing
price of the Companys ordinary shares for the last ten trading days prior to
September 14, 2004. The acquisition was accounted for as a purchase and the Company
allocated the purchase price according to the fair value of the tangible assets and
intangible assets acquired and liabilities assumed. As of October 2004, the purchase
price was re-calculated in accordance with EITF No. 99-12, Determination of the
measurement date for the market price of acquirer securities issued in purchase business
combination, based on the date the business combination was consummated, and was in
the amount of $ 1,245.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
addition, the Agreement provides for an additional consideration of up to $ 350 to be
paid to Nextel (the earn-out right) in the form of the Companys
ordinary shares pursuant to the earn-out formula based on ASECs 2004 and 2005
results. Accordingly, as of December 31, 2004, the Company recorded $ 175 from the
earn-out right against a liability in accordance with SFAS No. 150 Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and Equity,
which was settled by 14,298 ordinary shares at the fair market value of $ 175 that were
issued by the Company to Nextel in June 2005. Based on ASECs 2005 results, the
Company did not incur any further liability in connection with the earn-out formula.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
connection with the acquisition, the Company recognized goodwill of $ 167. Out of $ 1,437
of acquired intangible assets, $ 579 was assigned to a brand, $ 406 was assigned to
contracts with customers which are both being amortized over up to five years and $ 452
was assigned to know how, which is being amortized over one-and-a-half years.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | D. | Intercard
Gmbh Kartensysteme
| | -- | ----------------------------

| | On
September 14, 2004, the Company entered into an agreement under which in October 2004,
the Company sold its wholly-owned German subsidiary InterCard GmbH Kartensysteme (KS)
in consideration for $ 2,500, which should be paid in two installments. The first
installment in the amount of $1,250 was paid by receiving $ 685 in cash, offsetting an
amount of euro 325 thousand ($432) against a loan granted to the buyer, which is
repayable in 32 monthly installments of euro 10 thousand and a final installment of euro
5 thousand, beginning on February 1, 2005 and that is interest-free and offsetting an
amount of euro 100 thousand ($ 133) against a loan granted to the buyer, which is
repayable in 12 monthly installments of euro 9 thousand, beginning on February 1, 2005.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 20

---

---



|Note 5 |  | Investments (contd)
|------ | - | --------------------

| | D. | Intercard
Gmbh Kartensysteme (contd)
| | -- | -------------------------------------

| | The
second installment in the amount of $ 1,250 shall be paid in 25 quarterly payments
beginning on April 1, 2005. The total present value of the purchase price amounted to $
2,178. In October 2005, the Company entered into a settlement agreement according to
which the outstanding balances of the two loans was reduced by Euro 115 thousand ($136)
and combined to one loan which is payable in 24 monthly installments of Euro 10 thousand
each and a final installment of Euro 5 thousand.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
gain from the sale of KS including the effect of the aforesaid deduction from the
proceeds was $ 374 and was recognized in 2005.
| | ------------------------------------------------------------------------------------------------------------------------------------

| | The
Companys control over KS ceased on the closing date, which was October 1, 2004, and
therefore the Company ceased to consolidate the financial statements of KS effective
October 1, 2004.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | E. | E-Smart
Systems Inc. (formerly Oti Asia Pacific Ltd.)
| | -- | -----------------------------------------------------

| | In
February 2000, the Company and Cheung Kong Holdings Ltd. (CK) established a
cooperative joint venture, e-Smart Systems Inc. (e-Smart), which will
purchase and distribute the Companys products to Greater China (the Peoples
Republic of China, Taiwan, Hong Kong and Macao).
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
of December 31, 2003 the Companys investment in e-Smart was zero.
| | ---------------------------------------------------------------------

| | In
June 2004, the Company signed an agreement with CK for the sale of the Companys 50%
interest in the issued share capital of e-Smart to CK and the transfer of the e-Smart
exclusive distribution rights in the Greater China to the Company. According to the
agreement, the Company received $10 in consideration for the acquisition of the shares by
CK and paid $ 40 and $ 20 for the transfer of e-Smart exclusive distribution rights and
for management services provided by CK to e-Smart, respectively. In addition, the Company
agreed to pay e-Smart royalties equivalent to a certain percentage of the Companys
net revenues generating from its activities in the Greater China up to $ 300.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | F. | Investment
in affiliated company
| | -- | --------------------------------

| | During
2005, an affiliated company has been established together with an Asian government
entity, in the form of a joint venture, for the manufacture and sale of OTI-based travel
document inlays for such government. The joint venture was approved for establishment by
the Asian government authorities. As of December 31, 2005, the affiliated company has not
yet commenced its operations.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 21

---

---



|Note 5 |  | Investments
(contd)
|------ | - | --------------------

| | G. | Intangible
assets, net
| | -- | ----------------------

|                               | December 31
|------------------------------ | -----------
|
|
|
|
|Cost                           |            
|Technology                     |            
|Brand                          |            
|Know-How                       |            
|Customer contracts             |            
|Customer relationships         |            
|                               |            
|                               |            
|Total cost                     |            
|                               |            
|Accumulated amortization       |            
|Technology                     |            
|Brand                          |            
|Know-How                       |            
|Customer contracts             |            
|Customer relationships         |            
|                               |            
|Total Accumulated amortization |            
|                               |            
|                               |            
|                               |            
|                               |            

| | a. | Amortization
expenses amounted to $ 188, $ 290 and $ 700 for the years ended                December
31, 2003, 2004 and 2005, respectively.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------

| | b. | Estimated
amortization expenses for the years ending:
| | -- | -----------------------------------------------------

|December 31 | 
|----------- | 
|
|
|
|
|2006        | 
|2007        | 
|2008        | 
|2009        | 
|2010        | 

F - 22

---

---



|Note 6 |  | Property, Plant and Equipment, Net
|------ | - | ----------------------------------

| | A. | Consist
of:
| | -- | -----------

|                                                | December 31
|----------------------------------------------- | -----------
|
|
|
|
|Cost                                            |            
|Land                                            |            
|Leasehold land (1)                              |            
|Buildings on leasehold land (1)                 |            
|Buildings                                       |            
|Computers, software and manufacturing equipment |            
|Office furniture and equipment                  |            
|Motor vehicles                                  |            
|                                                |            
|                                                |            
|Total cost                                      |            
|                                                |            
|                                                |            
|Total accumulated depreciation                  |            
|                                                |            
|                                                |            
|Net book value                                  |            
|                                                |            

| | (1) | The
leasehold land consists of two plots owned by the Israel Lands
               Administration. Rights to leasehold land on the first plot extend over the
               original period of 49 years ending in the year 2041 with an option to
extend for                an additional 49 years, and on the second plot for a period of
49 years, which                will end in the year 2047 with an option to extend for a
further 49 years. The                amount includes payments on account of land
development and payments of the                capitalization of leasing payments. The
rent for the initial 49-year term of                each of these leases was prepaid in
its entirety at the beginning of the lease                terms as is customary in Israel
for leases of property for industrial purposes                from the Israel Lands
Authority.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | As
to liens  See Note 9C.
| | --- | --------------------------

| | B. | On
April 28, 2005, the Company entered into a Production Line Equipment Supply
               Agreement (the Equipment Agreement) with POE, under which POE
has                agreed to supply the Company with specified equipment and machinery
for the                manufacture of smart cards for an aggregate purchase price of $
1,700, which was                paid to POE through the issuance of 137,208 of the Companys
ordinary                shares in August 2005. Pursuant to terms of the Equipment
Agreement, the shares                will be held in escrow with Z.A.G. Trust Company
Ltd., as escrow agent (the                Escrow Agent), on behalf of POE,
until such time as POE has                delivered the equipment and machinery to the
Company. Upon receiving written                confirmation from the Company that the
Company has received the equipment and                machinery from POE, the Escrow
Agent has been instructed to sell the shares                following certain guidelines
and remit the cash proceeds from the sale of the                shares to POE. As at
December 31, 2005 the equipment has not yet been received                and the shares
were held in escrow.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 23

---

---

|Note 7 |  | Other
Current Liabilities
|------ | - | -------------------------

|                                                       | December 31
|------------------------------------------------------ | -----------
|
|
|
|
|Employees and related expenses                         |            
|Accrued expenses                                       |            
|Customer advances                                      |            
|Liability with respect to the purchase of a subsidiary |            
|(see Note 5C)                                          |            
|Deferred gain from the sale of KS (see Note 5D)        |            
|Other current liabilities                              |            
|                                                       |            
|                                                       |            
|                                                       |            
|                                                       |            
|                                                       |            

|Note 8 |  | Loans
|------ | - | -----

| | A. | Composition
of Long-Term Loans:
| | -- | -------------------------------

|                          | December 31
|------------------------- | -----------
|
|
|
|
|Long-term loans           |            
|Less - current maturities |            
|                          |            
|                          |            
|                          |            
|                          |            

| | As
of December 31, 2005, the loans are from banks and are denominated in US dollars ($ 1,803),
South African Rand ($ 119), Polish Zloty ($ 79) and NIS ($ 41) and bear interest of
4.6%-10.5% per annum.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Repayments
of Long-Term Loans Dates Subsequent to December 31, 2005:
| | -- | --------------------------------------------------------------------

|                                | 
|------------------------------- | 
|
|
|
|
|First year (current maturities) | 
|Second year                     | 
|Third year                      | 
|Fourth year                     | 
|Fifth year and thereafter       | 
|                                | 
|                                | 
|                                | 
|                                | 

F - 24

---

---



|Note 8 |  | Loans
(contd)
|------ | - | --------------

| | C. | Composition
of Short-Term Bank Credit and Current Maturities of Long-Term           Loans:
| | -- | ------------------------------------------------------------------------------------------

|                       | December 31 | December 31
|---------------------- | ----------- | -----------
|
|
|
|
|In Polish Zloty        |             |            
|In New Israeli shekels |             |            
|In Euro                |             |            
|                       |             |            
|                       |             |            
|Current maturities of  |             |            
|long-term loans        |             |            
|                       |             |            
|                       |             |            
|                       |             |            

| | The
weighted average interest rate for the years ended December 31, 2004 and 2005 were 6.2%
and 5.5%, respectively.
| | -------------------------------------------------------------------------------------------------------------------

| | D. | Liens
for short-term and long-term borrowings  see Note 9C.
| | -- | ------------------------------------------------------------

| | E. | As
of December 31, 2005, the Group has authorized credit lines of approximately $1,300.
| | -- | ---------------------------------------------------------------------------------------

|Note 9 |  | Commitments
and Contingencies
|------ | - | -----------------------------

| | A. | Commitments
and Contingencies:
| | -- | ------------------------------

| | The
Company and its Israeli subsidiary, EasyPark, have entered into several research and
development agreements, pursuant to which the Company and EasyPark are obligated to pay
royalties to the Government of Israel at a rate of 3% and 3.5% of its sales up to the
amounts granted (linked to the US dollar with annual interest at LIBOR as of the date of
approval, for programs approved from January 1, 1999 and thereafter). As at December 31,
2005, the total amount of grants received, net of royalties paid, was approximately $
5,760.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Royalties
paid or accrued amounted to $ 199, $ 187 and $ 690 for the years ended December 31, 2003,
2004 and 2005, respectively, and were charged to cost of revenues.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 25

---

---



|Note 9 |  | Commitments
and Contingencies (contd)
|------ | - | --------------------------------------

| | B. | Leases
| | -- | ------

| | The
Group operates from leased facilities in the United States, Israel, Poland, Germany,
South Africa and China, leased for periods expiring in years 2006 through 2010.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Minimum
future rentals of premises under non-cancelable operating lease agreements at rates in
effect as of December 31, 2005 are as follows:
| | ---------------------------------------------------------------------------------------------------------------------------------------------

|     | 
|---- | 
|
|
|
|
|2006 | 
|2007 | 
|2008 | 
|2009 | 
|2010 | 
|     | 
|     | 
|     | 

| | Rent
expense amounted to $ 201, $ 475 and $ 690 for the years ended December 31, 2003, 2004
and 2005, respectively.
| | -------------------------------------------------------------------------------------------------------------------

| | C. | Liens
| | -- | -----

| | Leasehold
land is pledged in favor of a bank in relation to both long-term and short-term
borrowings, and the Company has recorded a floating charge on all of its tangible assets.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Companys manufacturing facilities have been pledged as security in respect of a
loan received from a bank.
| | ---------------------------------------------------------------------------------------------------------------

| | D. | Legal
claims
| | -- | ------------

| | (1) | On
September 3, 2003, Edi Wuhl (in this paragraph, the Plaintiff), a
               former employee of the Company, filed a suit against the Company to the
District                Labor Court in Nazareth in the amount of NIS 3,953 (approximately
$ 900). The                suit is based on the Plaintiffs claims that the Company
has breached the                employment agreement with him, and that the Company owes
him commission payment                for certain sales. On December 17, 2003, the
Company filed a statement of                defense. On May 23, 2004, a preliminary
hearing was conducted, which did not                lead to any settlement. The proof
hearing that was scheduled to September 25,                2005 was postponed for April
23, 2006. The Company is required to file its                answers in May 2006. In the
opinion of the Company, based on its legal advisor,                the plaintiffs
chances of prevailing against the Company are remote. No                provision in
respect thereof has been included in the financial statements.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 26

---

---



|Note 9 |  | Commitments
and Contingencies (contd)
|------ | - | --------------------------------------

| | D. | Legal
claims (contd)
| | -- | ---------------------

| | (2) | On
October 15, 2005, Sinocard Technology Limited (in this paragraph, the
               Plaintiff) filed a suit against e-Pilot Group Limited and
Oriental                Power Technology Limited, two subsidiaries of the Company (the
               Subsidiaries) and certain directors of the Subsidiaries, in
the High                court of The Hong Kong SAR (the Suit). The Suit is
based, inter                alia, on the Plaintiffs claims that it is entitled to
one third of the                issued and outstanding shares of Oriental Power
Technology Limited, pursuant to                a certain agreement that allegedly exists
between the parties. The Plaintiff                demands that the Subsidiaries shall
cause the issuance of such shares. In                addition, the Plaintiff seeks to be
compensated for damages and for alleged                unjustified enrichment of the
defendants (including the Subsidiaries). The                Subsidiaries and the other
defendants filed their statement of defense. Pursuant                to the rules of Hong
Kong Court, the Plaintiff must lodge an application at                Court seeking
instructions for further conduct of the matter. By March 24, 2006                such
application has not been made. This case is in preliminary stage so it is
               not possible to asses the likelihood of an unfavorable outcome or the
magnitude                of any potential loss. No provision in respect thereof has been
included in the                financial statements.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 10 |  | Shareholders Equity
|------- | - | --------------------

| | A. | Share
capital
| | -- | -------------

| | 1. | In
July 2003, pursuant to stock purchase agreements, the Company issued to two
               investors 231,818 ordinary shares in consideration for $637 and received a
firm                commitment from one of the investors to purchase an additional
100,000 ordinary                shares in consideration for an additional $275, when the
Company notifies the                investor that the effectiveness of a registration
statement covering shares for                resale in the U.S. is imminent. Additional
warrants to purchase 50,000 ordinary                shares at an exercise price of $5.75
per share will also be issued upon the                completion of such registration.
Concurrently with the above share issuance, the                Company issued to the two
investors warrants to purchase 50,000 and 90,909                ordinary shares at a per
share exercise price of $5.75 and $3.85, respectively.                The warrants are
fully exercisable and expire in July 2008.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company paid, in respect of the above, a finders fee in cash equivalent to 10% of the
amount raised by the Company and in addition warrants to purchase 18,182 ordinary shares
with an exercise price of $3.85 per share and warrants to purchase 10,000 ordinary shares
with an exercise price of $5.75 per share.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | On
November 2003, convertible promissory notes (the Notes) in the
               amount of $250 were converted into 52,000 ordinary shares.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------

| | In
connection with the issuance of these Notes, in December 2002, the Company also issued
detachable warrants to purchase an aggregate of 16,757 ordinary shares, at an exercise
price of 120% of the average per share price for the ordinary shares for the ten (10)
consecutive day trading period prior to the closing. The warrants will expire on December
31, 2007.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 27

---

---



|Note 10 |  | Shareholders Equity
(contd)
|------- | - | -----------------------------

| | A. | Share
capital (contd)
| | -- | ----------------------

| | 3. | On
November 14, 2003, upon the shareholders approval for the transaction,
               the Company issued to investors 228,044 ordinary shares in consideration
for                $624. Concurrently with the above share issuance, the Company issued
to the                investors warrants to purchase 112,305 ordinary shares, with a per
share                exercise price of $5.75. The warrants are fully exercisable and
expire on July                2008.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4. | On
November 14, 2003, the Companys shareholders approved the increase in
               the Companys authorized share capital of NIS 500,000 comprising of
               5,000,000 ordinary shares of NIS 0.1 par value each. Following the
aforesaid                Companys shareholders approval, the Companys
authorized share                capital is comprised of 10,000,000 ordinary shares of NIS
0.1 par value each.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 5. | In
November 2003, pursuant to a stock and warrant purchase agreements, the
               Company issued to investors 113,235 ordinary shares in consideration for
$385.                Concurrently with the above share issuance, the Company issued to
the investors                warrants to purchase 56,617 ordinary shares at a per share
exercise price of $5.                The warrants are exercisable upon the occurrence of
certain events as set forth                in the agreements and expire in November 2008.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 6. | In
December 2003, pursuant to a stock and warrant purchase agreements, the
               Company issued to investors 288,889 ordinary shares in consideration for
$1,300.                Concurrently with the above share issuance, the Company issued to
the investors                warrants to purchase 144,447 ordinary shares at a per share
exercise price of                $6.5. The warrants are fully exercisable and expire in
December 2008.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company incurred, in respect of the above finders fee, costs equivalent to 7% of
the amount raised by the Company.
| | -----------------------------------------------------------------------------------------------------------------------

| | 7. | In
December 2003, pursuant to a stock and warrant purchase agreements, the
               Company issued to an investor 650,000 ordinary shares in consideration for
               $3,413. Concurrently with the above share issuance, the Company issued to
the                investor warrants to purchase 325,000 ordinary shares at a per share
exercise                price of $6.5. The warrants are fully exercisable and expire in
December 2008.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company incurred, in respect of the above, finders fee expenses equivalent to 4% of the
amount raised by the Company and, in addition, issued warrants to purchase 45,500
ordinary shares at a per share exercise price of $6.5.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 8. | In
December 2003, pursuant to stock and warrant purchase agreements, the Company
               issued to investors 450,476 ordinary shares in consideration for $2,365.
               Concurrently with the above share issuance, the Company issued to the
investors                warrants to purchase 166,667 and 58,571 ordinary shares at a per
share exercise                price of $6.5 and $7.5, respectively. The warrants are
fully exercisable and                expire in December 2008.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company incurred, in respect of the above, finders fee costs in the amount of $148 and,
in addition, issued warrants to purchase 26,667 and 8,200 ordinary shares at a per share
exercise price of $6.5 and $7.5, respectively.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 28

---

---



|Note 10 |  | Shareholders Equity
(contd)
|------- | - | -----------------------------

| | A. | Share
capital (contd)
| | -- | ----------------------

| | 9. | In
December 2003, pursuant to stock and warrant purchase agreements, the Company
               issued to two investors 82,241 ordinary shares in consideration for $400.
               Concurrently with the above share issuance, the Company issued to the
investors                warrants to purchase 41,120 ordinary shares at a per share
exercise price of                $6.5. The warrants are fully exercisable and expire in
December 2008.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10. | Following
a private placement agreement signed on October 23, 2003, the Company
               signed on January 7, 2004, a stock purchase agreement pursuant to which
the                Company issued to investors 100,000 ordinary shares in consideration
for $ 315.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 11. | On
April 6, 2004, the Companys shareholders approved the increase of the
               Companys authorized share capital by NIS 2,000,000 comprising of
               20,000,000 ordinary shares of NIS 0.1 par value each. Following the
increase,                the Companys authorized share capital is comprised of
30,000,000 ordinary                shares of NIS 0.1 par value each.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 12. | On
April 29, 2004, pursuant to a Securities Purchase Agreement, the Company
               issued to investors 1,300,000 ordinary shares in consideration for $
15,132.                Concurrently, with the above share issuance, the Company issued to
the investors                warrants to purchase 780,000 ordinary shares at a per share
exercise price of $                13.97. The warrants are fully exercisable and expire
in April 2009.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company incurred, in respect of the above, finders fee expenses equivalent to
approximately 6% of the amount raised by the Company and, in addition, issued warrants to
purchase 124,800 ordinary shares at a per share exercise price of $13.97. The warrants
are fully exercisable and expire in April 2009.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 13. | During
2004 warrants to purchase 1,051,224 ordinary shares were converted into
               ordinary shares in consideration of $ 6,092. Additional warrants to
purchase                140,764 ordinary shares were converted into 53,975 ordinary
shares through                cashless exercise.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 14. | On
November 1, 2005, the Company issued and sold to certain financial
               institutions, in a private placement, 1,828,026 of its units, 1,544,568 of
which                consisted of one ordinary share and a warrant to purchase
three-fifths of an                ordinary share and 283,458 of which consisted of one
ordinary share and a                warrant to purchase one-half of an ordinary share.
The aggregate purchase price                of the units was $ 22,211, based on a market
price of $ 12.15 per unit, which                was the average closing price of the
Companys ordinary shares for the last                five trading days prior to
October 24, 2005, the pricing date. The warrants,                which are for the
purchase of an aggregate of up to 1,068,471 ordinary shares,                are
immediately exercisable, have terms of five years and an exercise price of $
               14.58 per share, and may be redeemed by the Company after two years if the
               market price of the underlying ordinary shares reaches $ 26.24 and certain
other                conditions are met. The Company did not receive any additional
consideration for                its issuance of the warrants to the financial
institutions, which purchased its                ordinary shares. In addition to the
issuance of warrants to the financial                institutions, the Company also
issued an aggregate of 127,961 warrants to the                placement agent for the
private placement of the units and to certain other                persons who
facilitated the offering. In respect of the warrants issued to the                agent,
the Company recorded issuance expenses in the amount of $1,048.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 29

---

---



|Note 10 |  | Shareholders Equity
(contd)
|------- | - | -----------------------------

| | A. | Share
capital (contd)
| | -- | ----------------------

| | 15. | During
2005, warrants to purchase 151,480 ordinary shares were converted into
               ordinary shares in consideration of $ 1,358. Additional warrants to
purchase                16,000 ordinary shares were converted into 5,130 ordinary shares
through                cash-less exercise.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Options
to non-employees
| | -- | ------------------------

| | The
Company issued options to non-employees, which are accounted for in accordance with SFAS
No. 123 and EITF No. 96-18 Accounting For Equity Instruments That Are Issued to
Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services:
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1. | In
2003, the Company issued 261,203 options to non-employees in respect of
               services rendered. The aggregate fair value of the options was $ 927 based
on                the Black-Scholes option model with the following assumptions: (1)
contractual                life of 5 years, (2) no dividend yield, (3) expected
volatility of 82%                 86% and (4) risk free interest rate of 2.5%.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | In
2004, the Company issued 326,888 options to non-employees in respect of
               services rendered. The aggregate fair value of the options was $ 2,537
based on                the Black-Scholes option model with the following assumptions:
(1) contractual                life of 5 years (2) no dividend yield, (3) expected
volatility of 78%                 85% and (4) risk free interest rate of 2.5%  3.29%.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | In
2005, the Company issued 286,300 options to non-employee in respect to
               services rendered. The aggregate fair value of the options was $ 3,192
based on                the Black-Scholes option model with the following assumptions:
(1) contractual                life of 5 year, (2) no dividend yield, (3) expected
volatility of 72%-76% and                (4) risk-free interest rate of 4.1%-4.5%.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | Stock
option plans
| | -- | ------------------

| | 1. | In
1995, the Companys Board of Directors approved a stock option plan,
               under which up to 45,000 share options are to be granted to the Groups
               employees, directors and consultants. The vesting period for the options
ranges                from immediate vesting to ratable vesting over a ten-year period.
The exercise                price of options under the plan is at varying prices ranging
from $0 to market                value at the date of grant. Those options will expire up
to ten years after the                date of the grant. Any options which are forfeited
or cancelled before                expiration become available for future grants. In July
1998, the Board of                Directors expanded the plan for an additional 20,000
share options to be                granted. In November 1999, the Board of Directors
resolved to expand the plan                with an additional 35,000 share options to be
granted. In July 2002, the Board                of Directors expanded the number of
options available by 30,300.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 30

---

---



|Note 10 |  | Shareholders Equity
(contd)
|------- | - | -----------------------------

| | C. | Stock
option plans (contd)
| | -- | ---------------------------

| | 2. | In
February 2001, the Companys Board of Directors approved an additional
               option plan, under which up to 75,000 share options are to be granted to
the                Companys employees, directors and consultants and those of the
               Companys subsidiaries and affiliates.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
February 2002, the Companys Board of Directors approved an increase of the number
of available options by 150,000 and in July 2002 by a further 600,000.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
March, July and September 2003, the Companys Board of Directors approved an
increase of 375,000, 550,000 and 500,000 shares, respectively, to be reserved under the
Companys share option plan.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
November 17, 2003, the Companys Board of Directors approved an increase of 500,000
shares to be reserved under the Companys share option plan. The vesting period for
the options ranges from immediate vesting to ratable vesting over a ten- year period. The
exercise price of options under the plan is at varying prices ranging from $0 to market
value at the date of the grant. Those options will expire up to ten years after the date
of the grant. Any options which are forfeited or cancelled before expiration become
available for future grants.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | On
February 26, 2002, the Board of Directors approved a grant by which, inter
               alia, the Company may pay, during a 12-month period, the salaries of
certain of                its employees who agree to participate, by way of grant of
options at an                exercise price of par value. All such options are to be held
by a trustee, for                the benefit of each such employee. At the direction of
and in accordance with                instructions given by an employee who has received
options, the trustee shall                exercise such options and sell the shares
issued upon such exercise. The                proceeds mentioned above will be released
on a monthly basis by the trustee (net                of deductions required by law) to
the maximum extent necessary for payment of                such monthly salary to such
employee. The Company undertook to pay from its own                sources any and all
differences between the relevant monthly salary and such                proceeds. The
arrangement was subject to the Company, the employees and the                trustees
signature on a detailed agreement and necessary ancillary                documents.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
March 28, 2003, the Board of Directors approved an extension to the arrangement of the plan
approved by the Board of Directors on February 26, 2002 to pay salaries of certain of its
employees who agree to participate in the plan, by way of grant of options for an
additional period of 6 months starting May 2003.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 31

---

---



|Note 10 |  | Shareholders Equity
(contd)
|------- | - | -----------------------------

| | C. | Stock
option plans (contd)
| | -- | ---------------------------

| | On
October 28, 2003, the Companys Board of Directors approved the extension of the
arrangement of the plan approved by the Board of Directors on February 26, 2002 to pay
salaries of certain of its employees who agree to participate in the plan, by way of
grant of options, only for the employees of Inter-Card group, for the period commencing
November 2003 and ending July 2004.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
August 26, 2004, the Companys Board of Directors approved the extension of the
arrangement of the plan approved by the Board of Directors on February 26, 2002 to pay
salaries of certain of its employees who agree to participate in the plan, by way of
grant of options, for the period commencing July 2004 and ending December 2004.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
November 26, 2004, the Companys Board of Directors approved the extension of the
arrangement of the plan approved by the Board of Directors on February 26, 2002 to pay
salaries of certain of its employees who agree to participate in the plan, by way of
grant of options, for a 12-month period commencing January 2005 and ending December 2005.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
April 20, 2005, the Companys Board of Directors approved the extension of the
arrangement of the plan approved by the Board of Directors on February 26, 2002 to pay
salaries to certain of its employees who agree to participate in the plan, by way of
grant of options for a 12-month period commencing April 2005 and ending March 2006.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
of December 31, 2003, 2004 and 2005, 621,768, 1,055,439 and 1,106,910 options
respectively, have been granted in respect of the above-mentioned grants. The exercise
price per share for such options is equal to the par value of the ordinary shares of the
Company.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4. | On
November 26, 2004, the Companys Board of Directors approved the
               conversion grant of 130,230 fully vested options with an exercise price of
NIS                0.1 per share to OTI Africa Ltd. employees in exchange of each OTI
Africa Ltd.                employee waiving his rights to receive options and/or shares,
he is entitled.                The transaction resulted in a new measurement date and
expenses in the amount of                $ 1,112 were recorded.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 5. | The
Company applies APB Opinion No. 25 and related interpretations in accounting
               for its stock compensation programs benefiting employees and directors and
               recorded compensation expenses of $1,897, $ 4,872 and $ 8,948 in the years
ended                December 31, 2003, 2004 and 2005, respectively, according to the
intrinsic value                of the above options.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company applies SFAS No. 123 in respect of options granted to consultants and goods
providers and recorded compensation costs of $ 927, $ 2,537 and $ 3,192 in the years
ended December 31, 2003, 2004 and 2005, respectively, related to the above options
according to the Black-Scholes model.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 32

---

---



|Note 10 |  | Shareholders Equity
(contd)
|------- | - | -----------------------------

| | C. | Stock
option plans (contd)
| | -- | ---------------------------

| | The
Companys options activity (including options to non-employees) and options
outstanding as of December 31, 2003, 2004 and 2005 are summarized in the following table:
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                | Number of
options
outstanding | Weighted
average exercise
price per share
|------------------------------- | ----------------------------- | -----------------------------------------
|
|
|
|
|Outstanding - January 1, 2003   |                               |                                          
|Options granted                 |                               |                                          
|Options cancelled or forfeited  |                               |                                          
|Options exercised               |                               |                                          
|                                |                               |                                          
|Outstanding - December 31, 2003 |                               |                                          
|Options granted                 |                               |                                          
|Options cancelled or forfeited  |                               |                                          
|Options exercised               |                               |                                          
|                                |                               |                                          
|Outstanding - December 31, 2004 |                               |                                          
|Options granted                 |                               |                                          
|Options cancelled or forfeited  |                               |                                          
|Options exercised               |                               |                                          
|                                |                               |                                          
|Outstanding - December 31, 2005 |                               |                                          
|                                |                               |                                          
|Exercisable as of:              |                               |                                          
|                                |                               |                                          
|December 31, 2003               |                               |                                          
|                                |                               |                                          
|December 31, 2004               |                               |                                          
|                                |                               |                                          
|December 31, 2005               |                               |                                          
|                                |                               |                                          

| | The
following table summarizes information about options outstanding and exercisable
(including options to non-employees) as of December 31, 2005:
| | --------------------------------------------------------------------------------------------------------------------------------------------------

|  | Options outstanding | Options Exercisable
|- | ------------------- | -------------------
|
|
|
|
|$ | 0-0.02              |                    
|  | 2.75                |                    
|  | 3.25-5.16           |                    
|  | 6.10-8.17           |                    
|  | 8.21-9.89           |                    
|  | 10.00-14.00         |                    
|  | 16.03-34.00         |                    
|  | 42.50-123.60        |                    
|  |                     |                    
|  |                     |                    
|  |                     |                    

F - 33

---

---



|Note 10 |  | Shareholders Equity
(contd)
|------- | - | -----------------------------

| | C. | Stock
option plans (contd)
| | -- | ---------------------------

| | The
amounts of deferred stock compensation recognized arising from the difference between the
exercise price and the fair market value on the date of the grant of $ 2,039, $ 7,168 and
$ 6,228 options granted in the years ended December 31, 2003, 2004 and 2005,
respectively, are included in shareholders equity and are being amortized over the
vesting periods of the respective options in accordance with APB 25.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
weighted average fair values of options (including non-employees) granted during the
years ended December 31, 2003, 2004 and 2005 were:
| | -------------------------------------------------------------------------------------------------------------------------------------------

|                 | For exercise price on the grant date that:
|---------------- | ------------------------------------------
|
|
|
|
|Weighted average |                                           
|exercise prices  |                                           
|Weighted average |                                           
|fair values on   |                                           
|grant date       |                                           

| | D. | Warrants
| | -- | --------

| | The
Company issued warrants with respect to investments made in the Company. The number of
warrants issued by the Company during the years ended December 31, 2003, 2004 and 2005
were 1,553,957, 904,800 and 1,196,431, respectively, with a per share weighted average
exercise price of $5.95, $13.97 and $ 14.58, respectively.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
following table summarizes information about warrants outstanding and exercisable as of
December 31, 2005:
| | --------------------------------------------------------------------------------------------------------------

|  | Warrants outstanding
|- | --------------------
|
|
|
|
|$ | 3.85                
|  | 5.75 - 7.50         
|  | 9.51 - 9.99         
|  | 11.42 - 14.58       
|  |                     
|  |                     
|  |                     

F - 34

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---



|Note 10 |  | Shareholders Equity
(contd)
|------- | - | -----------------------------

| | E. | Employee
Share Purchase Plan
| | -- | ----------------------------

| | In
2001, the Company established an Employee Share Purchase Plan pursuant to which 67,500
shares have been reserved for employees including the Companys subsidiaries who
have been employed for at least six months. The purchase price of the shares will be 85%
of the trading price on the date of purchase. As of the date of these financial
statements, no shares have been issued to any employees under this plan.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 11 |  | Income
Taxes
|------- | - | ------------

| | A. | The
Company and its Israeli subsidiaries
| | -- | ----------------------------------------

| | 1. | Measurement
of taxable income under the Income Tax (Inflationary Adjustments)           Law, 1985
| | -- | -------------------------------------------------------------------------------------------------

| | Results
for tax purposes are measured and adjusted in accordance with the change in the Israeli
Consumer Price Index (CPI). As explained in Note 2C the consolidated
financial statements are presented in U.S. dollars. The differences between the change in
the Israeli CPI and in the NIS/U.S. dollar exchange rate causes a difference between the
Companys and its Israeli subsidiaries taxable income or loss and their income
or loss before taxes reflected in the consolidated financial statements. In accordance
with paragraph 9(f) of SFAS No. 109, the Company and its Israeli subsidiaries have not
provided deferred income taxes on this difference between the financial reporting basis
and the tax basis of assets and liabilities.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Tax
benefits under the Law for the Encouragement of Capital Investments, 1959
| | -- | -----------------------------------------------------------------------------

| | The
Company maintains three investment programs in buildings, equipment and production
facilities which have been granted the status of Approved Enterprise under
the Law for the Encouragement of Capital Investments, 1959. The Company elected to adopt
the Alternative Benefits Program status. This status entitles the Company to
an exemption from taxes on income derived therefrom for a period of 10 years starting in
the year in which the Company first generates taxable income, but not later than 14 years
from the date of approval (the last of which was received in February 2000) or 12 years
from commencement of operations. The tax-exempt profits that will be earned by the Companys
Approved Enterprises can be distributed to shareholders, without imposing tax
liability on the Company only upon its complete liquidation. If these retained tax-exempt
profits are distributed in a manner other than in the complete liquidation of the Company
they would be taxed at the corporate tax rate applicable to such profits as if the
Company had not elected the alternative system of benefits (depending on the level of
foreign investment in the Company) currently between 10% to 25% for an Approved
Enterprise. As the Company has not yet reported any taxable income, the benefit
period has not yet commenced.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 35

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|Note 11 |  | Income
Taxes (contd)
|------- | - | ---------------------

| | A. | The
Company and its Israeli subsidiaries (contd)
| | -- | -------------------------------------------------

| | 2. | Tax
benefits under the Law for the Encouragement of Capital Investments, 1959           (contd)
| | -- | ------------------------------------------------------------------------------------------------

| | Income
from sources other than the Approved Enterprise during the benefit period
will be subject to tax at the regular corporate tax rate (see 4 below).
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
entitlement to the above mentioned benefits is conditional upon the Companys
fulfilling the conditions stipulated by the above mentioned law, regulations published
thereunder and the certificates of approval for the specific investments in approved
enterprises. In the event of failure to comply with these conditions, the benefits may be
canceled and the Company may be required to refund the amount of the benefits, in whole
or in part, with the addition of linkage differences to the CPI and interest. Management
believes that the Company is in compliance with the above-mentioned conditions as of
December 31, 2005.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | The
Law for the Encouragement of Industry (taxes), 1969
| | -- | -------------------------------------------------------

| | In
the Companys management estimation, the Company is also an Industrial Company under
the Law for the Encouragement of Industry. The principal benefits for the Company are the
deductibility of costs in connection with public offerings and accelerated depreciation.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4. | Tax
rates
| | -- | ---------

| | On
July 25, 2005 the Knesset The Israeli Parliament passed the Law for the
Amendment of the Income Tax Ordinance (No.147 and Temporary Order)  2005
(hereinafter  the Second Amendment). The Amendment provides for a gradual reduction
in the company tax rate in the following manner: in 2006 the tax rate will be 31%, in
2007 the tax rate will be 29%, in 2008 the tax rate will be 27%, in 2009 the tax rate
will be 26% and from 2010 onward the tax rate will be 25%. Furthermore, as from 2010,
upon reduction of the company tax rate to 25%, real capital gains will be subject to tax
of 25%. This change had no effect on the financial statements of the Company.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Non-Israeli
subsidiaries are taxed based on tax laws in their country of                residence.
| | -- | --------------------------------------------------------------------------------------------------

| | C. | As
of December 31, 2005, the net operating loss carryforwards for tax purposes
               relating to Israeli companies amounted to approximately $ 44,000.
Carryforward                losses in Israel may be carried forward indefinitely and may
be offset against                future taxable income. Under the Income Tax
(Inflationary Adjustments) Law,                1985, carryforward losses are linked to
the CPI. The Company expects that during                the period in which these tax
losses are utilized its income would be                substantially tax exempt, and
accordingly, no deferred tax asset has been                recorded. Carryforward losses
relating to non-Israeli companies aggregate                approximate $ 1,350, which
expires as follows: 2007  $ 87, 2010  $                154, 2025  $
895. The remaining balance  $ 214 can be utilized with                no expiration
date.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | D. | Deferred
taxes in respect of temporary differences between carrying amounts of
               assets and liabilities for financial reporting and amounts used for tax
               reporting purposes are immaterial.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 36

---

---



|Note 12 |  | Related
Party Balances and Transactions
|------- | - | ---------------------------------------

| | A. | Balances
| | -- | --------

|                  | December 31
|----------------- | -----------
|
|
|
|
|Assets            |            
|Trade receivables |            
|                  |            
|                  |            
|Liabilities       |            
|Trade payables    |            
|                  |            

| | B. | Transactions
| | -- | ------------

|                   | Year ended December 31
|------------------ | ----------------------
|
|
|
|
|Revenues           |                       
|                   |                       
|                   |                       
|Costs and expenses |                       
|                   |                       
|                   |                       

F - 37

---

---



|Note 13 |  | Geographic
Information and Major Customers
|------- | - | ------------------------------------------

| | The
Company manages its business on the basis of one reportable segment. The data is
presented in accordance with SFAS 131, Disclosures About Segments of an Enterprise
and Related Information.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                  | Year ended December 31
|--------------------------------- | ----------------------
|
|
|
|
|Revenues by geographical areas of |                       
|end customers                     |                       
|America                           |                       
|Far East                          |                       
|Africa                            |                       
|Europe                            |                       
|                                  |                       
|Total export                      |                       
|Domestic (Israel)                 |                       
|                                  |                       
|                                  |                       
|                                  |                       
|                                  |                       

|                                        | December 31
|--------------------------------------- | -----------
|
|
|
|
|Long lived assets by geographical areas |            
|Israel                                  |            
|Germany                                 |            
|Poland                                  |            
|Far East                                |            
|Other                                   |            
|                                        |            
|                                        |            
|                                        |            
|                                        |            

| | Major
Customers
| | ---------------

| | Revenues
from one customer represent approximately 30% of the consolidated revenues for the year
ended December 31, 2005.
| | -------------------------------------------------------------------------------------------------------------------------

F - 38

---

---



Consent of Independent
Registered Public Accounting Firm

The Board of DirectorsOn
Track Innovations Ltd.

We consent to the incorporation by
reference in the registration statements on Form F-3 (No. 333-115953, No. 333-121316 and
No. 333-130324), in the registration statements on Form F-3/A (No. 333-111770 and No.
333-127615) and in the registration statement on Form S-8 (333-128106) of On Track
Innovations Ltd. of our report dated March 24, 2006, with respect to the consolidated
balance sheets of On Track Innovations Ltd. and its subsidiaries as of December 31, 2005
and 2004 and the related consolidated statements of operations, shareholders equity
and comprehensive loss and cash flows for each of the years in the three-year period ended
December 31, 2005, which report appears in the report on Form 6-K of On Track Innovations
Ltd. furnished to the Securities and Exchange Commission on March 31, 2006.

|/s/ Somekh Chaikin
Certified Public Accountants (Israel)Member Firm of KPMG International
|-----------------------------------------------------------------------------------------

Tel Aviv, Israel
March 31, 2006

F - 39

---

---



# SIGNATURES

The registrant hereby certifies that
it meets all of the requirements for filing on Form 20-F and that it has duly caused and
authorized the undersigned to sign this annual report on its behalf.

| |  | ON TRACK INNOVATIONS LTD.By: /s/ Oded Bashan
Oded BashanPresident, Chief Executive Officer
and Chairman of the Board
| |  | ----------------------------------------------------------------------------------------------------------------------------------

| |  | By: /s/ Guy Shafran
Guy ShafranChief Financial Officer
| |  | --------------------------------------------------------------------

Date:  May
22, 2006

85

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