**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      20-F**




o
            REGISTRATION
                STATEMENT PURSUANT TO SECTION 12(b) OR (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,
                2007




OR




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




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.............




For
      the
      transition period from _________________ to ________________




Commission
      file number 000-26495




**COMMTOUCH
      SOFTWARE LTD.**


(Exact
      name of Registrant as specified in its charter and


t ranslation
      of Registrant’s name into English)




**Israel**


(Jurisdiction
      of incorporation or organization)


**4A
        Hazoran Street**
 **Poleg
        Industrial Park,**
 **P.O.
        Box 8511**
 **Netanya
        42504, Israel**
 **011-972-9-863-6888**
 (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****Ordinary
                Shares, par value NIS 0.15 per share***
            
            **NASDAQ
                Capital Market**




Securities
      registered or to be registered pursuant to Section 12(g) of the Act:
      None




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




None




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
      (December 31, 2007).




Ordinary
                Shares, par value NIS 0.15*
            
            
            25,346,042*







Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. Yes o No x




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. Yes o No x




Note:
      Checking the above box 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. Yes x No o




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. Check
      one:




Large
                accelerated filer o
            Accelerated
                filer x
            Non-accelerated
                filer o




Indicate
      by check mark which financial statement item the registrant has elected to
      follow. Item 17 o Item
      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). Yes o No x




*The
      Company effected a reverse split at a ratio of one for three Ordinary Shares
      on
      January 2, 2008. At December 31, 2007, on a pre-split basis, the outstanding
      share capital of the Company totaled 76,038,207
      Ordinary Shares, par value NIS 0.05 per share. Unless
      otherwise indicated, all shareholding related information contained in this
      report reflects post-reverse split data.












**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.**




Unless
      otherwise indicated, all references in this document to “Commtouch,” “the
      Company,” “we,” “us” or “our” are to Commtouch Software Ltd. or its wholly-owned
      subsidiary, Commtouch Inc., as relating to consolidated financial information
      contained herein, and former majority-owned subsidiary, Commtouch K.K. (Japan)
      (during 2002 Commtouch divested itself of its majority holdings and retained
      an
      equity interest in this company, which is now known as Imatrix
      Corporation).




The
      selected consolidated statements of operations data for the years ended December
      31, 2005, 2006 and 2007 and the selected consolidated balance sheet data as
      of
      December 31, 2006 and 2007 have been derived from the Consolidated Financial
      Statements of Commtouch included elsewhere in this report. The selected
      consolidated statements of operations data for the years ended December 31,
      2003
      and 2004 and the selected consolidated balance sheet data as of December 31,
      2003, 2004 and 2005 have been derived from the Consolidated Financial Statements
      of Commtouch not included elsewhere in this report. Our historical results
      are
      not necessarily indicative of results to be expected for any future period.
      The
      data set forth below should be read in conjunction with “Item 5. Operating and
      Financial Review and Prospects” and the Consolidated Financial Statements and
      the Notes thereto included elsewhere herein:




**Year
                Ended December 31,****2003**
            
            **2004**
            
            **2005**
            
            **2006**
            
            **2007****(USD
                in thousands, except per share data)**Selected
                Data:Revenues
            
            $
            329
            
            $
            1,523
            
            $
            3,925
            
            $
            7,234
            
            $
            11,250Net
                income (loss) attributable to ordinary and equivalently participating
                shareholders
            
            $
            (6,834
            )
            $
            (7,193
            )
            $
            (2,690
            )
            $
            (190
            )
            $
            2,109Basic
                and diluted net earnings (loss) per share
            
            $
            (0.84
            )
            $
            (0.54
            )
            $
            (0.28
            )
            $
            (0.01
            )
            $
            0.08Weighted
                average number of shares used in computing basic net earnings (loss)
                per
                share
            
            
            8,191
            
            
            13,323
            
            
            15,802
            
            
            22,113
            
            
            24,847Weighted
                average number of shares used in computing diluted net earnings (loss)
                per
                share
            
            
            8,191
            
            
            13,323
            
            
            15,802
            
            
            22,113
            
            
            27,591Total
                Assets
            
            $
            6,855
            
            $
            5,479
            
            $
            7,995
            
            $
            11,999
            
            $
            18,210




**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 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 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” and
      Item 5 - “Operating and Financial Review and Prospects,” 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 update or revise 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
      below.**









**RISK
      FACTORS**




You
      should carefully consider the following risk factors before you decide to buy
      our Ordinary Shares. You should also consider the other information in this
      report. If any of the following risks actually occur, our business, financial
      condition, operating results or cash flows could be materially adversely
      affected. This could cause the trading price of our Ordinary Shares to decline,
      and you could lose part or all of your investment. The risks described below
      are
      not the only ones facing us. Additional risks not presently known to us, or
      that
      we currently deem immaterial, may also impair our business
      operations.




**Business
      Risks**




***If
      the market does not continue to respond favorably to our current advanced email
      defense solutions, including our anti-spam and anti-virus solutions, or our
      future solutions do not gain acceptance, we will fail to generate sufficient
      revenues.*** **




Our
      success depends on the continued acceptance and use of our advanced email
      defense solutions by current and new enterprise, Original Equipment Manufacturer
      or “OEM”, and Internet Service Provider or “ISP” customers and technology
      licensees. We have been selling our anti-spam products for over four years,
      our
      Zero-HourTM virus outbreak detection product for approximately three years and
      our IP reputation service (our latest version being known as GlobalViewTM Mail
      Reputation) for less than two years.




As
      the
      market for email defense products continues to mature, we are seeing increasing
      competitive pressures and demands for even higher quality products at lower
      prices. This increasing demand comes at a time when email threats are more
      varied and intensive, challenging even the top end of email defense solutions
      to
      keep their threat detection at an industry acceptable high level of accuracy.
      If
      our solutions do not continue to evolve to meet market demand, or newer products
      on the market prove more effective, our business could fail. Also, if the growth
      in the market for email defense solutions unexpectedly begins to slow, our
      business will suffer dramatically.




***Governmental
      regulation could decrease the distribution of unsolicited bulk (spam) email
      and
      malicious software and decrease demand for our solutions or increase our cost
      of
      doing business.***




On
      December 16, 2003, President Bush signed into law the Controlling the Assault
      of
      Non-Solicited Pornography and Marketing Act of 2003 (CAN-SPAM Act), which
      establishes a framework of administrative, civil, and criminal tools to combat
      spam. The law establishes both civil and criminal prohibitions to assist in
      deterring the most offensive forms of spam, including unmarked sexually-oriented
      messages and emails containing fraudulent headers. Under the law, senders of
      email are required to honor a request by a consumer not to receive any further
      unsolicited messages. While past high profile prosecutions of direct marketers
      seemingly have not had much of a deterrent effect on marketers of unsolicited
      email, it is not known whether or not future legislative endeavors will prove
      effective.




In
      addition, various state legislatures have enacted laws aimed at regulating
      the
      distribution of unsolicited email.




These
      and
      similar legal measures may have the effect of reducing the amount of unsolicited
      email and malicious software that is distributed and hence diminish the need
      for
      our solutions. Any such developments would have an adverse impact on our
      revenues.




2




***We
      depend upon OEM partners and resellers and we have a limited concentration
      of
      products.***




We
      expect
      to continue to be dependent upon resellers and OEM partners for a significant
      portion of our revenues, which will be derived from sales of our email defense
      solutions. Our operating results and financial condition may be materially
      adversely affected if:




•
            Our
              limited product suite fails to remain attractive in the email defense
              market;




•
            Anticipated
                orders or royalty payments from these resellers and OEM partners
                fail to
                materialize;




•
            We
                are unable to locate and or sign additional OEM partners (given the
                limited pool of available candidates for our technology);
                or




•
            Some
                of the key resellers or OEM partners cease the promotion of our business
                or begin to promote additional solutions in a layered approach to
                email
                defense management.




***Our
      quarterly operating results may fluctuate, which could adversely affect the
      value of your investment.***




A
      number
      of factors, many of which are enumerated in this “Risk Factors” section, are
      likely to cause fluctuations in our operating results or cause our share price
      to decline. These factors include:




•
            Our
                ability to successfully develop and market our email defense solutions
                to
                new markets, both domestic and
                international;




•
            Our
                ability to successfully develop and market new, modified or upgraded
                solutions, as may be needed;




•
            The
                continued market acceptance of our new email defense
                solutions;




•
            Our
                ability to expand our workforce with qualified personnel, as may
                be
                needed;




•
            Unanticipated
                bugs or other problems affecting the delivery of our email defense
                solutions to customers;




•
            The
                success of our resellers’ and OEM partners’ sales efforts to potential
                customers;




•
            The
                solvency of our resellers and OEM partners and their ability to allocate
                sufficient resources towards the marketing of our email defense solutions
                to their potential customers;




•
            Our
                OEM partners’ ability to effectively integrate our solutions into their
                product offerings;




•
            The
                rate of adoption of email defense solutions by
                customers;




•
            The
                substantial decrease in information technology
                spending;




•
            The
                pricing of our solutions;




•
            Our
                ability to timely collect fees owed by resellers and OEM partners;




•
            Our
                ability to add space and equipment to our current detection centers
                in a
                timely and effective manner to match the rate of growth in our business,
                plus our ability to build new detection centers as worldwide demand
                for
                our products may require; and




•
            The
                effectiveness of our customer support, whether provided by our resellers
                and OEM partners, or directly by
                Commtouch.




We
      commenced operations in 1991. Up until 1998, we focused on selling, maintaining
      and servicing stand-alone email client software products for mainframe and
      personal computers. From 1998 through 2001, we were a provider of outsourced
      Web-based email services and, during the first half of 2002, we concentrated
      on
      marketing our software messaging solution. In mid-2002, we began focusing on
      the
      email defense market, and with the subsequent completion of development of
      our
      anti-spam solutions, we began to sell those products during the latter half
      of
      2003. In late 2004, we added to our repertoire of email defense products our
      Zero-HourTM anti-virus solution and, in late 2006, we also announced the
      availability of our IP reputation service, now known as GlobalView Mail
      Reputation. The above described changes in business models required that we
      adjust our business processes and workforce, which caused fluctuations in our
      results from operations. While during the past four years our business has
      been
      more stable and we have had success in particular in signing agreements with
      OEM
      partners, we remain subject to future fluctuations in our results of operations
      if any of the enumerated risks occurs. As an example, our current and future
      expense levels are, to a large extent, fixed, so we may be unable to adjust
      spending quickly to compensate for any revenue shortfall caused by any of the
      enumerated risks described herein. Thus, any significant revenue shortfall
      would
      have an immediate negative effect on our results of operations and share
      price.




3


***We
      have many established competitors who are offering a multitude of solutions
      to
      the problems of spam and virus distribution.***




The
      market for email defense products in general and anti-spam solutions in
      particular is intensely competitive and we expect it to be increasingly
      competitive. During 2006 and 2007, we began to see more OEM security vendors
      adopting a “layered approach” to protecting email systems - adding more than one
      email defense solution to their products in an effort to achieve maximum
      results. During 2008, it is likely that this approach will remain popular,
      if
      not continue to grow. Increased competition and the adoption of a layered
      approach to fighting spam and viruses could result in pricing pressures, low
      operating margins and smaller market share, any of which could cause our
      business to suffer.




In
      the
      market for email defense solutions, there are less providers offering somewhat
      ineffectual “content filtering” solutions (solutions focusing solely on the
      content of potential spam email) than in the past, and more sophisticated
      offerings that compete with our solutions. Email defense providers offering
      forms of software (gateway), multi-functional appliances and managed service
      solutions and which may be viewed as both competitors and potential customers
      to
      Commtouch include Symantec (Brightmail), TrendMicro, McAfee, Secure Computing
      (CipherTrust) and Cisco (IronPort). Email defense providers offering solutions
      on an OEM basis similar to Commtouch’s business model, and which may be viewed
      as direct competitors, include Cloudmark, Mailshell and Mail-Filters. As this
      market continues to develop, it is likely that companies with greater resources
      than ours will attempt to either enter or increase their presence in this market
      by acquiring or forming strategic alliances with our competitors or business
      partners. Some examples of this are the acquisitions of IronPort by Cisco,
      CipherTrust by Secure Computing, Brightmail by Symantec Corp. and Microsoft
      of
      both Frontbridge Technologies and Sybari Software (which, up until the
      acquisition, was one of our largest distributors).




Also,
      there are companies that develop and maintain in-house anti-spam solutions,
      such
      as Google and Yahoo. These and other companies could potentially leverage their
      existing capabilities and relationships to enter the email defense industry.




Competitors
      could introduce products with superior features, scalability and functionality
      at lower prices than our products and could also bundle existing or new products
      with other more established products that discourage users from purchasing
      our
      products. As noted above, our market’s level of competition has increased as
      current competitors have improved the sophistication and effectiveness of their
      offerings and as new participants have entered the market. In the future, as
      we
      expand our offerings, we may encounter increased competition in the development
      and distribution of these solutions. Some of our current and potential
      competitors have longer operating histories, larger customer bases, greater
      brand recognition and greater financial, technical, sales, marketing and other
      resources than we do and may enter into strategic or commercial relationships
      on
      more favorable terms. New technologies and the expansion of existing
      technologies may increase competitive pressures on us, and we may not be able
      to
      compete successfully against current and future competitors.




***Our
      ability to continue to increase our revenues will depend on our ability to
      successfully execute our sales and business development
      plan.***




The
      complexity of the underlying technological base of email defense solutions
      and
      the current landscape of the market require highly trained sales and business
      development personnel to educate prospective resellers, OEM partners and
      customers regarding the use and benefits of our solutions. It may take time
      for
      our current and future employees, OEM partners and resellers to learn how to
      most effectively market our solutions. As a result, our sales and business
      development personnel may not be able to compete successfully against larger,
      more heavily financed and more experienced sales and business development
      departments of our competitors.




***The
      loss of our key employees would adversely affect our ability to manage our
      business, therefore causing our operating results to suffer and the value of
      your investment to decline.***




Our
      success depends on the skills, experience and performance of our senior
      management and other key personnel. The loss of the services of any of our
      senior management or other key personnel, including Gideon Mantel, our Chief
      Executive Officer, and Amir Lev, our President and Chief Technical Officer,
      could materially and adversely affect our business. The loss of our software
      developers may also adversely affect the continued development and support
      of
      our email defense solutions, therefore causing our operating results to suffer
      and the value of your investment to decline. We do not have employment
      agreements inclusive of set periods of employment with any of our key personnel.
      We cannot prevent them from leaving at any time. We do not maintain key-person
      life insurance policies, listing us as a beneficiary, on any of our
      employees.




4


***Our
      business and operating results could suffer if we do not successfully address
      potential risks inherent in doing business overseas.***




As
      of
      December 31, 2007, we had sales offices in Israel and the United States. We
      also
      are marketing our email defense solutions in international markets by utilizing
      appropriate distribution channels. However, we may not be able to compete
      effectively in international markets due to various risks inherent in conducting
      business internationally, such as:




•
            Differing
                technology standards;




•
            Inability
                of distribution channels to successfully market our
                solutions;




•
            Export
                restrictions;




•
            Difficulties
                in collecting accounts receivable and longer collection
                periods;




•
            Unexpected
                changes in regulatory requirements;




•
            Political
                and economic instability;




•
            Potentially
                adverse tax consequences;




•
            The
                adoption of new legislation-backed penalties which may discourage
                the
                distribution of unsolicited email messages;
                and




•
            Limited
                enforcement mechanisms for protecting intellectual property
                rights.




Any
      of
      these factors could adversely affect the Company’s prospective international
      sales and, consequently, business and operating results.




**Technology
      Risks**




***We
      may not have the resources or skills required to adapt to the changing
      technological requirements and shifting preferences of our customers and their
      users.***




The
      email
      defense industry is characterized by difficult technological challenges,
      sophisticated “spammers”, multiple-variant viruses, unique phishing scams and
      constantly evolving malevolent software distribution practices and targets
      that
      could render our solutions and proprietary technology ineffective. Our success
      depends, in part, on our ability to continually enhance our existing email
      defense solutions and to develop new solutions, functions and technology that
      address the potential needs of prospective customers, OEM partners and their
      users. The development of proprietary technology and necessary enhancements
      entails significant technical and business risks and requires substantial
      expenditures and lead-time. We may not be able to keep pace with the latest
      technological developments. We may not be able to use new technologies
      effectively or adapt to customer, OEM or end user requirements or emerging
      industry standards. Also, we must be able to act more quickly than our
      competition, and may not be able to do so.




***Our
      solutions may be adversely affected by defects or denial of service attacks,
      which could cause our customers, OEM partners or end users to stop using our
      solutions.***




Our
      email
      defense solutions are based in part upon new and complex software and highly
      advanced computer systems. Complex software and computer systems can contain
      defects, particularly when first introduced or when new versions are released,
      and are possible targets for denial of service attacks instigated by “hackers”.
      Although we conduct extensive testing and implement Internet security processes,
      we may not discover defects to or vulnerabilities in our software or systems
      that affect our new or current solutions or enhancements until after they are
      delivered. Although we have not experienced any material defects or
      vulnerabilities to date in our email defense solution offerings, it is possible
      that, despite testing by us, defects or vulnerabilities may exist in the
      solutions we license. These defects or vulnerabilities could cause or lead
      to
      interruptions for customers of our email defense solutions, resulting in damage
      to our reputation, legal risks, loss of revenue, delays in market acceptance
      and
      diversion of our development resources, any of which could cause our business
      to
      suffer.




5


***Our
      solutions may be adversely affected if we are not able to receive a sufficient
      sampling of internet traffic.***




Our
      email
      defense solutions are dependent, in part, on the ability of our Detection
      Centers to analyze, in an automated fashion, live feeds of internet traffic
      received through our services to customers and other contractual arrangements.
      If we were to suffer an unanticipated, substantial decrease in such traffic,
      the
      effectiveness of our technology would drop, and our product offerings would
      become less attractive.




**Investment
      Risks**




***If
      we will be in need of additional capital, we may not be able to secure
      additional funds on acceptable terms and the Company could
      fail.***




We
      have
      invested heavily in technology development. We expect to continue to spend
      financial and other resources on developing and introducing new offerings and
      maintaining our corporate organizations and strategic relationships. We also
      expect to invest resources in research and development projects to develop
      a URL
      categorization and blocking service and enhanced anti-spam and anti-virus
      solutions for enterprises and, possibly, other target markets.




The
      Company has exhibited incremental improvement in its financial condition over
      the past few years, eventually leading to the Company becoming profitable in
      2007. Nevertheless, we might become dependent upon raising additional funds
      to
      finance our business or strategic initiatives. Our cash balance (including
      marketable securities) was approximately $14.4 million at December 31, 2007.
      Based on the cash balance at December 31, 2007, current projections of revenues,
      related expenses and the ability to further curtail certain discretionary
      expenses, the Company believes it has sufficient cash to continue operations
      through at least March 2009.




In
      the
      past we have received funds for the development of our business from the State
      of Israel through the Office of the Chief Scientist, or the OCS. If additional
      funding becomes necessary and we are unable to raise those funds, the Company
      could fail. There can be no assurance that we will be able to raise necessary
      funds or that we will be able to do so on terms acceptable to us. Even if
      available on acceptable terms, any such additional funding may result in
      significant dilution to existing shareholders.




***If
      we cannot continue to satisfy NASDAQ’s maintenance requirements, it may delist
      our Ordinary Shares and we may not have an active public market for our Ordinary
      Shares. The absence of an active trading market would likely make our Ordinary
      Shares an illiquid investment.***




Our
      Ordinary Shares are quoted on The NASDAQ Capital Market. To continue to be
      listed, among other requirements, we are required a) to maintain shareholders’
equity of at least $2,500,000, or market value of our outstanding shares
      (excluding shares held by Company insiders and principal shareholders) of at
      least $35,000,000, or we must have realized at least $500,000 in net income
      from
      continuing operations in our last fiscal year or in two of our last three fiscal
      years and b) we must maintain a minimum bid price per Ordinary Share of $1.00.
      Up through 2006, the Company did not meet the applicable listing requirements
      on
      several occasions. The Company believes it has solidified its position on The
      NASDAQ Capital Market and, with the effectuation of a reverse split on January
      2, 2008, the Company intended to achieve the requirements necessary to move
      its
      listing to The NASDAQ Global Market. A subsequent downturn in the financial
      markets in general at the beginning of 2008 and in the Company’s stock price in
      particular has delayed the Company’s ability to apply for listing on The NASDAQ
      Global Market. There can be no assurance that the Company will be able to list
      its Ordinary Shares on The NASDAQ Global Market.




If
      the
      Company’s business or stock price deteriorates significantly, we may be at risk
      for a delisting by NASDAQ from the Capital Market.




***Our
      directors, executive officers and principal shareholders will be able to exert
      significant influence over matters requiring shareholder approval and could
      delay or prevent a change of control.***




Our
      directors and affiliates of our directors, our executive officers and our
      shareholders who currently individually beneficially own over five percent
      of
      the voting power in the Company (together known as “affiliated entities”),
      beneficially own, in the aggregate, approximately 30% of our outstanding
      Ordinary Shares as of December 31, 2007. Included in the calculation of voting
      power are warrants and options exercisable by the affiliated entities within
      60
      days thereof. If they vote together (especially if they were to convert all
      beneficial holdings into shares entitled to voting rights in the Company),
      these
      shareholders will be able to exercise significant influence over all matters
      requiring shareholder approval, including the election of directors and approval
      of significant corporate transactions. This concentration of ownership could
      also delay or prevent a change in control of Commtouch. In addition, conflicts
      of interest may arise as a consequence of the significant shareholders control
      relationship with us, including:




6


•
            Conflicts
                between significant shareholders, and our other shareholders whose
                interests may differ with respect to, among other things, our strategic
                direction or significant corporate
                transactions;




•
            Conflicts
                related to corporate opportunities that could be pursued by us, on
                the one
                hand, or by these shareholders, on the other hand;
                or




•
            Conflicts
                related to existing or new contractual relationships between us,
                on the
                one hand, and these shareholders, on the other
                hand.




***Substantial
      sales of our Ordinary Shares could adversely affect our share price and dilute
      the interests of our existing shareholders.***




The
      sale,
      or availability for sale, of large quantities of our Ordinary Shares may have
      the effect of further depressing its market price. We continue to maintain
      various registration statements declared effective in prior years by the
      Securities and Exchange Commission, or SEC, which cover the resale of shares
      issued and shares to be issued on the exercise of warrants issued under certain
      private placements closed prior to 2006. In particular, the additional Ordinary
      Shares to be issued if and when outstanding warrants to purchase 1,035,502
      Ordinary Shares (as of January 2, 2008) are exercised will dilute existing
      shareholders of Ordinary Shares.




***If
      we fail to honor registration rights for past private placements, we will be
      subject to payment of liquidated damages.***




According
      to registration rights agreements with the selling security holders listed
      under
      registration statements on Form F-3 filed by us with the SEC between 2004 and
      2006, should we fail to maintain the effectiveness of those registration
      statements for the periods stated in the respective agreements, we risk having
      imposed on us liquidated damages as defined in those agreements. For example,
      one of the agreements provides for liquidated damages of up to one million
      additional unregistered Series A Preferred Shares (which, given the prior
      conversion of all outstanding Series A Preferred Shares, and taking into account
      the reverse split effective January 2, 2008 now equals 666,667 unregistered
      Ordinary Shares). These liquidated damages would dilute the value of Ordinary
      Shares held by other shareholders.




**Intellectual
      Property Risks**




***If
      we fail to adequately protect our intellectual property rights or face a claim
      of intellectual property infringement by a third party, we could lose our
      intellectual property rights or be liable for significant
      damages.***




We
      regard
      our patented and patent pending technology, copyrights, service marks,
      trademarks, trade secrets and similar intellectual property as critical to
      our
      success, and rely on patent, trademark and copyright law, trade secret
      protection and confidentiality or license agreements with our employees and
      customers to protect our proprietary rights.




During
      2004, we purchased a United States patent, U.S. Patent No. 6,330,590. During
      2005, we filed in the United States two anti-spam related patent applications,
      claiming priority for prior periods based on filings of U.S. Provisional Patent
      Applications, and one virus outbreak detection related patent application.
      During 2006, we filed in the United States a patent application relating to
      the
      prevention of spam in streaming systems or, in other words, unwanted
      conversational media sessions (i.e. voice and video related). We may seek to
      patent certain additional software or other technology in the future. Any such
      patent applications might not result in patents issued within the scope of
      the
      claims we seek, or at all.




Despite
      our precautions, unauthorized third parties may copy certain portions of our
      technology, reverse engineer or obtain and use information that we regard as
      proprietary or otherwise infringe or misappropriate our patent or our patent
      pending technology, trade secrets, copyrights, trademarks and similar
      proprietary rights. We may not have the proper resources in order to adequately
      protect our intellectual property. In addition, the laws of some foreign
      countries do not protect proprietary rights to the same extent as do the laws
      of
      the United States. Our means of protecting our proprietary rights in the United
      States or abroad may not be adequate and competitors may independently develop
      similar technology.




7


We
      cannot
      be certain that our software does not infringe issued patents that may relate
      to
      our anti-spam or anti-virus solutions. In addition, because patent applications
      in the United States are not publicly disclosed until the patent is issued,
      applications previously may have been filed which relate to our anti-spam and
      virus outbreak detection solutions. Therefore, other parties, whether in the
      United States or elsewhere, may assert infringement claims against us. We may
      also be subject to legal proceedings and claims from time to time in the
      ordinary course of our business, including claims of alleged infringement of
      the
      patents, trademarks and other intellectual property rights of third parties
      by
      ourselves and our licensees. Such claims, even if not meritorious, could result
      in the expenditure of significant financial and managerial resources. We may
      not
      have the proper resources in order to adequately defend against such
      claims.




**Risks
      Relating to Operations in Israel**




***We
      have important facilities and resources located in Israel, which has
      historically experienced severe economic instability and military and political
      unrest.***




We
      are
      incorporated under the laws of the State of Israel. Our principal research
      and
      development facilities are located in Israel. Although the substantial majority
      of our past sales were made to customers outside Israel, we are nonetheless
      directly influenced by the political, economic and military conditions affecting
      Israel. Any major hostilities involving Israel, or the interruption or
      curtailment of trade between Israel and its present trading partners, could
      significantly harm our business, operating results and financial
      condition.




Since
      the
      State of Israel was established in 1948, a number of armed conflicts have
      occurred between Israel and its Arab neighbors. Since October 2000,
      terrorist violence in Israel has increased significantly. Recently, there was
      an
      escalation in violence among Israel, Hamas, the Palestinian Authority and other
      groups, as well as extensive hostilities along Israel's northern border with
      Lebanon in the summer of 2006, and extensive hostilities along Israel's border
      with the Gaza Strip since June 2007 when the Hamas effectively took control
      of
      the Gaza Strip. Ongoing and revived hostilities or other Israeli political
      or
      economic factors could harm our operations and cause our revenues to decrease.




In
      addition, Israel and some companies doing business with Israel have been the
      subject of an economic boycott by Arab countries since Israel’s establishment.
      These restrictive laws and policies may have an adverse impact on our operating
      results, financial condition or expansion of our business.




***Our
      results of operations may be negatively affected by the obligation of key
      personnel to perform military service.***




Certain
      of our officers and employees are currently obligated to perform annual reserve
      duty in the Israel Defense Forces and are subject to being called for active
      military duty at any time in the event of a national emergency. Although
      Commtouch has operated effectively under these requirements since its inception,
      we cannot predict the effect of these obligations on Commtouch in the future.
      Our operations could be disrupted by the absence for a significant period of
      one
      or more of our officers or key employees due to military service. Any disruption
      in our operations would harm our business.




***Because
      a substantial portion of our revenues historically have been generated in U.S.
      dollars and a portion of our expenses have been incurred in New Israeli Shekels,
      our results of operations may be adversely affected by currency
      fluctuations.***




We
      have
      generated a substantial portion of our revenues in U.S. dollars and incurred
      a
      portion of our expenses, principally salaries and related personnel expenses
      in
      Israel, in New Israeli Shekels, or NIS. We anticipate that a significant portion
      of our expenses will continue to be denominated in Israeli shekels. As a result, we
      are
      exposed to risk to the extent that the value of the U.S. dollar decreases
      against the NIS . In
      that
      event, the U.S. dollar cost of our operations will increase and our U.S.
      dollar-measured results of operations will be adversely affected, as occurred in
      2006
      and 2007, when the NIS appreciated against the U.S. dollar, which resulted
      in a
      significant increase in the U.S. dollar cost of our operations . We
      cannot
      predict the trend for future years. Our operations also could be adversely
      affected if we are unable to guard against currency fluctuations in the future. To
      date,
      we have not engaged in hedging transactions. In
      the
      future, we may enter into currency hedging transactions to decrease the risk
      of
      financial exposure from fluctuations in the exchange rate of the dollar against
      the NIS. These measures, however, may not adequately protect us from material
      adverse effects due to the impact of inflation in Israel.




8


***The
      government programs and benefits which we previously received require us to
      meet
      several conditions and may be terminated or reduced in the future.***




Prior
      to
      1998, we received grants from the Government of Israel, through the OCS, for
      the
      financing of a significant portion of our research and development expenditures
      in Israel. These grants totaled $0.6 million. In 2001, we received $0.6 million
      and in 2002 we received $0.2 million. We did not submit an application for
      funding during the period 2004 - 2007. We have not received OCS funding in
      recent years, but we may apply for additional grants in the future. The OCS
      budget has been subject to reductions which may affect the availability of
      funds
      for possible future grants. Therefore, we cannot be certain that we will be
      able
      to receive future grants in similar amounts, or at all. In addition, the terms
      of any future OCS grants may be less favorable than our past
      grants.




In
      order
      to meet specified conditions in connection with the grants and programs of
      the
      OCS, we have made representations to the Israel government about our Israeli
      operations. From time to time the conduct of our Israeli operations has deviated
      from our forecasts. If we fail to meet the conditions of the grants, including
      the maintenance of a material presence in Israel, or if there is any material
      deviation from the representations made by us to the Israeli government, we
      could be required to refund the grants previously received (together with an
      adjustment based on the Israeli consumer price index and an interest factor)
      and
      would likely be ineligible to receive OCS grants in the future.




Under
      the
      Law for the Encouragement of Industrial Research and Development, 5744-1984
      and
      the related regulations, the discretionary approval of an OCS committee is
      required for any transfer of technology developed with OCS funding or for the
      transfer of manufacturing rights outside of Israel. OCS approval is not required
      for the export of any products resulting from the research and development.
      There is no assurance that we will receive the required approvals for any
      proposed future transfer. Such approvals, if granted, may be subject to the
      following additional restrictions:




·
            a
                requirement to pay the OCS a portion of the consideration we receive
                upon
                any sale of such technology to an entity that is not Israeli. The
                scope of
                the support received, the royalties that were paid by us, the amount
                of
                time that elapsed between the date on which the know-how was transferred
                and the date on which the grants were received, as well as the sale
                price,
                will be taken into account in order to calculate the amount of the
                payment; and




·
            the
                transfer of manufacturing rights could be conditioned upon an increase
                in
                the royalty rate and payment of increased aggregate royalties (up
                to 300%
                of the amount of the grant plus interest, depending on the percentage
                of
                the manufacturing that is foreign).




These
      restrictions may impair our ability to sell certain of our older technology
      assets outside of Israel. The restrictions will continue to apply even after
      we
      repay the full amount of royalties payable for the grants.




***The
      tax benefits from our approved enterprise programs require us to satisfy
      specified conditions. If we fail to satisfy these conditions, we may be required
      to pay additional taxes and would likely be denied these benefits in the
      future.***





The
      Investment Center of the Israeli Ministry of Industry, Trade and Labor has
      granted approved enterprise status to several investment programs at our
      facility. The portion of our income derived from these approved enterprise
      programs, commencing when we begin to generate net income from these programs,
      will be exempt from tax for a period of two years and will be subject to a
      reduced tax rate for an additional five to eight years, depending on the
      percentage of our share capital held by non-Israelis. The benefits available
      to
      an approved enterprise program are dependent upon the fulfillment of conditions
      stipulated in applicable law and in the certificate of approval. If we fail
      to
      comply with these conditions, in whole or in part, we may be required to pay
      additional taxes during the period in which we would have benefited from the
      tax
      exemption or reduced tax rates and would likely be denied these benefits in
      the
      future.




***You
      may have difficulties enforcing a U.S. judgment against us and our executive
      officers and directors or asserting U.S. securities laws claims in
      Israel.***


We
      are
      organized under the laws of Israel, and we maintain significant operations
      in
      Israel. In addition, several of our directors and executive officers are not
      residents of the United States and most of their assets and our assets are
      located outside the United States. Service of process upon our non-U.S. resident
      directors or executive officers and enforcement of judgments obtained in the
      United States against us and our directors and executive officers may be
      difficult to obtain within the United States. It may be difficult to assert
      U.S.
      securities law claims in original actions instituted in Israel. Israeli courts
      may refuse to hear a claim based on a violation of U.S. securities laws because
      Israel is not the most appropriate forum in which to bring such a claim. In
      addition, even if an Israeli court agrees to hear a claim, it may determine
      that
      Israeli law and not U.S. law is applicable to the claim. If U.S. law is found
      to
      be applicable, the substance of the applicable U.S. law must be proved as a
      fact, which can be a time-consuming and costly process. Certain matters of
      procedure will also be governed by Israeli law. Furthermore, there is little
      binding case law in Israel addressing these matters.


9




Israeli
      courts might not enforce judgments rendered outside Israel which may make it
      difficult to collect on judgments rendered against us. Subject to certain time
      limitations, an Israeli court may declare a foreign civil judgment enforceable
      only if it finds that (a) the judgment was rendered by a court which was,
      according to the laws of the state of the court, competent to render the
      judgment; (b) the judgment may no longer be appealed; (c) the obligation imposed
      by the judgment is enforceable according to the rules relating to the
      enforceability of judgments in Israel and the substance of the judgment is
      not
      contrary to public policy; and (d) the judgment is executory in the state in
      which it was given.





Even
      if
      these conditions are satisfied, an Israeli court will not enforce a foreign
      judgment if it was given in a state whose laws do not provide for the
      enforcement of judgments of Israeli courts (subject to exceptional cases) or
      if
      its enforcement is likely to prejudice the sovereignty or security of the State
      of Israel. An Israeli court also will not declare a foreign judgment enforceable
      if (i) the judgment was obtained by fraud; (ii) there is a finding of lack
      of
      due process; (iii) the judgment was rendered by a court not competent to render
      it according to the laws of private international law in Israel; (iv) the
      judgment is at variance with another judgment that was given in the same matter
      between the same parties and that is still valid; or (v) at the time the action
      was brought in the foreign court, a suit in the same matter and between the
      same
      parties was pending before a court or tribunal in Israel.





***Provisions
      of Israeli law may delay, prevent or make difficult an acquisition of Commtouch,
      which could prevent a change of control and therefore depress the price of
      our
      shares.***




Israeli
      corporate law regulates mergers and acquisitions of shares through tender
      offers, requires special approvals for transactions involving significant
      shareholders and regulates other matters that may be relevant to these types
      of
      transactions. Furthermore, Israeli tax law treats stock-for-stock acquisitions
      between an Israeli company and a foreign company less favorably than does U.S.
      tax law. For example, Israeli tax law may subject a shareholder who exchanges
      his Ordinary Shares for shares in a foreign corporation to immediate taxation
      or
      to taxation before his investment in the foreign corporation becomes liquid.
      These provisions may adversely affect the price of our shares.




**Item
      4. Information on the Company.**




*Overview*




The
      legal
      name of the Company is Commtouch Software Ltd., and its principal executive
      offices are located at 4A Hazoran Street, Poleg Industrial Park, P.O.Box 8511,
      Netanya 42504, Israel, where our telephone number is 011-972-9-863-6888. The
      Company was incorporated under the laws of the State of Israel on February
      5,
      1991 and its
      legal
      form is a company limited by shares. Its
      Articles of Association are on file in Israel with the office of the Israeli
      Registrar of Companies and available for public inspection from the Israel
      Companies Registrar. The Company’s wholly owned subsidiary, Commtouch Inc., is
      located at 292 Gibraltar Drive, Suite 107, Sunnyvale, California 94089, where
      our telephone number is (650) 864-2000.




We
      are a
      provider of email defense products to enterprise customers and OEM distribution
      partners, including real-time anti-spam, virus outbreak detection and IP
      reputation solutions. The Company offers its email defense solutions to small,
      medium and large enterprises through a variety of third party distribution
      channels. The solutions are also available for integration with security,
      content filtering, anti-virus and other filtering solutions through alliances
      and strategic technology partnerships. A combination of proprietary patented
      and
      patent-pending technologies makes it possible for Commtouch to detect, alert
      and
      block spam and virus attacks as they are distributed over the Internet. At
      the
      core of Commtouch email defense offerings is Commtouch’s proprietary Recurrent
      Pattern Detection (RPD)TM technology which, in general terms, analyzes messages
      associated with mass email outbreaks and directs the blocking of such emails,
      without the need to analyze individual messages.




10




*Commtouch
      Offerings*




We
      offer
      a Software Development Kit or "SDK" comprised of multiple components; each
      different component enables third-party vendors to integrate one of the
      Company’s licensing offerings. Two components, known as ctasd and ctengine, are
      two different methods of enabling third-party vendors to integrate the Commtouch
      anti-spam solution into their existing offerings. Both ctengine and ctasd
      provide these manufacturers or service providers with full spam identification
      and spam classification services from the Commtouch Detection Centers (described
      below). The SDK communicates fully with a remote Detection Center, receiving
      results to queries about suspicious messages and acting according to set
      policies on the customer side. These same two components also enable integration
      of the Company’s Zero-HourTM virus outbreak protection, which is built on our
      proprietary Recurrent Pattern DetectionTM technology. This solution provides
      customers with the ability to block malevolent software (or as known in the
      industry "malware"), including email borne viruses, in real time, at the moment
      the initial attack occurs. During the initial attack phase, traditional
      anti-virus vendors are typically analyzing messages to determine whether they
      are indeed infected with a virus. It is this critical lag in response time
      by
      traditional anti-virus vendors that the Zero-Hour solution has been developed
      to
      remedy.




A
      third
      component of the SDK, known as ctipd, enables integration of the Company’s Mail
      Reputation Service. The Reputation Service is typically integrated into a device
      that sits at the perimeter of the organization, deciding which email traffic
      to
      allow to enter the organization, and which to block. It accomplishes this by
      receiving classification data from a Commtouch Detection Center about the sender
      of each email message. During 2007, the Company launched an advanced version
      of
      this Reputation Service known as “GlobalView”.




Products
      that may benefit from integration of the SDK solution include:




•
            Anti-virus
                applications;




•
            Content
                filtering solutions;




•
            Firewall
                systems;




•
            Security
                servers; and




•
            Other
                network appliances




We
      also
      offer an enterprise anti-spam solution, consisting of both a software element,
      or the “Enterprise Gateway”, and a service component, or a Commtouch “Detection
      Center”. At the Enterprise Gateway, messages are filtered at the customer
      organization’s entry point, before being distributed to recipients, with added
      user-level controls and a top level of secure spam detection services from
      the
      Detection Center, all allowing for real-time reaction to worldwide spam attacks.
      At the heart of the solution, however, is the Detection Center, which detects
      new spam attacks as soon as they are launched and distributed over the Internet.
      The Detection Center provides real-time spam detection services to enterprise
      customers by maintaining constant communication with Enterprise Gateways that
      are locally installed at customer premises in different locations worldwide.
      The
      Detection Center collects information from multiple sources about new spam
      attacks, analyzes the input using Commtouch patented technology, identifies
      and
      detects spam, classifies the data, matches its stored information against
      outstanding queries for spam detection from Enterprise Gateways and replies
      in
      real-time back to the Enterprise Gateways with a prioritized resolution.




In
      particular, the Commtouch anti-spam solution operates to help eliminate spam
      as
      follows:




·
            Inbound
                email enters the Enterprise Gateway, a software add-on to the enterprise
                SMTP server;




·
            The
                Enterprise Gateway matches key characteristics of the message with
                predefined spam policies created by IT managers or
                end-users;




·
            If
                the solution does not match the message to a known source, either
                spam or
                non-spam, it compares characteristics of the incoming message against
                the
                Enterprise Gateway cache of recently identified
                spam;




·
            If
                the message remains suspicious, but cannot be confirmed as spam,
                the
                Enterprise Gateway queries the Detection Center for remote spam detection
                and classification services;




·
            The
                outgoing query consists of digital signatures taken from email header
                information.The
                signatures may be hashed (one-way encrypted) to ensure enterprise
                security
                and confidentiality. The query does not contain the full email body
                or its
                attachments and it is therefore very small in size (500 Bytes);




·
            The
                Detection Center weighs the values of the outstanding query against
                its
                vast database of real-time information about known spam patterns
                and
                sources of spam, and replies to the Enterprise Gateway with a unique
                and
                up-to-date classification; and




11


·
            The
                Enterprise Gateway applies a locally predefined action to the message
                and
                may store the information internally to match against new incoming
                messages bearing similar
                characteristics.




Latly,
      the Company expects to release a URL categorization and blocking service during
      2008 that will analyze and categorize for customers of our OEM partners (i.e.
      enterprises, ISPs and consumers) the source of URLs being accessed by such
      customers, in order to prevent the possibility of malware attacks being
      propogated by malicious URLs.




*Competitive
      Landscape*




The
      markets in which Commtouch competes are intensely competitive and rapidly
      changing. We believe there is no single competitor that offers the complete
      package of anti-spam, anti-virus and IP reputation protections that Commtouch
      provides. We are aware of competitors that provide anti-spam, anti-virus and
      reputation services either alone or as part of a complete messaging system
      or
      email security system. However, in the past few years, we began to see more
      OEM
      security vendors adopting a “layered approach” to protecting email systems -
      adding more than one email defense solution to their products in an effort
      to
      achieve maximum results. During 2008 it is likely that this approach will remain
      popular, thereby creating pricing pressure, reduced gross margins and possibly
      loss of market share for us.




Commtouch’s
      GlobalView Mail Reputation Service competes in a relatively young and
      continuously evolving market. While this provides opportunity to attempt to
      shape the market to suit our strengths, there is also risk that this space
      will
      not fully evolve, or that a strong competitor will define the market to suit
      its
      needs. While the space is immature, there are some established vendors,
      including TrendMicro, that are offering reputation-based solutions. In some
      cases, while the product positioning may be new, the underlying solutions may
      be
      mature - for example, Spamhaus repositioning its RBL, or “Real-time Block List”,
      service as a commercial reputation service. In addition, there are several
      startups competing in this space, perhaps the most notable being
      Karmasphere.




In
      the
      market for email defense solutions, there are fewer providers offering somewhat
      ineffectual “content filtering” solutions (solutions focusing solely on the
      content of potential spam email) than in the past, and more sophisticated
      offerings that compete with our solutions. Email defense providers offering
      forms of software (gateway), multi-functional appliances and managed service
      solutions and which may be viewed as both competitors and potential customers
      to
      Commtouch include Symantec (Brightmail), TrendMicro, McAfee, Secure Computing
      (CipherTrust) and Cisco (IronPort). Email defense providers offering solutions
      on an OEM basis similar to Commtouch’s business model, and which may be viewed
      as direct competitors, include Cloudmark, Mailshell and
      Mail-Filters.




The
      principal competitive factors in our industry include price, product
      functionality, product integration, platform coverage and ability to scale,
      worldwide sales infrastructure and global technical support. Some of our
      competitors have greater financial, technical, sales, marketing and other
      resources than we do, as well as greater name recognition and a larger installed
      customer base. Additionally, some of these competitors have research and
      development capabilities that may allow them to develop new or improved products
      that may compete with product lines we market and distribute.




We
      expect
      that the market for email defense solutions will continue to become more
      consolidated, with companies having greater resources than ours increasing
      their
      presence in this market by acquiring or forming strategic alliances with our
      competitors or business partners. Some examples of this are the acquisitions
      of
      IronPort by Cisco, CipherTrust by Secure Computing, Brightmail by Symantec
      Corp.
      and Microsoft of Sybari Software (which, up until the acquisition, was one
      of
      our largest distributors).




Our
      success will depend on our ability to adapt to these competing forces, to
      develop more advanced products more rapidly and less expensively than our
      competitors, and to educate potential customers as to the benefits of licensing
      our products rather than developing their own products. Competitors could
      introduce products with superior features, scalability and functionality at
      lower prices than our products and could also bundle existing or new products
      with other more established products that discourage users from purchasing
      our
      products.




The
      market for real-time virus protection products is constantly evolving, as those
      promoting the proliferation of viruses continually seek new distribution
      techniques. Commtouch’s offering differs from traditional anti-virus solutions
      in that we are offering an additional, complementary solution to signature
      and
      heuristic-based anti-virus engines. For this reason, our Zero-Hour virus
      outbreak protection engine has been licensed by several anti-virus companies,
      including F-Secure and VirusBuster. If virus distribution methods continue
      to
      migrate from email to other formats, there may be less of a demand for our
      Zero-Hour solution and more of a demand for a web security solution of the
      type
      in which we have begun to invest R&D resources.




12


See
      also
      disclosure under “Item 3. Key Information- RISK FACTORS—Business Risks—We have
      many established competitors who are offering a multitude of solutions to the
      problems of spam and virus distribution.”




*Sales
      and Marketing*




We
      utilize third party distribution channels to sell our products. Generally,
      our
      SDK is licensed to OEM customers, who in turn integrate the SDK into their
      product offerings for sale to their customers. We are paid license fees or
      royalties under a variety of fee structures, including fixed fee and fee sharing
      arrangements.




Our
      enterprise anti-spam solution is sold through resellers, who pay us
      pre-negotiated fees from each sale closed with a reseller’s
      customer.




All
      Company sales are managed by the Company’s and its U.S. subsidiary’s business
      development departments, each of which consists of a department head and a
      relatively small number of business development professionals. The Company’s
      marketing efforts are aimed mainly at potential OEM customers. The marketing
      department is concentrated in the Company’s Israel office, though our personnel
      travel internationally in furtherance of the Company’s marketing
      goals.




*Intellectual
      Property*




We
      regard
      our patented and patent pending anti-spam and anti-virus technology, copyrights,
      service marks, trademarks, trade secrets and similar intellectual property
      as
      critical to our success, and rely on patent, trademark and copyright law, trade
      secret protection and confidentiality and/or license agreements with our
      employees, customers, partners and others to protect our proprietary rights.
      During 2004, we purchased a United States patent, Patent No. 6,330,590, which
      we
      believe to be an integral part of our patent strategy aimed at protecting our
      proprietary anti-spam technology. During 2005, we filed in the United States
      two
      anti-spam related patent applications, claiming priority for prior periods
      based
      on filings of U.S. Provisional Patent Applications, and one virus outbreak
      detection related patent application. During 2006, we filed in the United States
      a patent application relating to the prevention of spam in streaming systems
      (i.e. voice and video related email). We are only actively maintaining our
      registered trademark for “COMMTOUCH”, which is registered in the U.S., Canada,
      India, Israel, European Union, China, Mexico, Norway, Taiwan, Russian
      Federation, South Korea and Australia. While previous registrations of PRONTO
      (Canada and South Korea) may still be in force, we are not currently actively
      maintaining these trademarks and they will lapse. Since at least September
      2003,
      we are also claiming trademark rights in “RPD” and “Recurrent Pattern
      Detection”, as applicable to our email defense solutions. We have also been
      claiming trademark rights in Zero-Hour in relation to our virus outbreak
      detection product and GlobalView in relation to our IP reputation
      product.




It
      may be
      possible for unauthorized third parties to copy or reverse engineer certain
      portions of our products or obtain and use information that we regard as
      proprietary. In addition, the laws of some foreign countries do not protect
      proprietary rights to the same extent as do the laws of the United States.
      There
      can be no assurance that our means of protecting our proprietary rights in
      the
      United States or abroad will be adequate or that competing companies will not
      independently develop similar technology.




Other
      parties may assert infringement claims against us. We may also be subject to
      legal proceedings and claims from time to time in the ordinary course of our
      business, including claims of alleged infringement by us and/or our licensees
      of
      the trademarks and other intellectual property rights of third parties. Such
      claims, even if not meritorious, could result in the expenditure of significant
      financial and managerial resources.




Government
      Regulation




Laws
      aimed at curtailing the spread of spam have been adopted by the United States
      federal government, i.e. CAN-SPAM Act, and some individual U.S. states, with
      the
      CAN-SPAM Act superseding some state laws or certain elements thereof. See also
      disclosure under “Item 3. Key Information- RISK FACTORS—Business Risks—
“Governmental regulation could decrease the distribution of unsolicited bulk
      (spam) email and malicious software and decrease demand for our solutions or
      increase our cost of doing business *.* ”
Despite
      this legislation, we have not seen abatement in the amount of spam traffic
      on
      the Internet; rather, a continuing increase in large numbers that is being
      distributed in more sophisticated ways. The continuing growth and development
      of
      the spam market may prompt calls for even more stringent Internet user
      protection laws that would limit the ability of companies and individuals
      promoting or delivering spam online, and thus potentially negatively affect
      our
      business.




13


The
      propagation of email viruses aimed at destroying or stealing third party data
      is
      illegal under standard state and federal law outlawing theft, misappropriation,
      conversion, etc., without the need for special legislation prohibiting such
      activities on the Internet. Despite the existence of these laws, sources for
      Internet viruses continue to spread multi-variant viruses seemingly without
      much
      fear of recrimination. New laws providing for more stringent penalties could
      be
      adopted in various jurisdictions, but it is unclear what, if any, affect these
      would have on the anti-virus industry in general and our Zero-Hour Virus
      Outbreak Detection solution in particular.




*Employees*




As
      of
      December 31, 2007, 2006 and 2005, we had 60, 46 and 35 employees, respectively.
      None of our U.S. employees are covered by a collective bargaining agreement.
      As
      of December 31, 2007, our employees were categorized as follows:




**LOCATION**
            
            **General &**
              **Administrative**
            
            **Sales &**
              **Marketing**
            
            **Research &**
              **Development**
            
            **Hosting**
              **(Operations)**
            
            **TOTAL:**ISRAEL
                OFFICE
            
            
            9
            
            
            12
            
            
            27
            
            
            -
            
            
            48U.S.
                OFFICE
            
            
            3
            
            
            6
            
            
            -
            
            
            3
            
            
            12




We
      believe that our relations with our employees are good.




Israeli
      law and certain provisions of the nationwide collective bargaining agreements
      between the Histadrut (General Federation of Labor in Israel) and the
      Coordinating Bureau of Economic Organizations (the Israeli federation of
      employers’ organizations) apply to Commtouch’s Israeli employees. These
      provisions principally concern the maximum length of the workday and workweek,
      minimum wages, contributions to a pension fund, insurance for work-related
      accidents, procedures for dismissing employees, determination of severance
      pay
      and other conditions of employment. Furthermore, pursuant to such provisions,
      the wages of most of Commtouch’s Israeli employees are subject to cost of living
      adjustments, based on changes in the Israeli Consumer Price Index. The amounts
      and frequency of such adjustments are modified from time to time. Pursuant
      to an order issued in December 2007 by the Israeli Minister
      of Industry, Trade and Labor, new provisions relating to pension arrangements
      in
      the collective bargaining agreements will apply to all employees in
      Israel ,
      including our employees. According to these provisions, all employees employed
      for at least nine months (or six months commencing in 2009) will be entitled
      to
      pension benefits to be funded by preset monthly contributions of the employee
      and the employer. **** Israeli
      law generally requires the payment of severance pay upon the retirement or
      death
      of an employee or upon termination of employment by the employer or, in certain
      circumstances, by the employee. We currently fund our ongoing severance
      obligations by making monthly payments for insurance policies and by an accrual.
      A general practice in Israel followed by Commtouch, although not legally
      required, is the contribution of funds on behalf of certain employees to an
      individual insurance policy known as “Managers’ Insurance.” This policy provides
      a combination of savings plan, insurance and severance pay benefits to the
      insured employee. It provides for payments to the employee upon retirement
      or
      death and secures a substantial portion of the severance pay, if any, to which
      the employee is legally entitled upon termination of employment. Each
      participating employee contributes an amount equal to 5% of such employee’s base
      salary, and the employer contributes between 13.3% and 15.8% of the employee’s
      base salary. Full-time employees who are not insured in this way are entitled
      to
      a savings account, to which each of the employee and the employer makes a
      monthly contribution of 5% of the employee’s base salary. We also provide
      certain Israeli employees with an Education Fund, to which each participating
      employee contributes an amount equal to 2.5% of such employee’s base salary, and
      the employer contributes an amount equal to 7.5% of the employee’s base salary,
      up to a certain maximum base salary set by law.




*Description
      of Property*




All
      of
      our facilities are leased. Out headquarters, in Netanya, Israel, is
      approximately 1,007.4 square meters, and it houses senior management, research
      and development, sales, marketing and administrative personnel. Our subsidiary’s
      Sunnyvale, California office, which is approximately 3,600 square feet in size,
      houses administrative, sales and hosting (operations) personnel.




14


*Geographic
      Information*




The
      Company conducts its business on the basis of one reportable segment (see also
      Note 1 of Notes to the Financial Statements for a brief description of the
      Company’s business). The Company has adopted SFAS No. 131, "Disclosures About
      Segments of an Enterprise and Related Information".




*Revenues
      for Last Three Financial Years*




See
      Item
      5. Operating and Financial Review and Prospects - “Revenue Sources” and the F
      pages to this Form 20-F below. Below is a breakdown of our revenues by location
      (in thousands):




**Year
                December 31,****2005**
            
            **2006**
            
            **2007**Israel
            
            $
            365
            
            $
            344
            
            $
            742North
                America
            
            
            2,737
            
            
            4,525
            
            
            6,424Europe
            
            
            687
            
            
            1,715
            
            
            2,735Asia
            
            
            136
            
            
            493
            
            
            1,038Other
            
            
            -
            
            
            157
            
            
            34$
            3,925
            
            $
            7,234
            
            $
            11,250




We
      have
      had only negligible capital expenditures and divestitures in the last three
      financial years.




**Item
      4A. Unresolved Staff Comments.**




[None.]




**Item
      5. Operating and Financial Review and Prospects.**




The
      following discussion should be read in conjunction with the Consolidated
      Financial Statements and the Notes thereto included elsewhere in this report.
      This discussion contains forward-looking statements based upon current
      expectations that involve risks and uncertainties. Any statements contained
      herein that are not statements of historical fact may be deemed to be
      forward-looking statements. For example, the words “expects,” “anticipates,”
“believes,” “intends,” “plans,” “seeks” and “estimates” and similar expressions
      are intended to identify forward-looking statements. Commtouch’s actual results
      and the timing of certain events may differ significantly from those projected
      in the forward-looking statements. Factors that might cause future results
      to
      differ materially from those projected in the forward-looking statements
      include, but are not limited to, those set forth under “Item 3. Key
      Information-Risk Factors” and in the Company’s other filings with the
      SEC.




*Overview*




From
      2003
      through 2007, the focus of our business has been the development and selling,
      through reseller and OEM distribution channels, anti-spam, Zero-Hour virus
      outbreak detection and IP reputation solutions to enterprise class customers.
      While no uniform definition of spam exists, the Company generally defines “spam”
as the sending of unsolicited bulk email for commercial and non-commercial
      purposes.




Subsequent
      to balance sheet date, in January 2008, the Board of Directors and shareholders
      approved a 3:1 reverse stock split of the Company's share capital. As a result
      of this action, every three shares (including all authorized, issued and
      outstanding shares and all outstanding warrants and options to purchase shares)
      will be combined into one share of the same respective class of shares bearing
      a
      par value of NIS 0.15 each. All of the Company's authorized, issued and
      outstanding shares (including all outstanding warrants and options to purchase
      shares) as of December 31, 2007 and 2006, have been restated to reflect the
      effect of the reverse stock split.


15




*Critical
      Accounting Policies and Estimates*




Operating
      and Financial Review and Prospects are based upon the Company’s consolidated
      financial statements, which have been prepared in accordance with United States
      generally accepted accounting principles. The preparation of these financial
      statements requires management to make estimates and judgments that affect
      the
      reported amounts of assets, liabilities, revenues and expenses and related
      disclosure of contingent assets and liabilities. Management believes the
      critical accounting policies and areas that require the most significant
      judgments and estimates to be used in the preparation of the consolidated
      financial statements are accounting for stock-based compensation, revenue
      recognition, investment in affiliate and commitments and contingencies.




*Accounting
      for Stock-Based Compensation:*





On
      January 1, 2006, we adopted SFAS No. 123 (revised 2004), "Share-Based Payment"
      ("SFAS No. 123(R)") which requires the measurement and recognition of
      compensation expense based on estimated fair values for all share-based payment
      awards made to employees and directors. SFAS No. 123(R) supersedes Accounting
      Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees"
      ("APB No. 25"), for periods beginning in fiscal year 2006. In March 2005, the
      Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
      ("SAB 107") relating to SFAS No. 123(R). We have applied the provisions of
      SAB
      107 in its adoption of SFAS No. 123(R). SFAS No. 123(R) requires companies
      to
      estimate the fair value of equity-based payment awards on the date of grant
      using an option-pricing model. The value of the portion of the award that is
      ultimately expected to vest is recognized as an expense over the requisite
      service periods in the our consolidated operations statements.





At
      December 31, 2007, we has three stock-based employee compensation plans, which
      are described more fully in Note 5 of the financial statements. Prior to January
      1, 2006, we accounted for those plans under the recognition and measurement
      provisions of APB No. 25, "Accounting for Stock Issued to Employees" (“Opinion
      25”), and related interpretations, as permitted by FASB Statement No. 123,
      "Accounting for Stock-Based Compensation". During the years ended December
      31,
      2005 and 2004, the Company recognized stock-based compensation expenses in
      the
      amount of zero and $ 30 thousands, respectively.





Effective
      January 1, 2006, we adopted the fair value recognition provisions of SFAS No.
      123(R), "Share-Based Payment", using the modified-prospective-transition method.
      Under that transition method, compensation cost recognized during 2006 includes:
      (a) compensation cost for all share-based payments granted prior to, but not
      yet
      vested as of January 1, 2006, based on the grant date fair value estimated
      in accordance with the original provisions of SFAS 123, and (b) compensation
      cost for all share-based payments granted subsequent to January 1, 2006,
      based on the grant-date fair value estimated in accordance with the provisions
      of Statement 123(R). Results for prior periods have not been
      restated.





As
      a
      result of adopting SFAS No. 123(R) on January 1, 2006, our net loss for the
      year
      ended December 31, 2006, is $ 790 thousand higher than if we had continued
      to account for share- based compensation under Opinion 25. Basic and diluted
      loss per share for the year ended December 31, 2006, is $ 0.03 higher than
      if we had continued to account for share-based compensation under Opinion
      25.





We
      estimate the fair value of stock options granted using the Black-Scholes option
      pricing model. The option-pricing model requires a number of assumptions, of
      which the most significant are the expected stock price volatility and the
      expected option term. Expected volatility was calculated based upon actual
      historical stock price movements. The expected term of options granted is based
      upon historical experience and represents the period of time that options
      granted are expected to be outstanding. The risk-free interest rate is based
      on
      the yield from U.S. treasury bonds with an equivalent term. We have historically
      not paid dividends and has no foreseeable plans to pay dividends. We recognize
      the related expenses over the vesting period using the straight line
      method.


16


*Revenue
      recognition*




Revenue
      is recognized when the earnings process is complete, as evidenced by an
      agreement between the customer and the Company, when delivery has occurred
      or
      services have been rendered, when the fee is fixed or determinable and when
      collection is probable. The service component of the Company’s solutions is
      considered essential to the functionality of the software components.
      Furthermore, the software components cannot be used on a standalone basis,
      or
      with another party’s service. The customer has no ability to run the software or
      the SDK on its own hardware. As the software portion of the product can not
      stand on its own, the Company considers each sale as a service arrangement.
      Therefore, revenues deriving from anti-spam services are recognized ratably
      over
      the service term, which generally includes a term period of one year to three
      years. The Company’s revenue recognition policy is discussed in Note 2 of Notes
      to Consolidated Financial Statements.




*Commitments
      and Contingencies*




Commtouch
      periodically records the estimated impacts of various conditions, situations
      or
      circumstances involving uncertain outcomes. These events are called
“contingencies”, and Commtouch’s accounting for such events is prescribed by
      Statement of Financial Accounting Standards No. 5, “Accounting for
      Contingencies” (“SFAS No. 5”). SFAS No. 5 defines a contingency as “an existing
      condition, situation, or set of circumstances involving uncertainty as to
      possible gain or loss to an enterprise that will ultimately be resolved when
      one
      or more future events occur or fail to occur.”




SFAS
      No.
      5 does not permit the accrual of gain contingencies under any circumstances.
      For
      loss contingencies, the loss must be accrued if (1) information is available
      that indicates it is probable that the loss has been incurred, given the
      likelihood of the uncertain future events; and (2) that the amount of the loss
      can be reasonably estimated.




The
      accrual of a contingency involves considerable judgment on the part of
      management. Commtouch uses its internal expertise, and outside experts (such
      as
      lawyers, tax specialists and engineers), as necessary, to help estimate the
      probability that a loss has been incurred and the amount (or range) of the
      loss.
      The Company has recorded contingencies in situations where management determined
      it was probable a loss had been incurred and the amount could be reasonably
      estimated.




*Valuation
      of investments*




Fair
      values of marketable securities are estimated using quoted market prices where
      available. Our marketable securities consist of highly-rated federal backed
      student loan securities. As of December 31, 2007, the marketable securities
      are
      stated at market value which is equivalent to par value. We classify our
      investments as available for sale. Changes in fair value of investments
      classified as available for sale are not recognized to income during the period,
      but rather are recognized as a separate component of equity until realized.




Subsequent
      to balance sheet date, commencing in February 2008, the auction rate securities
      suffered from failed auctions.




*Accounting
      for income tax* *es*




On
      January 1, 2007, we adopted FIN 48, “Accounting for Uncertainty in Income
      Taxes,” which contains a two-step approach to recognizing and measuring
      uncertain tax positions accounted for in accordance with Statement 109,
“Accounting for Income Taxes.” The first step is to evaluate the tax position
      taken or expected to be taken in a tax return by determining if the weight
      of
      available evidence indicates that it is more likely than not that, on an
      evaluation of the technical merits, the tax position will be sustained on audit,
      including resolution of any related appeals or litigation processes. The second
      step is to measure the tax benefit as the largest amount that is more than
      50%
      likely to be realized upon ultimate settlement. Prior to January 1, 2007,
      we estimated our uncertain income tax obligations in accordance with SFAS
      No. 109, “Accounting for Income Taxes” (SFAS No. 109) and SFAS
      No. 5 “Accounting for Contingencies” (“SFAS No. 5”). No provision was
      recommended as a result of the adoption of FIN 48 or for the year ended December
      31, 2007.


17


*The
      Company and its subsidiary have provided a valuation allowance in respect to
      the
      deferred tax assets resulting from operating loss carryforwards and other
      temporary differences. Management currently believes that since the Company
      and
      its subsidiary have a history of losses it is more likely than not that the
      deferred tax regarding the loss carryforwards and other temporary differences
      will not be realized in the foreseeable future.*




*Revenue
      Sources*




Service
      Fees.




We recognize
      revenues from anti- spam,
      Zero-Hour virus outbreak detection and GlobalView Mail
      Reputation Service. Revenues from anti-spam , Zero-Hour virus outbreak detection
      services and GlobalView Mail Reputation Service are recognized when persuasive
      evidence of an arrangement exists, services are provided, the fee is fixed
      or
      determinable and collectibility is probable. Revenues deriving from anti-spam
      and Zero-Hour virus outbreak detection services are recognized ratably over
      the
      life of the service period.




Patent
      License Fees.




We
      also
      recognize revenues from our patent licensing program. Revenues from patent
      licenses are recognized when persuasive evidence of an arrangement exists,
      delivery has occurred and the Company has no further obligations, the fee is
      fixed or determinable and collectibility is probable.




*Results
      of Operations*




The
      following table sets forth financial data for the years ended December 31,
      2005,
      2006 and 2007 (in thousands):


2005
              
              2006
              
              2007Revenues
              
              $
              3,925
              
              $
              7,234
              
              $
              11,250Cost
                  of revenues
              
              
              700
              
              
              901
              
              
              1,411Gross
                  profit
              
              
              3,225
              
              
              6,333
              
              
              9,839Operating
                  expenses:Research
                  and development
              
              
              1,524
              
              
              1,763
              
              
              2,187Sales
                  and marketing
              
              
              2,476
              
              
              2,686
              
              
              3,453General
                  and administrative
              
              
              1,881
              
              
              2,299
              
              
              2,589Total
                  operating expenses
              
              
              5,881
              
              
              6,748
              
              
              8,229Operating
                  income (loss)
              
              
              (2,656
              )
              
              (415
              )
              
              1,610Interest
                  and other income (expenses), net
              
              
              141
              
              
              274
              
              
              527Equity
                  in losses of affiliate
              
              
              (175
              )
              
              (49
              )
              
              -Net
                  income (loss) before taxes
              
              
              (2,690
              )
              
              (190
              )
              
              2,137Taxes
                  on income
              
              
              -
              
              
              -
              
              
              28Amortization
                  of beneficial conversion featurerelating
                  to convertible Series A Preferred Shares
              
              
              (1,751
              )
              
              —
              
              
              -Net
                  income (loss) attributable to ordinary and equivalentlyparticipating
                  shareholders
              
              $
              (4,441
              )
              $
              (190
              )
              $
              2,109




*Comparison
      of Years Ended December 31, 2007 and 2006*




*Revenues* .
      Revenues increased by $4.1 million from $7.2 million in 2006 to $11.3 million
      in
      2007. The increase is due to an increase in market share, especially in the
      international market. The number of OEM’s increased by 35 in 2007 and amounted
      to 88 as of December 31, 2007.




*Cost
      of Revenues.* Cost of
      revenues increased by $0.5 million from $0.9 million in 2006 to $1.4 million
      in
      2007. The increase in 2007 is mainly due to higher facility costs and hosting
      expenses aiming to serve the increasing number of customers. Cost of revenues
      did not increase in the same proportion as sales in 2007 due to economies of
      scale. Most costs of revenues are fixed and are not affected by increases or
      decreases in revenues.




18


*Research
      and Development* .
      Research and development expenses increased by 24% and amounted to $2.2 million
      in 2007 compared to $1.8 million in 2006. The increase is due to recruitment
      of
      more employees as part of the Company’s decision to develop new products.
      Research and development expenses include $246,000 of expenses in connection with
      SFAS No.
      123 (R) .




*Sales
      and Marketing* .
      Sales
      and marketing expenses increased by 29% and amounted to $3.5 million compared
      to
      $2.7 million in 2006. The increase is mainly due to recruitment of employees
      and
      increased selling and marketing activity. In 2007, sales and marketing expenses
      included $194,000 expenses in connection with SFAS
      No.
      123(R)




*General
      and Administrative* .
      General
      and administrative expenses increased by 13% from $2.3 million in 2006 to $2.6
      million in 2007. The increase is mainly due to the recruitment of two
      new employees. In 2007, general and administrative expenses included $544,000
      expenses in connection with SFAS
      No.
      123(R) .




*Interest
      and Other Income (Expenses), Net* .
      Interest and other income (expenses), net, increased by 92% from net income
      of
      $274,000 in 2006 to net income of $527,000 in 2007. The increase is primarily
      due to interest income derived from the proceeds of an equity financing round
      in
      2007




*Equity
      in Earnings (Losses) of Affiliate* .
      In
      2006, the Company recorded losses that occurred in Imatrix affiliate up to
      the
      carrying amount of its investment as of December 31, 2006. In 2007, since
      Imatrix did not incur income in excess of its cumulative losses, no equity
      loss
      was recorded with respect to such affiliate . Due to our dilution in the equity
      ownership and lack of significant in influence in Imatrix, the investment will
      be accounted for under the cost method as of December 31, 2007.




*Comparison
      of Years Ended December 31, 2006 and 2005*




Revenues.
      Revenues increased by $3.3 million from $3.9 million in 2005 to $7.2 million
      in
      2006. Revenues increased in 2006 as the Company’s
      new Virus
      outbreak detection service was
      available for the full year of 2006 but
      only
      a portion of 2005, and
      also
      due to increase in market share.




*Cost
      of Revenues* .
      Cost of
      revenues increased by $0.2 million from $0.7 million in 2005 to $0.9 million
      in
      2006. The increase in cost of revenues is due to an increase in sales. Cost
      of
      revenues did not increase in the same proportion as sales in 2006 due to
      economies of scale. Most costs of revenues are fixed and are not affected by
      increases or decreases in revenues. ******




*Research
      and Development* .
      Research and development expenses increase by 16% and amounted to $1.8 million
      in 2006 compared to $1.5 million in 2005. The increase is mainly due to the
      implementation of SFAS
      No. 123 ( R ) ,  starting
      January 1, 2006. The adoption of SFAS No.123(R) increased research and development expenses by $196,000 (see also note 2l of
      the
      consolidated financial statements).




*Sales
      and Marketing* .
      Sales
      and marketing expenses increased by 8% from $2.5 million in 2005 to $2.7 million
      in 2006. The increase is mainly due to the implementation of SFAS No.123(R)
      starting January 1, 2006. The adoption of SFAS No.123(R) increased Sales and
      marketing expenses by $96,000 (see also note 2l of the consolidated financial
      statements). The increase is also due to payroll of new recruitments in the
      sales and marketing department and due to increased marketing activity as part
      of our decision to meet the increasing demand of our products and to gain more
      market share.




*General
      and Administrative* .
      General
      and administrative expenses increased by 22% from $1.9 million in 2005 to $2.3
      million in 2006. The increase is due to the implementation of SFAS No.123(R)
      starting January 1, 2006. The adoption of FAS123R increased General and
      administrative expenses by $483,000 (see also note 2l of the consolidated
      financial statements).




*Interest
      and Other Income (Expenses), Net* .
      Interest and other income (expenses), net, increased by 94% from net income
      of
      $141,000 for 2005 to net income of $274,000 in 2006, primarily due to interest
      income derived from the proceeds of an equity financing round in
      2006.




*Equity
      in Earnings (Losses) of Affiliate* .
      Equity
      in losses of an affiliate decreased by 72% from $175,000 for 2005 to $49,000
      in
      2006. During 2006 we recorded losses that occurred in the affiliate up to the
      carrying amount of its investment as of December 31, 2005 ***.***




19




*Quarterly
      Results of Operations (Unaudited)*




The
      following table sets forth certain unaudited quarterly statements of operations
      data for the eight quarters ended December 31, 2007. This information has been
      derived from the Company’s consolidated unaudited financial statements, which,
      in management’s opinion, have been prepared on the same basis as the audited
      consolidated financial statements, and include all adjustments, consisting
      only
      of normal recurring adjustments, necessary for a fair presentation of the
      information for the quarters presented. This information should be read in
      conjunction with our audited consolidated financial statements and the notes
      thereto included elsewhere in this report. The operating results for any quarter
      are not necessarily indicative of the operating results for any future period.




Three
                Months EndedMar.
                31,
            
            Jun.
                30,
            
            Sept.
                30,
            
            Dec.
                31,
            
            Mar.
                31,
            
            Jun
                30,
            
            Sept.
                30,
            
            Dec.
                31,2006
            
            2006
            
            2006
            
            2006
            
            2007
            
            2007
            
            2007
            
            2007(in
                thousands)(unaudited)Revenues
            
            $
            1,473
            
            $
            1,698
            
            $
            1,866
            
            $
            2,197
            
            $
            2,405
            
            $
            2,617
            
            $
            2,930
            
            $
            3,298Cost
                of revenues
            
            
            218
            *
            
            208*
            
            
            220
            *
            
            255
            
            
            286
            
            
            346
            
            
            357
            
            
            422Gross
                profit
            
            
            1,255
            
            
            1,490
            
            
            1,646
            
            
            1,942
            
            
            2,119
            
            
            2,271
            
            
            2,573
            
            
            2,876Operating
                expenses:Research
                and development
            
            
            396
            *
            
            433*
            
            
            422
            *
            
            512
            
            
            456
            
            
            539
            
            
            559
            
            
            633Sales
                and marketing
            
            
            688
            *
            
            635*
            
            
            636
            *
            
            727
            
            
            826
            
            
            810
            
            
            874
            
            
            943General
                and administrative
            
            
            579
            *
            
            570*
            
            
            518
            *
            
            632
            
            
            661
            
            
            627
            
            
            620
            
            
            681Total
                operating expenses
            
            
            1,663
            
            
            1,638
            
            
            1,576
            
            
            1,871
            
            
            1,943
            
            
            1,976
            
            
            2,053
            
            
            2,257Operating
                income (loss)
            
            
            (408
            )
            
            (148
            )
            
            70
            
            
            71
            
            
            176
            
            
            295
            
            
            520
            
            
            619Interest
                and other income (expenses), net
            
            
            64
            
            
            49
            
            
            79
            
            
            82
            
            
            91
            
            
            188
            
            
            119
            
            
            129Equity
                in losses of affiliate
            
            
            (34
            )
            
            (15
            )
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Net
                income (loss)
            
            
            (378
            )
            
            (114
            )
            
            149
            
            
            153
            
            
            267
            
            
            483
            
            
            639
            
            
            748Taxes
                on income
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            28Net
                income (loss) attributable to ordinary and equivalently participating
                shareholders
            
            $
            (378
            )
            $
            (114
            )
            $
            149
            
            $
            153
            
            $
            267
            
            $
            483
            
            $
            639
            
            $
            720BasicNet
                income (loss) per share
            
            $
            (0.03
            )
            $
            (0.00
            )
            $
            0.00
            
            $
            0.00
            
            $
            0.01
            
            $
            0.02
            
            $
            0.03
            
            $
            0.03Diluted
                net income (loss) per share
            
            $
            (0.03
            )
            $
            (0.00
            )
            $
            0.00
            
            $
            0.00
            
            $
            0.01
            
            $
            0.02
            
            $
            0.02
            
            $
            0.03




*
      Certain
      amounts from prior quarters have been reclassified to conform to the current
      presentation.




Up
      through early 2006, we had a history of incurring operating losses, and we
      cannot be certain that we will continue to achieve profitability on a quarterly
      or annual basis in the future. A relatively large expense in a quarter could
      have a negative effect on our financial performance in that quarter.
      Additionally, as a strategic response to a changing competitive environment,
      we
      may elect from time to time to make certain pricing, service, marketing or
      acquisition decisions that could have a negative effect on our quarterly
      financial performance. Other factors that may cause our future operating results
      to fluctuate include, but are not limited to:




•
            Our
                ability to successfully develop and market our email defense solutions
                to
                new markets, both domestic and
                international;




•
            Our
                ability to successfully develop and market new, modified or upgraded
                solutions, as may be needed;




•
            The
                continued market acceptance of our new email defense
                solutions;




20


•
            Our
                ability to expand our workforce with qualified personnel, as may
                be
                needed;




•
            Unanticipated
                bugs or other problems affecting the providing of our email defense
                solutions to customers;




•
            The
                success of our resellers’ and OEM partners’ sales efforts to potential
                customers;




•
            The
                solvency of our resellers and OEM partners and their ability to allocate
                sufficient resources towards the marketing of our email defense solutions
                to their potential customers;




•
            Our
                OEM partners’ ability to effectively integrate our solutions into their
                product offerings;




•
            The
                rate of adoption of email defense solutions by
                customers;




•
            The
                substantial decrease in information technology
                spending;




•
            The
                pricing of our solutions;




•
            Our
                ability to timely collect fees owed by resellers and OEM partners;




•
            Our
                ability to add space and equipment to our current Detection Centers
                in a
                timely and effective manner to match the rate of growth in our business,
                plus our ability to build new Detection Centers as worldwide demand
                for
                our products may require; and




•
            The
                effectiveness of our customer support, whether provided by our resellers
                and OEM partners, or directly by
                Commtouch.




In
      addition to the factors set forth above, our operating results will be impacted
      by the extent to which we incur non-cash charges associated with stock-based
      arrangements with employees and non-employees.




*New
      Accounting Pronouncements*




In
      September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS
      No. 157, “Fair Value Measurements” (“SFAS No. 157”). This Standard defines fair
      value, establishes a framework for measuring fair value in generally accepted
      accounting principles and expands disclosures about fair value measurements.
      The
      provisions of SFAS No. 157 are effective for financial statement
      issued for fiscal years beginning on January 1, 2008. The FASB issues a
      FASB Staff Position (FSP) to defer the effective date of SFAS No. 157 for one
      year for all non-financial assets and non-financial liabilities, except for
      those items that are recognized or disclosed at fair value in the financial
      statements on a recurring basis. We are not expecting the adoption will have
      material impact on our consolidated financial statements.




In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159
      permits companies to choose to measure certain financial instruments and certain
      other items at fair value. The standard requires that unrealized gains and
      losses on items for which the fair value option has been elected be reported
      in
      earnings. The provisions of SFAS No. 159 are effective for financial
      statement issued for fiscal years beginning on January 1, 2008. We are not
      expecting the adoption will have material impact on our consolidated financial
      statements




In
      December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business
      Combinations” (“SFAS 141R”). SFAS 141R establishes principles and
      requirements for how an acquirer recognizes and measures in its financial
      statements the identifiable assets acquired, the liabilities assumed, any
      non-controlling interest in the acquiree and the goodwill acquired.
      SFAS 141R also establishes disclosure requirements to enable the evaluation
      of the nature and financial effects of the business combination. SFAS 141R
      is effective for fiscal years beginning after December 15, 2008. Earlier
      adoption is prohibited. We are not expecting the adoption of SFAS 141R will
      have material impact on our consolidated results of operations and financial
      condition.




In
      December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in
      Consolidated Financial Statements, an amendment of ARB No. 51”. SFAS
      No. 160 establishes accounting and reporting standards that require that
      the ownership interests in subsidiaries held by parties other than the parent
      be
      clearly identified, labeled, and presented in the consolidated statement of
      financial position within equity, but separate from the parent’s equity; the
      amount of consolidated net income attributable to the parent and to the
      non-controlling interest be clearly identified and presented on the face of
      the
      consolidated statement of income; and changes in a parent’s ownership interest
      while the parent retains its controlling financial interest in its subsidiary be
      accounted for consistently. SFAS No. 160 is effective for fiscal years, and
      interim periods within those fiscal years, beginning on or after
      December 15, 2008. We are not expecting that the adoption of SFAS No. 160
      will have significant impact on our consolidated financial
      statement.




21


On
      December 21, 2007 the SEC staff issued Staff Accounting Bulletin No. 110 (SAB
      110), which, effective January 1, 2008, amends and replaces SAB 107, Share-Based
      Payment. SAB 110 expresses the views of the SEC staff regarding the use of
      a
“simplified” method in developing an estimate of expected term of “plain
      vanilla” share options in accordance with FASB Statement No. 123(R), Share-Based
      Payment. Under the “simplified” method, the expected term is calculated as the
      midpoint between the vesting date and the end of the contractual term of the
      option.





The
      use
      of the “simplified” method, which was first described in Staff Accounting
      Bulletin No. 107, was scheduled to expire on December 31, 2007. SAB 110 extends
      the use of the “simplified” method for “plain vanilla” awards in certain
      situations. The SEC staff does not expect the “simplified” method to be used
      when sufficient information regarding exercise behavior, such as historical
      exercise data or exercise information from external sources, becomes available.
      We are currently assessing the potential impact that the adoption of SAB 110
      could have on our financial statements.




*Liquidity
      and Capital Resources*




We
      have
      financed our operations from the issuance of equity securities and, to a lesser
      extent, from private loans and research and development grants from the Israeli
      government.






On
      May 8,
      2006, the Company entered into a small financing transaction with one private
      investor, whereby the Company received $100,000 against the issuance of 31,153
      Ordinary Shares and warrants to purchase an additional 23,364 Ordinary Shares.




As
      of
      December 31, 2006 and December 31, 2007, we had approximately $10.0 million
      and
      $14.4 million of cash and cash equivalents and marketable securities,
      respectively. The increase was due to positive operating cash flow and receipt
      of proceeds from the exercise of warrants and options in the amount of $1.7
      million.




In
      2007,
      net cash provided by operating activities was approximately $4.1 million. The
      increase in operating cash flow was mainly due to our net income in 2007
      compared to a loss in 2006. Net cash provided by financing activities in 2007
      was approximately $2.5 million, due to option and warrant exercises. Net cash
      used by investing activities in 2007 was $3.0 million and consisted primarily
      of
      an increase in short term cash deposits of $1.6 million, an investment of $0.8
      million in an affiliate and purchase of property and equipment in the amount
      of
      $0.6 million. As of December 31, 2006 and December 31, 2007, we had working
      capital of $7.5 million and $11.8 million, respectively.




Based
      on
      the cash balance at December 31, 2007, current projections of revenues and
      related expenses, the Company believes it has sufficient cash to continue
      operations at least through March 2009.




*Contractual
      obligations*




The
      following table summarizes our outstanding contractual obligations as of
      December 31, 2007 (in thousands):




Contractual
                Obligation
            
            Payments
                due by period
              (USD
                in thousands)Total
            
            Less
                than 1
              year
            
            1-3
                years
            
            3-5
                years
            
            More
                than 5
              yearsOperating
                lease obligation
            
            $
            438
            
            $
            285
            
            $
            153
            
            $
            -
            
            $
            -Other
                Long-term liabilities reflected on the Company’s Balance Sheet - Accrued
                severance pay
            
            
            931
            
            
            -
            
            
            -
            
            
            -
            
            
            931Other
                Long-term asset reflected on the Company’s Balance Sheet - severance pay
                fund
            
            
            (821
            )
            
            -
            
            
            -
            
            
            -
            
            
            (821
            )Net
                - severance pay liability
            
            
            110
            
            
            -
            
            
            -
            
            
            -
            
            
            110Total
            
            **$**
            **548**
            
            **$**
            **285**
            
            **$**
            **153**
            
            **$**
            **-**
            
            **$**
            **110**




22




*Effective
      Corporate Tax Rates*




Our
      tax
      rate will reflect a mix of the U.S. statutory tax rate on our U.S. income and
      the Israeli tax rate discussed below. Israeli companies are generally subject
      to
      corporate tax on their taxable income. The applicable corporate tax rate was
      29%
      in 2007 and will be progressively reduced to the following tax rates: 2008
      -
      27%, 2009 - 26%, 2010 and thereafter - 25%.





As
      of
      December 31, 2007, the Company's net operating loss carry forwards for tax
      purposes amounted to approximately $71,000, which may be carried forward and
      offset against taxable income in the future, for an indefinite
      period.





As
      of
      December 31, 2007, for federal income tax purposes, our U.S. subsidiary had
      net
      operating loss carry-forwards of approximately $ 91 million. These losses
      may offset any future U.S. taxable income of the U.S. subsidiary and will expire
      in the years 2009 through 2025. In light of the subsidiary's recent history
      of
      operating losses, the Company has recorded a valuation allowance for all of
      its
      deferred tax assets.





Utilization
      of U.S. net operating losses may be subject to substantial annual limitation
      due
      to the "change in ownership" provisions of the Internal Revenue Code of 1986
      and
      similar state provisions. The annual limitations may result in the expiration
      of
      net operating losses before utilization.





The
      Company and its subsidiary have provided valuation allowances in respect to
      the
      deferred tax assets resulting from operating loss carry forwards and other
      temporary differences. Management currently believes that since the Company
      and
      its subsidiary, until recently, has had a history of losses, it is more likely
      than not that the deferred tax assets regarding the loss carry forwards and
      other temporary differences will not be realized in the foreseeable future.




*Impact
      of Inflation and Currency Fluctuations*




Most
      of
      our sales are in U.S. dollars. However, a portion of our costs relates to our
      operations in Israel. A substantial portion of our operating expenses in Israel,
      primarily our research and development expenses, is denominated in NIS. Costs
      not denominated in U.S. dollars are re-measured to U.S. dollars, when recorded,
      at prevailing rates of exchange. This is done for the purposes of our financial
      statements and reporting. As a result, we
      are
      exposed to risk to the extent that the value of the U.S. dollar decreases
      against the NIS . In
      that
      event, the U.S. dollar cost of our operations will increase and our U.S.
      dollar-measured results of operations will be adversely affected, as occurred in
      2006
      and 2007, when the NIS appreciated against the U.S. dollar, which resulted
      in a
      significant increase in the U.S. dollar cost of our operations . Consequently,
      we are and will be affected by changes in the prevailing NIS/U.S. dollar
      exchange rate.




The
      annual rate of inflation in Israel was 3.4% in 2007, (0.1%) in 2006 and 2.4%
      in
      2005. The NIS appreciated against the U.S. dollar by approximately (8.9%) in
      2007 and (8.2%) in 2006 and depreciated against the U.S. dollar by approximately
      6.85% in 2005. The representative dollar exchange rate for converting the NIS
      to
      U.S. dollars, as reported by the Bank of Israel, was NIS 3.846 for one U.S.
      dollar on December 31, 2007. The representative dollar exchange rate was NIS
      3.474 at March 14, 2008. Because exchange rates between the NIS and the dollar
      fluctuate continuously, exchange rate fluctuations and especially larger
      periodic devaluations will have an impact on our operating results and
      period-to-period comparisons of our results. The effects of foreign currency
      re-measurements are reported in the consolidated financial statements for
      relevant periods in the statement of operations.




23


The
      Company’s affiliate's (Imatrix’s) functional currency is the Japanese Yen.
      Consequently Imatrix’s results of operations are translated into U.S. dollars.
      Because exchange rates between the Yen and the dollar fluctuate continuously,
      exchange rate fluctuations will have an impact on the Company’s shareholders
      equity.




**Item
      6. Directors, Senior Management and Employees**




The
      following table presents information with respect to our directors’ beneficial
      ownership of our Ordinary Shares as of December 31, 2007. Beneficial ownership
      is determined in accordance with the rules of the SEC and includes voting or
      investment power, with respect to shares. To our knowledge, except under
      applicable community property laws or as otherwise indicated, the persons named
      in the table have sole voting and sole investment control and rights to receive
      economic benefits with respect to all shares beneficially owned. The applicable
      percentage of ownership for each director is based on 25,346,042 Ordinary Shares
      outstanding as of December 31, 2007, as adjusted for the reverse split of
      January 2, 2008. Ordinary Shares issuable upon exercise of options and other
      rights held and exercisable on or within sixty days of December 31, 2007 are
      deemed outstanding for the purpose of computing the percentage ownership of
      the
      director holding those options and other rights.




**Name
                and Position**
            
            **Age**
            
            **Ordinary**
              **Share**
              **Beneficial**
              **Ownership**
              **>1%**
            
            **Number
                of**
              **Ordinary
                Shares**
              **Beneficially
                Owned**
            
            **Number
                of Options and Warrants included in**
              **Beneficial
                Ownership**Amir
                Lev, Director, President and CTO
            
            
            47
            
            
            2.5
            %
            
            637,156
            
            
            476,005
                options (6), at exercise prices ranging from $0.0375 to $6.60 per
                Ordinary
                Share. Expiration dates range from 3/2/08 to 8/4/15Aviv
                Raiz, Director (1)
            
            
            49
            
            
            20.9
            %
            
            5,371,233
            
            
            29,167
                options, at exercise prices ranging from $3.12 to $6.60 per Ordinary
                Share. Expiration dates range from 12/30/11 to 12/14/13. Also, 333,333
                warrants, with an exercise price of $1.95, expiring in early October
                2010Gideon
                Mantel, Director, Chairman of the Board and CEO
            
            
            48
            
            
            4.1
            %
            
            1,056,022
            
            
            652,996
                options, at exercise prices ranging from $0.0375 to $6.60. Expiration
                dates range from 8/15/11 to 8/4/15Nahum
                Sharfman, Director(1)(3)(5)
            
            
            59
            
            
            2.4
            %
            
            608,656
            
            
            92,188
                options, at exercise prices ranging from $0.0375 to $6.60. Expiration
                dates range from 8/15/11 to 12/6/14Lloyd
                E. Shefsky, Director(2)(3)(4)
            
            
            67
            
            
            1.2
            %
            
            299,030
            
            
            68,750
                options, at exercise prices ranging from $1.17 to $6.60. Expiration
                dates
                range from 12.30.11 to 3.29.15. Also, 56,453 warrants, with exercise
                prices ranging from $0.75 to $1.50, and expiration dates from 2/17/08
                to
                12/25/08Dr.
                Orna Berry, Director (Outside Director) (2)(3)(5)
            
            
            58
            
            
            <1
            %
            
            <1
            %Ofer
                Segev, Director (Outside Director) (1)(2)(5)
            
            
            48
            
            
            <1
            %
            
            <1
            %




24


(1)
            Member
                of the Compensation Committee




(2)
            Member
                of the Audit Committee




(3)
            Member
                of the Nominating Committee




(4)
            Mr.
                Shefsky’s ownership information includes his individual holdings and
                holdings of LENE L.P., in which Mr. Shefsky currently holds a relatively
                nominal, limited partnership
                interest.




(5)
            Orna
                Berry’s and Ofer Segev’s respective terms as outside directors expired in
                late March 2008, and Nahum Sharfman resigned from the Board effective
                March 31, 2008. See “Election of Directors” below for additional
                details.




(6)
            10,000
                of these options expired unexercised on March 2,
                2008.






*Other
      Management Employees:*




The
      following table sets forth the names and positions of our management employees
      at December 31, 2007:




**Name**
            
            **Age**
            
            **Ownership
                >1%**
            
            **Position**Gideon
                Mantel
            
            48
            
            See
                table above
            
            CEO
                and Chairman of the BoardAmir
                Lev
            
            47
            
            See
                table above
            
            President
                and Chief Technical OfficerRon
                Ela
            
            37
            
            (1)
            
            Chief
                Financial OfficerAvner
                Amram
            
            46
            
            (1)
            
            Executive
                Vice President, Commtouch Inc.Gary
                Davis
            
            46
            
            (1)
            
            Vice
                President, General Counsel and Corporate SecretaryUdi
                Trugman(2)
            
            37
            
            (1)
            
            Vice
                President, Research and Development,Commtouch
                Software Ltd.Ronni
                Zehavi(2)
            
            42
            
            (1)
            
            Vice
                President, International Business Development, Commtouch Software
                Ltd.Haggai
                Carmon
            
            49
            
            (1)
            
            Vice
                President, Products, Commtouch Software Ltd.Jay
                Goldin
            
            39
            
            (1)
            
            Vice
                President, Business Development North AmericaYossi
                Maslaton
            
            41
            
            (1)
            
            Vice
                President, Network Operations & Customer
                Services




(1)
            less
                than 1%




(2)
            Mr.
                Trugman and Mr. Zehavi left the employment of the Company at the
                end of
                January 2008. During early 2008, Ohad Sheory joined the Company as
                Vice
                President of Research and Development,Asaf
                Greiner joined the Company as Vice President of Web Security Products
                and
                Ido Hadari joined the Company as Senior Director of International
                Sales
                and Business Development. Their biographies may be found on the Company’s
                website atwww.commtouch.com,
                under the “Management” page.




Amir
      Lev
      is a co-founder of Commtouch and has served as its Chief Technology Officer
      and
      as a Director since its inception in 1991. Mr. Lev was also the General Manager
      of Commtouch from January 1997 through April 2000, and in May 2000 became
      President. Mr. Lev received a B.A. in Computer Science and Economics from Hebrew
      University, Jerusalem.




25


Aviv
      Raiz ** has
      served as a Director since December 2005. He is the founder and President of
      Eurotrust Ltd. Mr. Raiz has been active in the foreign exchange markets for
      the
      past twenty years, and has been a private equity investor in several high-tech,
      bio-tech and Internet companies for the past ten years. He holds an M.B.A.
      from
      Tel Aviv University.




Gideon
      Mantel is a co-founder of Commtouch and served as its Chief Financial Officer
      from its inception in February 1991 until October 1995, when he became
      Commtouch’s Chief Operating Officer. In November 1997, he became Commtouch’s
      Chief Executive Officer, and in December 2006, he was confirmed as Chairman
      of
      the Board. He has also served as a Director of Commtouch since inception. Mr.
      Mantel received a B.A. in Political Science and an M.B.A. from Tel Aviv
      University.




Nahum
      Sharfman rejoined the Board of Directors in March 2000. Mr. Sharfman is a
      co-founder of Commtouch and served as its Chief Executive Officer and Chairman
      of the Board from its inception in February 1991. In November 1997 Mr. Sharfman
      resigned as Chief Executive Officer to become a founder of Dealtime.com (now
      known as Shopping.com). Mr. Sharfman remained Chairman of the Board of Commtouch
      and a Director until January 1999. Prior to founding Commtouch, Mr. Sharfman
      spent eleven years with National Semiconductor Corporation in various
      development and management roles. Mr. Sharfman received a Ph.D. in High Energy
      Nuclear Physics from Carnegie Mellon University and M.S. and B.S. degrees in
      Physics from the Technion- Israel Institute of Technology, Haifa.




Dr.
      Orna
      Berry joined the Board of Directors as an Outside Director under the Israel
      Companies Law in March 2005. Dr. Berry is a Venture Partner in Gemini Israel
      Funds Ltd. Dr. Berry co-founded ORNET Data Communication Technologies Ltd.,
      an
      early Gemini portfolio company, which was sold to Siemens for $30 million.
      In
      addition, she serves as the Chairperson in several Gemini portfolio companies.
      From 1997 through 2000, Dr. Berry served as the Chief Scientist of the Ministry
      of Industry, Trade and Labor of the Government of Israel. In this capacity
      she
      was responsible for implementing government policy regarding support and
      encouragement of industrial research and development. Dr. Berry also has served
      as the Chief Scientist of Fibronics and, prior to that, Dr. Berry served as
      a
      senior research engineer in companies such as IBM and UNISYS. Dr. Berry received
      her Ph.D. in Computer Science from the University of Southern California, and
      M.A. and B.A. degrees in Statistics and Mathematics from Tel Aviv and Haifa
      Universities. She is a frequent lecturer on "High-Tech" worldwide.




Ofer
      Segev has
      served as an Outside Director under the Israel Companies Law since February
      2002. Since April 1, 2007, Mr. Segev is the Executive Vice President and Chief
      Financial Officer for Ness Technologies, a global provider of end-to-end IT
      services and solutions. Mr. Segev was the CFO of Attunity Ltd from 2003 through
      early 2007 and, prior to that position, he served as the CEO for TeleKnowledge,
      and as CFO for Tundo. Prior to his position at Tundo, Mr. Segev was a partner
      at
      Ernst & Young Israel where he led the High Tech Industry practice group. Mr.
      Segev has a B.A. in economics and accounting from Bar Ilan University in Israel,
      and has studied at the Kellogg Graduate School of Management at Northwestern
      University.





Lloyd
      E.
      Shefsky  has
      served as a Director of Commtouch since October 2003. He is a Clinical Professor
      of Entrepreneurship and Co-Director of the Center for Family Enterprises at
      the
      Kellogg School of Management and has taught in several countries. In 1970,
      he
      founded the Chicago law firm, Shefsky & Froelich Ltd., where has been Of
      Counsel since 1996. Since 1981 he has represented the Government of Israel
      throughout the Midwestern U.S. For nearly forty years he has represented
      hundreds of entrepreneurs and their companies, and during the past twenty-five
      years, such representation has included numerous Israeli companies with U.S.
      operations. Mr. Shefsky authored Entrepreneurs
      Are Made Not Born, which
      was translated into five foreign languages. He received his J.D. from the
      University of Chicago Law School, a B.S.C. from De Paul University (accounting),
      is a member of the Illinois and Florida Bars, and has a CPA certificate in
      Illinois.





Avner
      Amram joined Commtouch in 1996 and currently serves as Executive Vice President.
      Mr. Amram has over 17 years of experience in the areas of technology,
      operational management and leadership, and is also a founder of CVDO. Before
      2002, Mr. Amram served as COO of Commtouch and was responsible for worldwide
      operations. Mr. Amram also held a number of positions at Commtouch prior to
      being appointed COO. From 1995 to 1996, Mr. Amram served as project manager
      for
      Medatech, a leading provider of customer relationship management (CRM)
      solutions, developing and managing complex installations at large organizations.
      Prior to Medatech, Mr. Amram acted as General Manager of Fuga Nursery in Israel,
      where he was responsible for operations, production, marketing and distribution.
      Mr. Amram holds a Bachelors of Science (BSC), in Computer Engineering and
      graduated Cum Laude from the Technion, Israel Institute of
      Technology.




26


Ron
      Ela
      joined Commtouch in July 2006 as its Chief Financial Officer.  A
      Certified Public Accountant, Mr. Ela formerly held management positions at
      two
      Israeli-based Nasdaq listed companies, and most recently held the role of
      Controller at Verint Systems Ltd., a wholly-owned subsidiary of Verint Systems
      Inc. During the five years prior to that time, Mr. Ela served as Deputy
      Controller and subsequently Controller for Partner Communication Ltd. Also,
      Mr.
      Ela spent 3 years in public accounting with Kesselman & Kesselman, a member
      of PricewaterhouseCoopers in Israel. Mr. Ela has a B.A. in business
      administration majoring in accounting from the College of Management Academic
      Studies.




Gary
      Davis joined Commtouch in September 1999 and serves as Vice President, General
      Counsel and Corporate Secretary. Mr. Davis has over 20 years of legal experience
      in both private law firm and corporate practices. Mr. Davis is certified to
      practice law in both the State of Israel and California. Prior to September
      1999, Mr. Davis was in-house counsel to Israel Military Industries and Elta
      Electronics Industries. He received a B.A. in Political Economy of Industrial
      Societies from U.C. Berkeley and a J.D. in law from Golden Gate
      University.




Udi
      Trugman joined Commtouch in December 1996 and served as Vice President of
      Research and Development until January 2008. Prior to 2002, Mr. Trugman was
      Senior Director of Systems in the R&D group. Mr. Trugman has over 17 years
      of software development and management experience. Prior to working at
      Commtouch, Mr. Trugman specialized in development of commercial
      applications.




Ronni
      Zehavi joined Commtouch in June 1999 and served as Vice President of
      International Business Development until January 2008. Prior to joining
      Commtouch, Mr. Zehavi was Human Resources and Training Manager for “Mondex -
      ecash”, a subsidiary company of International Mastercard from 1997 to 1999. From
      1994 to 1997, Mr. Zehavi was an Organizational Consultant in a counseling firm.
      Mr. Zehavi received his M.A. degree in Organizational Sociology from Bar-Ilan
      University and his B.A. degree in History and Educational Psychology from
      Tel-Aviv University.




Haggai
      Carmon joined Commtouch in January 2002 and serves as Vice President of
      Products. From 1998 to 2002, Mr. Carmon was Vice President of Corporate
      Marketing and of Sales in Asia-Pacific for VCON Telecommunications, a public
      vendor of corporate videoconferencing solutions, and was also responsible for
      international pre-sales and technical support. Prior to that, Mr. Carmon was
      at
      NetManage Ltd., a public software company of TCP/IP applications for Windows,
      a
      founder and CEO of Applico, a Computer-aided Design for Architecture service
      firm, and managed a college of Fine Arts. Mr. Carmon has over 17 years of
      experience in technology and international management.




Jay
      Goldin joined Commtouch in March 2006, as the Vice President Business
      Development, North America.  Prior to joining Commtouch, Mr. Goldin was a
      consultant to networking and security companies, including Commtouch.  Mr.
      Goldin was a founder of Digital Fountain, a wireless and media networking
      technology company, where he served as Vice President of Business
      Development.   He also co-founded Alyanza Infosystems, and was a
      management consultant with Pacific Rim Consulting Group.  Mr. Goldin
      received his M.B.A and A.B. in Economics from Stanford University.




Yossi
      Maslaton joined Commtouch in 1998 and has served as Vice President of Network
      Operations and Customer Services since early 2005.  Before 2005 he was
      Director of Service Operations.  With over 20 years of experience in the
      fields of Information Technology and Networking, Mr. Maslaton
      is responsible for the operations of Commtouch's data centers and
      customer services, servicing tens of millions of users daily with the
      highest standards of uptime.  From 1991 to 1998 Mr. Maslaton was Manager of
      Information Systems and labs for RND Networks, a group of hi-tech startups
      in
      the network-routing field.  Prior to that, Mr. Maslaton managed the
      technical field-operations of a large project for the Israel Defense Forces
      in
      the areas of distributed computing systems and radio
      communications.




*Election
      of Directors*




Directors
      (other than outside directors, as explained below) are elected by shareholders
      at the annual general meeting of the shareholders and hold office until the
      next
      annual general meeting following the general meeting at which such director
      is
      elected and until a successor is elected, or until the director is removed.
      An
      annual general meeting must be held at least once in every calendar year, but
      not more than fifteen months after the preceding annual general meeting.
      Directors may be removed and other directors may be elected in their place
      or to
      fill vacancies in the Board of Directors at any time by the holders of a
      majority of the voting power at a general meeting of the shareholders. Until
      a
      vacancy is filled by the shareholders, the Board of Directors may appoint new
      directors temporarily to fill vacancies on the Board of Directors. The Amended
      and Restated Articles of Association of Commtouch authorize the shareholders
      to
      determine, from time to time, the number of directors. The maximum number of
      directors is currently fixed at ten directors, though only seven directors
      are
      currently serving on the Board of Directors. An extraordinary general meeting
      of
      shareholders is scheduled for March 31, 2008 to elect two new outside directors,
      Yair Shamir and Yair Bar-Touv, to replace the Company's two outside directors,
      Orna Berry and Ofer Segev, whose respective terms will expire. Information
      concerning the nominees for election is set forth in the Company's proxy
      statement for the extraordinary general meeting of shareholders, a copy of
      which
      is attached as an exhibit to the Company's Form 6-K filed with the Securities
      and Exchange Commission on March 19, 2008. Furthermore, effective March 31,
      2008, Nahum Sharfman resigned from the Board, and the Board appointed Hila
      Karah
      to fill the resulting Board vacancy. It is anticipated that Ms. Karah will
      stand
      for reelection at the next annual general meeting of shareholders. Information
      concerning Ms. Karah is set forth in the Company’s press release of March 19,
      2008 which also was filed as an exhibit to the aforementioned Form
      6-K.




27


There
      are
      no family relationships among any of the directors, officers or key employees
      of
      Commtouch.




*Alternate
      Directors*




The
      Amended and Restated Articles of Association of Commtouch provide that any
      director may appoint another person to serve as an alternate director and may
      remove such alternate. Any alternate director possesses all the rights and
      obligations of the director who appointed him, except that the alternate has
      no
      standing at any meeting while the appointing director is present, the alternate
      may not in turn appoint an alternate for himself (unless the instrument
      appointing him otherwise expressly provides) and the alternate is not entitled
      to remuneration. A person who is not qualified to be appointed as a director
      may
      not be appointed as an alternate director. Unless the appointing director limits
      the time or scope of the appointment, the appointment is effective for all
      purposes until the appointing director ceases to be a director or terminates
      the
      appointment. The appointment of an alternate director does not in itself
      diminish the responsibility of the appointing director as a
      director.




*Independent
      and Outside Directors*




The
      Israel Companies Law requires Israeli companies with shares that have been
      offered to the public in or outside of Israel to appoint at least two outside
      directors. No person may be appointed as an outside director if the person
      or
      the person’s relative, partner, employer or any entity under the person’s
      control has or had, on or within the two years preceding the date of the
      person’s appointment to serve as outside director, any affiliation with the
      company or any entity controlling, controlled by or under common control with
      the company. The term affiliation includes:




•
            an
                employment relationship;




•
            a
                business or professional relationship maintained on a regular
                basis;




•
            control;
                and




•
            service
                as an office holder.




No
      person
      may serve as an outside director if the person’s position or other business
      activities create, or may create, a conflict of interest with the person’s
      responsibilities as an outside director or may otherwise interfere with the
      person’s ability to serve as an outside director. If, at the time outside
      directors are to be appointed, all current members of the Board of Directors
      are
      of the same gender, then at least one outside director must be of the other
      gender. At
      least
      one of the outside directors is required to have "financial and accounting
      expertise," unless another member of the audit committee, who is an independent
      director under the NASDAQ Marketplace Rules, has "financial and accounting
      expertise," and the other outside director or directors are required to have
      "professional expertise," all as defined under the Israel Companies Law.




Outside
      directors are to be elected by a majority vote at a shareholders’ meeting,
      provided that either:




•
            such
                majority includes at least one-third of the shares held by non-controlling
                shareholders who are present and voting at the meeting;
                or




•
            the
                total number of shares held by non-controlling shareholders voting
                against
                the election of the director at the meeting does not exceed one percent
                of
                the aggregate voting rights in the
                company.




The
      initial term of an outside director is three years and may be extended for
      an
      additional period of three years. Outside directors may be removed only by
      the
      same percentage of shareholders as is required for their election, or by a
      court, and then only if the outside director ceases to meet the statutory
      qualifications for their appointment or if they violate their fiduciary duty
      to
      the company. Each committee of a company’s Board of Directors must include at
      least one outside director and the audit committee (the existence of which
      is
      required under the Israel Companies Law) must include all outside directors.
      An
      outside director is entitled to compensation as provided in the regulations
      adopted under the Israel Companies Law and is otherwise prohibited from
      receiving any other compensation, directly or indirectly, in connection with
      service provided as an outside director.




28


Dr.
      Berry
      and Mr. Segev currently serve as the Company’s outside directors. As stated
      above under "Election of Directors", an extraordinary general meeting of
      shareholders is scheduled for March 31, 2008 to appoint two new outside
      directors to replace Dr. Berry and Mr. Segev, whose respective terms will
      expire. Information concerning the nominees for election is set forth in the
      Company's proxy statement for the extraordinary general meeting of shareholders,
      a copy of which is available in the Company's Form 6-K filed with the Securities
      and Exchange Commission on March 19, 2008.




In
      addition, the NASDAQ Capital Market currently requires Commtouch to have at
      least a majority of independent directors, as defined under Marketplace Rule
      4200(a)(15), on the Board of Directors and to maintain an audit committee of
      at
      least three members, each of whom must:




(i)
            be
                independent as defined under Marketplace Rule
                4200(a)(15);




(ii)
            meet
                the criteria for independence set forth in Rule 10A-3(b)(1) under
                the
                Securities Exchange Act of 1934, as amended, or “Exchange Act”, as set
                forth below (subject to the exemptions provided in Exchange Act Rule
                10A-3(c);




(iii)
            not
                have participated in the preparation of the financial statements
                of the
                Company or any current subsidiary of the Company at any time during
                the
                past three years; and




(iv)
            be
                able to read and understand fundamental financial statements, including
                a
                company’s balance sheet, income statement, and cash flow statement.




Under
      limited circumstances, the Company may have one audit committee member not
      independent in accordance with the above, but such a member would only be able
      to serve for a maximum of two years.




Exchange
      Act Rule 10A-3(b)(1) requires that members of the audit committee meet that
      rule’s definition of independence, which requires that an audit committee member
      may not, except in his or her capacity as a director or committee member, (i)
      accept directly or indirectly any consulting, advisory, or other compensatory
      fee from the Company or any of its subsidiaries (except for fixed amounts of
      compensation under a retirement plan for prior service with the Company,
      provided that such compensation is not contingent in any way on continued
      service), and (ii) be an “affiliated person” of the Company or any of its
      subsidiaries.





NASDAQ
      rules also require that the Company certify that it has, and will continue
      to
      have, at least one member of the audit committee who has past employment
      experience in finance or accounting, requisite professional certification in
      accounting, or any other comparable experience or background which results
      in
      the individual’s financial sophistication, including being or having been a
      chief executive officer, chief financial officer or other senior officer with
      financial oversight responsibilities. Also, under Item 401(h) of Regulation
      S-K,
      the Company is currently obligated to disclose whether or not it has a
“financial expert” on its audit committee, as defined under this regulation (See
      Item 16A. Audit Committee Financial Expert).




The
      three
      directors who serve on our audit committee, Dr. Berry, Mr. Segev and Mr.
      Shefsky, qualify as independent directors under NASDAQ Marketplace Rules
      (including Exchange Act Rule 10A-3). Furthermore, Dr. Berry and Mr. Segev meet
      the qualification requirements for outside directors, as required under the
      Israel Companies Law.




The
      Company has identified the following Board members as “Independent directors”
pursuant to NASDAQ Marketplace Rule 4200(a)(15):





a.
            Ofer
                Segev


b.
            Dr.
                Orna Berry


c.
            Aviv
                Raiz


d.
            Nahum
                Sharfman


e.
            Lloyd
                Shefsky


f.
            Yair
                Shamir, Yair Bar-Touv and Hila Karah (assuming they join the Board
                at the
                end of March 2008)


29




*Audit
      Committee*




As
      noted
      above in the discussion under “ *Independent
      and Outside Directors* ”,
      the
      Israel Companies Law requires public companies to appoint an audit committee.
      The responsibilities of the audit committee include identifying irregularities
      in the management of the Company’s business, approving management compensation
      and approving related party transactions as required by law. An audit committee
      must consist of at least three directors meeting the independence standards
      under the NASDAQ Marketplace Rules and must include all outside directors under
      the Israel Companies Law, all as described above. Furthermore, the Israel
      Companies Law specifically prohibits the chairman of the Board of Directors,
      any
      director employed by or otherwise providing services to a company and a
      controlling shareholder or any relative of a controlling shareholder from being
      a member of the audit committee. Our Audit Committee is in compliance with
      the
      noted requirements.




*Compensation
      Committee*




The
      Compensation Committee is responsible for determining salaries, incentives
      and
      other forms of compensation for Commtouch’s directors and its executive
      officers. The Compensation Committee is also responsible for administering
      the
      various stock option plans, including the issuance of grants of options to
      employees of the Company and its subsidiary.




*Nominating
      Committee*




The
      committee’s responsibilities include identifying individuals qualified to
      become board members and recommending director nominees to the
      board.




*Internal
      Auditor*




Under
      the
      Companies Law, the Board of Directors must appoint an internal auditor,
      nominated by the audit committee. The role of the internal auditor is to
      examine, among other matters, whether a company’s actions comply with relevant
      law and orderly business procedure. Under the Companies Law, the internal
      auditor may be an employee of the company but not an interested party or office
      holder, or a relative of an interested party or office holder, and he or she
      may
      not be the company’s independent accountant or its representative. The Company
      engaged a qualified internal auditor during 2007.




*Approval
      of Certain Transactions; Obligations of Directors, Officers and
      Shareholders*




The
      Israel Companies Law codifies the fiduciary duties that office holders,
      including directors and executive officers, owe to a company. An office holder’s
      fiduciary duties consist of a duty of care and a duty of loyalty. Each person
      listed in the first table that appears above at the beginning of this Item
      6 is
      an office holder.




The
      duty
      of loyalty requires an office holder to act in good faith and for the benefit
      of
      the company, including to avoid any conflict of interest between the office
      holder’s position in the company and such person’s personal affairs, avoiding
      any competition with the company, avoiding exploiting any corporate opportunity
      of the company in order to receive personal advantage for such person or others,
      and revealing to the company any information or documents relating to the
      company’s affairs which the office holder has received due to his or her
      position as an office holder. A company may approve any of the acts mentioned
      above provided that all the following conditions apply: the office holder acted
      in good faith and neither the act nor the approval of the act prejudices the
      good of the company, and the office holder disclosed the essence of his personal
      interest in the act, including any substantial fact or document, a reasonable
      time before the date for discussion of the approval.





The
      duty
      of care requires an office holder to act with a level of care that a reasonable
      office holder in the same position would employ under the same circumstances.
      This includes the duty to use reasonable means to obtain information regarding
      the advisability of a given action submitted for his or her approval or
      performed by virtue of his or her position and all other relevant information
      material to these actions.





Under
      the
      Israel Companies Law, all arrangements as to compensation of office holders
      who
      are not directors require approval of the Board of Directors unless the Articles
      of Association provide otherwise. Arrangements regarding the compensation of
      directors also require audit committee and shareholder approval.




The
      Israel Companies Law requires that an office holder promptly disclose 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. "Personal
      interest," as defined by the Companies Law, includes a personal interest of
      any
      person in an act or transaction of the company, including a personal interest
      of
      his relative or of a corporation in which that person or a relative of that
      person is a 5% or greater shareholder, a holder of 5% or more of the voting
      rights, a director or general manager, or in which he or she has the right
      to
      appoint at least one director or the general manager. "Personal interest" does
      not apply to a personal interest stemming merely from holding shares in the
      company.




30


The
      office holder must make the disclosure of his personal interest no later than
      the first meeting of the company's board of directors that discusses the
      particular transaction. This duty does not apply to the personal interest of
      a
      relative of the office holder in a transaction unless it is an "extraordinary
      transaction." An
“extraordinary transaction” is defined as a transaction not in the ordinary
      course of business, a transaction that is not on market terms, or a transaction
      that is likely to have a material impact on the company’s profitability, assets
      or liabilities, and
      a
      "relative" as a spouse,
      siblings, parents, grandparents, descendants, spouse’s descendants and the
      spouses of any of the foregoing.




In
      the
      case of a transaction that is not an extraordinary transaction, after the office
      holder complies with the above disclosure requirement, only Board approval
      is
      required unless the Articles of Association of the company provide otherwise.
      Our Amended and Restated Articles of Association do not provide otherwise.
      Such
      approval must determine that the transaction is not adverse to the company’s
      interest. If the transaction is an extraordinary transaction, then in addition
      to any approval required by the Articles of Association, it also must be
      approved by the audit committee and by the Board and, under specified
      circumstances, by a meeting of the shareholders. An Israeli company whose shares
      are publicly traded shall not be entitled to approve such a transaction unless,
      at the time the approval was granted, two members of the audit committee were
      outside directors and at least one of them was present at the meeting at which
      the audit committee decided to grant the approval. An office holder who has
      a
      personal interest in a matter that is considered at a meeting of the Board
      of
      Directors or the audit committee generally may not be present at this meeting
      or
      vote on this matter unless
      a
      majority of the board of directors or the audit committee has a personal
      interest in the matter. If a majority of the board of directors or the audit
      committee has a personal interest in the transaction, shareholder approval
      also
      would be required .




The
      Israel Companies Law applies the same disclosure requirements to a controlling
      shareholder of a public company, which includes a shareholder that holds 25%
      or
      more of the voting rights if no other shareholder owns more than 50% of the
      voting rights in the company. Extraordinary transactions, including a private
      placement, with a controlling shareholder or in which a controlling shareholder
      has a personal interest, and the terms of compensation of a controlling
      shareholder who is an office holder, require the approval of the audit
      committee, the Board of Directors and the shareholders of the company. The
      shareholder approval must either include at least one-third 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 one percent of the
      voting rights in the company.




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




•
            any
                amendment to the Articles of
                Association;




•
            an
                increase of the company’s authorized share
                capital;




•
            a
                merger; or




•
            approval
                of interested party transactions that require shareholder
                approval.




In
      addition, any controlling shareholder, any shareholder who can determine the
      outcome of a shareholder vote and any shareholder who, under the 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 Israel
      Companies Law provides that a breach of the duty of fairness will be governed
      by
      the laws governing breach of contract. The Israel Companies Law does not
      describe the substance of this duty.




*Insurance,
      Indemnification and Exculpation of Directors and Officers; Limitations on
      Liability*




The
      Israel Companies Law permits a company to insure an office holder in respect
      of
      liabilities incurred by him or her as a result of the breach of his or her
      duty
      of care to the company or to another person, or as a result of the breach of
      his
      or her duty of loyalty to the company, to the extent that he or she acted in
      good faith and had reasonable cause to believe that the act would not prejudice
      the company. A company can also insure an office holder for monetary liabilities
      as a result of an act or omission that he or she committed in connection with
      his or her serving as an office holder. Moreover, a company can indemnify an
      office holder for (a) any monetary liability imposed upon such a office holder
      for the benefit of a third party pursuant to a court judgment, including a
      settlement or an arbitrator’s decision, confirmed by a court, (b) reasonable
      legal costs, including attorney’s fees, expended by a office holder as a result
      of an investigation or proceeding instituted against the office holder by a
      competent authority, provided that such investigation or proceeding concludes
      without the filing of an indictment against the office holder and either i)
      no
      financial liability was imposed on the office holder in lieu of criminal
      proceedings or ii) financial liability was imposed on the office holder in
      lieu
      of criminal proceedings but the alleged criminal offense does not require proof
      of criminal intent, and (c) reasonable litigation expenses, including legal
      fees, actually incurred by such a office holder or imposed upon the office
      holder by a court order, in a proceeding brought against the office holder
      by or
      on behalf of the company or by others, or in a criminal action in which he
      was
      acquitted, or in a criminal action which does not require proof of criminal
      intent in which he was convicted. The Companies Law further provides that the
      indemnification provision in a company’s articles of association (i) may be an
      obligation to indemnify in advance, provided that, other than litigation
      expenses, it is limited to events the board of directors can foresee in light
      of
      the company’s actual activities when providing the obligation and that it is
      limited to a sum or standards the board of directors determines is reasonable
      in
      the circumstances, and (ii) may permit the company to indemnify an officer
      or a
      director after the fact.




31


Furthermore,
      a company can, with one limited exception, exculpate an office holder in
      advance, in whole or in part, from liability for damages sustained by a breach
      of duty of care to the company.




All
      of
      these provisions are specifically limited in their scope by the Companies Law,
      which provides that a company may not indemnify or exculpate an officer or
      director nor enter into an insurance contract that would provide coverage for
      any monetary liability incurred as a result of (i) a breach by the officer
      or
      director of the duty of loyalty, unless the officer or director acted in good
      faith and had a reasonable basis to believe that the act would not prejudice
      the
      company, in which case the company is permitted to indemnify and provide
      insurance to but not to exculpate; (ii) an intentional or reckless breach by
      the
      officer or director of the duty of care, other than if solely done in
      negligence; (iii) any act or omission done with the intent to derive an illegal
      personal benefit; or (iv) any fine levied or forfeit against the director or
      officer.




Our
      Amended and Restated Articles of Association allow us to insure, exculpate
      and
      indemnify office holders to the fullest extent permitted by law provided such
      insurance, exculpation or indemnification is approved in accordance with the
      Israel Companies Law. We have acquired directors’ and officers’ liability
      insurance covering the officers and directors of Commtouch and its subsidiary
      for certain claims. At the annual meeting of shareholders held on November
      18,
      2002, the shareholders approved a form of indemnification, exculpation and
      insurance agreement that is applicable to all our directors. The form of this
      agreement, as well as related provisions in our Amended and Restated Articles
      of
      Association, were amended at the annual meeting of shareholders held on December
      30, 2005.




*Compensation
      of Directors and Executive Officers*




The
      directors of Commtouch can be remunerated by Commtouch for their services as
      directors to the extent such remuneration is approved by Commtouch’s audit
      committee, Board of Directors and shareholders. Directors currently do not
      receive cash compensation for their services as directors but are reimbursed
      for
      their expenses for each Board of Directors meeting attended. However, see Item
      10 ** “Amended
      and Restated 1999 Non-employee Directors Stock Option Plan” for a discussion of
      director compensation in the form of option grants. ** During
      2007, options to purchase 384,800 Ordinary Shares (post reverse-split) were
      granted to directors and executive officers under the Company’s stock option
      plans at a weighted average exercise price of $2.20 per share.




The
      aggregate direct remuneration paid by Commtouch to all directors and executive
      officers (8 persons) in 2007 was approximately $539 thousand. During the same
      period Commtouch accrued or set aside approximately $39 thousand for the same
      group to provide pension, retirement or similar benefits. As of December 31,
      2007, directors and executive officers of Commtouch (8 persons) held an
      aggregate of 2,576,382 stock options (post-reverse split) to purchase a like
      number of Ordinary Shares, with 1,496,328 of those options having vested.




*Options
      to Purchase Securities from Registrant or Subsidiaries*




As
      of
      December 31, 2007, 4,762,259 stock options (post-reverse split) to purchase
      Ordinary Shares had been granted to then existing employees, consultants,
      executive officers and non-employee directors under the Company’s stock option
      plans, net of forfeited options, and there were 797,382 shares available for
      grant under all plans. Of the number of options granted, 3,949,836 had not
      been
      exercised and had exercise prices ranging from $0.0375 to $6.60 per share and
      a
      weighted average per share exercise price of approximately $2.67, and were
      held
      by 51 persons. These options have termination dates ranging from March 2008
      to
      August 2015.




32


*Employee
      Stock Option Plans*




Employees,
      including executive officers and other management employees, participate in
      the
      Company’s employee option plans. The Commtouch Software Ltd. 2006 U.S. Stock
      Option Plan, primarily covering the granting of options to employees and
      consultants based in the United States, was adopted on December 15, 2006 and
      has
      a term of ten years. The Commtouch Software Ltd. Amended and Restated Israeli
      Share Options Plan, primarily covering the granting of options to employees,
      consultants and directors based in Israel, was adopted on June 22, 2003 and
      has
      a term of ten years. While Israeli based directors receive their grants under
      the Israeli plan, the principal terms of their grants are identical to those
      of
      non-Israeli based directors receiving their grants under the non-employee
      director plan ( discussed
      below).




Some
      previous employee option plans have either terminated or were amended and
      restated, though options remain outstanding and exercisable under those plans.
      Such plans include the Amended and Restated 1996 CSI Stock Option Plan which
      expired on January 1, 2006 and the  Amended
      and Restated 1999 3(i) Share Option Plan, which was replaced by the above
      described Israeli Share Option Plan.





All
      employee stock option plans are administered by the Compensation Committee.
      Subject to the provisions of the employee stock plans and applicable law, the
      Compensation Committee has the authority to determine, among other things,
      to
      whom options may be granted; the number of Ordinary Shares to which an option
      may relate; the exercise price for each share; the vesting period of the option
      and the terms, conditions and restrictions thereof, including accelerated
      vesting on change of control provisions; to amend provisions relating to such
      plans; and to make all other determinations deemed necessary or advisable for
      the administration of such plans.




*Amended
      and Restated 1999 Non-Employee Directors Stock Option Plan*




New
      directors are currently entitled to an initial grant of 50,000 options.
      Directors who are reelected at the annual meeting of shareholders are entitled
      to additional grants of 16,667 options.




Under
      the
      Non-Employee Directors Plan, each option becomes exercisable at a rate of 1/16th
      of the option shares every three months, and has an exercise price equal to
      the
      fair market value of the Ordinary Shares on the grant date of such option.
      Up
      through 2004, each option has a maximum term of ten years, but will terminate
      earlier if the optionee ceases to be a member of the Board of Directors. Options
      granted to directors during 2005 - 2007 have a maximum term of six years. At
      the
      annual meeting of shareholders of December 30, 2005, shareholders approved
      an
      amendment to the Non-Employee Directors Plan to allow for the acceleration
      of
      unvested options for any director who has served the company for at least three
      years, unless the director resigned voluntarily or was removed from the Board
      of
      Directors due to a failure to perform any of his/her duties to the Company.




*Employees*




See
      Item
      4: Employees




**Item
      7. Major Shareholders and Related Party Transactions.**




The
      following table presents information with respect to beneficial ownership of
      our
      Ordinary Shares as of December 31, 2007, including:




•
            each
                person or entity known to Commtouch to own beneficially more than
                five
                percent of Commtouch’s Ordinary Shares,
                and




•
            all
                executive officers and directors as a
                group.




Beneficial
      ownership is determined in accordance with the rules of the SEC and includes
      voting or investment power, with respect to shares. To our knowledge, except
      under applicable community property laws or as otherwise indicated, the persons
      named in the table have sole voting and sole investment control and rights
      to
      receive economic benefits with respect to all shares beneficially owned. The
      applicable percentage of ownership for each shareholder is based on 25,346,042
      Ordinary Shares outstanding as of December 31, 2007 (on a post reverse-split
      basis). Ordinary Shares issuable upon exercise of options and other rights
      held
      and exercisable on or within sixty days of December 31, 2007 are deemed
      outstanding for the purpose of computing the percentage ownership of the person
      holding those options and other rights and for all directors and officers as
      a
      group, but are not deemed outstanding for computing the percentage ownership
      of
      any other person. Major shareholders in the Company have the same voting rights
      as all other shareholders.




33




**MAJOR
                SHAREHOLDERS OF ORDINARY SHARES**
            
            
            **Amount**
              **Owned**
            
            
            **Percent
                of**
              **Class**Aviv
                Raiz*
            
            
            5,371,233
            **
            
            20.9
            %All
                directors and officers as a group (8 persons)
            
            
            8,127,306
            ***
            
            29.9
            %





*
            This
                shareholder of record resides in the host country,
                Israel.


**
            Includes
                29,167 options and 333,333 warrants, exercisable into a like number
                of
                Ordinary Shares.


***
            Includes
                1,474,315 options exercisable into a like number of Ordinary Shares.
                Also,
                this number includes 134,265 shares and warrants held by LENE L.P.,
                in
                which Mr. Lloyd Shefsky holds a relatively small limited partner
                interest,
                without any control over partnership
                management.





Based
      on
      a review of the information provided to us by our transfer agent, as
      of December 31,
      2007, there were  92 holders
      of record of our Ordinary Shares, including 57 holders
      of record residing in the United States holding 20,721,615 Ordinary
      Shares, or 82% of the
      aggregate 25,346,042 Ordinary
      Shares outstanding as of such date. 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 78% of our
      outstanding Ordinary Shares as of such date).




*Significant
      Changes in Percentage Ownership During the Past Three Years*




·
            Aviv
                Raiz participated in the private placements of October 31, 2004 (the
                preferred share issuance) and October 2, 2005, acquiring 500,000
                convertible Series A Preferred Shares, 4 million Ordinary Shares
                and 2
                million warrants exercisable into a like number of Ordinary Shares.
                Subsequent to the preferred share round of October 2004, Mr. Raiz
                has also
                purchased in private transactions 1.1 million convertible Series
                A
                Preferred Shares from certain investors who participated in that
                round.
                The shareholdings referenced in this paragraph are in their original,
                pre-reverse split format. Together with his holdings from purchases
                on the
                open market and director options vesting within 60 days of December
                31,
                2007, Mr. Raiz beneficially holds 20.9% in the Company. Mr. Raiz
                is a
                director of the Company.




·
            Cranshire
                Capital LP, Omicron Master Trust, Smithfield Fiduciary LLC and Vertical
                Ventures, LLC became major shareholders of the Company’s Ordinary Shares
                by virtue of their participation in the private placements of November
                26,
                2003, May 18, 2004 and October 31, 2004 (though Vertical Ventures
                did not
                participate in this transaction), as well as the Redemption, Amendment
                and
                Exchange Agreement of October 31, 2004. Due to their sales of Ordinary
                Shares during 2005, 2006 and, to a lesser extent, 2007, including
                all
                Ordinary Shares acquired on the conversion of Series A Preferred
                Shares
                and all warrants issued in the November 2003 private placement, plus
                the
                increase in the outstanding shares of the Company during the past
                few
                years, none of these shareholders remains a major shareholder of
                the
                Company. As of December 31, 2007, the total beneficial holdings for
                all
                four shareholders amounted to less than 2%, with the overwhelming
                majority
                of these holdings being in the form of warrants.




·
            Israel
                Seed IV, L.P. was a significant participant in the July 29, 2003,
                November
                26, 2003 and May 18, 2004 private placements, as well as the Redemption,
                Amendment and Exchange Agreement of October 31, 2004. At December
                31,
                2004, its beneficial ownership in the Company reached 19.8%. However,
                due
                to a number of sales of shares during 2005, 2006 and 2007, the percentage
                of beneficial ownership of Israel Seed IV, L.P. at December 31, 2007
                was
                zero.




34




***Interest
      of Management and their Family Members in Certain Transactions***




There
      were no material related party transactions during 2007 or through the date
      of
      filing of this Form 20-F.




**Item
      8. Financial Information.**




See
      Item
      18: Financial Statements. If the Company decides to distribute a cash dividend
      out of income that has been tax exempt due to an “approved enterprise” status
      under the Law for the Encouragement of Capital Investments, 5719-1959, the
      amount of cash dividend will be subject to corporate tax at the rate then in
      effect under Israeli law. The Company has never declared or paid cash dividends
      on its Ordinary Shares and does not anticipate paying any cash dividends during
      2008. The Company intends to retain future earnings to finance the development
      of its business.




We
      are
      not a party to any litigation, and we are not aware of any threatened litigation
      which, in the aggregate, would be material to the business of the Company.





Except
      as
      otherwise disclosed in this Annual Report, there has been no material change
      in
      our financial position since December 31, 2007.




**Item
      9. The Offer and Listing.**




The
      Company’s Ordinary Shares have been traded publicly on NASDAQ as
      follows:




a.
            From
                July 13, 1999 through June 29, 2004, under the symbol “CTCH” (up to June
                7, 2002 on the National Market, and subsequently on the Small Cap
                Market,
                which during 2005 was renamed the “Capital Market”);




b.
            From
                June 30, 2004 through June 26, 2005, under the symbol “CTCHC”;




c.
            From
                June 27, 2005 through January 1, 2008, under the symbol
                “CTCH”;




d.
            From
                January 2, 2008 through January 29, 2008, under the symbol “CTCHD”;
                and




e.
            From
                January 30, 2008, under the symbol CTCH.




The
      Company continues to contemplate the filing of an application for admission
      to
      the Tel Aviv Stock Exchange, or “TASE”, which would result in the dual listing
      of its Ordinary Shares on the TASE and NASDAQ Capital Market. It is not certain
      that the Company will file such an application during 2008 or, if it does
      proceed with a filing, the TASE will approve the application.




The
      following table lists the high and low closing sales prices for the Company’s
      Ordinary Shares, for the periods indicated:




**High**
            
            **Low**2003:
            
            $
            4.41
            
            $
            0.302004:
            
            $
            3.72
            
            $
            0.812005:
            
            $
            3.90
            
            $
            1.352006:
            
            $
            4.08
            
            $
            2.102007:
            
            $
            7.44
            
            $
            3.69





2006:First
                Quarter
            
            $
            4.08
            
            $
            2.79Second
                Quarter
            
            $
            3.54
            
            $
            2.10Third
                Quarter
            
            $
            2.82
            
            $
            2.22Fourth
                Quarter
            
            $
            3.60
            
            $
            2.64


35





2007:First
                Quarter
            
            $
            4.80
            
            $
            3.69Second
                Quarter
            
            $
            6.15
            
            $
            4.41Third
                Quarter
            
            $
            7.44
            
            $
            4.89Fourth
                Quarter
            
            $
            7.41
            
            $
            5.73




Most
      Recent Six Months:





September
                2007
            
            $
            5.97
            
            $
            5.64October2007
            
            $
            7.41
            
            $
            5.73November
                2007
            
            $
            7.20
            
            $
            6.15December
                2007
            
            $
            6.75
            
            $
            6.00January
                2008
            
            $
            6.22
            
            $
            3.80February
                2008
            
            $
            4.78
            
            $
            4.20




**Item
      10. Additional Information.**




Under
      current Israeli regulations, any dividends or other distributions paid in
      respect of Ordinary Shares purchased by non-residents of Israel with certain
      non-Israeli currencies (including dollars) will be freely repatriable in such
      non-Israeli currencies at the rate of exchange prevailing at the time of
      conversion, provided that Israeli income tax has been paid on, or withheld
      from,
      such payments.




Neither
      the Amended and Restated Articles of Association of the Company nor the laws
      of
      the State of Israel restrict in any way the ownership or voting of Ordinary
      Shares by non-residents of Israel, except with respect to subjects of countries
      which are at a state of war with Israel.




We
      are
      registered under the Israel Companies Law as a public company with registration
      number 52-004418-1. The objective stated in our memorandum of association is
      to
      engage in any lawful activity.




**DESCRIPTION
      OF SHARES**




Set
      forth
      below is a summary of the material provisions governing our share capital.
      This
      summary is not complete and should be read together with our Memorandum of
      Association and Amended and Restated Articles of Association, copies of which
      are filed with this report or have been filed as exhibits to certain of our
      prior filings with the SEC.




As
      of
      December 31, 2007 and as adjusted for the reverse split (one for three) on
      January 2, 2008, our authorized share capital consisted of 55,353,340 Ordinary
      Shares, NIS 0.15 par value. As of December 31, 2007, there were 25,346,042
      Ordinary Shares issued and outstanding.




**DESCRIPTION
      OF ORDINARY SHARES**




All
      issued and outstanding Ordinary Shares of Commtouch are duly authorized and
      validly issued, fully paid and nonassessable.




The
      Ordinary Shares do not have preemptive rights. Our Memorandum of Association,
      Amended and Restated Articles of Association and the laws of the State of Israel
      do not restrict in any way the ownership or voting of Ordinary Shares by
      non-residents of Israel, except with respect to subjects of countries which
      are
      in a state of war with Israel.




**DIVIDEND
      AND LIQUIDATION RIGHTS**




The
      Ordinary Shares are entitled to their full proportion of any cash or share
      dividend declared.




Subject
      to the rights of the holders of shares with preferential or other special rights
      that may be authorized, the holders of Ordinary Shares are entitled to receive
      dividends in proportion to the sums paid up or credited as paid up on account
      of
      the nominal value of their respective holdings of the shares in respect of
      which
      the dividend is being paid (without taking into account the premium paid up
      on
      the shares) out of assets legally available therefor and, in the event of our
      winding up, to share ratably in all assets remaining after payment of
      liabilities in proportion to the nominal value of their respective holdings
      of
      the shares in respect of which such distribution is being made, subject to
      applicable law. Declaration of a dividend requires Board of Directors
      approval.




36




**MODIFICATION
      OF CLASS RIGHTS**




If
      at any
      time the share capital is divided into different classes of shares, then, unless
      the conditions of allotment of such class provide otherwise, the rights,
      additional rights, advantages, restrictions and conditions attached or not
      attached to any class, at any given time, may be modified, enhanced, added
      or
      abrogated by resolution at a meeting of the holders of the shares of such
      class.




**SPECIAL
      PROVISIONS IN AMENDED AND RESTATED ARTICLES OF ASSOCIATION RELATING TO
      DIRECTORS**




The
      discussion regarding approval of director compensation and transactions with
      the
      Company under “Item 6. Directors, Senior Management and Employees - Approval of
      Certain Transactions; Obligations of Directors, Officers and Shareholders” is
      incorporated herein by reference.




**VOTING,
      SHAREHOLDER MEETINGS AND RESOLUTIONS**




Holders
      of Ordinary Shares have one vote for each share held on all matters submitted
      to
      a vote of shareholders.




An
      annual
      general meeting must be held once every calendar year at such time (not more
      than 15 months after the last preceding annual general meeting) and at such
      place, either within or outside the State of Israel, as may be determined by
      the
      Board of Directors. The quorum required for a general meeting of shareholders
      consists of at least two shareholders present in person or by proxy and holding
      at least one-third of the voting rights of the issued share capital. A meeting
      adjourned for lack of a quorum may be adjourned to the same day in the next
      week
      at the same time and place, or to such time and place as the Board of Directors
      may determine in a notice to shareholders. At such reconvened meeting any two
      shareholders entitled to vote and present in person or by proxy will constitute
      a quorum. Generally, shareholder resolutions will be deemed adopted if approved
      by the holders of a majority of the voting power represented at the meeting,
      in
      person or by proxy, and voting thereon. For certain matters as described under
      the Israel Companies law, there is a requirement that the majority
      include the affirmative vote of at least one-third of the votes cast by
      shareholders who are not controlling shareholders of the Company or interested
      parties in the matter to be voted upon (or their representatives) or,
      alternatively, the total shareholdings of the votes cast against the proposal
      (other than by the Company’s controlling shareholders or interested parties in
      the matter to be voted upon) must not represent more than one percent of the
      voting rights in the Company.




**ANTI-TAKEOVER
      PROVISIONS UNDER ISRAELI LAW**




Under
      the
      Companies Law, a merger is generally required to be approved by the shareholders
      and board of directors of each of the merging companies. If the share capital
      of
      the company that will not be the surviving company is divided into different
      classes of shares, the approval of each class is also required. In addition,
      a
      merger can be completed only after 30 days have passed from the shareholders’
approval of each of the merging companies, all approvals have been submitted
      to
      the Israeli Registrar of Companies and at least fifty days have passed from
      the
      time that a proposal for approval of the merger was filed with the
      Registrar.




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 25% shareholder of the company, unless there is already another
      25% shareholder of the company. Similarly, the Companies Law provides that
      an
      acquisition of shares in a public company must be made by means of tender offer
      if as a result of the acquisition the purchaser would become a 45% shareholder
      of the company, unless someone else already holds 45% of the voting power of
      the
      company. These rules do not apply if the acquisition is made by way of a merger.
      Regulations promulgated under the Companies Law provide that these tender offer
      requirements 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:




37


•
            there
                is a limitation on acquisition of any level of control of the company;
                or




•
            the
                acquisition of any level of control requires the purchaser to do
                so by
                means of a tender offer to the
                public.




Finally,
      Israeli tax law treats specified acquisitions, including a stock-for-stock
      swap
      between an Israeli company and a foreign company, less favorably than does
      U.S.
      tax law. For example, Israeli tax law may subject a shareholder who exchanges
      his Ordinary Shares for shares in a foreign corporation to taxation before
      it
      would become taxable in the United States, even though the investment has not
      become liquid.




**TRANSFER
      OF SHARES AND NOTICES**




Fully
      paid Ordinary Shares that are issued and not subject to any legal restrictions
      on transference may be transferred freely. Each shareholder of record is
      entitled to receive at
      least
      twenty-one days' prior notice (and for certain matters, thirty-five days’ prior
      notice) before the date of a shareholder meeting and at least five days notice
      before the record date for the meeting .
      For
      purposes of determining the shareholders entitled to notice and to vote at
      such
      meeting, the Board of Directors may fix a record date not exceeding 40 days
      prior to the date of any shareholder meeting.




**DISCLOSURE
      OF SHAREHOLDERS OWNERSHIP**




The
      Israeli Securities Law and regulations promulgated thereunder do not require
      a
      company whose shares are publicly traded solely on a stock exchange outside
      of
      Israel, as in the case of our Company, to disclose its share
      ownership.




**CHANGES
      IN OUR CAPITAL**




Changes
      in our capital are subject to the approval of the shareholders by a majority
      of
      the votes of shareholders present by person or by proxy and voting at the
      shareholders meeting.




**DESCRIPTION
      OF INVESTOR AND SERVICE PROVIDER WARRANTS**




The
      following summarizes warrants outstanding as of December 31, 2007:




**JANUARY
      2003 CONVERTIBLE LOAN WARRANTS**




The
      discussion regarding the January 2003 convertible loan warrants under Item
      18,
      Note 5 to the Notes to Consolidated Financial Statements - Shareholders’ Equity
      is incorporated herein by reference.




**JULY
      2003 INVESMENT ROUNDS WARRANTS**




The
      discussion regarding the two July 2003 investment rounds warrants under Item
      18,
      Note 5 to the Notes to Consolidated Financial Statements - Shareholders’ Equity
      is incorporated herein by reference.




**MAY
      2004 INVESTMENT ROUND WARRANTS**




The
      discussion regarding the May 2004 investment round warrants under Item 18,
      Note
      5 to the Notes to Consolidated Financial Statements - Shareholders’ Equity is
      incorporated herein by reference.




**OCTOBER
      2005 INVESTMENT ROUND WARRANTS**




The
      discussion regarding the October 2005 investment round warrants under Item
      18,
      Note 6 to the Notes to Consolidated Financial Statements - Shareholders’ Equity
      is incorporated herein by reference.




**ADVISOR
      WARRANT**




The
      discussion under Item 18, Note 6 to the Notes to Consolidated Financial
      Statements - Shareholders’ Equity, regarding a warrant issued in relation to a
      small investment made by an advisor to the Company during May 2006, is
      incorporated herein by reference.




38




**REGISTRATION
      RIGHTS**




The
      Company has not granted registration rights within the two year period prior
      to
      the filing of this Form 20-F.




**ACCESS
      TO INFORMATION**




We
      file
      reports with the Israeli Registrar of Companies regarding our registered
      address, our registered capital, our shareholders of record and the number
      of
      shares held by each, the identity of the directors and details regarding
      security interests on our assets. In addition, Commtouch must file with the
      Israeli Registrar of Companies its Amended and Restated Articles of Association
      and any further amendments thereto. The information filed with the Registrar
      of
      Companies is available to the public. In addition to the information available
      to the public, our shareholders are entitled, upon request, to review and
      receive copies of all minutes of meetings of our shareholders.




We
      are
      subject to certain of the information reporting requirements of the Exchange
      Act. As a “foreign private issuer,” we are exempt from the rules and regulations
      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, with respect to their purchase and sale of
      the
      ordinary shares. In addition, we are not required to file reports and financial
      statements with the SEC as frequently or as promptly as U.S. companies whose
      securities are registered under the Exchange Act. However, we file with the
      SEC
      an Annual Report on Form 20-F containing financial statements audited by an
      independent accounting firm. We also furnish quarterly reports on Form 6-K
      containing unaudited financial information after the end of each calendar
      quarter. We post our Annual Report on Form 20-F on our Website
      (www.commtouch.com) promptly following the filing of our Annual Report with
      the
      Securities and Exchange Commission.





This
      report and other information filed or to be filed by us can be inspected and
      copied at the public reference facilities maintained by the SEC at:





100
      F
      Street, NE


Public
      Reference Room


Washington,
      D.C. 20549





The
      SEC
      maintains a Web site at www.sec.gov that
      contains reports, proxy and information statements, and other information
      regarding registrants that make electronic filings with the SEC using its EDGAR
      system.




**TRANSFER
      AGENT AND REGISTRAR**




The
      transfer agent and registrar for our Ordinary Shares is Wells Fargo Bank, N.A.
      Shareowner Services of St. Paul, Minnesota.




**MATERIAL
      CONTRACTS DURING PAST TWO YEARS**




*Equity
      Investment* .
      Commtouch made a $750 thousand investment in Mirapoint, a secure messaging
      vendor and an OEM licensee, as part of Mirapoint's larger financing round in
      the
      fourth quarter of 2007. In connection therewith, Commtouch received a minority
      ownership interest in Mirapoint of approximately 8%.




*Amended
      and Restated Articles of Association*




See
      the
      discussion under Item 4 “Information on the Company- Overview” for instructions
      on how to locate the Company’s Amended and Restated Articles of Association. In
      addition, the Articles are incorporated by reference to this Form 20-F under
      Exhibit 1.2 below.




**ISRAELI
      TAXATION AND INVESTMENT PROGRAMS**




The
      following is a summary of the principal tax laws applicable to companies in
      Israel, including special reference to their effect on us, and Israeli
      government programs benefiting us. This section also contains a discussion
      of
      the material Israeli tax consequences to you if you acquire Ordinary Shares
      of
      our company. This summary does not discuss all the acts of Israeli tax law
      that
      may be relevant to you in light of your personal investment circumstances or
      if
      you are subject to special treatment under Israeli law. To the extent that
      the
      discussion is based on new tax legislation which has not been subject to
      judicial or administrative interpretation, we cannot assure you that the views
      expressed in this discussion will be accepted by the tax authorities. The
      discussion should not be understood as legal or professional tax advice and
      is
      not exhaustive of all possible tax considerations.




39




*General
      Corporate Tax Structure*




Generally,
      Israeli companies are subject to “Corporate Tax” on their taxable income. On
      July 25, 2005, the Knesset (Israeli Parliament) approved the Law of the
      Amendment of the Income Tax Ordinance (No. 147), 2005, which prescribes, among
      others, a gradual decrease in the corporate tax rate in Israel to the following
      tax rates: in 2006 - 31%, in 2007 - 29%, in 2008 - 27%, in 2009 - 26% and in
      2010 and thereafter - 25%. However, the effective tax rate payable by a company
      which derives income from an approved enterprise (as further discussed below)
      may be considerably less.




*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 the income of which in a given tax year exclusive of income from
      specified government loans, capital gains, interest and dividends, 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 a number of
      corporate tax benefits, including:




·
            deduction
                of purchase of know-how and patentsand/or
                right to use a patentover an eight-year period;


·
            the
                right to elect, under specified conditions, to file a consolidated
                tax
                return with additional related Israeli industrial companies and an
                industrial holding company;


·
            accelerated
                depreciation rates on equipment and
                buildings.


·
            Expenses
                related to a public offering on TA stock exchange and as of 1.1.2003
                on
                recognized stock markets outside of Israel, are deductible in equal
                amounts over three years.





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 the operations begin and
      the
      number of work shifts. An industrial company owning an approved enterprise
      may
      choose between these special depreciation rates and the depreciation rates
      available to the approved enterprise.





Eligibility
      for benefits under the Industry Encouragement Law is not subject to receipt
      of
      prior approval from any governmental authority.





We
      believe that we currently qualify as an industrial company within the definition
      of the Industry Encouragement Law. We cannot assure you that the Israeli tax
      authorities will agree that we qualify, or, if we qualify, 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 Measurement of Taxable Income*




Our
      compan y is taxed
      under the Income Tax Law (Inflationary Adjustments), 1985, generally referred
      to
      as the Inflationary Adjustments Law. The Inflationary Adjustments Law is highly
      complex and represents an attempt to overcome the problems presented to a
      traditional tax system by an economy undergoing rapid inflation. Its features,
      which are material to us, are summarized as follows:


40




·
            Where
                a company’s equity, as calculated under the Inflationary Adjustments Law,
                exceeds the depreciated cost of its fixed assets (as defined in the
                Inflationary Adjustments Law), a deduction from taxable income is
                permitted equal to the excess multiplied by the applicable annual
                rate of
                inflation. The maximum deduction permitted in any single tax year
                is 70%
                of taxable income, with the unused portion permitted to be carried
                forward, linked to the Israeli consumer price index. The unused portion
                that was carried forward may be deductible in full in the following
                year.




·
            Where
                a company’s depreciated cost of fixed assets exceeds its equity, then the
                excess multiplied by the applicable annual rate of inflation is added
                to
                taxable income. (hereinafter: “**Inflation
                supplement**”).
                Note, the inflation supplement will only be added to the corporate
                income
                but not to other incomes such as capital
                gains.




·
            Subject
                to specified limitations, depreciation deductions on fixed assets
                and
                losses carried forward are adjusted for inflation based on the change
                in
                the consumer price index.





The
      Minister of Finance may, with the approval of the Knesset Finance Committee,
      determine by decree, during a certain fiscal year (or until February
      28 th of the
      following year) in which the rate of increase of the Israeli consumer price
      index would not exceed or did not exceed, as applicable, 3.0%, that some or
      all
      of the provisions of the Inflationary Adjustments Law shall not apply with
      respect to such fiscal year, or that the rate of increase of the Israeli
      consumer price index relating to such fiscal year shall be deemed to be 0%,
      and
      to make the adjustments required to be made as a result of such
      determination




*Tax
      Benefits of Research and Development*




Israeli
      tax law permits, under some conditions, a tax deduction in the year incurred
      for
      expenditures, including capital expenditures, in scientific research and
      development projects, if the expenditures are approved by the relevant
      government ministry and if the research and development is for the promotion
      of
      the enterprise and is carried out by, or on behalf of, a company seeking the
      deduction.




The
      OCS
      has approved some of our research and development programs and we have been
      able
      to deduct, for tax purposes, a portion of our research and development expenses
      net of the grants received. Other research and development expenses that are
      not
      approved may be deducted for tax purposes in 3 equal installments during a
      3-year period.




*Capital
      Gains Tax on Sales of Our Ordinary Shares*




Israeli
      law generally imposes a capital gains tax on the sale of any capital assets
      by
      residents of Israel, as defined for Israeli tax purposes, and on the sale of
      assets located in Israel, including shares in Israeli companies, by both
      residents and non-residents of Israel, unless a specific exemption is available
      or unless a tax treaty between Israel and the shareholder’s country of residence
      provides otherwise. The law distinguishes between real gain and inflationary
      surplus. The inflationary surplus is a portion of the total capital gain which
      is equivalent to the increase of the relevant asset’s purchase price which is
      attributable to the increase in the Israeli consumer price index or, in certain
      circumstances, a foreign currency exchange rate, 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.




As
      of
      January 1, 2006, the tax rate applicable to capital gains derived from the
      sale
      of shares, whether listed on a stock market or not, is 20% for Israeli
      individuals, unless such shareholder claims a deduction for financing expenses
      in connection with such shares, in which case the gain will generally be taxed
      at a rate of 25%. Additionally, if such shareholder is considered a “material
      shareholder” at any time during the 12-month period preceding such sale, i.e.,
      such shareholder holds directly or indirectly, including with others, at least
      10% of any means of control in the company, the tax rate shall be 25%. Israeli
      companies are subject to the Corporate Tax rate on capital gains derived from
      the sale of shares, unless such companies were not subject to the Adjustments
      Law (or certain regulations) at the time of publication of the aforementioned
      amendment to the Tax Ordinance that came into effect on January 1, 2006, in
      which case the applicable tax rate is 25%. However, the foregoing tax rates
      do
      not apply to: (i) dealers in securities; and (ii) shareholders who acquired
      their shares prior to an initial public offering (that may be subject to a
      different tax arrangement).




41


Non-Israeli
      residents are exempt from Israeli capital gains tax on any gains derived from
      the sale of shares of Israeli companies publicly traded on a recognized stock
      exchange or regulated market outside of Israel, provided however that such
      capital gains are not derived from a permanent establishment in Israel, such
      shareholders are not subject to the Adjustments Law, and such shareholders
      did
      not acquire their shares prior to an initial public offering. However,
      non-Israeli corporations will not be entitled to such exemption if an Israeli
      resident (i) has a controlling interest of 25% or more in such non-Israeli
      corporation, or (ii) is the beneficiary or is entitled to 25% or more of the
      revenues or profits of such non-Israeli corporation, whether directly or
      indirectly.




In
      some
      instances where our shareholders may be liable to Israeli tax on the sale of
      their ordinary shares, the payment of the consideration may be subject to the
      withholding of Israeli tax at the source.




Pursuant
      to the Convention Between the government of the United States of America and
      the
      government of Israel with Respect to Taxes on Income, as amended (the
“U.S.-Israel Tax Treaty”), the sale, exchange or disposition of ordinary shares
      by a person who (i) holds the ordinary shares as a capital asset, (ii) qualifies
      as a resident of the United States within the meaning of the U.S.-Israel Tax
      Treaty and (iii) is entitled to claim the benefits afforded to such person
      by
      the U.S.-Israel Tax Treaty, generally, will not be subject to the Israeli
      capital gains tax. Such exemption will not apply if (i) such Treaty 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 such sale,
      exchange or disposition, subject to certain conditions, or (ii) the capital
      gains from such sale, exchange or disposition can be allocated to a permanent
      establishment in Israel. In such case, the sale, exchange or disposition of
      ordinary shares would be subject to Israeli tax, to the extent applicable;
      however, under the U.S.-Israel Tax Treaty, such Treaty U.S. Resident would be
      permitted to claim a credit for such taxes against the U.S. federal income
      tax
      imposed with respect to such 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.




*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. Such sources of income include passive income such as dividends,
      royalties and interest, as well as non-passive income from services rendered
      in
      Israel. On distributions of dividends other than bonus shares, or stock
      dividends, income tax is withheld at the source at the following rates: for
      dividends distributed on or after January 1, 2006 - 20%, or 25% for a
      shareholder that is considered a “material shareholder” at any time during the
      12-month period preceding such distribution, unless a different rate is provided
      in a treaty between Israel and the 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 Treaty U.S. Resident is 25%. However, under the
      Investments Law, dividends generated by an Approved Enterprise (or Benefited
      Enterprise) are taxed at the rate of 15%. Furthermore, dividends not generated
      by an Approved Enterprise (or Benefited Enterprise) paid to a U.S. corporation
      holding at least 10% of our issued voting power during
      the part of the tax year which precedes the date of payment of the dividend
      and
      during the whole of its prior tax year ,
      are
      generally taxed at a rate of 12.5%.




For
      information with respect to the applicability of Israeli capital gains taxes
      on
      the sale of ordinary shares by United States residents, see above “— Capital
      Gains Tax on Sales of Our Ordinary Shares.”




**U.S.
      TAX CONSIDERATIONS REGARDING ORDINARY SHARES ACQUIRED BY U.S. TAXPAYERS**




The
      following discussion summarizes the material U.S. federal income tax
      consequences arising from the purchase, ownership and sale of the Ordinary
      Shares. This summary is based on the provisions of the Internal Revenue Code
      of
      1986, as amended (the “Code”), final, temporary and proposed U.S. Treasury
      Regulations promulgated thereunder, and administrative and judicial
      interpretations thereof, in effect as of the date of this report, all of which
      are subject to change, possibly with retroactive effect. Commtouch will not
      seek
      a ruling from the Internal Revenue Service with regard to the United States
      federal income tax treatment relating to investment in the Ordinary Shares
      and,
      therefore, no assurance exists that the Internal Revenue Service will agree
      with
      the conclusions set forth below. The summary below does not purport to address
      all of
      the
      U.S. federal
      income tax consequences that may be relevant to particular investors. This
      summary does not address the consequences that may be applicable to particular
      classes of taxpayers, including investors that hold Ordinary Shares as a
      hedge, part
      of a
      hedge, straddle or , conversion or
      constructive sale transaction, life insurance
      companies, banks ,
      regulated investment companies, or other
      financial institutions or a
“financial services entity” ,
      broker - or dealers in
      securities or foreign currency ,
      tax-exempt organizations ,
      persons
      that acquire Ordinary Shares in connection with employment or other performance
      of services, real estate investments, investors that have a functional currency
      other than the U.S. dollar, and
      investors who own (directly, indirectly or through attribution) 10% or more
      of
      Commtouch’s outstanding voting stock. Further, it does not address the
      alternative minimum tax consequences of an investment in Ordinary Shares or
      the
      indirect consequences to U.S. Holders, as defined below, of equity interests
      in
      investors in Ordinary Shares. This summary is addressed only to holders that
      hold Ordinary Shares as a capital asset within the meaning of Section 1221
      of
      the Code, are U.S. citizens, individuals resident in the United States for
      purposes of U.S. federal income tax, domestic corporations or partnerships
      and
      estates or trusts treated as “United States persons” under Section 7701 of the
      Code (“U.S. Holders”). This
      summary also does not address state, local or non-U.S. taxes.




42




**EACH
      INVESTOR SHOULD CONSULT WITH HIS OR HER OWN TAX ADVISOR AS TO THE PARTICULAR
      U.S. FEDERAL INCOME TAX CONSEQUENCES OF THE PURCHASE, OWNERSHIP AND SALE OF
      ORDINARY SHARES, INCLUDING THE EFFECTS OF APPLICABLE STATE, LOCAL, FOREIGN
      OR
      OTHER TAX LAWS AND POSSIBLE CHANGES IN THE TAX LAWS.**




*Tax
      Basis of Ordinary Shares*




A
      U.S.
      Holder’s tax basis in his or her Ordinary Shares will be the purchase price paid
      therefore by such U.S. Holder. The holding period of each Ordinary Share owned
      by a U.S. Holder will commence on the day following the date of the U.S.
      Holder’s purchase of such Ordinary Share and will include the day on which such
      U.S. Holder sells the Ordinary Share.




*Sale
      or Exchange of Ordinary Shares*




A
      U.S.
      Holder’s sale or exchange of Ordinary Shares will generally **** result
      in
      the recognition of gain or loss by such U.S. Holder in an amount equal to the
      difference between the amount realized and the U.S. Holder’s basis in the
      Ordinary Shares sold. Subject to the following discussion of the consequences
      of
      Commtouch being treated as a Passive Foreign Investment Company or a Foreign
      Investment Company, such gain or loss will be capital gain or loss if such
      Ordinary Shares are a capital asset in the hands of the U.S. Holder. Gain or
      loss realized on the sale of Ordinary Shares will be long-term capital gain
      or
      loss if the Ordinary Shares sold had been held for more than one year at the
      time of their sale. Long-term capital gains recognized by certain taxpayers
      generally are subject to a reduced rate of **U.S** . **** federal
      tax (currently a maximum of 15%). If the U.S. Holder’s holding period on the
      date of the sale or exchange was one year or less, such gain or loss will be
      short-term capital gain or loss. Short-term capital gains generally are subject
      to tax at the same rates as ordinary income. In general, any capital gain
      recognized by a U.S. Holder upon the sale or exchange of Ordinary Shares will
      be
      treated as U.S.-source income for U.S. foreign tax credit purposes.




See
      discussion under this Item 10 “Israeli Taxation and Investment Programs—Capital
      Gains and Income Taxes Applicable to Non-Israeli Shareholders” for a discussion
      of taxation by Israel of capital gains realized on sales of capital
      assets.




*Taxation
      of Dividends Paid On Ordinary Shares*





A
      U.S.
      Holder will be required to include in gross income as ordinary income the amount
      of any distribution paid on Ordinary Shares, including any Israeli taxes
      withheld from the amount paid, to the extent the distribution is paid out of
      our
      current or accumulated earnings and profits as determined for U.S. federal
      income tax purposes. Distributions in excess of these earnings and profits
      will
      be applied against and will reduce the U.S. Holder's basis in the Ordinary
      Shares and, to the extent in excess of this basis, will be treated as gain
      from
      the sale or exchange of Ordinary Shares.





Previously
      enacted amendments to the Code provide that dividend income may be eligible
      for
      a reduced rate of taxation. Dividend income will be taxed at the applicable
      long-term capital gains rate if the dividend is received from a "qualified
      foreign corporation," and the shareholder of such foreign corporation holds
      such
      stock for more than 61 days
      during the 120 day period that begins on the date that is 60 days before the
      ex-dividend date for the stock. The holding period is tolled for any days on
      which the shareholder has reduced his risk of loss. A "qualified foreign
      corporation" is one that is eligible for the benefits of a comprehensive income
      tax treaty with the United States. A foreign corporation will be treated as
      qualified with respect to any dividend paid, if its stock is readily tradable
      on
      an established securities market. However, a foreign corporation will not be
      treated as a qualified foreign
      corporation if it is
      a Passive Foreign Investment Company (as discussed below) for the year in which
      the dividend was paid or the preceding year.


43





Distributions
      of current or accumulated earnings and profits paid in foreign currency to
      a
      U.S. Holder will be includible in the income of a U.S. Holder in a U.S. dollar
      amount calculated by reference to the exchange rate on the day the distribution
      is received. A U.S. Holder that receives a foreign currency distribution and
      converts the foreign currency into U.S. dollars subsequent to receipt will
      have
      foreign exchange gain or loss based on any appreciation or depreciation in
      the
      value of the foreign currency against the U.S. dollar, which will generally
      be
      U.S. source ordinary income or loss.




As
      described above, we will generally be required to withhold Israeli income tax
      from any dividends paid to holders who are not resident in Israel. See "Israeli
      Tax Considerations — Taxation of Non-Resident Holders of Shares." If a U.S.
      Holder receives a dividend from Commtouch that is subject to Israeli
      withholding, the following would apply:




·
            You
                must include the gross amount of the dividend, not reduced by the
                amount
                of Israeli tax withheld, in your U.S. taxable
                income.




·
            You
                may be able to claim the Israeli tax withheld as a foreign tax credit
                against your U.S.federal****incometax
                liability.




·
            The
                foreign tax credit is subject to significant and complex limitations.
                Generally, the credit can offset only the part of your U.S. tax
                attributable to your net foreign source passive income. Additional
                special
                rules apply to taxpayers predominantly engaged in the active conduct
                of a
                banking, insurance, financing or similar business. Additionally,
                if we pay
                dividends at a time when 50% or more of our stock is owned by U.S.
                persons, you may be required to treat the part of the dividend
                attributable to U.S. source earnings and profits as U.S. source income,
                possibly reducing the allowable credit, unless you elect to calculate
                your
                foreign tax credit separately with respect to Commtouch
                dividends.




·
            A
                U.S. Holder will be denied a foreign tax credit with respect to Israeli
                income tax withheld from dividends received on the Ordinary Shares
                to the
                extent the U.S. Holder has not held the Ordinary Shares for at least
                16
                days of the 31-day period beginning on the date which is 15 days
                before
                the ex-dividend date or to the extent the U.S. Holder is under an
                obligation to make related payments with respect to substantially
                similar
                or related property. Any days during which a U.S. Holder has substantially
                diminished its risk of loss on the Ordinary Shares are not counted
                toward
                meeting the 16-day holding period required by the statute. A. U.S.
                Holder
                will also be denied a foreign tax credit if the U.S. Holder’s reasonably
                expected economic profit is insubstantial compared to the foreign
                taxes
                expected to be paid or accrued.




·
            Ifyou
                do not elect to claim foreign taxes as a credit, you will be entitled
                to
                deduct the Israeli income tax withheld from your Commtouch dividends
                in
                determining your taxable income.The
                rules relating to the determination of the U.S. 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.****Individuals
                who do not claim itemized deductions, but instead utilize the standard
                deduction, may not claim a deduction for the amount of the Israeli
                income
                taxes withheld.




·
            If
                you are a U.S. corporation holding our stock, you cannot claim the
                dividends-received deduction with respect to our
                dividends.




Special
      rules, described below, apply if Commtouch is a passive foreign investment
      company.




*Information
      Reporting and Backup Withholding*




U.S.
      Holders generally are subject to information reporting requirements with respect
      to dividends paid in the United States on Ordinary Shares. Existing regulations
      impose back-up withholding on dividends paid in the United States on Ordinary
      Shares unless the U.S. Holder provides IRS Form W-9 or otherwise establishes
      an
      exemption. U.S. Holders are subject to information reporting and back-up
      withholding at a rate of 28% on proceeds paid from the disposition of Ordinary
      Shares unless the U.S. Holder provides IRS Form W-9 or otherwise establishes
      an
      exemption.




44


Backup
      withholding will not apply with respect to payments made to certain exempt
      recipients, such as corporations and tax exempt organizations.





Non-U.S.
      Holders generally are not subject to information reporting or back-up
      withholding with respect to dividends paid on, or upon the disposition of,
      Ordinary Shares, provided that the non-U.S. Holder provides taxpayer
      identification number, certifies to its foreign status, or otherwise establishes
      an exemption.





Prospective
      investors should consult their tax advisors concerning the effect, if any,
      of
      these Treasury regulations on an investment in Ordinary Shares. The amount
      of
      any back-up withholding will be allowed as a credit against a U.S. or Non-U.S.
      Holder's United States federal income tax liability and may entitle the Holder
      to a refund, provided that specified required information is furnished to the
      IRS.





*Tax
      Consequences If We Are a Passive Foreign Investment Company*





Generally,
      a foreign corporation is treated as a passive foreign investment company
      (“PFIC”) for U.S. federal
      income tax purposes for any tax year if, in such tax year, either (i) 75% or
      more of its gross income (including
      its pro rata share of gross income for any company (U.S. or foreign) in which
      it
      is considered to own 25% or more of the shares by value), is
      passive in nature (the “Income Test”), or (ii) the average percentage of its
      assets during such tax year (including
      its pro rata share of the assets of any Company (U.S. or foreign) in which
      it is
      considered to own 25% or more of the shares by value), that
      produce, or are held for the production of, passive income (determined by
      averaging the percentage of the fair market value of its total assets which
      are
      passive assets as of the end of each quarter of such year) is 50% or more (the
      “Asset Test”).





Because
      less than 75% of our gross income in 2007
      and
      in prior years constituted passive income, as defined for purposes of the Income
      Test, we do not believe that application of the Income Test would have resulted
      in our classification as a PFIC for any of such years.





For
      2003, 2004 , 2005, 2006 and
      2007, however,
      it is possible that we could be classified as a PFIC under the Asset Test
      principally because a significant portion of our assets continued to consist
      of
      the cash raised in connection with both a public offering and a private offering
      of our Ordinary Shares in 2000, coupled with the decline in the public market
      value of our Ordinary Shares during 2001, 2002 and through the beginning of
      2003
      and the timing of the required valuations, although there is no definitive
      method prescribed in the Code, United States Treasury Regulations or
      administrative or judicial interpretations thereof for determining the value
      of
      a foreign corporation’s assets for purposes of the Asset Test. While the
      legislative history of the United States Taxpayer Relief Act of 1997 indicates
      that “the total value of a publicly-traded foreign corporation’s assets
      generally will be treated as equal to the sum of the aggregate value of its
      outstanding stock plus its liabilities”, there remains substantial uncertainty
      regarding the valuation of a publicly-traded foreign corporation’s assets for
      purposes of the Asset Test, and it is theoretically arguable that under
      alternative valuation methodologies, the value of our total assets as of the
      relevant valuation dates in 2003, 2004 ,
      2005,
      2006 and/or 2007 would
      not result in our classification as a PFIC during any or all of such years.





In
      view
      of the uncertainty regarding the valuation of our assets for purposes of the
      Asset Test and the complexity of the issues regarding our treatment as a PFIC,
      U.S. Shareholders are urged to consult their own tax advisors for guidance
      as to
      our status as a PFIC. For those U.S. Shareholders who determine that we were
      a
      PFIC and notify us in writing of their request for the information required
      in
      order to effectuate the QEF Election described below, we will promptly make
      such
      information available to them.





If
      we are
      treated as a PFIC for United States federal income tax purposes for any year
      during a U.S. Shareholder’s holding period of Ordinary Shares and the U.S.
      Shareholder does not make a QEF Election or a “mark-to-market” election (both as
      described below), any gain recognized by the U.S. Shareholder upon the sale
      of
      Ordinary Shares (or the receipt of certain distributions) would be treated
      as
      ordinary income. This income would be allocated over the U.S. Shareholder’s
      holding period with respect to his Ordinary Shares and an interest charge would
      be imposed on the amount of deferred tax on the income allocated to prior
      taxable years.





Although
      we generally will be treated as a PFIC as to any U.S. Shareholder if we are
      a
      PFIC for any year during the U.S. Shareholder’s holding period, if we cease to
      satisfy the requirements for PFIC classification, then under such circumstances,
      the U.S. Shareholder may avoid the consequences of PFIC classification for
      subsequent years if he elects to recognize gain based on the unrealized
      appreciation in the Ordinary Shares through the close of the tax year in which
      we cease to be a PFIC. Additionally, if we are treated as a PFIC, a U.S.
      Shareholder who acquires Ordinary Shares from a decedent would be denied the
      normally available step-up in tax basis for these Ordinary Shares to fair market
      value at the date of death and instead would have a tax basis equal to the
      decedent’s tax basis in these Ordinary Shares.


45





For
      any
      tax year in which we are treated as a PFIC, a U.S. Shareholder may elect to
      treat his Ordinary Shares as an interest in a qualified electing fund (a “QEF
      Election”), in which case, the U.S. Shareholder would be required to include in
      income currently his proportionate share of our earnings and profits in years
      in
      which we are a PFIC regardless of whether distributions of our earnings and
      profits are actually distributed to the U.S. Shareholder. Any gain subsequently
      recognized upon the sale by the U.S. Shareholder of his Ordinary Shares,
      however, generally would be taxed as capital gain.





As
      an
      alternative to a QEF Election, a U.S. Shareholder may elect to mark his Ordinary
      Shares to market annually, recognizing ordinary income or loss (subject to
      certain limitations) equal to the difference between the fair market value
      of
      his Ordinary Shares and the adjusted tax basis of his Ordinary Shares. Losses
      would be allowed only to the extent of net mark-to-market gain accrued under
      the
      election.





*We
      cannot assure you that we* **** *have
      not been or* *are
      not a PFIC or will avoid becoming a PFIC. U.S. holders who hold Ordinary Shares
      during a period when we are a PFIC will be subject to the foregoing rules,
      even
      if we cease to be a PFIC. U.S. Holders are urged to consult their tax advisors
      about the PFIC rules, including QEF elections* .




**Item
      11. Qualitative and Quantitative Disclosure about Market Risk.**




We
      develop our technology in Israel and seek to provide our services worldwide.
      As
      a result, our foreign currency exposures give rise to market risk associated
      with exchange rate movements of the U.S. dollar, our functional and reporting
      currency, against the shekel. We are exposed to the risk of fluctuation in
      the
      U.S. dollar/shekel exchange rate. Our shekel-denominated expenses consist
      principally of salaries and related personnel expenses, as well as vehicle
      lease
      payments. Neither a ten percent increase nor decrease in current exchange rates
      would have a material effect on our consolidated financial statements in the
      next six months.





Due
      to
      the fact that we do not have any material debt, we have concluded that there
      is
      currently no material interest market risk exposure.




Therefore,
      no quantitative tabular disclosures are provided.




**Item
      12. Description of Securities Other than Equity
      Securities.**




Not
      applicable.




**PART
      II**




**Item
      13. Defaults, Dividend Arrearages and Delinquencies.**




Not
      applicable.




**Item
      14. Material Modifications to the Rights of Security Holders and Use of
      Proceeds.**




Other
      than the reverse stock split described elsewhere in this report, this item
      is
      not **** applicable
      for **** the
      period since January 1, 2007 to date.




46




**Item
      15. Controls and Procedures.**




(a)
      As of
      December 31, 2007, we performed an evaluation under
      the
      supervision and with the participation of our management, including our Chief
      Executive Officer and Chief Financial Officer, of
      the
      effectiveness of the
      design and operation of our
      disclosure controls and procedures (as
      defined in Rules 13a-15(e) and 15d-15(e) of
      the
      Exchange Act) .
      Our
      management recognizes that any controls and procedures, no matter how well
      designed and operated, can provide only reasonable assurance of achieving their
      objectives and our management necessarily applies its judgment in evaluating
      the
      cost-benefit relationship of possible controls and procedures. Based on this
      evaluation, our Chief Executive Officer and Chief Financial Officer concluded
      that our disclosure controls and procedures are effective as of December 31,
      2007, to provide reasonable assurance that the information required to be
      disclosed in filings and submissions under the Exchange Act, is recorded,
      processed, summarized, and reported within the time periods specified by the
      SEC’s rules and forms, and that such information related to us and our
      consolidated subsidiaries is accumulated and communicated to management,
      including the Chief Executive Officer and Chief Financial Officer, as
      appropriate to allow timely decisions about required disclosure.




(b)
      and
      (c) Our management is responsible for establishing and maintaining adequate
      internal control over our financial reporting, as such term is defined in Rule
      13a-15(f) under the Security Exchange Act. Our internal control over financial
      reporting system was designed to provide reasonable assurance regarding the
      reliability of financial reporting and the preparation of financial statements
      for external purposes in accordance with generally accepted accounting
      principles.




Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements and even when determined to be effective can
      only provide reasonable assurance wit respect to financial statements. Also
      projections of any evaluation of effectiveness to future periods are subject
      to
      the risk that controls may become inadequate because of changes in conditions,
      or that the degree of compliance with the policies or procedures may
      deteriorate.




Our
      management assessed our internal control over financial reporting as of December
      31, 2007. Our management based its assessment on criteria established in
      Internal Control- Integrated Framework issued by the Committee of Sponsoring
      Organization of the Treadway Commission. Based on this assessment, our
      management has cocluded that, as of December 31, 2007, our internal control
      over
      financial reporting is effective.




(d)
      Our
      independent registered public accounting firm, Kost, Forer, Gabbay &
Kasierer, a member of Ernst & Young Global, audited management's assessment
      and independently assessed the effectiveness of the Company's internal
      controlover financial reporting. Kost, Forer, Gabbay & Kasierer, a member of
      Ernst & Young Global, has issued an attestation report concurring with
      management's assessment, which is included under Item 18 on page F-3, F-4 of
      this annuale report.




(e)
      During the period covered by this annual report on Form 20-F, there were no
      changes to our internal control over financial reporting that occurred during
      the year ended December 31, 2007 that have materially affected, or are
      reasonably likely to materially affect, our internal control over financial
      reporting.




47




Item
      16.Reserved




**Item
      16A. Audit Committee Financial Expert.**




The
      Board
      of Directors of the Company has determined that Mr. Ofer Segev, a member of
      the
      Audit Committee, is an audit committee financial expert as that term is defined
      in Item 16A of Form 20-F and is independent as that term is defined in each
      of
      NASDAQ Marketplace Rule 4200(a)(15) and SEC Rule 10A-3(b)(1). Mr. Segev’s term
      on the Board and Audit Committee will expire in March 2008. At that time, it
      is
      expected that Mr. Yair Shamir will replace Mr. Segev as a Board member and
      audit
      committee financial expert.




**Item
      16B. Code of Ethics.**




The
      Company, by way of Board of Directors resolution, has adopted a Code of Ethics
      applicable to its senior financial officers, including its principal executive,
      financial and accounting officers. The Code of Ethics is posted on the Company’s
      website at **www.commtouch.com** ,
      under
      the link to “investor relations”.




**Item
      16C. Principal Accountant Fees and Services.**




Kost,
      Forer, Gabbay & Kasierer, a member of Ernst & Young Global, has served
      as our Independent Registered Public Accounting Firm for each of the fiscal
      years in the three-year period ended December 31, 2007, for which audited
      financial statements appear in this annual report on Form 20-F. The following
      table presents the aggregate fees for professional and other services rendered
      by Kost, Forer, Gabbay & Kasierer for 2007 and 2006:




**Year
                  ended December 31,****2007**
              
              **2006****Fees**
              
              **Fees**Audit
                  fees (1)
              
              $
              107,000
              
              $
              92,000Tax
                  and other (2)
              
              $
              72,500
              
              $
              88,500**Total**
              
              **$**
              **179,500**
              
              **$**
              **180,500**





(1)
      Audit
      fees consist of fees billed for the annual audit services engagement and other
      audit services, which are those services that only the Independent Registered
      Public Accounting Firm can reasonably provide, and include the group audit
      including checking our internal control over Financial reporting; statutory
      audits; consents; attest services; and assistance in connection with documents
      filed with the SEC. These **** fees
      also
      include the attestation of our internal control over financial
      reporting





**** (2)
      Tax
      fees include fees billed for tax compliance services, including the preparation
      of original and amended tax returns and claims for refund; tax consultations,
      such as assistance and representation in connection with tax audits and appeals,
      transfer pricing, and requests for rulings or technical advice from taxing
      authority; and tax planning services.





*Audit
      Committee Pre-approval Policies and Procedures*





Below
      is
      a summary of our current Policies and Procedures:




The
      main
      role of the Company’s audit committee is to assist the Board of Directors in
      fulfilling its responsibility for oversight of the quality and integrity of
      the
      accounting, auditing and reporting practices of the Company. The Audit Committee
      oversees the appointment, compensation, and oversight of the Company’s
      independent registered public accounting firm engaged to prepare or issue an
      audit report on the financial statements of the Company. The audit committee’s
      specific responsibilities in carrying out its oversight role include the
      approval of all audit and non-audit services to be provided by the external
      auditor and the quarterly review of the firm’s non-audit services and related
      fees. These services may include audit services, audit-related services, tax
      services and other services, as described above. It is the policy of the audit
      committee to approve in advance the particular services or categories of
      services to be provided to the Company periodically. Additional services may
      be
      pre-approved by the audit committee on an individual basis during the year. The
      audit
      committee did not avail itself of section (c)(7)(i)(C) of Rule 2-01 of
      Regulation S-X during 2007, which allows for an exemption from the pre-approval
      process under certain limited circumstances.




48


**Item
      16D** . **Exemptions
      from the Listing Standards for Audit Committees.**





Not
      applicable.





**Item
      16E** . **Purchases
      of Equity Securities by the Issuer and Affiliated
      Purchasers.**





Not
      applicable.


49




**PART
      III**




**Item
      17. Financial Statements.**




The
      Company has responded to Item 18




**Item
      18. Financial Statements.**




(a)
      Financial Statements





PageReports
                of Independent Registered Public Accounting Firm
            F-2Consolidated
                Balance Sheets
            F-4Consolidated
                Statements of Operations
            F-6Statement
                of Changes in Shareholders’ Equity
            F-7Consolidated
                Statements of Cash Flows
            F-10Notes
                to Consolidated Financial Statements
            F-12




(b)
      Financial Statement Schedule:




Schedules
      have been omitted because the information required to be set forth therein
      is
      not applicable or is shown in the consolidated financial statements or notes
      thereto.




50




**COMMTOUCH
        SOFTWARE LTD. AND ITS SUBSIDIARY**
 
 **CONSOLIDATED
        FINANCIAL STATEMENTS**
 
 **AS
        OF DECEMBER 31, 2007**
 
 **U.S.
        DOLLARS IN THOUSANDS**
  
 **INDEX**
 **Page****Reports****of Independent Registered Public Accounting Firm**
                
                
                **2
                    - 3****Consolidated
                    Balance Sheets**
                
                
                **4
                    - 5****Consolidated
                    Statements of Operations**
                
                
                **6****Statements
                    of Changes in Shareholders' Equity**
                
                
                **7
                    - 9****Consolidated
                    Statements of Cash Flows**
                
                
                **10
                    - 11****Notes
                    to Consolidated Financial Statements**
                
                
                **12
                    - 29**
 
 
 F-1
 
 Ernst
 **REPORT
          OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 **To
          the Board of Directors and Shareholders of**
 
 **COMMTOUCH
          SOFTWARE LTD.**
 
 
 We
          have
          audited the accompanying consolidated balance sheets of Commtouch Software
          Ltd.
          ("the Company") and its subsidiary as of December 31, 2006 and 2007, and
          the
          related consolidated statements of operations, changes in shareholders'
          equity
          and cash flows for each of the three years in the period ended December
          31,
          2007. These financial statements are the responsibility of the Company's
          management. Our responsibility is to express an opinion on these 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 evaluating
          the overall financial statement 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 consolidated financial position of the Company
          and
          its subsidiary as of December 31, 2006 and 2007, and the consolidated results
          of
          their operations and their cash flows for each of the three years in the
          period
          ended December 31, 2007, in conformity with U.S. generally accepted
          accounting principles.
 
 As
          discussed in Note 2 to the consolidated financial statements, in 2006 the
          Company adopted Statement of Financial Accounting Standards Board No. 123
          (R),
          "Share-Based Payment".
 
 We
          also
          have audited, in accordance with the standards of the Public Company Accounting
          Oversight Board (United States), the Company and its subsidiary's internal
          control over financial reporting as of December 31, 2007, based on criteria
          established in Internal Control-Integrated Framework issued by the Committee
          of
          Sponsoring Organizations of the Treadway Commission and our report dated
          March
          31, 2008 expressed an unqualified opinion thereon.
 
 
 Tel-Aviv,
                    Israel
                KOST
                    FORER GABBAY & KASIERERMarch
                    31, 2008
                A
                    Member of Ernst & Young Global
 F-2
 
 Ernst
 
 **REPORT
          OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 **To
          the Board of Directors and Shareholders of**
 
 **COMMTOUCH
          SOFTWARE LTD.**
 
 
 We
          have
          audited Commtouch Software Ltd.'s and
          its
          subsidiary("Commtouch" or the "Company") internal control over financial
          reporting as of December 31, 2007, based on criteria established in Internal
          Control-Integrated Framework issued by the Committee of Sponsoring Organizations
          of the Treadway Commission (the "COSO criteria"). Commtouch's management
          is
          responsible for maintaining effective internal control over financial reporting
          and for its assessment of the effectiveness of internal control over financial
          reporting. Our responsibility is to express an opinion on the Company's
          internal
          control over financial reporting based on our audit.
 
 We
          conducted our audit 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 effective
          internal control over financial reporting was maintained in all material
          respects. Our audit included obtaining an understanding of internal control
          over
          financial reporting, assessing the risk that a material weakness exists,
          testing
          and evaluating the design and operating effectiveness of internal control
          based
          on the assessed risk, and performing such other procedures as we considered
          necessary in the circumstances. We believe that our audit provides a reasonable
          basis for our opinion.
 
 A
          company's internal control over financial reporting is a process designed
          to
          provide reasonable assurance regarding the reliability of financial reporting
          and the preparation of financial statements for external purposes in accordance
          with generally accepted accounting principles. A company's internal control
          over
          financial reporting includes those policies and procedures that (1) pertain
          to
          the maintenance of records that, in reasonable detail, accurately and fairly
          reflect the transactions and dispositions of the assets of the company;
          (2)
          provide reasonable assurance that transactions are recorded as necessary
          to
          permit preparation of financial statements in accordance with generally
          accepted
          accounting principles, and that receipts and expenditures of the company
          are
          being made only in accordance with authorizations of management and directors
          of
          the company; and (3) provide reasonable assurance regarding prevention
          or timely
          detection of unauthorized acquisition, use, or disposition of the company's
          assets that could have a material effect on the financial
          statements.
 
 Because
          of its inherent limitations, internal control over financial reporting
          may not
          prevent or detect misstatements. Also, projections of any evaluation of
          effectiveness to future periods are subject to the risk that controls may
          become
          inadequate because of changes in conditions, or that the degree of compliance
          with the policies or procedures may deteriorate.
 
 In
          our
          opinion, Commtouch maintained in all material respects, effective internal
          control over financial reporting as of December 31, 2007, based on the
          COSO
          criteria.
 
 We
          also
          have audited, in accordance with the standards of the Public Company Accounting
          Oversight Board (United States), the consolidated balance sheets of Commtouch
          and its subsidiary as of December 31, 2006 and 2007, and the related
          consolidated statements of operations, changes in shareholders' equity
          and cash
          flows for each of the three years in the period ended December 31, 2007 and
          our report dated March 31 ,2008 expressed an unqualified opinion
          thereon.
 
 
 Tel-Aviv,
                    Israel
                KOST
                    FORER GABBAY & KASIERERMarch
                    31, 2008
                A
                    Member of Ernst & Young
                    Global
 F-3
 
 **COMMTOUCH
          SOFTWARE LTD. AND ITS SUBSIDIARY**
  **CONSOLIDATED
        BALANCE SHEETS**
 
 U.S.
        dollars in thousands
 **December
                    31****2006**
                
                **2007**ASSETSCURRENT
                    ASSETS:Cash
                    and cash equivalents
                
                $
                8,004
                
                $
                10,807Short-term
                    cash deposit
                
                
                -
                
                
                1,600Marketable
                    securities
                
                
                2,000
                
                
                2,000Trade
                    receivables
                
                
                570
                
                
                1,110Prepaid
                    expenses
                
                
                134
                
                
                193Other
                    accounts receivable
                
                
                62
                
                
                110Total
                    current assets
                
                
                10,770
                
                
                15,820LONG-TERM
                    ASSETS:Long-term
                    lease deposits
                
                
                13
                
                
                33Investment
                    in affiliate
                
                
                -
                
                
                750Severance
                    pay fund
                
                
                607
                
                
                821Property
                    and equipment, net
                
                
                609
                
                
                786Total
                    long-term assets
                
                
                1,229
                
                
                2,390Total
                    assets
                
                $
                11,999
                
                $
                18,210
 
 The
          accompanying notes are an integral part of the consolidated financial
          statements.
 F-4
 **COMMTOUCH
          SOFTWARE LTD. AND ITS SUBSIDIARY**
 **CONSOLIDATED
        BALANCE SHEETS**
 U.S.
        dollars in thousands,
        except
        share and per share data
 **December
                    31****2006**
                
                **2007**LIABILITIES
                    AND SHAREHOLDERS' EQUITYCURRENT
                    LIABILITIES:Accounts
                    payable
                
                $
                344
                
                $
                335Employees
                    and payroll accruals
                
                
                503
                
                
                746Accrued
                    expenses and other liabilities
                
                
                187
                
                
                351Government
                    authorities
                
                
                192
                
                
                64Deferred
                    revenues
                
                
                2,032
                
                
                2,534Total
                    current liabilities
                
                
                3,258
                
                
                4,030LONG-TERM
                    LIABILITIES:Long-term
                    deferred revenues
                
                
                542
                
                
                901Accrued
                    severance pay
                
                
                706
                
                
                931Total
                    long-term liabilities
                
                
                1,248
                
                
                1,832COMMITMENTS
                    AND CONTINGENCIESSHAREHOLDERS'
                    EQUITY:Ordinary
                    shares nominal value NIS 0.15 par value-Authorized:
                    55,353,340 shares as of December 31, 2006 and 2007, respectively;
                    Issued
                    and outstanding: 24,011,155 and 25,346,042 shares as of December 31,
                    2006 and 2007, respectively
                
                
                845
                
                
                893Additional
                    paid-in capital
                
                
                177,095
                
                
                179,793Accumulated
                    other comprehensive income
                
                
                23
                
                
                23Accumulated
                    deficit
                
                
                (170,470
                )
                
                (168,361
                )Total
                    shareholders' equity
                
                
                7,493
                
                
                12,348Total
                    liabilities and shareholders' equity
                
                $
                11,999
                
                $
                18,210
 The
          accompanying notes are an integral part of the consolidated financial
          statements.
  F-5
 **COMMTOUCH
          SOFTWARE LTD. AND ITS SUBSIDIARY**
  **CONSOLIDATED
          STATEMENTS OF OPERATIONS**
 
 ,
          except
          share and per share data
 
 **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Revenues
                
                $
                3,925
                
                $
                7,234
                
                $
                11,250Cost
                    of revenues
                
                
                700
                
                
                901
                
                
                1,411Gross
                    profit
                
                
                3,225
                
                
                6,333
                
                
                9,839Operating
                    expenses:Research
                    and development
                
                
                1,524
                
                
                1,763
                
                
                2,187Sales
                    and marketing
                
                
                2,476
                
                
                2,686
                
                
                3,453General
                    and administrative
                
                
                1,881
                
                
                2,299
                
                
                2,589Total
                    operating expenses
                
                
                5,881
                
                
                6,748
                
                
                8,229Operating
                    income (loss)
                
                
                (2,656
                )
                
                (415
                )
                
                1,610Financial
                    income (expenses), net
                
                
                141
                
                
                274
                
                
                527Equity
                    in losses of affiliate
                
                
                (175
                )
                
                (49
                )
                
                -Net
                    income (loss) before taxes on income
                
                
                (2,690
                )
                
                (190
                )
                
                2,137Taxes
                    on income
                
                
                -
                
                
                -
                
                
                28Amortization
                    of beneficial conversion feature relating to convertible Series
                    A
                    Preferred shares
                
                
                (1,751
                )
                
                -
                
                
                -Net
                    income (loss) attributable to Ordinary and equivalently participating
                    shareholders
                
                $
                (4,441
                )
                $
                (190
                )
                $
                2,109Basic
                    and diluted net earnings (loss) per share
                
                $
                (0.28
                )
                $
                (0.01
                )
                $
                0.08Weighted
                    average number of shares used in computing basic net earnings
                    (loss) per
                    share
                
                
                15,801,945
                
                
                22,112,944
                
                
                24,846,690Weighted
                    average numbers of shares used in computing diluted net earnings
                    (loss)
                    per share
                
                
                15,801,945
                
                
                22,112,994
                
                
                27,591,498
  
 
 The
          accompanying notes are an integral part of these consolidated financial
          statements.
 F-6
 **COMMTOUCH
              SOFTWARE LTD. AND ITS SUBSIDIARY**
 **STATEMENT** **S
          OF CHANGES IN SHAREHOLDERS' EQUITY**
 
 ,
          except
          share data
  
 **Series
                    A Preferred shares**
                
                **Series
                    A Preferred shares amount**
                
                **Ordinary
                    shares**
                
                **Ordinary
                    shares amount**
                
                **Additional
                    paid-in capital**
                
                **Accumulated
                    other comprehensive income**
                
                **Accumulated
                    deficit**
                
                **Total
                    comprehensive loss**
                
                **Total**Balance
                    as of January 1, 2005
                
                
                2,426,667
                
                $
                83
                
                
                14,262,608
                
                $
                520
                
                $
                167,784
                
                $
                45
                
                $
                (165,839
                )
                
                
                
                $
                2,593Issuance
                    of shares and warrants, net
                
                
                -
                
                
                -
                
                
                2,000,000
                
                
                65
                
                
                2,857
                
                
                -
                
                
                -
                
                
                
                
                
                2,922Issuance
                    of shares upon exercise of options and warrants
                
                
                -
                
                
                -
                
                
                1,232,723
                
                
                43
                
                
                1,263
                
                
                -
                
                
                -
                
                
                
                
                
                1,306Conversion
                    of Series A Preferred shares to Ordinary shares
                
                
                (650,000
                )
                
                (22
                )
                
                1,133,333
                
                
                36
                
                
                (14
                )
                
                -
                
                
                -
                
                
                
                
                
                -Amortization
                    of beneficial conversion feature relating to Convertible Series
                    A
                    Preferred Shares
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                1,751
                
                
                -
                
                
                (1,751
                )
                
                
                
                
                -Stock-based
                    compensation related to options granted to non-employees
                
                
                
                
                
                
                
                
                -
                
                
                -
                
                
                92
                
                
                -
                
                
                -
                
                
                
                
                
                92Foreign
                    currency translation adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (24
                )
                
                -
                
                $
                (24
                )
                
                (24
                )Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (2,690
                )
                
                (2,690
                )
                
                (2,690
                )Total
                    comprehensive loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                (2,714
                )Balance
                    as of December 31, 2005
                
                
                1,776,667
                
                $
                61
                
                
                18,628,664
                
                $
                664
                
                $
                173,733
                
                $
                21
                
                $
                (170,280
                )
                
                
                
                $
                4,199
 
 
 The
          accompanying notes are an integral part of the consolidated financial
          statements.
  F-7
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
 **STATEMENTS
          OF CHANGES IN SHAREHOLDERS' EQUITY**
 ,
          except
          share data
 
 **Series
                    A Preferred shares**
                
                **Series
                    A Preferred shares amount**
                
                **Ordinary
                    shares**
                
                **Ordinary
                    shares amount**
                
                **Additional
                    paid-in capital**
                
                **Accumulated
                    other comprehensive income**
                
                **Accumulated
                    deficit**
                
                **Total
                    comprehensive loss**
                
                **Total**Balance
                    as of January 1, 2006
                
                1,776,667
                
                $61
                
                18,628,664
                
                $664
                
                $173,733
                
                $21
                
                $(170,280)
                
                
                
                $4,199Issuance
                    of shares
                
                -
                
                -
                
                31,153
                
                1
                
                99
                
                -
                
                -
                
                
                
                100Issuance
                    of shares upon exercise of options and warrants
                
                -
                
                -
                
                1,798,005
                
                58
                
                2,379
                
                -
                
                -
                
                
                
                2,437Conversion
                    of Series A Preferred shares to Ordinary Shares
                
                (1,776,667)
                
                (61)
                
                3,553,333
                
                122
                
                (61)
                
                -
                
                -
                
                
                
                -Stock-based
                    compensation related to employees
                
                -
                
                -
                
                -
                
                -
                
                790
                
                -
                
                -
                
                
                
                790Stock-based
                    compensation related to options granted to non-employees
                
                -
                
                -
                
                -
                
                -
                
                155
                
                -
                
                -
                
                
                
                155Foreign
                    currency translation adjustment
                
                -
                
                -
                
                -
                
                -
                
                -
                
                2
                
                -
                
                $2
                
                2Net
                    loss
                
                -
                
                -
                
                -
                
                -
                
                -
                
                -
                
                (190)
                
                (190)
                
                (190)Total
                    comprehensive loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $(188)Balance
                    as of December 31, 2006
                
                -
                
                $-
                
                24,011,155
                
                $845
                
                $177,095
                
                $23
                
                $(170,470)
                
                
                
                $7,493
 
 
 The
          accompanying notes are an integral part of the consolidated financial
          statements.
  F-8
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
 **STATEMENTS
          OF CHANGES IN SHAREHOLDERS' EQUITY**
 
 ,
          except
          share data
  **Ordinary
                      shares**
                  
                  **Ordinary
                      shares amount**
                  
                  **Additional
                      paid-in capital**
                  
                  **Accumulated
                      other comprehensive income *)**
                  
                  **Accumulated
                      deficit**
                  
                  **Total
                      comprehensive income**
                  
                  **Total**Balance
                      as of January 1, 2007
                  
                  
                  24,011,155
                  
                  $
                  845
                  
                  $
                  177,095
                  
                  $
                  23
                  
                  $
                  (170,470
                  )
                  $
                  -
                  
                  $
                  7,493Issuance
                      of shares upon exercise of options and warrants
                  
                  
                  1,334,887
                  
                  
                  48
                  
                  
                  1,615
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,663Stock-based
                      compensation related to employees
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,015
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,015Stock-based
                      compensation related to options granted to non-employees
                  
                  
                  -
                  
                  
                  -
                  
                  
                  68
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  68Net
                      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2,109
                  
                  $
                  2,109
                  
                  
                  2,109Total
                      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  2,109Balance
                      as of December 31, 2007
                  
                  
                  25,346,042
                  
                  $
                  893
                  
                  $
                  179,793
                  
                  $
                  23
                  
                  $
                  (168,361
                  )
                  
                  
                  
                  $
                  12,348
 
 *)
                Relates
                    to foreign currency translation adjustments
 
 The
          accompanying notes are an integral part of the consolidated financial
          statements.
 F-9
 **COMMTOUCH
              SOFTWARE LTD. AND ITS SUBSIDIARY**
 **CONSOLIDATED
              STATEMENTS OF CASH FLOWS**
 
   **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Cash
                    flows from operating activities:Net
                    income (loss)
                
                $
                (4,441
                )
                $
                (190
                )
                $
                2,109Adjustments
                    to reconcile net income (loss) to net cash provided by (used
                    in) operating
                    activities:Depreciation
                    and amortization
                
                
                147
                
                
                209
                
                
                397Amortization
                    of convertible loan discount and beneficial conversion feature
                
                
                1,751
                
                
                -
                
                
                -Compensation
                    related to options granted to employees and non-employees
                
                
                92
                
                
                945
                
                
                1,083Equity
                    in losses of affiliate
                
                
                175
                
                
                49
                
                
                -Changes
                    in assets and liabilities:Increase
                    in trade receivables
                
                
                (258
                )
                
                (215
                )
                
                (540
                )Increase
                    in prepaid expenses and other accounts receivable
                
                
                (21
                )
                
                (28
                )
                
                (107
                )Increase
                    (decrease) in accounts payable
                
                
                76
                
                
                (40
                )
                
                24Increase
                    (decrease) in employees and payroll accruals, accrued expenses
                    and other
                    liabilities and Government authorities
                
                
                41
                
                
                (37
                )
                
                279Increase
                    in deferred revenues
                
                
                719
                
                
                655
                
                
                861Increase
                    in accrued severance pay, net
                
                
                11
                
                
                8
                
                
                11Other
                
                
                (7
                )
                
                -
                
                
                (2
                )Net
                    cash provided by (used in) operating activities
                
                
                (1,715
                )
                
                1,356
                
                
                4,115Cash
                    flows from investing activities:Change
                    in short-term cash deposit
                
                
                -
                
                
                -
                
                
                (1,600
                )Decrease
                    (increase) in long-term lease deposits
                
                
                -
                
                
                5
                
                
                (20
                )Purchase
                    of marketable securities
                
                
                (2,500
                )
                
                -
                
                
                -Sale
                    of marketable securities
                
                
                -
                
                
                500
                
                
                -Investment
                    in affiliate
                
                
                -
                
                
                -
                
                
                (750
                )Purchase
                    of property and equipment
                
                
                (176
                )
                
                (380
                )
                
                (605
                )Net
                    cash provided by (used in) investing activities
                
                
                (2,676
                )
                
                125
                
                
                (2,975
                )Cash
                    flows from financing activities:Proceeds
                    from issuance of shares and warrants, net
                
                
                2,922
                
                
                100
                
                
                -Proceeds
                    from options and warrants exercised
                
                
                1,306
                
                
                2,437
                
                
                1,663Net
                    cash provided by financing activities
                
                
                4,228
                
                
                2,537
                
                
                1,663Increase
                    (decrease) in cash and cash equivalents
                
                
                (163
                )
                
                4,018
                
                
                2,803Cash
                    and cash equivalents at the beginning of the year
                
                
                4,149
                
                
                3,986
                
                
                8,004Cash
                    and cash equivalents at the end of the year
                
                $
                3,986
                
                $
                8,004
                
                $
                10,807
 
 The
          accompanying notes are an integral part of the consolidated financial
          statements.
  F-10
 **COMMTOUCH
          SOFTWARE LTD. AND ITS SUBSIDIARY**
  **CONSOLIDATED
          STATEMENTS OF CASH FLOWS**
 
 
 **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**(a)
                
                
                Non-cash
                    transactions:Amortization
                    of beneficial conversion feature relating to convertible Series
                    A
                    Preferred Shares
                
                $
                (1,751
                )
                $
                -
                
                $
                -Conversion
                    of Series A Preferred shares to Ordinary shares
                
                $
                36
                
                $
                122
                
                $
                -Purchase
                    of property and equipment - trade payables
                
                $
                -
                
                $
                (33
                )
                $
                65
 
 F-11
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
          except share and per share data**
 
 **NOTE
                    1:**
                **GENERAL**
 
 a.
                Commtouch
                    Software Ltd. ("Commtouch" or the Company") was incorporated
                    under the
                    laws of Israel in 1991. The Company and its subsidiary (Commtouch
                    Inc.)
                    develop and provide email defense solutions to OEM licensees
                    and
                    enterprises. During 2005, 2006 and 2007, the Company's business
                    was to
                    develop and sell, through a variety of third party distribution
                    channels,
                    email defense solutions to various customers. The Company's email
                    defense
                    solutions are comprised of anti-spam, Zero-Hour anti-virus and
                    GlobalView
                    Mail Reputation solutions.
 
 b.
                During
                    the second half of 2003, the Company launched its first anti-spam
                    solution, and began generating revenues therefrom. During 2004,
                    the
                    Company launched its Zero Hour solution, and began recognizing
                    revenues
                    from this product. During 2005, the Company also began to recognize
                    revenues from its patent licensing program. These revenues were
                    not
                    significant during 2006 and 2007. In late 2006, the Company launched
                    itsGlobalViewReputation
                    Services.
 
 c.
                The
                    Company expects that it will continue to be dependent upon third
                    party
                    distribution channels for a significant portion of its revenues,
                    which are
                    expected to be derived from sales of the Company's anti-spam,
                    anti-virus
                    solutions and reputation services. See Note 7c for Company's
                    major
                    customer.
 
 d.
                Subsequent
                    to balance sheet date, the Company consummated a 3:1 revenue
                    stock split
                    of the Company's share capital, see Note
                    5a.
 
 
 **NOTE
                    2:**
                **SIGNIFICANT
                    ACCOUNTING POLICIES**
 
 The
          consolidated financial statements have been prepared in accordance with
          accounting principles generally accepted in the United States ("U.S.
          GAAP").
 
 a.
                Use
                    of estimates:
 
 The
          preparation of consolidated financial statements in conformity with generally
          accepted accounting principles requires management to make estimates and
          assumptions that affect the amounts reported in the consolidated financial
          statements and accompanying notes. Actual results could differ from those
          estimates.
 
 b.
                Financial
                    statements in U. S. dollars:
 
 A
          majority of the revenues of the Company and its subsidiary is generated
          in
          United States dollars ("dollars"). In addition, a substantial portion of
          their
          costs is incurred or determined in dollars. The Company's management believes
          that the dollar is the currency of the primary economic environment in
          which the
          Company and its subsidiary operate. Thus, the dollar is their functional
          and
          reporting currency. Accordingly, monetary accounts maintained in currencies
          other than the dollar are remeasured into U.S. dollars, in accordance with
          Statement of Financial Accounting Standard ("SFAS") No. 52, "Foreign Currency
          Translation" ("SFAS No. 52"). All transaction gains and losses of the remeasured
          monetary balance sheet items are reflected in the statements of operations
          as
          financial income or expenses, as appropriate.
  F-12
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
          except share and per share data**
 
 **NOTE
                    2:**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 The
          financial statements of the Company's affiliate, Imatrix Inc. ("Imatrix"),
          are
          reported using the equity method of accounting for
          the
          year ended December 31, 2007. Imatrix's functional currency is not the
          dollar. The results have been translated into dollars in accordance with
          SFAS
          No. 52. The resulting aggregate translation adjustments are reported as
          foreign
          currency translation adjustment under accumulated other comprehensive income
          (loss) in shareholders' equity.
 
 c.
                Principles
                    of consolidation:
 
 The
          consolidated financial statements include the accounts of the Company and
          its
          wholly-owned subsidiary. All inter-company balances and transactions have
          been
          eliminated upon consolidation.
 
 d.
                Cash
                    and cash equivalents:
 
 Cash
                    equivalents are short-term highly liquid investments that are
                    readily
                    convertible to cash with original maturities of three months
                    or less when
                    purchased.
 
 e.
                Marketable
                    securities:
 
 In
                    accordance with SFAS No. 115, "Accounting for Certain Investments
                    in Debt
                    and Equity Securities"("SFAS No. 115"), the Company has classified
                    its
                    marketable securities as available-for-sale. The marketable securities
                    that are held for the short-term and available for immediate
                    sale are
                    stated at quoted market prices at balance sheet date. The Company's
                    marketable securities consist of highly-rated auction rate (AAA)
                    securities ("ARS") which are federal backed student loan securities.
                    These
                    ARS may be liquidated at par value on the rate reset date, which
                    is
                    generally 30 days. Available-for-sale securities are carried
                    at fair
                    value, with the unrealized gains and losses, reported in "accumulated
                    other comprehensive income (loss)" in shareholders' equity. The
                    effective
                    maturity may differ from the contractual maturities, due to the
                    periodical
                    auction mechanism. Subsequent to balance sheet date, commencing
                    February
                    2008, the ARS (comprised of five securities) suffered from failed
                    auctions. Since the failed auctions only commenced in February
                    2008, there
                    is no effect on such securities as of December 31,
                    2007.
 
 f.
                Investment
                    in affiliate:
 
 For
          the
          purposes of these financial statements, an affiliated company is a company
          held
          to the extent of 20% or more, or a company less than 20% held, in which
          the
          Company can exercise significant influence over operating and financial
          policy
          of the affiliate. For the year ended December 31, 2007, 2006 and 2005,
          the
          investment in an affiliated company (Imatrix) is accounted for under the
          equity
          method in accordance with APB 18, "The Equity Method of Accounting for
          Investments in Common Stock". Profits on inter-company sales not realized
          outside the group were eliminated.
 
 As
          of
          December 31, 2007, the Company lacks the ability to exercise significant
          influence over operating and financial policies of Imatrix and, accordingly,
          the
          investment is accounted for on a cost basis.
  F-13
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 
 **NOTE
                    2:**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 The
          carrying amount of the investment in Imatrix as of December 31, 2006 and
          2007 is
          zero. During the year 2006, the Company recognized losses in respect of
          Imatrix
          up to the carrying amount of its investment as of December 31, 2006.
 
 In
          November 2007, the Company made a $ 750 cash investment in Mirapoint Inc.
          ("Mirapoint"), a secure messaging vendor and an OEM licensee. The investment
          (8%) in an affiliated company is accounted for under the cost method since
          the
          Company cannot exercise significant influence over the operating and financial
          policies of Mirapoint.
 
 The
          Company's investments are reviewed for impairment whenever events or changes
          in
          circumstances indicate that the carrying amount of an investment may not
          be
          recoverable. As of December 31, 2007, no impairment losses have been
          identified.
 
 g.
                Property
                    and equipment:
 
 Property
          and equipment are stated at cost net of accumulated depreciation. Depreciation
          is calculated using the straight line method over the estimated useful
          lives of
          the assets at the following annual rates:
 
 %Computers
                    and peripheral equipment
                
                33.33Office
                    furniture and equipment
                
                7
                    -
                    20Motor
                    vehicles
                
                15Leasehold
                    improvements
                
                Over
                    the shorter of the term of the lease or the life of the
                    assets
 
 h.
                Impairment
                    of long-lived assets:
 
 The
          Company and its subsidiary's long-lived assets 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. Recoverability of assets to
          be held
          and used is measured by a comparison of the carrying amount of an asset
          to the
          future undiscounted cash flows expected to be generated by the assets.
          If such
          assets are considered to be impaired, the impairment to be recognized is
          measured by the amount by which the carrying amount of the assets exceeds
          the
          fair value of the assets. Assets to be disposed of are reported at the
          lower of
          the carrying amount or fair value less costs to sell. No impairment losses
          were
          recorded in 2005 through 2007.
 
 i.
                Revenue
                    recognition:
 
 The
            company derives revenues from Anti-Spam, Zero-HourTM Virus Outbreak Protection
            and GlobalView Mail Reputation Services.
  F-14
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
  **NOTE
                    2:**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 Therefore,
            revenues from such services are recognized over the service term, which
            generally includes a term period of one year to three years.
 Revenue
          is recognized in accordance with Staff Accounting Bulletin ("SAB") No.
          104,
          "Revenue Recognition", when the earnings process is complete, as evidenced
          by an
          agreement between the customer and the Company, when delivery has occurred
          or
          services have been rendered, when the fee is fixed or determinable and
          when
          collectibility is probable.
 
 j.
                Research
                    and development costs:
 
 Statement
          of Financial Accounting Standards ("SFAS") No. 86, "Accounting for the
          Costs of
          Computer Software to be Sold, Leased or Otherwise Marketed", requires
          capitalization of certain software development costs subsequent to the
          establishment of technological feasibility.
  Based
          on
          the Company's product development process, technological feasibility is
          established upon completion of a working model. Costs incurred by the Company
          between completion of the working models and the point at which the products
          are
          ready for general release have been insignificant. Therefore, all research
          and
          development costs have been expensed.
 
 k.
                Concentrations
                    of credit risk:
 
 SFAS
          No.
          105, "Disclosure of Information About Financial Instruments with
          off-Balance-Sheet Risk and Financial Instruments with Concentration of
          Credit
          Risk" requires disclosure of any significant off balance sheet and credit
          risk
          concentrations. The Company and its subsidiary have no significant
          off-balance-sheet concentration of credit risk such as foreign exchange
          contracts, option contracts or other foreign hedging arrangements.
 
 Financial
          instruments that potentially subject the Company to concentrations of credit
          risk consist principally of trade receivables, marketable securities and
          cash
          and cash equivalents. The majority of the Company's cash and cash equivalents
          are invested in dollars and dollar linked investments and are deposited
          in major
          banks in the United States and Israel. Such investments in the United States
          may
          be in excess of insured limits and are not insured in other jurisdictions.
          Management believes that the financial institutions that hold the Company's
          investments are financially sound and, accordingly, minimal credit risk
          exists
          with respect to these investments.
 
 Marketable
          securities of the Company represent short-term municipal auction rate securities
          which are purchased at Par (100) and are valued at Par (100) as at December
          31,
          2007. They are all invested in triple A rating securities. Such investments
          in
          the United States may be in excess of insured limits and are not insured
          in
          other jurisdictions. Management believes that the financial institutions
          that
          hold the Company's investments are financially sound and, accordingly,
          minimal
          credit risk exists with respect to these investments.
 
 The
          trade
          receivables of the Company are derived from transactions with companies
          located
          primarily in North America, Europe, Israel and Asia. An allowance for doubtful
          accounts is determined with respect to those amounts that the Company and
          its
          subsidiary have determined to be doubtful of collection. The allowance
          for
          doubtful accounts was zero as at December 31, 2006 and 2007. Bad debt expense
          (recovery) for the years ended December 31, 2005, 2006 and 2007 was $ (6),
          $ 0 and $ 0, respectively.
  F-15
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 
 **NOTE
                    2:**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 l.
                Accounting
                    for stock-based compensation:
 
 On
          January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), "Share-Based
          Payment" ("SFAS No. 123(R)") which requires the measurement and recognition
          of
          compensation expense based on estimated fair values for all share-based
          payment
          awards made to employees and directors. SFAS No. 123(R) supersedes Accounting
          Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees"
          ("APB No. 25"), for periods beginning in fiscal year 2006. In March 2005,
          the
          Securities and Exchange Commission issued Staff Accounting Bulletin No.
          107
          ("SAB 107") relating to SFAS No. 123(R). The Company has applied the provisions
          of SAB 107 in its adoption of SFAS No. 123(R). SFAS No. 123(R) requires
          companies to estimate the fair value of equity-based payment awards on
          the date
          of grant using an option-pricing model. The value of the portion of the
          award
          that is ultimately expected to vest is recognized as an expense over the
          requisite service periods in the Company's consolidated income statement.
 
 At
          December 31, 2007, the Company has three active stock-based employee
          compensation plans, which are described more fully in Note 5. Prior to
          January
          1, 2006, the Company accounted for those plans under the recognition and
          measurement provisions of APB No. 25, "Accounting for Stock Issued to Employees"
          ("Opinion 25"), and related interpretations, as permitted by FASB Statement
          No.
          123, "Accounting for Stock-Based Compensation". During
          all years up through December 31, 2005, the Company recognized stock-based
          compensation expenses in the amount of zero.
 
 Effective
          January 1, 2006, the Company adopted the fair value recognition provisions
          of
          SFAS No. 123(R), "Share-Based Payment", using the
          modified-prospective-transition method. Under that transition method,
          compensation cost recognized during 2006 includes: (a) compensation cost
          for all
          share-based payments granted prior to, but not yet vested as of January 1,
          2006, based on the grant date fair value estimated in accordance with the
          original provisions of SFAS 123, and (b) compensation cost for all share-based
          payments granted subsequent to January 1, 2006, based on the grant-date
          fair value estimated in accordance with the provisions of Statement 123(R).
          Results for prior periods have not been restated.
 
 As
          a
          result of adopting SFAS No. 123(R) on January 1, 2006, the Company's net
          loss
          for the year ended December 31, 2006, is $ 790 higher than if it had
          continued to account for share- based compensation under Opinion 25. Basic
          and
          diluted loss per share for the year ended December 31, 2006, is $ 0.03
          higher than if the Company had continued to account for share-based compensation
          under Opinion 25.
 
 The
          Company estimates the fair value of stock options granted using the
          Black-Scholes- option pricing model. The option-pricing model requires
          a number
          of assumptions, of which the most significant are the expected stock price
          volatility and the expected option term. Expected volatility was calculated
          based upon actual historical stock price movements. The expected term of
          options
          granted is based on the simplified method, which is the mid-point between
          the
          vesting date and the end of the option contractual term. The risk-free
          interest
          rate is based on the yield from U.S. treasury bonds with an equivalent
          term. The
          Company has historically not paid dividends and has no foreseeable plans
          to pay
          dividends. The Company recognizes the related expenses over the vesting
          period
          using the straight line method.
  F-16
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 
 **NOTE
                    2:**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 The
          fair
          value for options granted in 2005, 2006 and 2007 is estimated at the date
          of
          grant using a Black-Scholes options pricing model with the following weighted
          average assumptions:
 
 **Year
                    ended December 31,****Employee
                    stock options**
                
                **2005**
                
                **2006**
                
                **2007**Volatility
                
                
                91
                %
                
                70
                %
                
                70
                %Risk-free
                    interest rate
                
                
                4.18
                %
                
                4.35%-4.85
                %
                
                3.76%-4.94
                %Dividend
                    yield
                
                
                0
                %
                
                0
                %
                
                0
                %Expected
                    life (years)
                
                
                4
                
                
                4.08
                
                
                4.08
 
 The
          following table illustrates the effect on 2005 net loss and loss per share
          if
          the Company had applied the fair value recognition provisions of Statement
          123
          to options granted under the Company's stock option plans in all periods.
          For
          purposes of this pro forma disclosure, the value of the options is estimated
          using a Black-Scholes option-pricing formula and amortized to expense over
          the
          options' vesting periods**.**
 
 Pro
          forma
          information under SFAS
          No. 123
          is as
          follows:
 
 **December
                    31,****2005**Net
                    loss as reported
                
                $
                (4,441
                )Add
                    - stock-based employee compensation - intrinsic value
                
                
                -Deduct
                    - stock-based employee compensation - fair value
                
                
                (414
                )Pro
                    forma net loss
                
                $
                (4,855
                )Basic
                    and diluted net loss per Ordinary share and equivalently participating
                    shareholders - as reported
                
                $
                (0.28
                )Basic
                    and diluted net loss per Ordinary share and equivalently participating
                    shareholders - pro forma
                
                $
                (0.30
                )
 
 m.
                Basic
                    and diluted net earnings (loss) per
                    share:
 
 Basic
          and
          diluted net earnings (loss) per share is presented in accordance with SFAS
          No.
          128, "Earnings per Share", for all periods presented.
 
 Basic
          net
          earnings (loss) per share has been computed using the weighted-average
          number of
          Ordinary shares outstanding during the year. Diluted net earning (loss)
          per
          share is computed based on the weighted average number of Ordinary shares
          outstanding during each year, plus the weighted average number of dilutive
          potential Ordinary shares considered outstanding during the
          year.
  F-17
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 
 **NOTE
                    2:**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 In
          compliance with Emerging Issues Task Force ("EITF") 03-6, "Participating
          Securities and the Two-Class Method under FASB No. 128", the series of
          Preferred
          shares that
          was
          outstanding in 2005 did not participate in
          losses, and therefore was not included in the computation of net earning
          (loss)
          per share for that year.
 
 In
          2005
          and 2006 all outstanding stock options and warrants have been excluded
          from the
          calculation of the diluted earnings (loss) per share because all such securities
          are anti-dilutive for all periods presented. In 2007, 363,133 weighted
          average
          number of shares related to options and warrants outstanding have been
          excluded
          from calculation of the diluted earnings per share since they would have
          an
          anti-dilutive effect.
 
 n.
                Severance
                    pay:
 
 The
          Company's liability for severance pay in Israel is calculated pursuant
          to
          Israel's 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. The Company's liability for all of its Israeli employees
          is
          fully provided by monthly deposits with severance pay fund's insurance
          policies
          and by an accrual. The value of those funds and policies is recorded as
          an asset
          in the Company's balance sheet.
 
 The
          deposited funds include profits accumulated up to the balance sheet date.
          The
          deposited funds may be withdrawn only upon the fulfillment of the obligation
          pursuant to Israel's Severance Pay Law or labor agreements. The value of
          the
          deposited funds is based on the cash surrendered value of these policies,
          and
          includes immaterial profits.
 
 Severance
          expense for the years ended December 31, 2005, 2006 and 2007 was approximately
          $ 11, $ 8 and $ 11, respectively.
 
 o.
                Fair
                    value of financial instruments:
 
 The
          carrying amounts of cash and cash equivalents, marketable securities, trade
          receivables, prepaid expenses, other accounts receivable and accounts payable,
          approximate their fair values due to the short-term maturities of financial
          instruments.
 
 p.
                Income
                    taxes:
 
 The
          Company accounts for income taxes in accordance with SFAS No. 109, "Accounting
          for Income Taxes" ("SFAS No. 109"). SFAS No. 109 prescribes the use of
          the
          liability method whereby deferred tax asset and liability account balances
          are
          determined based on differences between financial reporting and tax bases
          of
          assets and liabilities and are measured using the enacted tax rates and
          laws
          that will be in effect when the differences are expected to reverse. The
          Company
          provides a valuation allowance, if necessary, to reduce deferred tax assets
          to
          amounts more likely than not to be realized.
  F-18
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 
 **NOTE
                    2:**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 On
          January 1, 2007, the Company adopted FASB Interpretation No. 48,
          "Accounting for Uncertainty in Income Taxes, an Interpretation of FASB
          Statement
          No. 109" (FIN 48). FIN 48 contains a two-step approach to
          recognizing and measuring uncertain tax positions accounted for in accordance
          with SFAS No. 109. The first step is to evaluate the tax position taken
          or
          expected to be taken in a tax return by determining if the weight of available
          evidence indicates that it is more likely than not that, on an evaluation
          of the
          technical merits, the tax position will be sustained on audit, including
          resolution of any related appeals or litigation processes. The second step
          is to
          measure the tax benefit as the largest amount that is more than 50% likely
          to be
          realized upon ultimate settlement.
 
 q.
                Recently
                    issued accounting pronouncements:
 
 In
          September 2006, the Financial Accounting Standards Board ("FASB") issued
          SFAS
          No. 157, "Fair Value Measurements" ("SFAS No. 157"). This Standard defines
          fair value, establishes a framework for measuring fair value in generally
          accepted accounting principles and expands disclosures about fair value
          measurements. The provisions of SFAS No. 157 are effective for the
          Company beginning January 1, 2008. The FASB issues a FASB Staff Position
          (FSP) to defer the effective date of SFAS No. 157 for one year for all
          nonfinancial assets and nonfinancial liabilities, except for those items
          that
          are recognized or disclosed at fair value in the financial statements on
          a
          recurring basis. The Company does not expect the adoption will have material
          impact on its consolidated financial statements.
 
 In
          February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
          Financial Assets and Financial Liabilities" ("SFAS No. 159"). SFAS
          No. 159 permits companies to choose to measure certain financial
          instruments and certain other items at fair value. The standard requires
          that
          unrealized gains and losses on items for which the fair value option has
          been
          elected be reported in earnings. The provisions of SFAS No. 159 are
          effective for the Company beginning January 1, 2008. The Company does not
          expect the adoption of SFAS No. 159 will have an impact on its
          consolidated financial statements.
 
 In
          December 2007, the FASB issued SFAS No. 141 (revised 2007), "Business
          Combinations" ("SFAS 141R"). SFAS 141R establishes principles and
          requirements for how an acquirer recognizes and measures in its financial
          statements the identifiable assets acquired, the liabilities assumed, any
          non
          controlling interest in the acquiree and the goodwill acquired. SFAS 141R
          also establishes disclosure requirements to enable the evaluation of the
          nature
          and financial effects of the business combination. SFAS 141R is effective
          for fiscal years beginning after December 15, 2008. Earlier adoption is
          prohibited. The Company does not expect the adoption of SFAS 141R will have
          an impact on its financial statements.
  F-19
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 
 **NOTE
                    2:**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 In
          December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in
          Consolidated Financial Statements, an Amendment of ARB No. 51" ("SFAS No.
          160"). SFAS No. 160 establishes accounting and reporting standards that
          require that the ownership interests in subsidiaries held by parties other
          than
          the parent be clearly identified, labeled, and presented in the consolidated
          statement of financial position within equity, but separate from the parent's
          equity; the amount of consolidated net income attributable to the parent
          and to
          the noncontrolling interest be clearly identified and presented on the
          face of
          the consolidated statement of income; and changes in a parent's ownership
          interest while the parent retains its controlling financial interest in
          its
          subsidiary be accounted for consistently. SFAS No. 160 is effective for
          fiscal years, and interim periods within those fiscal years, beginning
          on or
          after December 15, 2008. The Company does not expect the adoption of SFAS
          No. 160 will have significant impact on its consolidated financial
          statements.
 
 On
          December 21, 2007 the SEC staff issued Staff Accounting Bulletin No. 110
          (SAB
          110), which, effective January 1, 2008, amends and replaces SAB 107,
          "Share-Based Payment". SAB 110 expresses the views of the SEC staff regarding
          the use of a "simplified" method in developing an estimate of expected
          term of
          "plain vanilla" share options in accordance with FASB Statement No. 123(R),
          "Share-Based Payment". Under the "simplified" method, the expected term
          is
          calculated as the midpoint between the vesting date and the end of the
          contractual term of the option.
 
 The
          use
          of the "simplified" method, which was first described in Staff Accounting
          Bulletin No. 107, was scheduled to expire on December 31, 2007. SAB 110
          extends
          the use of the "simplified" method for "plain vanilla" awards in certain
          situations. The SEC staff does not expect the "simplified" method to be
          used
          when sufficient information regarding exercise behavior, such as historical
          exercise data or exercise information from external sources, becomes available.
          We are currently assessing the potential impact that the adoption of SAB
          110
          could have on our financial statements.
 
 
 **NOTE
                    3:**
                **PROPERTY
                    AND EQUIPMENT, NET**
 
 **December
                    31****2006**
                
                **2007**Cost:Computers
                    and peripheral equipment
                
                $
                1,877
                
                $
                2,242Office
                    furniture and equipment
                
                
                589
                
                
                770Motor
                    vehicles
                
                
                88
                
                
                88Leasehold
                    improvements
                
                
                1,137
                
                
                1,1503,691
                
                
                4,250Less
                    accumulated depreciation
                
                
                (3,080
                )
                
                (3,464
                )Depreciated
                    cost
                
                $
                609
                
                $
                786
 
 Depreciation
          expense amounted to approximately $ 147, $ 209 and $ 397 in 2005, 2006
          and 2007,
          respectively.
  F-20
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 
 **NOTE
                    4:**
                **COMMITMENTS
                    AND CONTINGENCIES**
 
 Operating
          leases:
 
 The
          Company leases its facility in Israel under an operating lease agreement
          expiring on November 30, 2008. In 2007, lease payments under this non-cancelable
          lease were $ 96.
 
 The
          subsidiary leases its facility in the U.S. under an operating lease agreement
          expiring on February 28, 2009. In 2007, lease payments under this non-cancelable
          lease were $ 67.
 
 Rent
          expense for 2005, 2006 and 2007 was approximately $ 199, $ 131 and
          $164, respectively.
 Annual
          minimum future lease payments due under the above agreements (and motor
          vehicle
          leases), at the exchange rate in effect on December 31, 2007, are approximately
          as follows:
 
 2008
                
                $
                2852009
                
                
                1142010
                
                
                39$
                438
 
 **NOTE
                      5:**
                  **SHAREHOLDERS'
                      EQUITY**
 a.
                General:
 
 The
          Ordinary shares of the Company have been traded on the Nasdaq National
          Market
          and Nasdaq Capital Market (formerly The Nasdaq SmallCap Market), since
          July 1999
          and 2002, respectively.
 
 The
          Ordinary shares confer upon their holders the right to receive notice to
          participate and vote in general shareholder meetings of the Company and
          to
          receive dividends, if declared. Subsequent to balance sheet date, in January
          2008, the Board of Directors and shareholders approved a 3:1 reverse stock
          split
          of the Company's share capital. As a result of this action, every three
          shares
          (including all authorized, issued and outstanding shares and all outstanding
          warrants and options to purchase shares) will be combined into one share
          of the
          same respective class of shares bearing a par value of NIS 0.15 each. All
          of the
          Company's authorized, issued and outstanding shares (including all outstanding
          warrants and options to purchase shares) as of December 31, 2007 and 2006,
          have
          been restated to reflect the effect of the reverse stock split.
  F-21
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 **NOTE
                        5:**
                    **SHAREHOLDERS'
                        EQUITY (Cont.)**
 b.
                Warrants
                    to investors:
 
 As
          of
          December 31, 2007, the Company's outstanding warrants issued to various
          parties
          were as follows:
 
 **Issuance
                    date**
                
                **Warrants
                    granted for Ordinary shares**
                
                **Exercise
                    price per share**
                
                **Remaining
                    warrants exercisable**
                
                **Exercisable
                    through**January
                    2003
                
                1,884,072
                
                $0.75
                    - $1.50
                
                214,391
                
                January
                    2008July
                    2003
                
                480,000
                
                $0.50
                
                30,000
                
                August
                    2008May
                    2004
                
                969,971
                
                $2.211
                
                309,416
                
                June
                    2009October
                    2005 (i)
                
                500,000
                
                $1.95
                
                458,333
                
                October
                    2010May
                    2006 (ii)
                
                23,364
                
                $3.21
                
                23,364
                
                May
                    2011Total
                
                3,857,407
                
                
                
                1,035,504
 
 (i)
                Under
                    the Securities Purchase Agreement dated October 2, 2005, the
                    Company
                    issued 2,000,000 Ordinary shares at $ 1.50 per share for gross
                    proceeds of
                    $ 3,000. The investors also received two sets of warrants, each
                    representing an option to purchase up to 500,000 Ordinary shares,
                    with one
                    set exercisable within nine months at $ 1.50 per share and the
                    other set
                    exercisable within five years at $ 1.95 per share. The warrants
                    exercisable at $ 1.50 per share were exercised by the end of 2006 and
                    500,000 warrants exercisable at $ 1.95 per share are exercisable
                    through October 2010.
 
 (ii)
                In
                    May 2006, the Company issued warrants to purchase 23,364 of the
                    Company's
                    Ordinary shares at a price of $ 3.21 per share to one investor as
                    part of a private placement, in which the Company issued 31,153
                    Ordinary
                    shares for a total consideration of $ 100. The warrants will
                    expire in May
                    2011.
 c.
                  Preferred
                      share issuance:
 
 On
          October 31, 2004, the Company entered into a Securities Purchase Agreement
          ("SPA") for the sale of Series A Preferred shares to investors of the Company
          identified in the schedule of buyers to the SPA. The transaction closed
          on
          December 9, 2004. Under the transaction:
 
 1.
                The
                    Company issued 2,126,667 Series A Preferred shares to new and
                    existing
                    investors, including three of its directors at that time, for
                    an aggregate
                    purchase price of $ 3,190. The purchase price per share paid
                    in the
                    transaction was $ 1.50.
  2.
                The
                    Series A Preferred shares were convertible into the Company's
                    Ordinary
                    shares, and enjoyed certain preferences and other rights relating
                    to
                    liquidation and business combinations, as described in the Company's
                    Amended and Restated Articles of
                    Association.
  F-22
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 **NOTE
                        5:**
                    **SHAREHOLDERS'
                        EQUITY (Cont.)**
 In
          accordance with the terms of the SPA, the Redemption, Amendment and Exchange
          Agreement ("RAE") and the requirements of EITF 98-05 and EITF 00-27, a
          beneficial conversion feature for the Series A Preferred shares granted
          under
          the October 2004 agreements was valued at approximately $ 1,900, and was
          amortized over a nine month period as deemed dividends.
 
 A
          non-cash amortization of beneficial conversion feature, relating to the
          Series A
          Preferred share was recorded in the amounts of $ 141 and $ 1,751 in 2004
          and
          2005, respectively.
 
 During
          2005, 650,000 Series A Preferred shares were converted into 1,133,333 Ordinary
          shares.
 
 During
          the quarter ended March 31, 2006, 500,000 Series A Preferred shares were
          converted into 1,000,000 Ordinary shares. By early May 2006, 100,000 Series
          A
          Preferred Shares were converted into 200,000 Ordinary shares triggering
          a
          provision in the Company's Amended and Restated Articles of Association
          causing
          the conversion of the remaining outstanding 1,176,667 Series A Preferred
          shares
          into 2,353,333 Ordinary shares. This provision required the automatic conversion
          of all outstanding Preferred shares following conversions exceeding 50%
          of the
          originally issued Preferred shares. As a result, the Company no longer
          has a
          Preferred class of securities outstanding.
 
 d.
                Employee
                    stock options:
 
 In
          1996,
          the Company adopted the 1996 CI Stock Option Plan for granting options
          to its
          U.S. employees and consultants to purchase Ordinary shares of the Company.
          Until
          1999, the Company issued options to purchase Ordinary shares to its Israeli
          employees pursuant to individual agreements. In 1999, the Company approved
          the
          1999 Section 3(i) share option plan for its Israeli employees and consultants,
          (which was amended in 2001 and 2003 and renamed the Amended Israeli share
          option
          plan). **** As
          of
          December 31, 2007, an aggregate of 789,049 Ordinary shares of the Company
          are
          still available for future grant to employees and directors.
 
 Options
          granted under such plans and agreements up to September 2005, expire generally
          after 10 years from the date of grant, with grants from September 2005
          having
          six-year terms from the date of grant. Options cease vesting upon termination
          of
          the optionee's employment or other relationship with the Company. The options
          generally vest over a period of four years. The exercise price of the options
          granted under the individual agreements may not be less than the nominal
          value
          of the shares into which such options are exercisable. Any options that
          are
          canceled or not exercised within the option term become available for future
          grant.
 
  F-23
 **COMMTOUCH
              SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
              except share and per share data**
 **NOTE
                          5:**
                      **SHAREHOLDERS'
                          EQUITY
                          (Cont.)**
 
 A
          summary
          of the Company's employees share option activity under the plans is as
          follows:
 
 **Number
                    of shares**
                
                **Weighted
                    average exercise price****2005**
                
                **2006**
                
                **2007**
                
                **2005**
                
                **2006**
                
                **2007**Outstanding
                    at the beginning of the year
                
                
                2,134,645
                
                
                2,626,956
                
                
                3,063,413
                
                $
                0.90
                
                $
                1.29
                
                $
                1.80Granted
                
                
                759,167
                
                
                810,833
                
                
                626,135
                
                $
                2.43
                
                $
                3.15
                
                $
                5.97Exercised
                
                
                (73,397
                )
                
                (260,117
                )
                
                (345,713
                )
                $
                1.14
                
                $
                0.67
                
                $
                0.97Forfeited
                
                
                (193,459
                )
                
                (114,259
                )
                
                (60,668
                )
                $
                1.71
                
                $
                1.96
                
                $
                3.38Outstanding
                    at the end of the year
                
                
                2,626,956
                
                
                3,063,413
                
                
                3,283,167
                
                $
                1.29
                
                $
                1.80
                
                $
                2.65Exercisable
                    options at the end of the year
                
                
                1,285,636
                
                
                1,515,131
                
                
                1,736,229
                
                $
                0.69
                
                $
                0.96
                
                $
                1.42Options
                    vested and expected to vest at the end of the year
                
                
                
                
                
                2,939,411
                
                
                3,163,369
                
                
                
                
                $
                1.77
                
                $
                2.61Weighted
                    average fair value of options granted during the year
                
                
                
                
                
                
                
                
                
                
                $
                1.59
                
                $
                1.44
                
                $
                3.17
 
 The
                    aggregate intrinsic value of the Company's options is the difference
                    between the fair value of the Company's Ordinary shares and the
                    exercise
                    price, times the number of options. The total intrinsic value
                    of options
                    outstanding at December 31, 2006 and 2007 was $ 5,538 and $11,345,
                    respectively. The total intrinsic value of exercisable options
                    at the end
                    of 2006 and 2007 was approximately $ 4,018 and $8,048, respectively.
                    The
                    total intrinsic value of options vested and expected to vest
                    at December
                    31, 2006 and 2007 was approximately $ 5,389 and $ 11,071,
                    respectively. The total intrinsic value of options exercised
                    during the
                    year ended December 31, 2006 and 2007 was approximately $ 699 and
                    $ 2,223, respectively.
 
 As
          of
          December 31, 2007 the total unrecognized estimated compensation cost related
          to
          non-vested stock options granted prior to that date was $3,520 which is
          expected
          to be recognized over a period of up to four years.
  F-24
 **COMMTOUCH
              SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
              except share and per share data**
 **NOTE
                          5:**
                      **SHAREHOLDERS'
                          EQUITY
                          (Cont.)**
 
 The
          options outstanding as of December 31, 2007, have been separated into ranges
          of
          exercise price, as follows:
  **Exercise**
                  **price
                    per**
                  **share**
                
                **Options**
                  **outstanding
                    as of**
                  **December
                    31,**
                  **2007**
                
                **Weighted
                    average**
                  **remaining
                    contractual**
                  **life**
                  **(years)**
                
                **Weighted**
                  **average
                    exercise**
                  **price
                    per**
                  **share**
                
                **Options**
                  **exercisable**
                  **as
                    of**
                  **December
                    31,**
                  **2007**
                
                **Weighted
                    average exercise**
                  **price
                    per share of**
                  **exercisable**
                  **options**$0.03-$0.27
                
                
                132,620
                
                
                3.67
                
                $
                0.05
                
                
                132,620
                
                $
                0.05$0.33-$0.60
                
                
                500,000
                
                
                4.66
                
                $
                0.35
                
                
                500,000
                
                $
                0.35$0.81-$0.84
                
                
                38,667
                
                
                3.85
                
                $
                0.82
                
                
                38,667
                
                $
                0.82$0.93-$1.89
                
                
                721,458
                
                
                5.94
                
                $
                1.24
                
                
                514,542
                
                $
                1.19$2.31-$2.91
                
                
                268,167
                
                
                4.65
                
                $
                2.61
                
                
                190,326
                
                $
                2.53$3.12-$4.35
                
                
                1,073,455
                
                
                4.61
                
                $
                3.24
                
                
                360,074
                
                $
                3.25$4.35-$6.60
                
                
                548,800
                
                
                5.84
                
                $
                6.24
                
                
                -
                
                
                -$
                    0.03-$6.60
                
                
                3,283,167
                
                
                4.99
                
                $
                2.65
                
                
                1,736,229
                
                $
                1.42
 
 f.
                Non-employee
                    directors stock option plan:
 
 In
          1999,
          the Company adopted the 1999 Non-Employee Directors Stock Option Plan,
          which has
          since been amended. The original allotment of shares to this plan was 60,000
          Ordinary shares and was increased in several tranches to 1,263,333. On
          December
          15, 2006, the Company combined the remaining pool of options in the employee
          stock option plans' reserve with the amount of options remaining in the
          Non-Employee Directors Stock Option Plan reserve.
 
 Since
          the
          annual meeting of shareholders in 2003, new directors joining the Board
          are **** entitled **** to
          an
          option grant of 50,000 Ordinary shares **.** ******
 
 Each
          option granted under the Non-Employee Directors Stock Option Plan becomes
          exercisable at a rate of 1/16th of the shares every three months. Each
          option
          has an exercise price equal to the fair market value of the Ordinary shares
          on
          the grant date of such option. Until September 2005, each option granted
          had a
          maximum term of ten years, but since September 2005, the term of granted
          options
          is six years. Options will terminate earlier if the optionee ceases to
          be a
          member of the Board of Directors.
  During
          2006 and 2007, the Company granted 83,333 and 83,333 options, respectively,
          to
          non-employee directors at a weighted average exercise price of $ 3.12 and
          $6.60
          per share respectively. As of December 31, 2006 and 2007, 448,090 and 369,895
          options were vested and unexercised and 706,944 and 610,000 were outstanding
          under the Non-Employee Directors Stock Option Plan,
          respectively.
  F-25
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 **NOTE
                        5:**
                    **SHAREHOLDERS'
                        EQUITY (Cont.)**
 
 f.
                Options
                    to non-employees:
 
 **Issuance
                    date**
                
                **Options
                    granted for Ordinary Shares**
                
                **Exercise
                    price per share**
                
                **Remaining
                    options exercisable**
                
                **Exercisable
                    through**June
                    2004 (i)
                
                
                196,667
                
                $
                1.77
                
                
                -
                
                
                March
                    2007May
                    2006 (ii)
                
                
                66,667
                
                $
                $3.21-$5.73
                
                
                20,833
                
                
                May
                    2012Total
                
                
                263,334
                
                
                
                
                
                20,833
 
 (i)
                In
                    June 2004, 493,333 options were granted to the then Executive
                    Chairman of
                    the Board, with a four year vesting schedule. In August 2005,
                    the
                    Executive Chairman of the Board and the Company agreed to modify
                    the
                    number of options granted from 493,333 options to 246,667 options.
                    The
                    Company has accounted for this grant under the fair value method
                    of 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" ("EITF 96-18"). The fair value for these options
                    was
                    estimated using a Black-Scholes option-pricing model. Following
                    the
                    modification, the compensation expense for 2005, 2006 and 2007
                    amounted to
                    $ 92, $ 131 and $ 0, respectively. On December 15, 2006, the
                    term of the
                    Executive Chairman of the Board expired. In 2007, all 149,028
                    remaining
                    options as of December 31, 2006 were exercised.
 
 (ii)
                As
                    consideration for consulting services, on May 7, 2006 the Company
                    issued
                    50,000 options to a service provider to purchase the Company's
                    Ordinary
                    shares at a price of $ 3.21 per option. On May 5, 2007, the Company
                    issued additional 16,667 options to the service provider to purchase
                    the
                    Company's Ordinary shares at a price of $ 5.73 per option. The
                    options shall vest and become exercisable at a rate of 1/16 of
                    the options
                    every three months. The Company has accounted for this grant
                    under the
                    fair value method of EITF 96-18. The fair value for these options
                    was
                    estimated using a Black-Scholes option-pricing model. Compensation
                    expense
                    for 2006 and 2007 amounted to $ 24 and $ 70, respectively.
 h.
                  Total
                      stock-based compensation expenses recognized in 2006 and
                      2007:
 
 The
          total
          stock-based compensation expense related to all of the Company's equity-based
          awards, recognized for the year ended December 31, 2006 and 2007, was comprised
          as follows:
 
 **Year
                    ended**
                  **December
                    31,****2006**
                
                **2007**Cost
                    of revenues
                
                $
                15
                
                $
                31Research
                    and development
                
                
                196
                
                
                246Selling
                    and marketing
                
                
                96
                
                
                194General
                    and administrative
                
                
                638
                
                
                612$
                945
                
                $
                1,083
  F-26
 **COMMTOUCH
            SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
            except share and per share data**
 
 **NOTE
                    6:**
                **INCOME
                    TAXES**
 
 a.
                Corporate
                    tax structure:
 
 Taxable
          income of Israeli companies is subject to tax at the rate of 31% in 2006,
          29% in
          2007, 27% in 2008, 26% in 2009 and 25% in 2010 and thereafter.
 
 b.
                Measurement
                    of taxable income under the Income Tax (Inflationary Adjustments)
                    Law,
                    1985:
 
 Results
          for tax purposes are measured in terms of earnings in NIS after certain
          adjustments for increases in the Israeli Consumer Price Index ("CPI").
          As
          explained in Note 2b, the financial statements are measured in U.S. dollars.
          The
          difference between the annual change in the Israeli CPI and in the NIS/dollar
          exchange rate causes a further difference between taxable income and the
          income
          before taxes shown in the financial statements. In accordance with paragraph
          9(f) of SFAS No. 109, the Company has not provided deferred income taxes
          on the
          difference between the functional currency and the tax bases of assets
          and
          liabilities.
 Subsequent
          to balance sheet date, in February 2008, the inflation adjustment law was
          cancelled.
 
 c.
                Tax
                    benefits under Israel's Law for the Encouragement of Industry
                    (Taxation),
                    1969:
 
 The
          Company may currently qualify as an "industrial company" within the definition
          of the Law for the Encouragement of Industry (Taxation), as such, it may
          be
          eligible for certain tax benefits, including, inter alia, special depreciation
          rates for machinery, equipment and buildings, amortization of patents,
          certain
          other intangible property rights and deduction of share issuance expenses.
 
 d.
                Net
                    operating loss carryforwards:
 
 As
          of
          December 31, 2007, the Company's net operating loss carryforwards for tax
          purposes amounted to approximately $ 71,000 which may be carried forward
          and offset against taxable income in the future, for an indefinite
          period.
 
 As
          of
          December 31, 2007, for federal income tax purposes, the U.S. subsidiary
          had net
          operating loss carry-forwards of approximately $ 91,000. These losses may
          offset any future U.S. taxable income of the U.S. subsidiary and will expire
          in
          the years 2009 through 2025. In light of the subsidiary's history of operating
          losses, the Company has recorded a valuation allowance for all its deferred
          tax
          assets.
 
 Utilization
          of U.S. net operating losses may be subject to substantial annual limitation
          due
          to the "change in ownership" provisions of the Internal Revenue Code of
          1986 and
          similar state provisions. The annual limitations may result in the expiration
          of
          net operating losses before utilization.
 
 The
          Company and its subsidiary have provided valuation allowances in respect
          to the
          deferred tax assets resulting from operating loss carryforwards and other
          temporary differences. Management currently believes that since the Company
          and
          its subsidiary have a history of losses it is more likely than not that
          the
          deferred tax regarding the loss carryforwards and other temporary differences
          will not be realized in the foreseeable future.
 F-27
 **COMMTOUCH
              SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
              except share and per share data**
 
 **NOTE
                    6:-**
                **INCOME
                    TAXES (Cont.)**
 
 e.
                Deferred
                    income taxes:
 
 Deferred
          income taxes reflect the net tax effects of net operating loss carryforwards
          between the carrying amounts of assets and liabilities for financial reporting
          purposes and amounts used for income tax purposes. The Company's deferred
          tax
          assets resulting from tax loss carryforwards are as follows:
 
 **December
                    31,****2005**
                
                **2006**
                
                **2007**Deferred
                    tax assets are as follows:Operating
                    loss carry-forwards
                
                $
                47,002
                
                $
                50,098
                
                $
                51,520Non-deductible
                    expenses and other temporary differences
                
                
                952
                
                
                890
                
                
                1,016Deferred
                    tax asset before valuation allowance
                
                
                47,954
                
                
                50,988
                
                
                52,536Valuation
                    allowance
                
                
                (47,954
                )
                
                (50,988
                )
                
                (52,536
                )Net
                    deferred tax asset
                
                $
                -
                
                $
                -
                
                $
                -
 
 f.
                The
                    Company adopted the provisions of FIN 48 on January 1, 2007. The
                    adoption of FIN 48 did not result in a change to the Company's
                    accumulated
                    deficit.
 
 Income
          (loss) before taxes on income consists of the following:
 
 **Year
                    December 31,****2005**
                
                **2006**
                
                **2007**Israel
                
                $
                (2,668
                )
                $
                (393
                )
                $
                1,080U.S.
                
                
                (22
                )
                
                203
                
                
                1,057$
                (2,690
                )
                $
                (190
                )
                $
                2,137
 
 The
          Company is required to calculate and account for income taxes in each
          jurisdiction in which the Company or its subsidiary operate. Significant
          judgment is required in determining its worldwide provision for income
          taxes and
          recording the related assets and liabilities.
 F-28
 **COMMTOUCH
              SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
              except share and per share data**
   **NOTE
                    6:-**
                **INCOME
                    TAXES (Cont.)**
 
 
 g.
                Taxes
                    on income are comprised of the
                    following:
 
 Year
                    December 31,2005
                
                2006
                
                2007Domestic
                
                
                -
                
                
                -
                
                
                -Foreign
                
                
                -
                
                
                -
                
                $
                28
                *)-
                
                
                -
                
                
                28*)
                    Current
 
 
 
 h.
                The
                    main reconciling items between the statutory tax rate of the
                    Company and
                    the effective tax rate are the non-recognition of the benefits
                    from
                    accumulated net operating loss carry forward due to the uncertainty
                    of the
                    realization of such tax benefits.
 
 i.
                Tax
                    assessments:
 
 The
          Company has closed tax assessments in Israel until 2002. As a result of
          the
          closure of these tax assessments, the Company amended the tax return in
          Israel
          for tax year 2003, and reduced its net operating losses carryforwards for
          the
          respective years as reflected in f above.
 
 
 **NOTE
                    7:**
                **GEOGRAPHIC
                    INFORMATION**
 
 The
          Company conducts its business on the basis of one reportable segment. The
          Company has adopted SFAS No. 131, "Disclosures About Segments of an Enterprise
          and Related Information".
 
 a.
                Revenues
                    from external customers:
 
 **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Israel
                
                $
                365
                
                $
                344
                
                $
                742North
                    America
                
                
                2,737
                
                
                4,525
                
                
                6,424Europe
                
                
                687
                
                
                1,715
                
                
                2,735Asia
                
                
                136
                
                
                493
                
                
                1,038Other
                
                
                -
                
                
                157
                
                
                311$
                3,925
                
                $
                7,234
                
                $
                11,250
 F-29
 **COMMTOUCH
                SOFTWARE LTD. AND ITS SUBSIDIARY**
  **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **,
                except share and per share data**
 **NO****TE
                    7:**
                **GEOGRAPHIC
                    INFORMATION (Cont.)**
 
 
 
 b.
                The
                    Company's net amount of long-lived assets are as
                    follows:
 
 **December
                    31****2006**
                
                **2007**Israel
                
                $
                200
                
                $
                179U.S.A.
                
                
                409
                
                
                607$
                609
                
                $
                786
 
 c.
                Revenues
                    from principal customer:
  **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007****%**Customer
                    A
                
                
                9
                
                
                14
                
                
                9
 F-30




**Item
      19. Exhibits.**




The
      list
      of exhibits required by this Item is incorporated by reference to the Exhibit
      Index which precedes the exhibits to this report.




**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.




COMMTOUCH
                SOFTWARE LTD.By:
            /s/
                Ron ElaRon
                ElaChief
                Financial OfficerMarch
                31, 2008







**Item
      19. Exhibits** ****




Exhibit
              Number
            
            Description
                of Document1.1
            
            Memorandum
                of Association of the Company.(1)1.2
            
            Amended
                and Restated Articles of Association of the Company, as amended on
                December 14, 2007.2.1
            
            Amended
                and Restated Registration Rights Agreement dated as of April 19,
                1999.(1)2.1.1
            
            Amendment
                No. 1 to Amended and Restated Registration Rights Agreement dated
                as of
                December 29, 1999.(3)2.1.2
            
            Amendment
                No. 2 to Amended and Restated Registration Rights Agreement dated
                as of
                March 10, 2000.(4)2.2
            
            Ordinary
                Shares and Warrants Purchase Agreement dated as of February 27, 2002
                by
                and between Commtouch Software Ltd., and the Investors Listed on
                Exhibit A
                Thereto. (13)2.3
            
            Ordinary
                Shares and Warrants Purchase Agreement dated July 10, 2003, inclusive
                of
                Exhibits “A” and “B” thereto, between Commtouch Software Ltd. and certain
                investors thereunder.(9)2.4
            
            Ordinary
                Shares and Warrants Purchase Agreement dated July 29, 2003, inclusive
                of
                Exhibits “A” and “B” thereto, between Commtouch Software Ltd. and certain
                investors thereunder.(10)2.5
            
            Ordinary
                Shares and Warrants Purchase Agreement dated July 29, 2003, inclusive
                of
                Exhibits “A” and “B” thereto, between Commtouch Software Ltd. and certain
                investors thereunder.(11)2.6
            
            Exhibit
                “D” to Securities Purchase Agreement dated May 18, 2004 between Commtouch
                Software Ltd. and certain investors thereunder - Form of Registration
                Rights Agreement.(14)2.7
            
            Exhibit
                “A” to Securities Purchase Agreement dated May 18, 2004 between Commtouch
                Software Ltd. and certain investors thereunder - Form of Initial
                Warrants.(15)2.8
            
            Exhibit
                “A” to Securities Purchase Agreement dated October 31, 2004 between
                Commtouch Software Ltd. and certain investors thereunder - Form of
                Registration Rights Agreement.(16)2.9
            
            Redemption,
                Amendment and Exchange Agreement dated October 31, 2004 between Commtouch
                Software Ltd. and certain investors thereunder.(17)2.10
            
            Exhibit
                “B” to Securities Purchase Agreement dated October 2, 2005 between
                Commtouch Software Ltd. and certain investors thereunder - Form of
                Series
                2 Warrant.(18)2.11
            
            Exhibit
                “C” to Securities Purchase Agreement dated October 2, 2005 between
                Commtouch Software Ltd. and certain investors thereunder - Form of
                Registration Rights Agreement.(19)2.12
            
            Addendum
                1 to Registration Rights Agreement, dated October 6, 2005 between
                Commtouch Software Ltd. and certain investors
                thereunder.(20)4.1
            
            Commtouch
                Software Ltd. Amended and Restated 1996 CSI Stock Option
                Plan.(5)4.2
            
            Commtouch
                Software Ltd. 2006 U.S. Stock Option Plan.(6)4.3
            
            Amended
                and Restated 1999 Section 3(i) Share Option Plan.(12)4.4
            
            Amended
                and Restated Commtouch Software Ltd. 1999 Non-Employee Directors
                Stock
                Option Plan.(7)4.5
            
            Commtouch
                Software Ltd. Amended and Restated Israeli Share Option Plan [fka
                1999
                Section 3(i) Share Option Plan].(8)4.6
            
            Summary
                of Director Compensation.8
            
            List
                of Subsidiaries of the Company.








12.1
            
            Certification
                of Company’s Principal Executive Officer Pursuant to Exchange Act Rule
                13a-14(a) or 15d-14(a).12.2
            
            Certification
                of Company’s Principal Financial Officer Pursuant to Exchange Act Rule
                13a-14(a) or 15d-14(a).13
            
            Certification
                of Company’s Principal Executive Officer and Principal Financial Officer
                Pursuant to 18 U.S.C. 1350.15
            
            Consent
                of Kost, Forer, Gabbay & Kasierer, independent
                auditors.







(1)
            Incorporated
                by reference to exhibits in Amendment No. 1 to Registration Statement
                on
                Form F-1 of Commtouch Software Ltd., File No.
                333-78531.




(2)
            Reserved.




(3)
            Incorporated
                by reference to exhibit in Amendment No. 1 to Registration Statement
                on
                Form F-1 of Commtouch Software Ltd., File No.
                333-89773.




(4)
            Incorporated
                by reference to exhibits in Amendment No. 2 to Registration Statement
                on
                Form F-1 of Commtouch Software Ltd., File No. 333-89773, filed March
                28,
                2000.




(5)
            Incorporated
                by reference to Exhibit 99.2 to Registration Statement on Form S-8
                No.
                333-141177.




(6)
            Incorporated
                by reference to Exhibit 99.4 to Registration Statement on Form S-8
                No.
                333-141177.




(7)
            Incorporated
                by reference to Exhibit 99.1 to Registration Statement on Form S-8
                No.
                333-141177.




(8)
            Incorporated
                by reference to Exhibit 99.3 to Registration Statement on Form S-8
                No.
                333-141177.




(9)
            Incorporated
                by reference to Exhibit 2 to Report on Form 6-K for the month of
                July
                2003, filed July 28, 2003.




(10)
            Incorporated
                by reference to Exhibit 2 to Report on Form 6-K for the month of
                August
                2003, filed August 15, 2003.




(11)
            Incorporated
                by reference to Exhibit 3 to Report on Form 6-K for the month of
                August
                2003, filed August 15, 2003.




(12)
            Incorporated
                by reference to Exhibit 5 to Schedule TO, filed July 20,
                2001.




(13)
            Incorporated
                by reference to Exhibit 2.8 to Annual Report on Form 20-F for the
                year
                ended December 31, 2001.




(14)
            Incorporated
                by reference to Exhibit 99.2 to Report on Form 6-K for the month
                of May
                2004, filed May 19, 2004.




(15)
            Incorporated
                by reference to Exhibit 99.3 to Report on Form 6-K for the month
                of May
                2004, filed May 19, 2004.




(16)
            Incorporated
                by reference to Exhibit 99.4 to Report on Form 6-K for the month
                of
                November 2004, filed November 5,
                2004.




(17)
            Incorporated
                by reference to Exhibit 99.5 to Report on Form 6-K for the month
                of
                November 2004, filed November 5,
                2004.




(18)
            Incorporated
                by reference to Exhibit 99.6 to Report on Form 6-K for the month
                of
                October 2005, filed October 11,
                2005.




(19)
            Incorporated
                by reference to Exhibit 99.3 to Report on Form 6-K for the month
                of
                October 2005, filed October 11,
                2005.




(20)
            Incorporated
                by reference to Exhibit 99.4 to Report on Form 6-K for the month
                of
                October 2005, filed October 11,
                2005.