**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**




**Washington,
      D.C. 20549**







**FORM
      20-F**




**(Mark
      One)**




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,
                  2006**


**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




**Commission
      file number** **000-50790**







**VUANCE
      LTD.**


**(Exact
      name of Registrant as specified in its charter)**


**Not
      Applicable**


**(Translation
      of Registrant’s Name into English)**


**Israel**


**(Jurisdiction
      of incorporation or organization)**


**Sagid
      House “Hasharon Industrial Park”**


**P.O.B
      5039, Qadima 60920**


**Israel**


**(Address
      of principal executive offices)**







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


**None**




**Securities
  registered or to be registered pursuant to Section 12(g) of the Act. Ordinary
  Shares NIS0.0588235 nominal value**




**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:
      23,535,994  ordinary
      shares (pre-reverse share split) as of December 31, 2006.





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.    o Yes    x No





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 periods that the registrant was
      required to file such reports), and (2) has been subject to such reporting
      requirements for the past 90 days.


Yes  x No o Not
      applicable




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 o
            Non-accelerated
                filer x




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




(APPLICABLE
      ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS)


Indicate
      by check mark whether the registrant has filed all documents and reports
      required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange
      Act
      of 1934 subsequent to the distribution of securities under a plan confirmed
      by a
      court.


Yes  o No o









**TABLE
      OF CONTENTS**





**PART
                I**NOTES
                REGARDING FORWARD-LOOKING STATEMENTS
            
            5ITEM
                1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT & ADVISORS
            
            6ITEM
                2. OFFER STATISTICS AND EXPECTED TIMETABLE
            
            6ITEM
                3. KEY INFORMATION
            
            6Selected
                Financial Data
            
            6Capitalization
                and Indebtedness
            
            8Reasons
                for the Offer and Use of Proceeds
            
            8Risk
                Factors
            
            8ITEM
                4. INFORMATION ON THE CORPORATION
            
            25History
                and Development of the Corporation
            
            25Business
                Overview
            
            27Organizational
                Structure
            
            40Property,
                Plants and Equipment
            
            41ITEM
                4A. UNSOLVED STAFF COMMENTS
            
            42ITEM
                5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS
            
            42Operating
                Results
            
            42Liquidity
                and Capital Resources
            
            51Research
                and Development
            
            53Trend
                Information
            
            53Off-Balance
                Sheet Arrangements
            
            55Tabular
                Disclosure of Contractual Obligation
            
            55ITEM
                6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES
            
            56Directors
                and Senior Management
            
            56Compensation
            
            58Board
                Practices
            
            58Employees
            
            61Share
                Ownership
            
            62ITEM
                7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
            
            65Major
                shareholders
            
            65Related
                Party Transactions
            
            66Interests
                of Experts and Counsel
            
            67ITEM
                8. FINANCIAL INFORMATION
            
            68Consolidated
                Statements and Other Financial Information (Audited)
            
            68Significant
                Changes
            
            70


ITEM
                9THE
                OFFER AND LISTING
            
            70Offer
                and Listing Details
            
            70Plan
                of Distribution
            
            72Markets
            
            72Selling
                Shareholders
            
            72Dilution
            
            72Expenses
                of the Issue
            
            72




3




ITEM
                10. ADDITIONAL INFORMATION
            
            72Share
                Capital
            
            72Memorandum
                and Articles of Association
            
            72Material
                Contracts
            
            73Exchange
                Controls
            
            73Taxation
            
            73Dividends
                and Paying Agent
            
            82Statement
                by Experts
            
            82Documents
                on Display
            
            82Subsidiary
                Information
            
            83ITEM
                11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK
            
            83Quantitative
                and Qualitative Information about Market Risk
            
            83ITEM
                12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
            
            83**PART
                II**ITEM
                13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
            
            84ITEM
                14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY
                HOLDERSAND
                USE OF PROCEEDS
            
            84ITEM
                15. CONTROLS AND PROCEDURES
            
            84ITEM
                16. RESERVED
            
            84ITEM
                16A. AUDIT COMMITTEE FINANCIAL EXPERT
            
            84ITEM
                16B. CODE OF ETHICS
            
            84ITEM
                16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES
            
            85ITEM
                16 D. EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT
                COMMITTEES
            
            85ITEM
                16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED
                PURCHASERS
            
            85**PART
                III**ITEM
                17. FINANCIAL STATEMENTS
            
            85ITEM
                18. FINANCIAL STATEMENTS
            
            85ITEM
                19. EXHIBITS
            
            131SIGNATURE
            
            132





4


**NOTE
      REGARDING FORWARD-LOOKING STATEMENTS**





This
      Annual Report on Form 20-F (“Annual Report”) contains “forward-looking
      statements” with the meaning of the United States Private Securities Litigation
      Reform Act of 1995 that are not historical facts but rather reflect our present
      expectation concerning future results and events. Words such as “anticipate,”
“estimate,” “expects,” “may,” “projects,” “intends,” “plans,” “believes,”
“would,” “could” and words and terms of similar substance used in connection
      with any discussion of future operating or financial performance may identify
      forward-looking statements. These forward looking statements include, but are
      not limited to, statements
      regarding: (i) our belief about our competitive position in the security access,
      tracking, asset management and monitoring, active RFID, disaster recovery and
      incidental response management markets, and our
      ability to become a key technological player in such
      markets; (ii) our belief about
      the commercial possibilities for our products in
      such
      markets; (iii) our expectation to
      leverage our current products and technologies
      for the development of new applications and penetration to additional markets;
      (iv) our expectation to
      continue to participate in the government market; (v) our belief
      about our ability to leverage our public
      sector experience into the commercial sector ;
      (vi)
      our belief regarding the
      effects of competitive pricing on our margins, sales and market share; (vii)
      our
      expectations regarding the effects of the legal proceedings we
      are
      involved in on our sales
      and operating performance, including our belief regarding the merit of the
      claim
      of the Department for Resources Supply of the Ministry of Ukraine against
      us; (viii) our belief regarding the fluctuations of our operating
      results ,
      including our belief about the effects of inflation and the fluctuation of
      the
      NIS/dollar exchange rate on our operating results ;
      ( ix)
      our expectations about our future revenues (or absence of revenues); ; (x)
      our
      expectations about the effects of seasonality on our revenues and operating
      results; (xi) our expectations
      regarding development and introduction
      of future products; (xii) our expectations
      regarding revenues from our existing customer contracts and purchase orders,
      including, without limitation, the value of our agreement for our end-to-end
      system for a national multi ID issuing and control system with the government
      of
      a European country, and our expectations for increased revenues from sales
      of
      additional technology and raw materials to such government;
      (xiii) our expectations regarding the
      success of our new active
      RFID technology and our IRMS product; (xiv) our expectations regarding the
      effectiveness of our marketing programs and generation of business from those
      programs, including our ability
      to continue to sell products through
      strategic alliances and our
      belief about
      the role customer service plays in our sales and marketing programs; (xv) our anticipation
      that sales to a relatively small
      number of customers will
      continue to account for significant portion of our net sales; (xvi) our
      expectations regarding the mix
      of our sources of revenues; (xvii) our belief about the sufficiency of our
      capital resources and other sources of liquidity to fund our planned operations;
      (xiii) our expectations regarding our recurring revenues and backlog ; (xix)
      our
      belief about our compliance with the conditions and criteria of the Law for
      the
      Encouragement of Capital Investment, 1959 ; (xx) our belief that we
      have not been a passive foreign investment company (PFIC) for U.S. tax purposes;
      and (xxi) our belief regarding the impact of recently
      issued accounting pronouncements (see note
      2(z.a) to the financial statements included
      in this report) and adoption of new
      accounting pronouncements in
      the
      future on our earnings and operating results. All
      forward-looking statements are based
      on
      our management’s present assumptions and beliefs in light of the information
      currently available to us. Actual results, levels of activity, performance
      or
      achievements may differ
      materially from those expressed
      or implied in the
      forward-looking statements for a variety of reasons, including: changes in
      demand for our products; market conditions in our industry and the economy
      as a
      whole; variation, expansions or reductions in the mix of our product offerings;
      the timing of our product introductions; increased competition; introduction
      of
      new competing technologies; the increase of unexpected expenses; and such
      other factors
      discussed below under the
      captions “Risk Factors” in Item 1.D and “Operating and Financial Review and
      Prospects” in Item 5 and elsewhere in this
      Annual Report. We are not under any obligation, and expressly disclaim any
      obligation, to update or alter any forward-looking statements, whether as a
      result of new information, future events or otherwise. All subsequent
      forward-looking statements attributable to us or any person acting on our behalf
      are expressly qualified in their entirety by the cautionary statements contained
      or referred to in this section ,
      and
      you are
      cautioned not to place undue reliance on these
      forward-looking statements which speak only as of the date of this Annual
      Report.





In
      this Annual
      Report ,
      all
      references to "Vuance" "we," "us" or "our" are to Vuance Ltd., a company
      organized under the laws of the State of Israel, and its
      subsidiaries.





In
      this
      Annual Report, unless otherwise specified or unless the context otherwise
      requires, all references to "$" or "dollars" are to U.S. dollars and all
      references to "NIS" are to New Israeli Shekels. Except as otherwise indicated,
      the financial statements of and information regarding Vuance are presented
      in
      U.S. dollars.




**Note:** *Unless
      otherwise indicated herein, the prices and quantities of our ordinary shares
      provided in this annual report reflect the 1 to 5.88235 share consolidation
      (reverse share split) that we completed on April 29, 2007 and became effective
      for trading purpose as of May 14, 2007.*




5


**PART
      I**




**ITEM
      1.** ***Identity
      of Directors, Senior Management and Advisors.***





Not
      applicable.





**ITEM
      2.** ***Offer
      Statistics and Expected Timetables.***





Not
      applicable.





**ITEM
      3.** ***Key
      Information.*** ****





***A.    Selected
      Financial Data***




The
      following selected consolidated financial data as of December 31, 2004, 2005
      and
      2006 and for the years ended December 31, 2003, 2004 2005 and 2006 have been
      derived from our audited consolidated financial statements. These financial
      statements have been prepared in accordance with generally accepted accounting
      principles in the United States, or U.S. GAAP, and audited by Fahn Kanne &
Co., a member of Grant Thornton International. The consolidated selected
      financial data as of December 31 2002 have been derived from other consolidated
      financial statements prepared in accordance with U.S. GAAP and audited by Kost,
      Forer, Gabbay & Kasierer, a member of Ernst & Young Global. The selected
      consolidated financial data set forth below should be read in conjunction with
      and are qualified by reference to "Item 5, Operating and Financial Review and
      Prospects" and the consolidated financial statements and notes thereto and
      other
      financial information included elsewhere in this Annual Report. Historical
      results are not necessarily indicative of future results.




6


SUMMARY
      OF CONSOLIDATED FINANCIAL DATA


YEAR
      ENDED DECEMBER 31,





Audited
              (IN
                THOUSANDS OF U.S. DOLLARS, EXCEPT PER SHARE DATA)2002
            
            2003
            
            2004
            
            2005
            
            2006SUMMARY
                OF STATEMENT OF OPERATIONS:Revenues
            
            
            8,027
            
            
            7,244
            
            
            7,344
            
            
            8,462
            
            
            8,795Cost
                of Revenues
            
            
            1,830
            
            
            3,102
            
            
            3,730
            
            
            4,293
            
            
            3,494Inventory
                write-off
            
            
            —
            
            
            —
            
            
            —
            
            
            287
            
            
            —Gross
                Profit
            
            
            6,197
            
            
            4,142
            
            
            3,614
            
            
            3,882
            
            
            5,301Operating
                Expenses:Research
                and Development
            
            
            1,334
            
            
            918
            
            
            845
            
            
            1,182
            
            
            1,362Selling
                and Marketing
            
            
            2,828
            
            
            3,026
            
            
            2,445
            
            
            3,003
            
            
            5,619General
                and Administrative
            
            
            1,988
            
            
            1,829
            
            
            1,955
            
            
            2,968
            
            
            2,737Restructuring
                expenses
            
            
            —
            
            
            —
            
            
            —
            
            
            496
            
            
            —Litigation
                settlement expenses
            
            
            —
            
            
            —
            
            
            —
            
            
            129
            
            
            108Total
                Operating Expenses
            
            
            6,150
            
            
            5,773
            
            
            5,245
            
            
            7,778
            
            
            9,826Capital
                gain from the sale of the e-ID Division
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            10,536Operating
                Income (Loss)
            
            
            47
            
            
            (1,631
            )
            
            (1,631
            )
            
            (3,896
            )
            
            6,011Financial
                Income (Expenses), Net
            
            
            (35
            )
            
            (233
            )
            
            (214
            )
            
            (25
            )
            
            (204
            )OTHER
                INCOME (EXPENSES), NET
            
            
            6,203
            
            
            (83
            )
            
            (27
            )
            
            (30
            )
            
            (367
            )Income
                Loss before Taxes on Income
            
            
            6,215
            
            
            (1,947
            )
            
            (1,872
            )
            
            (3,951
            )
            
            5,440Share
                in Earnings (Loss) of an AffiliatedCompany
                and impairment, Net of taxes
            
            
            (38
            )
            
            (48
            )
            
            —
            
            
            —
            
            
            —Net
                Income (Loss) from continuingoperations
            
            
            6,177
            
            
            (1,995
            )
            
            (1,872
            )
            
            (3,951
            )
            
            5,440Loss
                from discontinued operations
            
            
            (427
            )
            
            —
            
            
            —
            
            
            —
            
            
            —Net
                income (loss)
            
            $
            5,750
            
            $
            (1,995
            )
            $
            (1,872
            )
            $
            (3,951
            )
            $
            5,440PER
                SHARE DATA:Basic
                earning (loss) from continuingoperations
            
            $
            2.86
            
            $
            (0.92
            )
            $
            (0.75
            )
            $
            (1.25
            )
            $
            1.37Diluted
                earning (loss) from continuingoperations
            
            $
            2.86
            
            $
            (0.92
            )
            $
            (0.75
            )
            $
            (1.25
            )
            $
            1.31Basic
                and Diluted loss fromDiscontinued
                operations
            
            $
            (0.2
            )
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —Basic
                earning (loss) per share
            
            $
            2.66
            
            $
            (0.92
            )
            $
            (0.75
            )
            $
            (1.25
            )
            $
            1.37Diluted
                earning (loss) per share
            
            $
            2.66
            
            $
            (0.92
            )
            $
            (0.75
            )
            $
            (1.25
            )
            $
            1.31SUMMARY
                OF BALANCE SHEET DATA:Cash
                and Cash Equivalents
            
            
            4,567
            
            
            1,729
            
            
            2,894
            
            
            2,294
            
            
            2,444Short
                term deposit
            
            
            —
            
            
            697
            
            
            353
            
            
            —
            
            
            —Marketable
                debt securities
            
            
            609
            
            
            117
            
            
            —
            
            
            650
            
            
            11,077Trade
                receivables (net of allowance for doubtfulaccounts
                of $ 3,397 and $ 3,487 as ofDecember
                31, 2005 and 2006, respectively)
            
            
            2,202
            
            
            1,808
            
            
            1,463
            
            
            1,053
            
            
            2,625Inventories
            
            
            3,144
            
            
            3,236
            
            
            2,165
            
            
            2,205
            
            
            270Total
                Current Assets
            
            
            11,092
            
            
            9,881
            
            
            9,254
            
            
            8,023
            
            
            17,992TOTAL
                ASSETS
            
            
            13,756
            
            
            12,685
            
            
            13,938
            
            
            12,276
            
            
            23,098Total
                Current Liabilities
            
            
            3,468
            
            
            4,450
            
            
            4,259
            
            
            3,218
            
            
            5,452Accrued
                Severance Pay
            
            
            362
            
            
            436
            
            
            564
            
            
            616
            
            
            323SHAREHOLDERS’
                EQUITY:TOTAL
                SHAREHOLDERS' EQUITY
            
            
            9,497
            
            
            7,612
            
            
            9,115
            
            
            8,247
            
            
            15,001





7




***B.***
              **Capitalization
                  and Indebtedness**


Not
      applicable.





***C.***
            ***Reasons
                for the Offer and Use of
                Proceeds***





Not
      applicable.





***D.***
            ***Risk
                Factors***





*You
      should carefully consider the following risks together with the other
      information in this Annual Report in evaluating our business, financial
      condition and our prospects. The risks and uncertainties described below are
      not
      the only ones that we face. Additional risks and uncertainties not presently
      known to us or that we consider immaterial may also impair our business
      operations, financial results and prospects. If any of the following risks
      actually occur, our business, financial results and prospects could be harmed.
      In that case, the trading price of our ordinary shares could decline. You should
      also refer to the other information set forth in this Annual Report, including
      our financial statements and related notes and the Section captioned “Note
      Regarding Forward-Looking Statements”.*




**We
      have a history of operating losses and negative cash flows and may not be
      profitable in the future.**





We
      have
      incurred substantial losses and negative cash flows since our inception. We
      had
      an operating cash flow deficit in each of 2004, 2005, and 2006. As of December
      31, 2006, we had an accumulated deficit of approximately $18,625,000. We
      incurred net losses of approximately $ 1,872,000 and $3,951,000 in
      the
      years ended December 31, 2004 and December 31, 2005, respectively. For the
      year
      ended December 31, 2006 we would have incurred a net loss of $5,096,000, but
      for
      the $10,536,000 capital
      gain from the sale of the e-ID Division .
      We
      expect to have net operating losses and negative cash flows for the foreseeable
      future, and expect to spend significant amounts of capital to enhance our
      products and services, develop further sales and operations and fund expansion.
      As a result, we will need to generate significant revenue to achieve
      profitability. Even if we do achieve profitability, we may not be able to
      sustain or increase profitability on a quarterly or annual basis.





Parts
      of
      our operating expenses levels are based on internal forecasts for future demand
      and not on firm customer orders for products or services. Our results may be
      negatively affected by fluctuating demand for our products and services from
      one
      quarter to the next and by increases in the costs of components and raw
      materials acquired from suppliers.




**We
      will face a need for additional capital and may need to curtail our operations
      if it is not available.**





We
      have
      partially funded our operations through the issuance of equity securities and
      convertible bond to investors and may not be able to generate a positive cash
      flow from operation in the future. If we are unable to generate sufficient
      cash
      flow from operations, we will need to seek additional funds through the issuance
      of additional equity or debt securities or other sources of financing. We may
      not be able to secure such additional financing on favorable terms, or at all.
      Any additional financings will likely cause substantial dilution to existing
      stockholders. If we are unable to obtain necessary additional financing, we
      may
      be required to reduce the scope of, or cease, our operations. We believe that,
      as of the filing date of
      this annual report, our current cash and cash equivalents and marketable
      securities, in addition to our revenues generated from our business operations,
      will satisfy our operating capital needs for at least the next twelve months
      based upon our anticipated business activities. However, we may need additional
      capital even within the next twelve months if we undertake large projects or
      have a delay in one of our anticipated projects. Our need for additional capital
      to finance our operations and growth will be greater should, among other things,
      our revenue or expense estimates prove to be incorrect.





**We
      derive a substantial portion of our revenue from a small number of customers,
      and the reduction of sales to any one of those customers could adversely impact
      our operating results by causing a drop in revenues.**





We
      depend
      on a limited number of customers for a substantial portion of our revenue.
      In
      each of 2004 and 2005, we derived 66% of our consolidated net revenue from
      four
      individual customers. In the year ended December 31, 2006, four of our customers
      accounted for 80% of our consolidated net revenues as follows: the government
      of
      a European country, China Travel Services (CHK) Ltd., China Travel Service
      (Holdings) H.K. Ltd. and an African governmental agency accounted for 59%,
      10%,
      6% and 5%, respectively, of our consolidated net revenues. A substantial
      reduction in sales to, or loss of, any of our significant customers would
      adversely affect our business unless we were able to replace the revenue we
      received from those customers, which replacement we may not be able to do.
      As a
      result of this concentration of revenue from a limited number of customers,
      our
      revenue has experienced wide fluctuations, and we may continue to experience
      wide fluctuations in the future. Part of our sales are not recurring sales,
      quarterly and annual sales levels could therefore fluctuate. Sales in any period
      may not be indicative of sales in future periods.




8





**We
      are relying on On Track Innovations Ltd. as a subcontractor in projects not
      transferred as part of the sale of our E-ID Division.**





On
      December 31, 2006 we sold our E-ID Division to On Track Innovations Ltd.
      (“OTI”), an Israeli public company (NASDAQ: OTIV). Simultaneously, we entered
      into a service and supply agreement with OTI under which OTI agreed to act
      as
      our subcontractor and provide services, products and materials necessary to
      carry out and complete our obligations with regard to certain projects that
      were
      not transferred to OTI (see description of the OTI Transaction under the caption
      “The OTI Transaction” in Item 4.A). **** We
      will
      be dependant on OTI to adequately provide such services, products, and materials
      in order for us to be in good standing in, and successfully complete, these
      projects. If OTI fails to fulfill it obligations and provide such services
      and
      products as necessary for the Existing Projects, it could delay our receipt
      of
      revenues for these projects, subject us to certain remedies available to our
      customers in the Existing Projects, and damage our business reputation, and
      therefore could have a material adverse effect on our business, operating
      results and financial condition.





**Our
      reliance on third party technologies, raw materials and components for the
      development of some of our products and our reliance on third parties for
      manufacturing may delay product launch, impair our ability to develop and
      deliver products or hurt our ability to compete in the
      market** .





Most
      of
      our products integrate third-party technology that we license and/or raw
      materials and components that we purchase or otherwise obtain the right to
      use,
      including: operating systems, microchips, security and cryptography technology
      for card operating systems, which prevents unauthorized parties from tampering
      with our cards, and dual interface technology, which enables cards to operate
      in
      both contact and contactless mode. Our ability to purchase and license new
      technologies and components from third parties is and will continue to be
      critical to our ability to offer a complete line of products that meets customer
      needs and technological requirements. We may not be able to renew our existing
      licenses or be able to purchase components and raw materials on favorable terms,
      or at all. If we lose the rights to a patented technology, we may need to stop
      selling or may need to redesign our products that incorporate that technology,
      and we may lose the potential competitive advantage such technology gave us.
      In
      addition, competitors could obtain licenses for technologies for which we are
      unable to obtain licenses, and third parties may develop or enable others to
      develop a similar solution to security issues, either of which events could
      adversely affect our results of operations. Also, dependence on the patent
      protection of third parties may not afford us any control over the protection
      of
      the technologies upon which we rely. If the patent protection of any of these
      third parties were compromised, our ability to compete in the market also would
      be impaired.





We
      do not
      have minimum supply commitments from our vendors for our raw materials or
      components and generally purchase raw materials **** and
      components on a purchase order basis. Although we generally use standard raw
      materials and components for our systems, some of the key raw materials or
      components are available only from a single source or from limited sources.
      For
      example, Teslin®, which is a primary raw material used in our smart card
      products is only available from a single source. Similarly, many of our various
      chips and toners are only available from limited sources. Even where multiple
      sources are available, we typically obtain components and raw materials from
      only one vendor to ensure high quality, prompt delivery and low cost. If one
      of
      our suppliers were unable to meet our supply demands and we could not quickly
      replace the source of supply, it could have a material adverse effect on our
      business, operating results and financial condition, for reasons including
      a
      delay of receipt of revenues and damage to our business reputation.





**Delays
      in deliveries from our suppliers or defects in goods or components supplied
      by
      our vendors could cause our revenues and gross margins to
      decline.**





We
      rely
      on a limited number of vendors for certain components for the products we are
      supplying and rely on a single vendor for Teslin®. We do not have any long-term
      contracts with our suppliers. Any undetected flaws in components or other
      materials to be supplied by our vendors could lead to unanticipated costs to
      repair or replace these parts or materials. Even though there are multiple
      suppliers, we purchase some of our components from a single supplier to take
      advantage of volume discounts, which presents a risk that the components may
      not
      be available in the future on commercially reasonable terms or at all. Although
      we believe that there are additional suppliers for the equipment and supplies
      that we require, we may not be able to make such alternative arrangement
      promptly. If one of our suppliers were unable to meet our supply demands and
      we
      could not quickly replace the source of supply, it could cause a delay of
      receipt of revenues and damage our business reputation.




9


**Our
      inability to maintain existing relationships with primary integrators for
      governmental secured ID and passport projects could impact our ability to obtain
      or sell our products, and prevent us from generating
      revenues.**





We
      obtain
      and sell many of our products through strategic alliance and supplier agreements
      in which we act as subcontractors or suppliers to the primary integrator or
      contractor, including China Travel Service (Holdings) H.K. Ltd. in Hong Kong
      for
      the Hong Kong passport project and China Travel Services (CHK) Ltd.
      for  the China
      re-entry card project. The loss of any of our existing strategic relationships,
      could adversely affect our ability to sell our products.





We
      sometimes depend upon our strategic partners to market our products and to
      fund
      and perform their obligations as contemplated by our agreements with them.
      We do
      not control the time and resources devoted by our partners to these activities.
      These relationships may not continue or may require us to spend significant
      financial, personnel and administrative resources from time to time. We may
      not
      have the resources available to satisfy our commitments, which may adversely
      affect our strategic relationships.





If
      alliance or supplier agreements are cancelled, modified or delayed, if alliance
      or supplier partners decide not to purchase our products or to purchase only
      limited quantities of our products, our ability to produce and sell our products
      and to generate revenues could be adversely affected.





**We
      have sought U.S. government contracts in the past and may seek additional U.S.
      government contracts in the future, which subjects us to certain risks
      associated with such types of contracts.**




Most
      U.S.
      government contracts are awarded through a competitive bidding process, and
      some
      of the business that we expect to seek in the future likely will be subject
      to a
      competitive bidding process. Competitive bidding presents a number of risks,
      including:




·
            the
                frequent need to compete against companies or teams of companies
                with more
                financial and marketing resources and more experience than we have
                in
                bidding on and performing major
                contracts;




·
            the
                need to compete against companies or teams of companies that may
                be
                long-term, entrenched incumbents for a particular contract we are
                competing for and which have, as a result, greater domain expertise
                and
                established customer relations;




·
            the
                need to compete on occasion to retain existing contracts that have
                in the
                past been awarded to us on a sole-source
                basis;




·
            the
                substantial cost and managerial time and effort necessary to prepare
                bids
                and proposals for contracts that may not be awarded to
                us;




·
            the
                need to accurately estimate the resources and cost structure that
                will be
                required to service any fixed-price contract that we are
                awarded;****and




·
            the
                expense and delay that may arise if our competitors protest or challenge
                new contract awards made to us pursuant to competitive bidding or
                subsequent contract modifications, and the risk that any of these
                protests
                or challenges could result in the resubmission of bids on modified
                specifications, or in termination, reduction or modification of the
                awarded contract.




We
      may
      not be afforded the opportunity in the future to bid on contracts that are
      held
      by other companies and are scheduled to expire if the U.S. government determines
      to extend the existing contract. If we are unable to win particular contracts
      that are awarded through the competitive bidding process, we may not be able
      to
      operate in the market for products and services that are provided under those
      contracts for a number of years. If we are unable to win new contract awards
      or
      retain those contracts, if any, that we are awarded over any extended period,
      our business, prospects, financial condition and results of operations will
      be
      adversely affected.





In
      addition, U.S. government contracts subjects us to risks associated with public
      budgetary restrictions and uncertainties, actual contracts that are less than
      awarded contract amounts, and cancellation at any time at the option of the
      government. Any failure to comply with the terms of any government contracts
      could result in substantial civil and criminal fines and penalties, as well
      as
      suspension from future contracts for a significant period of time, any of which
      could adversely affect our business by requiring us to pay significant fines
      and
      penalties or prevent us from earning revenues from government contracts during
      the suspension period. Cancellation of any one of our major government
      contracts, however, could have a material adverse effect on our financial
      condition.




10





The
      U.S.
      government may be in a position to obtain greater rights with respect to our
      intellectual property than we would grant to other entities. Government agencies
      also have the power, based on financial difficulties or investigations of their
      contractors, to deem contractors unsuitable for new contract awards. Because
      we
      will engage in the government contracting business, we will be subject to audits
      and may be subject to investigation by governmental entities. Failure to comply
      with the terms of any government contracts could result in substantial civil
      and
      criminal fines and penalties, as well as suspension from future government
      contracts for a significant period of time, any of which could adversely affect
      our business by requiring us to spend money to pay the fines and penalties
      and
      prohibiting us from earning revenues from government contracts during the
      suspension period.





Furthermore,
      government programs can experience delays or cancellation of funding, which
      can
      be unpredictable. For example, the U.S. military’s involvement in Iraq has
      caused the diversion of some Department of Defense funding away from the certain
      projects in which we participate, thereby delaying orders under certain of
      our
      governmental contracts. This makes it difficult to forecast our revenues on
      a
      quarter-by-quarter basis.





**If
      our current business will not generate sufficient revenues to compensate for
      the
      loss of revenue resulting from the OTI Transaction, our overall income might
      decline.**




While
      we
      currently continue to generate income from the Existing Projects, we do not
      expect to generate further income from additional projects related to the E-ID
      Division. If, in the long-term, we fail to generate sufficient revenues from
      our
      new business (IRMS and active RFID), our overall income might
      decline.





**We
      may suffer a loss on our investment in the OTI Transaction due to a decrease
      in
      the price of OTI’s shares.**





As
      of
      December 31, 2006 our investment in OTI’s ordinary shares consisted of
      $11,077,000 marketable securities (current assets) and $4,431,000 restricted
      marketable securities (long-term investment). As described above, the shares
      were restricted and are subject to a lock-up agreement, where one-seventh of
      the
      shares (403,885 ordinary shares) will be released from the lock-up restrictions
      every three months beginning on the closing date, December 31, 2006. OTI shares
      are traded on the NASDAQ Global Market. Profitability of our investment in OTI’s ordinary shares will depend on the
      share price and our ability to sell the OTI ordinary shares.





**Our
      dependence on third party distributors, sales agents, and value-added resellers
      could result in marketing and distribution delays, which would prevent us from
      generating sales revenues.**





We
      market
      and sell some of our products using a network of distributors covering several
      major world regions, including the United States. We
      establish relationships with distributors and resellers through written
      agreements that provide prices, discounts and other material terms and
      conditions under which the reseller is eligible to purchase our systems and
      products for resale. These agreements generally do not grant exclusivity to
      the
      distributors and resellers and, as a general matter, are not long-term
      contracts, do not have commitments for minimum sales and could be terminated
      by
      the distributor. We do not have agreements with all of our
      distributors. We are
      currently engaged
      in discussions with other potential distributors, sales agents, and value-added
      resellers. Such arrangements may never be finalized and, if finalized, such
      arrangements may not increase our revenues or enable us to achieve
      profitability.





Our
      ability to terminate a distributor who is not performing satisfactorily may
      be
      limited. Inadequate performance by a distributor would adversely affect our
      ability to develop markets in the regions for which the distributor is
      responsible and could result in substantially greater expenditures by us in
      order to develop such markets. Our operating results will be highly dependent
      upon: (i) our ability to maintain our existing distributor arrangements; (ii)
      our ability to establish and maintain coverage of major geographic areas and
      establish access to customers and markets; and (iii) the ability of our
      distributors, sales agents, and value-added resellers to successfully market
      our
      products. A failure to achieve these objectives could result in lower
      revenues.




11


**Third
      parties could obtain access to our proprietary information or could
      independently develop similar technologies.**





Despite
      the precautions we take, third parties may copy or obtain and use our
      proprietary technologies, ideas, know-how and other proprietary information
      without authorization or may independently develop technologies similar or
      superior to our technologies. In addition, the confidentiality and
      non-competition agreements between us and most of our employees, distributors
      and clients may not provide meaningful protection of our proprietary
      technologies or other intellectual property in the event of unauthorized use
      or
      disclosure. If we are not able to defend successfully our industrial or
      intellectual property rights, we might lose rights to technology that we need
      to
      develop our business, which may cause us to lose potential revenues, or we
      might
      be required to pay significant license fees for the use of such technology.
      To
      date, we have relied primarily on a combination of patent, trade secret and
      copyright laws, as well as nondisclosure and other contractual restrictions
      on
      copying, reverse engineering and distribution to protect our proprietary
      technology. Our patent portfolio currently consist of one patent application
      pending in the United States and an additional PCT application, related to
      our
      IRMS and RFID technologies.





Our
      patent applications may not result in issued patents, and even if they result
      in
      issued patents, the patents may not have claims of the scope we seek. Even
      in
      the event that these patents are not issued, the applications may become
      publicly available and proprietary information disclosed in the application
      will
      become available to others. In addition, any issued patents may be challenged,
      invalidated or declared unenforceable. Our present and future patents may
      provide only limited protection for our technology and may not be sufficient
      to
      provide competitive advantages to us. For example, competitors could be
      successful in challenging any issued patents or, alternatively, could develop
      similar or more advantageous technologies on their own or design around our
      patents .
      Any
      inability to protect intellectual property rights in our technology could enable
      third parties to compete more effectively with us and/or could reduce our
      ability to compete. In addition, these efforts to protect our intellectual
      property rights could require us to incur substantial costs even when our
      efforts are successful.





In
      addition, the laws of certain foreign countries may not protect our intellectual
      property rights to the same extent as do the laws of Israel or the United
      States. Our means of protecting our intellectual property rights in Israel,
      the
      United States or any other country in which we operate may not be adequate
      to
      fully protect our intellectual property rights. For instance, the intellectual
      property rights of our Asian subsidiary, SuperCom Asia Pacific Ltd. may not
      be
      fully protected by the laws of Hong Kong and the People’s Republic of China
      (“PRC”). The PRC does not yet possess a comprehensive body of intellectual
      property laws. As a result, the enforcement, interpretation and implementation
      of existing laws, regulations or agreements may be sporadic, inconsistent and
      subject to considerable discretion. The PRC’s judiciary has not had sufficient
      opportunity to gain experience in enforcing laws that exist, leading to a higher
      than usual degree of uncertainty as to the outcome of any litigation. As the
      legal system develops, entities such as ours may be adversely affected by new
      laws, changes to existing laws (or interpretations thereof) and preemption
      of
      provincial or local laws by national laws. Even when adequate law exists in
      the
      PRC, it may not be possible to obtain speedy and equitable enforcement of the
      law.





We
      may
      face intellectual property litigation, which could be costly, harm our
      reputation, limit our ability to sell our products, force us to modify our
      products or obtain appropriate licenses ,
      and
      divert the attention of management and technical personnel .





Our
      products employ technology that may infringe
      on the proprietary rights of others, and, as a result, we could become liable
      for significant damages and suffer other harm to our business. Other than the
      ongoing litigation with Secu-Systems Ltd., as described in Item 8 below under
      the caption “Legal Proceedings,” we have not been subject to intellectual
      property litigation to date. On August 8, 2003, we received a letter stating
      that we may be infringing certain patents of third parties with respect to
      our
      hot lamination process for plastic cards. We reviewed the claims made in the
      letter and we do not believe that our products or technology infringe any third
      party's patents as claimed in the letter. Since the initial letter, we received
      another letter dated July 13, 2004 from the same party requesting that we
      respond to their claim and stating that attractive licenses are available.
      On
      August 11, 2004 we responded to this letter and indicated that we
      do not infringe such parties’ patents. To date, no infringement claims have been
      filed against us in connection with the foregoing letters. We believe that
      hot
      lamination of plastic cards is a widely known process that is used by most
      card
      manufacturers. Even if it were determined that we are infringing such third
      party’s patents, we feel that we could use another process to laminate plastic
      cards and our business would not be materially affected.





Litigation
      may be necessary in the future to enforce any patents we may receive and other
      intellectual property rights, to protect our trade secrets, to determine the
      validity and scope of the proprietary rights of others, or to defend against
      claims of infringement or invalidity, and we may not prevail in any future
      litigation. Litigation, whether or not determined in our favor or settled,
      could
      be costly, could harm our reputation and could divert the efforts and attention
      of our management and technical personnel from normal business operations.
      In
      addition, adverse determinations in litigation could result in the loss of
      our
      proprietary rights, subject us to significant liabilities, require us to seek
      licenses from third parties, prevent us from licensing our technology or from
      selling or manufacturing our products, or require us to expend significant
      resources to modify our products or attempt to develop non-infringing
      technology, any of which could seriously harm our business.




12





Our
      products may contain technology provided to us by third parties. Because we
      did
      not develop such technology ourselves, we may have little or no ability to
      determine in advance whether such technology infringes the intellectual property
      rights of a third party. Our suppliers and licensors may not be required to
      indemnify us in the event that a claim of infringement is asserted against
      us,
      or they may be required to indemnify us only with respect to intellectual
      property infringement claims in certain jurisdictions, and/or only up to a
      maximum amount, above which we would be responsible for any further costs or
      damages. In addition, we have indemnification obligations to certain customers,
      as well as to OTI with respect to any infringement of third-party patents and
      intellectual property rights by our products. If litigation were to be filed
      against these parties in connection with our technology, we will be required
      to
      defend and indemnify such customers.





**A
      security breach of our internal systems or those of our customers could harm
      our
      business by adversely affecting the market's perception of our products and
      services thereby causing our revenues to decline.**





For
      us to
      penetrate further the marketplace, the marketplace must be confident that we
      provide effective security protection for national identity and other secured
      ID
      documents and cards. Although we have not experienced any act of sabotage or
      unauthorized access by a third party of our software or technology to date,
      if
      an actual or perceived breach of security occurs in our internal systems or
      those of our customers, regardless of whether we caused the breach, it could
      adversely affect the market's perception of our products and services. This
      could cause us to lose customers, resellers, alliance partners or other business
      partners thereby causing our revenues to decline. If we or our customers were
      to
      experience a breach of our internal systems, our business could be severely
      harmed by adversely affecting the market's perception of our products and
      services.





**We
      may be exposed to significant liability for actual or perceived failure to
      provide required products or services which could damage our reputation and
      adversely affect our business by causing our revenues to decline and our costs
      to rise.**




Products
      as complex as those we offer may contain undetected errors or may fail when
      first introduced or when new versions are released. Despite our product testing
      efforts and testing by current and potential customers, it is possible that
      errors will be found in new products or enhancements after commencement of
      commercial shipments. The occurrence of product defects or errors could result
      in adverse publicity, delay in product introduction, diversion of resources
      to
      remedy defects, loss of or a delay in market acceptance, or claims by customers
      against us, or could cause us to incur additional costs or lose revenues, any
      of
      which could adversely affect our business.





Because
      our customers rely on our products for critical security applications, we may
      be
      exposed to claims for damages allegedly caused to a customer as a result of
      an
      actual or perceived failure of our products. An actual or perceived breach
      of
      security systems of one of our customers, regardless of whether the breach
      is
      attributable to our products or solutions, could adversely affect our business
      reputation. Furthermore, our failure or inability to meet a customer's
      expectations in the performance of our services, or to do so in the time frame
      required by the customer, regardless of our responsibility for the failure,
      could result in a claim for substantial damages against us by the customer,
      discourage other customers from engaging us for these services, and damage
      our
      business reputation. We carry product liability insurance, but existing coverage
      may not be adequate to cover potential claims.





We
      carry
      product liability insurance, errors and omissions for high-technology companies
      insurance and insurance to guard against losses caused by employees' dishonesty.
      We believe that this insurance coverage is comparable to that of other similar
      companies in our industry. However, that insurance may not continue to be
      available to us on reasonable terms or in sufficient amounts to cover one or
      more large claims, or the insurer may disclaim coverage as to any future claim.
      We do not maintain insurance coverage for employee errors or security breaches,
      nor do we maintain specific insurance coverage for any interruptions in our
      business operations. The successful assertion of one or more large claims
      against us that exceed available insurance coverage, or changes in our insurance
      policies, including premium increases or the imposition of large deductibles
      or
      co-insurance requirements, could adversely affect our business by increasing
      our
      costs.




13


**Our
      efforts to expand our international operations are subject to a number of risks,
      any of which could adversely reduce our future international
      sales.**





Most
      of
      our revenues to date have been generated in jurisdictions other than the United
      States. Our inability to obtain or maintain federal or foreign regulatory
      approvals relating to the import or export of our products on a timely basis
      could adversely affect our ability to expand our international business.
      Additionally, our international operations could be subject to a number of
      risks, any of which could adversely affect our future international sales,
      including:





·
            increased
                collection risks;





·
            trade
                restrictions;





·
            export
                duties and tariffs;





·
            uncertain
                political, regulatory and economic
                developments;





·
            inability
                to protect our intellectual property rights;





·
            very
                aggressive competitors;





·
            lower
                gross margins in commercial sales in Hong Kong and
                China;





·
            business
                development in Hong Kong and China is time consuming and risky due
                to the
                uncertain political, regulatory and legal environment; and





·
            currency
                issues.





In
      addition, in many countries the national security organizations require our
      employees to obtain clearance before such employees can work on a particular
      transaction. Failure to receive, or delays in the receipt of, relevant foreign
      qualifications also could have a material adverse effect on our ability to
      obtain sales at all or on a timely basis. Additionally, as foreign government
      regulators have become increasingly stringent, we may be subject to more
      rigorous regulation by governmental authorities in the future. If we fail to
      adequately address any of these regulations, our business will be
      harmed.





**The
      markets that we target for a substantial part of our future growth are in very
      early stages of development, and if they do not develop our business might
      not
      grow as much or as profitably as we hope.**





Many
      of
      the markets that we target for our future growth are small or non-existent
      and
      need to develop if we are to achieve our growth objectives. If some or all
      of
      these markets do not develop, or if they develop more slowly than we anticipate,
      then we will not grow as quickly or profitably as we hope. In February 2006,
      we
      announced the introduction of a new technology and solution for actively
      tracking people, objects and assets. Active RFID Tracking Systems (PureRF)
      and
      the establishment of a new subsidiary (VUANCE RFID Inc., formerly PureRF Inc.)
      that will focus on this growing market. This new technology expands our Homeland
      Security offerings through a wireless asset tracking system for strategic and
      high-value assets and objects. We developed this new technology solution in
      response to growing market demand for asset tracking solutions in the Homeland
      Security and commercial markets. While the incident management and Homeland
      Security benefits provided by PureRF are relatively obvious we have also
      identified other market opportunities in the public and private sectors of
      the
      economy.




Our
      Incident Response Management System (IRMS) has not been widely adopted by state
      and local governments, largely due to the dependency on federal grants ,cost
      of
      the necessary infrastructure and the relatively limited capabilities of previous
      solutions. We are investing in the credentialing, identification ,active RFID
      and security networks products and services, but so far we have not deployed
      our
      systems on a widespread basis other than a growing demand based on our installed
      base.




In
      2006,
      our revenues from the government market totaled approximately $7,947,000
      compared to $848,000 from the commercial market. As a general matter, our
      revenues in the commercial market are derived from sales of products that we
      adapted to the commercial market from the government market. Although we believe
      the government market is critical to our success in the short term, we believe
      that both the government and commercial markets especially for the RFID
      applications will be critical to our long-term future success. The
      development of these markets will depend on many factors that are beyond our
      control, including the following
      factors (and factors
      that are discussed elsewhere in the
      Risk Factors); (1) there can be no assurances that we will be able to continue
      to apply our expertise and solutions developed for the government market into
      the commercial market; (2) the ability of public safety and other government
      agencies to access DHS and other homeland security-related grants for incident
      management and related purposes; (3) The ability of the commercial markets
      to
      adopt and adhere the Active RFID solutions; and (4) the ability of our
      management to successfully market its technologies to such government and/or
      commercial entities.




14




**The
      success of our new business lines, comprising of the IRMS and active RFID
      products, is dependent on several factors.**





The
      success of our
      IRMS
      and active RFID products is dependent on several factors, including proper
      new
      product definition, product cost, timely completion and introduction of the
      new
      products, differentiation
      of the new products from those of our competitors, market acceptance of these
      products, as well as our existing and potential customers’ varying budgets for
      capital expenditures and new product introduction. We have addressed the need
      to
      develop new
      products through our internal development efforts and joint development efforts
      with other companies. In light of the OTI Transaction, the IRMS and active
      RFID
      will be our main line of products in the future (although not our sole source
      of
      revenue, see description of the OTI Transaction and Existing Projects in Item
      4
      below). There can be no assurance that we will successfully identify new product
      opportunities and develop and bring our
      new
      products to market in a timely manner, or that the products and technologies
      developed by others will not render our products or technologies obsolete or
      noncompetitive. The failure of our
      new
      products development efforts could have a material adverse effect on our
      business and results of operations.





**If
      our smart card and highly secured document technology will cease to be adopted
      and used by government and industry organizations, we may lose some of our
      existing customers and our business might not maintain its profitably or even
      diminish.**




Our
      ability to grow depends significantly on whether governmental and industrial
      organizations adopt our technology and solutions as part of their new standards
      and whether we will be able to leverage our expertise with government products
      into commercial products .
      If
      these organizations do not adopt our technology, then we might not be able
      to
      penetrate some of the new markets we are targeting, or we might lose some of
      our
      existing customer base. There also can be no assurances that we will be able
      to
      continue to apply our expertise and solutions developed for the public sector
      into the commercial market.





In
      order
      for us to achieve our growth objectives, the credentialing ,identification
      ,tracking and active RFID technologies must be adopted in a variety of areas,
      including:




·
            public
                safety and emergency areas





·
            Asset
                management





·
            patient
                and critical equipment tracking in the health care sector





·
            Monitoring
                and controlling of evidence in a crime scene
                environment





·
            transportation
                applications using active RFID as method of monitor and
                control





·
            access
                control in such fields as education and health
                care.




Any
      or
      all of these areas may not adopt RFID and the IRMS technology.





We
      cannot
      accurately predict the future growth rate of this market, if any, or the
      ultimate size of the RFID and credentialing technology market. The expansion
      of
      the market for our products and services depends on a number of factors such
      as:





·
            the
                cost, performance and reliability of our products and services compared
                to
                the products and services of our
                competitors;


·
            customers’
                perception of the benefits of smart card
                solutions;




15




·
            public
                perceptions of the intrusiveness of these solutions and the manner
                in
                which organizations use the information
                collected;


·
            public
                perceptions regarding the confidentiality of private
                information;


·
            customers’
                satisfaction with our products and services;
                and


·
            marketing
                efforts and publicity regarding our products and
                services.




Even
      if
      credentialing and matching solutions gain wide market acceptance, our products
      and services may not adequately address market requirements and may not gain
      wide market acceptance. If smart card solutions or our products and services
      do
      not gain wide market acceptance our business and our financial results will
      suffer.





**We
      need to develop our position as a provider of IRMS and Active RFID systems
      and
      services to earn high margins from our technology, and if we are unable to
      develop such position, our business will not be as profitable as we hope, if
      profitable at all.**





The
      increasing sophistication of IRMS and Active RFID technologies places a premium
      on providing innovative software systems and services to customers, in addition
      to manufacturing and supplying IRMS and Active RFID systems. While we have
      had
      some early success positioning ourselves as a provider of services and systems,
      we may not continue to be successful with this strategy and we may not be able
      to capture a significant share of the market for the sophisticated services
      and
      systems that we believe are likely to produce attractive margins in the future.
      A significant portion of the value of IRMS and Active RFID technologies lies
      in
      the development of software and applications that will permit the use of IRMS
      and Active RFID systems in new markets. In contrast, the margins involved in
      manufacturing and selling IRMS and Active RFID systems can be relatively small,
      and might not be sufficient to permit us to earn an attractive return on our
      development investments.





**The
      time from our initial contact with a customer to a sale is long and subject
      to
      delays, which could result in the postponement of our receipt of revenues from
      one accounting period to the next, increasing the variability of our results
      of
      operations and causing significant fluctuations in our revenue from quarter
      to
      quarter.**




Our
      financial and operating results have fluctuated in the past and our financial
      and operating results could fluctuate in the future from quarter to quarter
      for
      the following reasons:





·
            long
                customer sales cycles;





·
            reduced
                demand for our products and
                services;




·
            price
                reductions, new competitors, or the introduction of enhanced products
                or
                services from new or existing
                competitors;




·
            changes
                in the mix of products and services we or our customers and distributors
                sell;




·
            contract
                cancellations, delays or amendments by
                customers;




·
            the
                lack of government demand for our products and services or the lack
                of
                government funds appropriated to purchase our products and
                services;




·
            unforeseen
                legal expenses, including litigation
                costs;




·
            expenses
                related to acquisitions;




·
            other
                non-recurring financial charges;




·
            the
                lack of availability or increase in cost of key components and
                subassemblies; and




·
            the
                inability to successfully manufacture in volume, and reduce the price
                of,
                certain of our products that may contain complex designs and
                components.





The
      period between our initial contact with a potential customer and the purchase
      of
      our products and services is often long and subject to delays associated with
      the budgeting, approval and competitive evaluation processes that frequently
      accompany significant capital expenditures, particularly by governmental
      agencies. The typical sales cycle for our government customers has to date
      ranged from three to 24 months and the typical sales cycle for our commercial
      customers has ranged from one to six months. A lengthy sales cycle may have
      an
      impact on the timing of our revenue, which may cause our quarterly operating
      results to fall below investor expectations. We believe that a customer's
      decision to purchase our products and services is discretionary, involves a
      significant commitment of resources, and is influenced by customer budgetary
      cycles. To successfully sell our products and services, we generally must
      educate our potential customers regarding their use and benefits, which can
      require significant time and resources. This significant expenditure of time
      and
      resources may not result in actual sales of our products and
      services.




16





The
      lead-time for ordering parts and materials and building many of our products
      can
      be many months. As a result, we must order parts and materials and build our
      products based on forecasted demand. If demand for our products lags
      significantly behind our forecasts, we may produce more products than we can
      sell, which can result in cash flow problems and write-offs or write-downs
      of
      obsolete inventory.





**Our
      markets are highly competitive and competition could harm our ability to sell
      products and services and could reduce our market share.**





The
      market for credentialing and active RFID enabled products and services is
      intensely competitive. We expect competition to increase as the industry grows
      and as credentialing and RFID technology begins to converge with the access
      control and information technology industry. We may not be able to compete
      successfully against current or future competitors. We face competition from
      technologically sophisticated companies, many of which have substantially
      greater technical, financial, and marketing resources than us. In some cases,
      we
      compete with entities that have pre-existing relationships with potential
      customers. As the RFID enabled solutions market expands, we expect additional
      competitors to enter the market.





Some
      of
      our competitors and potential competitors have larger technical staffs, larger
      customer bases, more established distribution channels, greater brand
      recognition and greater financial, marketing and other resources than we do.
      Our
      competitors may be able to develop products and services that are superior
      to
      our products and services, that achieve greater customer acceptance or that
      have
      significantly improved functionality as compared to our existing and future
      products and services. In addition, our competitors may be able to negotiate
      strategic relationships on more favorable terms than we are able to negotiate.
      Many of our competitors may also have well established relationships with our
      existing and prospective customers. Increased competition may result in our
      experiencing reduced margins, loss of sales or decreased market
      share.





The
      average selling prices for our products may decline as a result of competitive
      pricing pressures, promotional programs and customers who negotiate price
      reductions in exchange for longer-term purchase commitments. The pricing of
      products depends on the specific features and functions of the products,
      purchase volumes and the level of sales and service support required. As we
      experience pricing pressure, the average selling prices and gross margins for
      our products may decrease over product lifecycles. These
      same competitive pressures may require us to write down the carrying value
      of
      any inventory on hand, which would adversely affect our operating results and
      adversely affect our earnings per share.





**We
      may pursue acquisitions or investments in complementary technologies and
      businesses, which could harm our operating results and may disrupt our
      business.** ****





In
      the
      future, we may pursue acquisitions of, or investments in, complementary
      technologies and businesses. We may be unable to identify suitable acquisition
      candidates in the future or to make these acquisitions on a commercially reasonable basis,
      or
      at all. Acquisitions present a number of potential risks and challenges that
      could, if not met, disrupt our business operations, increase our operating
      costs
      and reduce the value to us of the acquired company. For example, if we identify
      an acquisition candidate, we may not be able to successfully negotiate or
      finance the acquisition on favorable terms. Even if we are successful, we may
      not be able to integrate the acquired businesses, products or technologies
      into
      our existing business and products. Furthermore, potential acquisitions and
      investments, whether or not consummated, may divert our management’s attention
      and require considerable cash outlays at the expense of our existing operations.
      In addition, to complete future acquisitions, we may issue equity securities,
      incur debt, assume contingent liabilities or have amortization expenses and
      write-downs of acquired assets, which could
      adversely affect our profitability.




17


**We
      rely on the services of certain executive officers and key personnel, the loss
      of whom could adversely affect our operations by causing a disruption to our
      business.**





Our
      future success depends largely on the efforts and abilities of our executive
      officers and senior management and other key employees, including technical
      and
      sales personnel. The loss of the services of any of these persons could disrupt
      our business until replacements, if available, can be found. We do not maintain
      any key-person insurance for any of our employees.





**Our
      ability to remain competitive depends in part on attracting, hiring and
      retaining qualified technical personnel and, if we are not successful in such
      hiring and retention, our business could be disrupted.**





Our
      future success depends in part on the availability of qualified technical
      personnel, including personnel trained in software and hardware applications
      within specialized fields. As a result, we may not be able to successfully
      attract or retain skilled technical employees, which may impede our ability
      to
      develop, install implement and otherwise service our software and hardware
      systems and to efficiently conduct our operations.





The
      information technology and network security industries are characterized by
      a
      high level of employee mobility and the market for technical personnel remains
      extremely competitive in certain regions, including Israel. This competition
      means there are fewer highly qualified employees available to hire, the costs
      of
      hiring and retaining such personnel are high and highly qualified employees
      may
      not remain with us once hired. Furthermore, there may be pressure to provide
      technical employees with stock options and other equity interests in us, which
      may dilute our earnings (loss) per share.





Additions
      of new personnel and departures of existing personnel, particularly in key
      positions, can be disruptive, might lead to additional departures of existing
      personnel and could have a material adverse effect on our business, operating
      results and financial condition.





**Our
      planned growth will place significant strain on our financial and managerial
      resources and may negatively affect our results of operations and ability to
      grow.**





Our
      ability to manage our growth effectively will require us:





·
            to
                continue to improve our operations, financial and management controls,
                reporting systems and procedures;





·
            to
                train, motivate and manage our employees;
                and





·
            as
                required, to install new management information
                systems.





Our
      existing management and any new members of management may not be able to augment
      or improve existing systems and controls or implement new systems and controls
      in response to anticipated future growth. If we are successful in achieving
      our
      growth plans, such growth is likely to place a significant burden on the
      operating and financial systems, resulting in increased responsibility for
      our
      senior management and other personnel.




18





**Some
      of our products are subject to government regulation of radio frequency
      technology which could cause a delay or inability to introduce such products
      in
      the United States and other markets.**





The
      rules
      and regulations of the United States Federal Communications Commission or,
      the
      "FCC" limit the radio frequency used by and level of power emitting from
      electronic equipment. Our readers, controllers and other radio frequency
      technology scanning equipment are required to comply with these FCC rules which
      may require certification, verification or registration of the equipment with
      the FCC. Certification and verification of new equipment requires testing to
      ensure the equipment's compliance with the FCC's rules. The equipment must
      be
      labeled according to the FCC's rules to show compliance with these rules.
      Testing, processing of the FCC's equipment certificate or FCC registration,
      and
      labeling may increase development and production costs and could delay
      introduction of our verification scanning device and next generation radio
      frequency technology scanning equipment into the U.S. market. Electronic
      equipment permitted or authorized to be used by the FCC through our
      certification or verification procedures must not cause harmful interference
      to
      licensed FCC users, and it is subject to radio frequency interference from
      licensed FCC users. Selling, leasing or importing non compliant equipment is
      considered a violation of FCC rules and federal law and violators may be subject
      to an enforcement action by the FCC. Any failure to comply with the applicable
      rules and regulations of the FCC could have a material adverse effect on our
      business, operating results and financial by increasing our costs due to
      compliance and/or limit our sales in the United States.





**Conditions
      in Israel affect our operations in Israel and may limit our ability to sell
      our
      products and services.**





We
      are
      incorporated under Israeli law and our principal executive offices,
      manufacturing facility and research and development facility are located in
      Israel. Political, economic and military conditions in Israel will, accordingly,
      directly affect our operations. Since the establishment of the State of Israel
      in 1948, a number of armed conflicts have taken place between Israel and its
      Arab neighbors and a state of hostility, varying from time to time in degree
      and
      intensity, has led to security and economic problems for Israel. Although
      Israel has entered into various agreements with its Arab neighbors and the
      Palestinian Authority, there has been an increase in unrest and terrorist
      activity in Israel, in varying levels of severity, since September 2000 through
      2006. The election in early 2006 of representatives of the Hamas, an Islamic
      resistance movement, to a majority of seats in the Palestinian Legislative
      Council and the resulting tension among the different Palestinian functions
      may
      create additional unrest and uncertainty. In July 2006, an armed conflict
      erupted between Israel and Hezbollah, a Lebanese Islamist Shiite militia group
      and political party, which involved rocket attacks on populated areas in the
      northern part of Israel. On August 14, 2006, a cease-fire between Hezbollah
      and
      Israel took effect. This situation may have an adverse effect on Israel’s
      economy, primarily in the geographical areas directly harmed by this conflict.
      Furthermore, several countries still restrict trade with Israeli companies,
      which may limit our ability to make sales in, or purchase components from,
      those
      countries. Any future-armed conflict, political instability, continued violence
      in the region or restrictions could have a material adverse effect on our
      business, operating results and financial condition. No predictions can be
      made
      as to whether or when a final resolution of the area’s problems will be achieved
      or the nature thereof and to what extent the situation will impact Israel’s
      economic development or our operations.





**Our
      operations could be disrupted as a result of the obligation of management or
      key
      personnel to perform military service in Israel.**





Generally,
      all nonexempt male adult citizens and permanent residents of Israel are
      obligated to perform annual military reserve duty and are subject to being
      called for active duty at any time under emergency circumstances.Currently,
      Israeli law requires most male Israeli citizens to perform military reserve
      duty
      annually until the age of 45. Generally, between five and ten, representing
      approximately 8% to 17%, of our officers and employees are at any one time
      obligated to perform annual reserve duty. We believe that a maximum of
      approximately 17% of our employees at any one time could be called for active
      duty under emergency circumstances. While we have operated effectively under
      these requirements since our incorporation, we cannot predict the full impact
      of
      such conditions on us in the future, particularly if emergency circumstances
      occur. If many of our employees are called for active duty, our operations
      in
      Israel and our business, results and financial condition may be adversely
      affected.





**Your
      rights and responsibilities as a shareholder will be governed by Israeli law
      and
      differ in some respects from the rights and responsibilities of shareholders
      under U.S. law.**




We
      are
      incorporated under Israeli law. The rights and responsibilities of holders
      of
      our ordinary shares are governed by our memorandum of association, articles
      of
      association and by Israeli law. These rights and responsibilities differ in
      some
      respects from the rights and responsibilities of shareholders in typical U.S.
      corporations. In particular, a shareholder of an Israeli company has a duty
      to
      act in good faith and customary manner, and to refrain from misusing his power,
      in exercising his or her rights and fulfilling his or her obligations toward
      the
      company and other shareholders and to refrain from abusing his power in the
      company, including, among other things, in voting at the general meeting of
      shareholders on certain matters. Israeli law provides that these duties are
      applicable in shareholder votes on, among other things, amendments to a
      company’s articles of association, increases in a company’s authorized share
      capital, mergers and interested party transactions requiring shareholder
      approval. A shareholder also has a general duty to refrain from oppressing
      any
      other shareholder of his or her rights as a shareholder. In addition, a
      controlling shareholder of an Israeli company or a shareholder who knows that
      it
      possesses the power to determine the outcome of a shareholder vote or who,
      under
      our articles of association, has the power to appoint or prevent the appointment
      of a director or executive officer in the company, has a duty of fairness toward
      the company. Israeli law does not define the substance of this duty of fairness,
      but provides that remedies generally available upon a breach of contract will
      apply also in the event of a breach of the duty to act with fairness. Because
      Israeli corporate law has undergone extensive revision in recent years, there
      is
      only little case law available to assist in understanding the implications
      of
      these provisions that govern shareholder behavior.




19





**Provisions
      of Israeli law may delay, prevent or otherwise encumber a merger with, or an
      acquisition of our company, which could prevent a change of
      control** **,
      even when the terms of such transaction are favorable to us and our
      shareholders.**





Israeli
      corporate law regulates mergers, requires tender offers for acquisitions of
      shares above specified thresholds, requires special approvals for transactions
      involving directors, officers or significant shareholders and regulates other
      matters that may be relevant to these types of transactions. For
      example, a merger may not be completed unless at least 50 days have passed
      from the date that a merger proposal was filed by each merging company with
      the
      Israel Registrar of Companies and at least 30 days from the date that the
      shareholders of both merging companies approved the merger. In addition, a
      majority of each class of securities of the target company is required to
      approve a merger. Furthermore,
      Israeli tax considerations may make potential transactions unappealing to us
      or
      to some of our shareholders whose
      country of residence does not have a tax treaty with Israel exempting such
      shareholders from Israeli tax . For
      example, Israeli tax law does not recognize tax-free share exchanges to the
      same
      extent as U.S. tax law. With respect to mergers, Israeli tax law allows for
      tax deferral in certain circumstances but makes the deferral contingent on
      the
      fulfillment of numerous conditions, including a holding period of two years
      from
      the date of the transaction during which time sales and dispositions of shares
      of the participating companies are restricted. Moreover, with respect to certain
      share swap transactions, the tax deferral is limited in time, and when the
      time
      expires, tax then becomes payable even if no actual disposition of the shares
      has occurred .
      These
      provisions of Israeli law could delay, prevent or impede a merger with, or
      an
      acquisition of our company, which could prevent a change of control, even when
      the terms of such transaction are favorable to us and our shareholders and
      therefore depress the price of our shares.





**Fluctuations
      in the exchange rate between the United States dollar and foreign currencies
      may
      affect our operating results.**





We
      incur
      expenses for our operations in Israel in New Israeli Shekels (NIS) and translate
      these amounts into United States dollars for purposes of reporting consolidated
      results. As a result, fluctuations in foreign currency exchange rates may
      adversely affect our expenses and results of operations, as well as the value
      of
      our assets and liabilities. Fluctuations may adversely affect the comparability
      of period-to-period results. In addition, we hold foreign currency balances,
      primarily NIS, that will create foreign exchange gains or losses, depending
      upon
      the relative values of the foreign currency at the beginning and end of the
      reporting period, affecting our net income and earnings per share. Although
      we
      may use hedging techniques in the future (which we currently
      do not use ),
      we may
      not be able to eliminate the effects of currency fluctuations. Thus, exchange
      rate fluctuations could have a material adverse impact on our operating results
      and stock price. In addition, future currency exchange losses may increase
      if we
      become subject to exchange control regulations restricting our ability to
      convert local currencies into United States dollars or other
      currencies.





**We
      are exposed to special risks in foreign markets which may make it difficult
      in
      settling transactions and thereby force us to curtail our business
      operations.**





In
      conducting our business in foreign countries, we are subject to political,
      economic, legal, operational and other risks that are inherent in operating
      in
      other countries. For instance, business development in Hong Kong and China
      is
      time consuming and risky due to the uncertain political, regulatory and legal
      environment. Other risks inherent to operating in other countries include range
      from difficulties in settling transactions in emerging markets to possible
      nationalization, expropriation, price controls and other restrictive
      governmental actions. We also face the risk that exchange controls or similar
      restrictions imposed by foreign governmental authorities may restrict our
      ability to convert local currency received or held by it in their countries
      into
      United States dollars or other currencies, or to take those dollars or other
      currencies out of those countries.




20





**The
      terrorist attacks of September 11, 2001, and the continuing threat of global
      terrorism, have increased financial expectations that may not
      materialize.**





The
      September 11, 2001 terrorist attacks, and continuing concerns about global
      terrorism, may have created an increase in awareness for smart card security
      solutions generally. However, it is uncertain whether the actual level of demand
      for our products and services will grow as a result of such increased awareness.
      Increased demand may not result in an actual increase in our revenues. In
      addition, it is uncertain which security solutions, if any, will be adopted
      as a
      result of the terrorism and whether our products will be a part of those
      solutions. The efforts of the United States in the war against terrorism, the
      war in Iraq, and the post-war reconstruction efforts in Iraq, may actually
      delay
      funding for the implementation of security solutions generally in the United
      States. Even if our products are considered or adopted as solutions to the
      terrorism, the level and timeliness of available funding are unclear. These
      factors may adversely impact us and create unpredictability in revenues and
      operating results.





**Our
      shareholders may face difficulties in the enforcement of civil liabilities
      against Vuance Ltd. and its officers and directors.**





Certain
      of our directors and our professional advisors are residents of Israel or
      otherwise reside outside of the United States. Vuance Ltd. is incorporated
      under
      Israeli law and its principal office and facilities are located in Israel.
      All
      or a substantial portion of the assets of such persons are or may be located
      outside of the United States. It may be difficult to effect service of process
      within the United States upon us or upon any such directors or professional
      advisors or to realize in the United States upon judgments of United States'
      courts predicated upon civil liability of Vuance Ltd. or such persons under
      United States federal securities laws. We have been advised by our Israeli
      counsel that there is doubt as to whether Israeli courts would (i) enforce
      judgments of United States' courts obtained against Vuance Ltd. or such
      directors or professional advisors predicated solely upon the civil liabilities
      provisions of United States' federal securities laws, or (ii) impose liabilities
      in original actions against Vuance Ltd. or such directors and professional
      advisors predicated solely upon such United States' laws. However, subject
      to
      certain time limitations, Israeli courts will enforce foreign (including United
      States) final executory judgments for liquidated amounts in civil matters,
      obtained after due trial before a court of competent jurisdiction which
      recognizes similar Israeli judgments, provided that (1) due process has been
      observed, (2) such judgments or the execution thereof are not contrary to
      Israeli law, public policy, security or sovereignty, (3) such judgments were
      not
      obtained by fraud and do not conflict with any other valid judgment in the
      same
      matter between the same parties and (4) an action between the same parties
      in
      the same matter is not pending in any Israeli court at the time the law suit
      is
      instituted in the foreign court.





**We
      are unlikely to pay dividends in the foreseeable future.**





We
      distributed a cash dividend to our shareholders on one occasion on August 26,
      1997 in the aggregate amount of NIS 1 million and prior to that dividends in
      the
      form of bonus shares were distributed on two other occasions. We do not expect
      to declare or pay cash dividends in the foreseeable future and intend to retain
      future earnings, if any, to finance the growth and development of our
      business.





**With
      our ordinary shares being traded only on the OTC Bulletin Board or on the "pink
      sheets" in the United States, the liquidity of our ordinary shares in the United
      States may be limited.**





Our
      ordinary shares trade on the OTC Bulletin Board in the United States. If we
      were
      unable to have a quotation of our ordinary shares on the OTC Bulletin Board
      System, our shares will only be traded on the "pink sheet" market. Stocks in
      the
      OTC Bulletin Board or in the "pink sheet" market ordinarily have much lower
      trading volume than in other markets, such as the Nasdaq Capital Market or
      the
      Nasdaq Global Market. Very few market makers take interest in shares traded
      over-the-counter, and accordingly the markets for such shares are less orderly
      than is usual for Nasdaq stocks. As a result of the low trading volumes
      ordinarily obtained in OTC Bulletin Board and "pink sheet" markets, sales of
      our
      ordinary shares in any significant amount could not be absorbed without a
      dramatic reduction in price. Moreover, thinly traded shares in the OTC Bulletin
      Board and in the "pink sheet" markets are more susceptible to trading
      manipulations than is ordinarily the case for more actively traded
      shares.





**Servicing
      our debt obligations requires a significant amount of cash, and our ability
      to
      obtain or generate cash depends on many factors beyond our
      control.**





Our
      ability to satisfy our debt service obligations, including to make the payments
      under the convertible bonds we issued in November, 2006 to a
      financial investor and to Special Situation Funds (the
      “Convertible Bonds”), will depend, among other things, upon our future operating
      performance and
      our
      ability to refinance indebtedness when necessary. Each of these factors is
      to a
      large extent dependent on economic,
      financial, competitive, legislative, regulatory and other factors that are
      beyond our control.




21





If,
      in
      the future, we cannot generate sufficient cash from our operations to meet
      our
      debt service obligations, we may need to reduce or delay capital expenditures
      or
      curtail research and development efforts. In addition, we may need to refinance
      our debt, obtain additional financing or sell assets, which we may not be able
      to do on commercially reasonable terms, if at all. We cannot assure you that
      our
      business will generate sufficient cash flow, or that we will be able to obtain
      funding, sufficient to satisfy our debt service obligations. We
      believe that, as of the filing date of this Annual Report, our current cash
      and
      cash equivalents, and marketable securities, in addition to the revenues
      generated from our business operations, will satisfy our operating capital
      needs
      for at least the next twelve months based upon our anticipated business
      activities. However, we may need additional capital even within the next twelve
      months if we undertake large projects or have a delay in one of our anticipated
      projects. Our need for additional capital to finance our operations and growth
      will be greater should, among other things, our revenue or expense estimates
      prove to be incorrect.





**Restrictions
      imposed by our Convertible Bonds and other debts instruments may limit our
      ability to finance future operations or capital needs or engage in other
      business activities that may be in our interest. Our failure to comply with
      our
      obligations under these instruments could lead to an acceleration of our
      indebtedness.**





The
      indenture governing the Convertible Bonds contains certain covenants that will,
      among other things, limit our ability and the ability of our restricted
      subsidiaries to: (1) create liens; (2) sell or otherwise dispose of assets;
      (3)
      engage in transactions with our affiliates; and (4) merge or consolidate with
      another entity or transfer all or substantially all of our assets. In addition,
      we undertook to maintain a certain level of EBTIDA for as long as the
      Convertible Bonds are outstanding. These restrictions could limit our ability
      to
      obtain future financing, make acquisitions or capital expenditures, withstand
      economic downturns in our business, industry or the economy in general, conduct
      operations or otherwise take advantage of business opportunities that
      arise.





Our
      failure to make any payments due under our debt instruments, or otherwise to
      comply with any of the restrictions or our obligations thereunder, could result
      in an event of default under such instruments and lead to an acceleration of
      our
      related indebtedness. We are not certain whether we would have, or be able
      to
      obtain, sufficient funds to make these accelerated payments. In that event,
      certain lenders could proceed against our assets that secure their
      debt.





**A
      significant number of our ordinary shares are or will be eligible for sale
      in
      the open market, which could reduce the market price for our ordinary shares
      and
      make it difficult for us to raise capital.**





As
      of
      June 20, 2007, 4,022,837 of our ordinary shares were outstanding. In addition,
      we had a total of 840,470 ordinary shares issuable upon exercise of outstanding
      options, which we have issued to our employees and certain other persons at
      various prices, some of which have exercise prices below the current market
      price for our ordinary shares. In
      December 2004, we filed a Registration Statement on Form S-8 with the U.S.
      Securities and Exchange Commission (the
      “SEC”) registering (i) 170,000 ordinary shares available for issuance upon exercise
      of
      stock options reserved for grant under the Option Plan, (ii) 594,034 ordinary
      shares issued or issuable upon exercise of options previously granted under
      the
      Option Plan, and (iii) 109,412 ordinary shares issued or issuable upon exercise
      of options previously granted under the 1999 Option Plan. As
      of
      June 20, 2007, we have
      also
      issued 759,935 warrants to acquire ordinary shares to investors and consultants,
      at various prices, which expire between 2009 to 2011. As of June 20, 2007,
      we
      have also issued convertible bonds to acquire 631,313 ordinary shares. As of
      June 20, 2007 warrants to acquire only 194,625 ordinary shares had been
      exercised. In November, 2004, we registered up to 1,078,092 ordinary shares
      pursuant to a Registration Statement on Form F-1 filed with the U.S. Securities
      and Exchange Commission, which included ordinary shares issuable upon exercise
      of our outstanding warrants. In January 2006, we registered up to 1,154,492
      ordinary shares pursuant to a Registration Statement on Form F-1 filed with
      the
      U.S. Securities and Exchange Commission, which included ordinary shares issuable
      upon exercise of our outstanding warrants. As of December 31, 2006, our
      registered capital permitted us to issue up to additional 853,752 ordinary
      shares in connection with future grants of options, warrants, shares and other
      financial instruments.





The
      issuance of a large number of additional ordinary shares upon the exercise
      or
      conversion of outstanding options or warrants would cause substantial dilution
      to existing stockholders and could decrease the market price of our ordinary
      shares due to the sale of a large number of shares in the market, or the
      perception that these sales could occur. These sales, or the perception of
      possible sales, could also impair our ability to raise capital in the
      future.




22


**"Penny
      stock" rules may make buying or selling our ordinary shares difficult, severely
      limiting the market price of our ordinary shares and the liquidity of our shares
      in the United States.**





Trading
      in our ordinary shares maybe subject to the "penny stock" regulations adopted
      by
      the SEC .
      These
      regulations generally define a "penny stock" to be any equity security that
      has
      a market price of less than $5.00 per share, subject to certain exceptions.
      These rules require that any broker-dealer who recommends our securities to
      persons other than prior customers and accredited investors, must, prior to
      the
      sale, make a special written suitability determination for the purchaser and
      receive the purchaser's written agreement to execute the transaction. Unless
      an
      exception is available, the regulations require delivery, prior to any
      transaction involving a "penny stock," of a disclosure schedule explaining
      the
      penny stock market and the risks associated with trading in the penny stock
      market. In addition, broker-dealers must disclose commissions payable to both
      the broker-dealer and registered representative and current quotations for
      the
      securities they offer. The additional burdens imposed upon broker-dealers by
      such requirements may discourage broker-dealers from effecting transactions
      in
      our stock, which could severely limit their market price and the liquidity
      of
      our stock.





**Our
      ordinary shares are traded on more than one market and this may result in price
      variations.**




Our
      ordinary shares are traded primarily on the OTC Bulletin Board in the United
      States and on the Euronext Brussels stock market in Belgium. Trading in our
      ordinary shares on these markets is made in different currencies (US dollars
      on
      the OTC Bulletin Board and Euros on Euronext Brussels), and at different times
      (resulting from different time zones, different trading days and different
      public holidays in the United States and Belgium). Consequently, the trading
      prices of our ordinary shares on these two markets often differ. Any decrease
      in
      the trading price of our ordinary shares on one of these markets could cause
      a
      decrease in the trading price of our ordinary shares on the other market. On
      May
      22, 2007, we applied for listing of our ordinary shares on the Nasdaq Capital
      Market. We cannot assure you that the Nasdaq Capital Market will approve the
      listing of our ordinary shares. If our ordinary shares become listed on the
      Nasdaq Capital Market, trading of our ordinary shares on the OTC Bulletin Board
      will cease.





**Our
      default under certain registration rights agreements may result in liquidated
      damages.**





In
      connection with private placements completed in September 2004 and December
      2005, in which we issued to the investors ordinary shares and warrants to
      purchase our ordinary shares, we entered into registration rights agreements
      pursuant to which we undertook to register such ordinary shares in accordance
      with the Securities Act of 1933. Accordingly, we filed Forms F-1 on November
      2004 and January 5, 2006. Our failure to properly update the Forms (and to
      make
      subsequent registrations) in accordance with the registration rights agreements
      could result in an event of default under such agreements and subject us to
      liquidated damages.




**We
      have a stockholder that is able to exercise substantial influence over us and
      all matters submitted to our stockholders which may make us difficult to be
      acquired and less attractive to new investors.**




Special
      Situations Fund III, L.P., and its affiliates (collectively, “SSF”) beneficially
      own, 991,388 of our ordinary shares, representing approximately 24.64% of our
      outstanding ordinary shares, based on 4,022,837 ordinary shares currently
      outstanding. In addition, SSF own warrants exercisable for an additional 267,823
      ordinary shares and convertible bond for additional 131,313 ordinary shares.
      Such ownership interest gives SSF substantial influence over the outcome of
      all
      matters submitted to our stockholders, including the election of directors
      and
      the adoption of a merger agreement, and such influence could make us a less
      attractive acquisition or investment target. In addition, our officers and
      directors beneficially own a significant amount of our ordinary shares, which
      may have a similar effect as SSF' ownership of our ordinary shares.




**The
      number of ordinary shares that are available for sale upon exercise of our
      outstanding warrants, options and convertible bonds is significant in relation
      to our currently outstanding ordinary shares and could cause downward pressure
      on the market price for our ordinary shares.**




The
      number of ordinary shares registered for resale upon exercise of our outstanding
      warrants, options and convertible bonds is significant in relation to the number
      of ordinary shares currently outstanding. If those warrant holders, option
      holders and convertible bonds holders determine to sell a substantial number
      of
      shares into the market at any given time, there may not be sufficient demand
      in
      the market to purchase the shares without a decline in the market price for
      our
      ordinary shares. Moreover, continuous sales into the market of a number of
      shares in excess of the typical trading volume for our ordinary shares, or
      even
      the availability of such a large number of shares, could depress the trading
      market for our ordinary shares over an extended period of time.




23




**If
      holders of convertible bonds convert their bonds into ordinary shares, existing
      shareholders may suffer substantial dilution.**





In
      a
      private placement to a single investor for an aggregate purchase price of
      $2,500,000, we sold units consisting of convertible bonds that are convertible
      into 500,000 ordinary shares and additional warrants to purchase 106,250
      ordinary shares at an exercise price of $5 per share. In addition, SSF, who
      were
      existing shareholders, have elected to exercise their preemptive rights and
      have
      purchased substantially similar units from us for an aggregate purchase price
      of
      $656,566 consisting of convertible bonds that are convertible into 131,313
      ordinary shares and additional warrants to purchase 27,904 ordinary shares
      at an
      exercise price of $5 per share. The bonds may be converted at any time, upon
      the
      option of their holder, in which case existing shareholders may suffer
      substantial dilution.




**If
      we were to be deemed an “investment company” under the Investment Company Act of
      1940, applicable restrictions could make it impractical for us to continue
      our
      business as contemplated and could have a material adverse effect on our
      business.**




A
      person
      will generally be deemed to be an “investment company” for purposes of the
      Investment Company Act of 1940 (“1940 Act”) if:




·
            it
                is or holds itself out as being engaged primarily, or proposes to
                engage
                primarily, in the business of investing, reinvesting or trading in
                securities; or




·
            absent
                an applicable exemption, it owns or proposes to acquire investment
                securities having a value exceeding 40% of the value of its total
                assets
                (exclusive of U.S. government securities and cash items) on an
                unconsolidated basis.




We
      believe that we are engaged primarily in of research and development of incident
      response management and tracking solutions for public safety agencies,
      commercial customers and governmental organizations and not in the business
      of
      investing, reinvesting or trading in securities. We also believe that the
      primary source of income from each of our businesses is properly characterized
      as income earned in exchange for the provision of services and sale of products.
      Accordingly, we do not believe that Vuance Ltd. is, or will be, an “orthodox”
investment company as defined in section 3(a)(1)(A) of the 1940 Act and
      described in the first bullet point above. Similarly, we do not believe we
      are
      an inadvertent investment company by virtue of the 40% test in section
      3(a)(1)(C) of the 1940 Act as described in the second bullet point above,
      despite our current holding of the ordinary shares of OTI (see description
      of
      the OTI Transaction under the caption “The OTI Transaction” in Item 4.A). In
      addition, we believe that we are not an investment company under section 3(b)(1)
      of the 1940 Act because we primarily engage in a non-investment company
      business.




The
      1940
      Act and the rules promulgated thereunder contain detailed parameters for the
      organization and operation of investment companies. Among other things, the
      1940
      Act and the rules thereunder limit or prohibit transactions with affiliates,
      impose limitations on the issuance of debt and equity securities, generally
      prohibit the issuance of options and impose certain governance requirements.
      We
      intend to conduct our operations so that we will not be deemed to be an
      investment company under the 1940 Act. If anything were to happen which would
      cause us to be deemed to be an investment company under the 1940 Act,
      requirements imposed by the 1940 Act, including limitations on our capital
      structure, ability to transact business with affiliates (including us) and
      ability to compensate key employees, could make it impractical for us to
      continue our business as currently conducted, impair the agreements and
      arrangements between and among us and our senior managing directors, or any
      combination thereof, and materially adversely affect our business, financial
      condition and results of operations. In addition, we may be required to limit
      the amount of investments that we make as a principal or otherwise conduct
      our
      business in a manner that does not subject us to the registration and other
      requirements of the 1940 Act.




**If
      persons engage in short sales of our ordinary shares, including sales of shares
      to be issued upon the exercise of our outstanding warrants, options and
      convertible bonds, the price of our ordinary shares may
      decline.**




Selling
      short is a technique used by a stockholder to take advantage of an anticipated
      decline in the price of a security. In addition, holders of options, warrants
      and convertible bonds will sometimes sell short knowing they can, in effect,
      cover through the exercise of an option or warrant or convertible bond, thus
      locking in a profit. A significant number of short sales or a large volume
      of
      other sales within a relatively short period of time can create downward
      pressure on the market price of a security. Further sales of ordinary shares
      issued upon exercise of our outstanding warrants or options or convertible
      bond
      could cause even greater declines in the price of our ordinary shares due to
      the
      number of additional shares available in the market upon such exercise or
      conversion, which could encourage short sales that could further undermine
      the
      value of our ordinary shares. You could, therefore, experience a decline in
      the
      value of your investment as a result of short sales of our ordinary
      shares.




24





**Being
      a foreign private issuer exempts us from certain** SEC **requirements.**





We
      are a
      foreign private issuer within the meaning of rules promulgated under the U.S.
      Securities and Exchange Act of 1934, as amended (the “Exchange Act”). As such,
      we are exempt from certain provisions applicable to United States public
      companies including:




·  the
        rules
        under the Exchange Act requiring the filing with the SEC of
        quarterly reports on Form 10-Q or current reports on Form
        8-K;





·  the
        sections of the Exchange Act regulating the solicitation of proxies, consents
        or
        authorizations in respect of a security registered under the Exchange
        Act;





·  the
        provisions of Regulation FD aimed at preventing issuers from making selective
        disclosures of material information;





·  the
        sections of the Exchange Act requiring insiders to file public reports of
        their
        stock ownership and trading activities and establishing insider liability
        for
        profits realized from any “short-swing” trading transaction (i.e., a purchase
        and sale, or sale and purchase, of the issuer’s equity securities within less
        than six months);




Because
      of these exemptions, investors are not afforded the same protections or
      information generally available to investors holding shares in public companies
      organized in the United States.





**ITEM
      4.** ***Information
      on the Corporation.*** ****





***A.    History
      and Development of the Corporation***





***History
      of the company***




****  Vuance
      Ltd. was incorporated in Israel, as a company limited by shares, on July 4,
      1988, under the provisions of the then-current Israeli Companies Ordinance.
      We
      now operate under the Israeli Companies Law, 5759-1999 (the “Israeli Companies
      Law”), which became effective on February 1, 2000, and the Israeli Companies
      Ordinance (New Version) 1983, as amended.





From
      our
      incorporation in 1988 until 1999, we were a development-stage company primarily
      engaged in research and development, establishing relationships with suppliers
      and potential customers and recruiting personnel with a focus on the
      governmental market. In 2001, we implemented a reorganization plan, which we
      completed in 2002. As a result of the reorganization, we expanded our marketing
      and sales efforts to include the commercial market with a new line of advanced
      smart card and identification technologies products, while maintaining our
      governmental market business.





During
      2002, we sold, in three separate transactions with third party purchasers,
      our
      entire equity interest in a U.S. subsidiary, InkSure Technologies, Inc., for
      which we received aggregate proceeds of approximately $6,600,000. In December
      2002, we discontinued the operations, disposed of all of the assets and
      terminated the employees of two U.S. subsidiaries, Genodus Inc. and Kromotek,
      Inc.





On
      November 17, 2003, we purchased the 20% equity interest of a minority
      shareholder in Supercom Asia Pacific Limited, our Hong Kong subsidiary, for
      approximately $70,000, whereupon Supercom Asia Pacific Limited became our
      wholly-owned subsidiary.





We
      became
      a publicly-traded company on NASDAQ Europe (Formerly EASDAQ, hereinafter “NASDAQ
      Europe”) on April 19, 1999. On October 23, 2003, following the closing of the
      NASDAQ Europe stock market, we transferred the listing of our ordinary shares
      to
      the Euronext Brussels stock market under the symbol “SUP”, which became “VUNC”
after our corporate name change on May 14, 2007.




25





On
      July
      29, 2004, we filed a Registration Statement on Form 20-F under the Exchange
      Act.
      When the Registration Statement became effective on September 29, 2004, we
      became a foreign private issuer reporting company under the Exchange Act. Since
      November 5, 2004, our ordinary shares have traded in the United States on the
      OTC Bulletin Board under the symbol “SPCBF.OB, which following our recent name
      change became “VUNCF.OB”. On May 22, 2007, we have applied to list our ordinary
      shares on the Nasdaq Capital Market. We cannot assure you that the Nasdaq
      Capital Market will approve the listing of our ordinary shares. If our ordinary
      shares become listed on the Nasdaq Capital Market, trading of our ordinary
      shares on the OTC Bulletin Board will cease.





During
      the fourth quarter of 2005, we established a new Delaware subsidiary (of which
      we initially owned 80%), VUANCE - RFID Inc. (formerly, Pure RF Inc.), which
      began operations during the first quarter of 2006. During the first quarter
      of
      2006, VUANCE - RFID Inc. established a wholly-owned Israeli subsidiary, Pure
      RF
      Ltd VUANCE - RFID Inc. and Pure RF Ltd. focus on new technologies and solutions
      for active tracking of people and objects. In February 2007, we purchased the
      remaining 20% of the stock of VUANCE - RFID Inc. from its minority stockholders
      for an amount of $100,000, whereupon Pure RF Inc. became our wholly-owned
      subsidiary.




***The
      OTI Transaction***





In
      2006
      we decided to sell our E-ID Division in order to focus on opportunities in
      the
      United States for our IRMS and active RFID tracking businesses and on December
      31, 2006, we sold the E-ID Division to On Track Innovations Ltd., for 2,827,200
      restricted ordinary shares of OTI. The ordinary shares were issued to us subject
      to a lock-up agreement, where one-seventh of the shares (403,885 ordinary
      shares) are released from the lock-up restrictions every three months beginning
      on December 31, 2006. We executed an irrevocable proxy appointing a person
      designated by OTI to vote the 2,827,200 ordinary shares issued to us in
      connection with the transaction. Under the terms of our agreement with OTI,
      OTI
      committed to file with the SEC a registration statement covering these ordinary
      shares and made such filing on April 24, 2007. We may gradually dispose of
      all
      or some of the OTI shares in order to finance our operation and in order to
      finance future acquisitions.





Simultaneously,
      we entered into a service and supply agreement with OTI under which (i) OTI
      agreed to act as our subcontractor and provide services, products and materials
      necessary to carry out and complete certain projects that were not transferred
      to OTI (the “Existing Projects”), and (ii) OTI granted us an irrevocable,
      worldwide, non-exclusive, non-assignable and non-transferable license to use
      in
      connection with our Existing Projects, certain intellectual property rights
      transferred to OTI as part of the OTI Transaction, for the duration of such
      projects. We expect that due to the revenues from the Existing Projects, our
      income in the short term will not be materially adversely affected. The sale
      of
      our E-ID division and the services and supply agreement are collectively
      referred to herein as the “OTI Transaction.”





***Recent
      Developments***




On
      June
      14, 2007 we announced that Mr. Lior Maza has joined the Company’s executive
      management team as Chief Financial Officer. Mr. Maza replaces Mr. Yaron Shalom.





In
      May
      2007, we announced that a t
      an
      extraordinary general meeting held on April 29, 2007, our shareholders approved
      (1) a change of our name from SuperCom Ltd. to Vuance Ltd., and (2) a
      1-for-5.88235 ‘reverse split’ of our ordinary shares. In May 2007, we announced
      that our name change and the reverse share split will become effective
      for trading purposes on May 14, 2007.





In
      April
      2007, we announced that Oliver “Buck” Revell, former Associate Deputy Director
      in charge of Criminal Investigations, Counter-Terrorism and Counter-Intelligence
      at the Federal Bureau of Investigation (FBI), has joined our Advisory Board
      (see
      the section captioned “Enhancing Our Presence” in Item 4.B for more information
      on our Advisory Board).




26




In
      January 2007 we announced that on December 31, 2006 we consummated the OTI
      Transaction described above. Upon consummation of the OTI Transaction a
      $2,500,000 loan was extended to us by a financial institution. The loan is
      secured by the shares we received from OTI and OTI has agreed to guarantee
      the
      loan on behalf of us.




In
      November 2006, we announced that we have raised $3.15 million through the
      issuance of units consisting of convertible bonds and warrants. Units valued
      at
      $2.5 million were issued to a financial investor, and units valued at $656,566
      were issued to SSF. The convertible bonds will mature three years from the
      date
      of issuance and will pay interest at a net rate of 8% per annum. Subject to
      certain redemption provisions, the bonds may be converted at any time, at the
      option of the investors, into our ordinary shares at a conversion price of
      $5
      per share. The investors were also granted warrants entitling them to acquire
      a
      total of 134,154 ordinary shares at an exercise price of $5 per share during
      the
      next five years.





In
      May
      2006, we announced that our U.S. subsidiary, SuperCom, Inc., had received a
      U.S.
      General Services Administration (GSA) Federal Supply Schedule Contract for
      its
      products. This contract enables all U.S. federal and state agencies to purchase
      our products from a GSA-approved price list in accordance with the terms and
      conditions set forth therein. GSA Schedules provide a direct and effective
      procurement vehicle that satisfies the U.S. government’s extensive requirements
      with simple administrative processes that significantly reduce the time and
      expense of acquisition, for both the contractor and the federal customer.





In
      April
      2006, Mr. Eyal Tuchman, who has been our Chief Financial Officer from July
      2002
      through- March 2006, replaced Avi Schechter as our Chief Executive Officer.
      Mr.
      Schechter served as a consultant for the Company until July 2006.




***Principal
      capital expenditures and divestitures***





From
      January 1, 2006 to December 31, 2006, our capital expenditures totaled
      approximately $93,000 (compared to $315,000 during 2005 and $1,087,000 during
      2004), of which approximately $69,000 (compared to $293,000 during 2005 and
      $1,017,000 during 2004) can be attributed to our facilities in Israel, and
      approximately $24,000 (compared to $22,000 during 2005 and $70,000 during 2004)
      can be attributed to various facilities of our subsidiaries outside of Israel.
      During the first financial quarter of 2007, our capital expenditures totaled
      approximately $37,000.





***Corporate
      information***





Our
      head
      office and principal place of business is located at Sagid House “Ha’Sharon
      Industrial Park”, Qadima 60920, Israel and our telephone number is
      +972-9-889-0800. Our Internet website address is http://www.vuance.com. The
      information contained on our corporate websites is not a part of this
      prospectus.





Our
      agent
      for SEC matters in the United States. is our subsidiary, SuperCom, Inc., whose
      address is: 2010 Corporate Ridge, Suite 700 McLean, VA 22102-7838.




***B.    Business
      Overview***





**** We
      develop and market incident response management and tracking solutions for
      public safety agencies, commercial customers and governmental organizations.
      We
      offer two principal products Suits to our customers, both of which we developed
      recently:





·
            IRMS
                Suite, an incident response management system, used to facilitate
                the
                authentication and flow of on-site personnel in disaster recovery
                operations, including police, fire and emergency medical service
                departments and other governmental agencies complying with U.S. Department
                of Homeland Security requirements, and


·
            PureRF
                Suite, an active radio frequency identification (RFID) system that
                utilizes radio frequency communications to track assets, people and
                objects for potential governmental agency and commercial
                customers.




27




From
      1988
      to 2006, our principal business was the design, development and marketing of
      advanced smart card and identification technologies and products for
      governmental and commercial customers in Europe, Asia and Africa. As mentioned
      above, in 2006 we decided to sell this division in order to focus on
      opportunities for our IRMS and active RFID tracking businesses. On December
      31,
      2006, we completed the OTI Transaction. (see full description above) We expect
      to continue to receive revenues from s the Existing Projects, which were not
      transferred to OTI, until 2016.





We
      believe that our exposure to the governmental market and experience in
      customizing solutions in our former E-ID Division will contribute to our ability
      to develop and market products in our IRMS and active RFID tracking businesses.
      We currently concentrate our marketing efforts for our IRMS and active RFID
      tracking systems on U.S. state and local government agencies that are seeking
      to
      comply with U.S. Department of Homeland Security requirements for implementation
      of new systems that facilitate government agency interaction in anticipation
      of
      and response to incidents that threaten public safety, and other homeland
      security objectives. We also plan to market our IRMS and active RFID tracking
      systems to commercial customers.





We
      currently operate in the United States through two wholly-owned subsidiaries,
      Supercom, Inc. and VUANCE - RFID Inc.





We
      currently operate in Asia Pacific through a wholly-owned subsidiary, Supercom
      Asia Pacific Ltd,.





**Our
      Strategy**





In
      2006,
      we decided to sell our E-ID division in order to focus on opportunities mainly
      in the U.S. for our IRMS and active RFID tracking businesses. The sale was
      completed on December 31, 2006 (see section captioned “The OTI Transaction” in
      this Item 4.A). We currently concentrate our marketing efforts for our IRMS
      and
      active RFID tracking systems on U.S. federal, state and local government
      agencies that are seeking to comply with U.S. Department of Homeland Security
      requirements for implementation of new systems that facilitate government agency
      interaction in anticipation of and response to incidents that threaten public
      safety, and other homeland security objectives. We also plan to market our
      IRMS
      and active RFID tracking systems to commercial customers.





***Enhancing
      Our Presence***





We
      decided to established an advisory board (the “Advisory Board”) to
      assist us in broadening our presence in the government, military, and law
      enforcement sectors and to identify the core technology needs of the homeland
      security and related markets, as well as new applications for our technologies.
      We have sought preeminent authorities to serve on the Advisory Board and
      in
      February 2006 we announced the creation of the Advisory Board and the
      appointment of R. James Woolsey, former Director of Central Intelligence and
      one
      of America’s preeminent authorities on security issues, as its Chairman. In
      August 2006, we announced that Neil C. Livingstone, one of America’s preeminent
      authorities on security issues and the chief executive officer of GlobalOptions
      Inc., a Washington-based international risk management and business solutions
      company, was appointed to the Advisory Board. In April 2007, we announced that
      Oliver "Buck" Revell, former Associate Deputy Director in charge of Criminal
      Investigations, Counter-Terrorism and Counter-Intelligence at the Federal Bureau
      of Investigation (FBI), and one of the world's most recognized experts in the
      fight against terrorism, has joined our Advisory Board.





We
      also
      hope to enhance our presence in the U.S. by attracting major city governments
      as
      customers for our solutions. For example, we entered
      into an agreement for the
      deployment of mobile credentialing and access control systems with the City
      of
      Los Angeles, California.





In
      order
      to expand our U.S. presence, we may pursue acquisitions of one or more
      companies, which have an existing customer base and revenues or that can
      otherwise offer business synergies to us.





***Identifying
      New Applications for Our Technologies***





Our
      management and its external advisors are working to identify new applications
      for our technologies in the homeland security, defense and other markets. In
      an
      area when both government and the private sector are faced with unprecedented
      challenges to protect public safety and personal privacy, we expect our Advisory
      Board to help to extend our forward-looking technologies into the U.S.
      market.




28


***Leveraging
      Knowledge and Experience***





We
      believe that our exposure to the governmental market and experience in
      customizing solutions in our former E-ID Division will contribute to our ability
      to develop and market products in our IRMS and active RFID tracking businesses.
      We intend to leverage such knowledge and experience in order to respond to
      the
      needs of existing and potential customers in the homeland security, defense
      and
      other markets.





***Leveraging
      Public Sector Expertise Into Commercial Applications***





We
      believe that significant commercial possibilities exist for our products and
      specifically for our active RF tracking products. For example, in addition
      to
      the use of our active RF tracking systems for security applications, our systems
      could be deployed for asset, supply chain, inventory, personnel, capacity or
      livestock management purposes. We intend to leverage our expertise in public
      sector projects into applications for commercial customers.





***Seeking
      Partnerships With Other Relevant Companies***





To
      bolster our sales and marketing efforts, we may seek to partner with
      distributors that can offer us new relationships with the homeland security
      sector or government agencies or help us increase our geographic breadth. In
      addition, we may partner with system integrators experienced in handling
      large-scale governmental projects under government contracts, since we
      believe such partners ,
      by
      virtue of their recognition by government agencies, may have an advantage in
      securing government contracts. Finally, we may enter into strategic partnerships
      with companies that offer technologies that complement ours.





**Current
      Businesses**




**Incident
      Response Management System Business**




***Overview***





Our
      incident response management systems represent a completely integrated solution
      for multiple applications. The applications include enabling state and local
      public safety agencies, such as police, fire and emergency medical services
      departments, and other governmental agencies to comply with U.S. Department
      of
      Homeland Security, or DHS, requirements regarding national incident management
      systems, security, protection of infrastructure and incident command
      systems.





***Product***





Our
      principal IRMS Suite product includes: Smart Disaster Site Management System,
      or
      SmartDSMS, Mobile Enrollment, Dynagate Units, Handheld Units and Communications
      Interoperability, as further described below.




***SmartDSMS*** - An
      incident management systems with a 900 MHz wireless wide area network, which
      supports access control and personnel authentication at a disaster
      site, as well as a self-contained stand-alone voice, data and video network
      for emergency responders.




***Mobile
      Enrollment*** - Issues
      secure smart-card credentials with or without biometric verification in any
      location, and updates databases instantly to ensure accountability for all
      people within an incident scene or secure area.




***Dynagate
      Units*** - The
      Dynagate is the cornerstone of both our wireless and 900 MHz solutions for
      many
      applications. It is very useful for field personnel verification and
      property/evidence inventory.




***Handheld
      Units*** -
      Lightweight, rugged verification units that read contact and contactless smart
      cards (soon to include Homeland Security FIPS-201, TSA/TWIC, and DOD/CAC cards)
      as well as any driver’s license or 2D Barcode enabled I.D.  These units can
      communicate with wireless including GPRS communications, or with our other
      systems for total communications reliability; with or without biometric
      verification.  These units are well-suited fit for use with constantly
      updated databases for patrol use in daily security, personnel, and police
      operations.




29




***Communications
      Interoperability*** - Our
      interoperability bridges link mobile and portable radios of all kinds, military
      and civilian, as well as cell/satellite/direct-connect and land-line
      telephones allowing responders to communicate across technological and
      organizational boundaries, without changing equipment or monopolizing their
      communications systems.  These bridges are P25 and VoIP compatible,
      allowing you the ability of utilizing our robust 900 MHz tripods as repeaters
      if
      none are available.





***Customers***





Our
      first
      customer for or IRMS products was the City of Columbus, Ohio, which deployed
      the
      SmartDSMS system in April 2005 and subsequently expanded its capabilities.
      In
      July 2006, we entered into an agreement with H.M.S. Telecom, LLC, a leading
      oil
      and gas industry consulting group from Houston, Texas to represent and market
      our IRMS products to the oil and gas industry. In November 2006, we entered
      into
      a contract to provide an IRMS system to the City of Los Angeles for the
      Department of General Services—Office of Public Safety, the Office of Personnel
      and the Police Department (Mobile Command Post Unit). In January 2007, we
      entered into two additional contracts for the deployment of IRMS systems with
      county governments in Pennsylvania.





***Market
      Opportunity***





In
      2002,
      following the terrorist attacks on September 11, 2001, and in accordance with
      The National Strategy for Homeland Security and the Homeland Security Act of
      2002, the Department of Homeland Security, or the DHS was formed. The main
      objective of the DHS is to
      provide the unifying core for the vast nationwide network of organizations
      and
      institutions involved in efforts to provide national security. DHS initiatives
      have emphasized “interoperability”—the implementation of new systems that
      facilitate interaction between government agencies, including first responders
      such as police, fire and emergency medical services departments, in anticipation
      of and response to incidents that threaten public safety. Presidential
      directives concerning homeland security call for the development
      of:





·
            a
                National Incident Management System that will provide a consistent
                framework for incident management at all jurisdictional levels regardless
                of the cause, size or complexity of the incident and provide first
                responders with a common foundation for incident management of terrorist
                attacks, natural disasters and other emergencies;
                and




·
            a
                National Response Plan that will provide the structure and mechanisms
                to
                coordinate and integrate incident management activities and emergency
                support functions across federal, state, local and tribal government
                entities, the private sector and non-governmental
                agencies.




The
      activities and projects necessary to achieve these goals are accomplished by
      furnishing federal funding to state and local government agencies. Since 2002,
      the DHS has allocated over $20 billion in grants and awards to state and local
      government agencies for the implementation of a broad range of security projects
      throughout the U.S. Much of the grants have not yet been spent by the recipient
      government agencies. In January 2007, the DHS announced plans to grant an
      additional $1.7 billion for specified security programs.





We
      believe that we are positioned to take advantage of the market opportunity
      presented by DHS-funded security projects of state and local government agencies
      throughout the U.S. Our IRMS systems can be used as standalone solutions for
      the
      access control, accountability and credentialing needs of law enforcement and
      first responder governmental agencies managing disaster sites, including sites
      of natural disasters, terrorist attacks, crime scenes or large scale accidents.
      The individual components of the *IRMS* system
      could also be marketed to the U.S. military or the DHS for more general
      perimeter security applications.





**Active
      RFID Tracking Business**




***Overview***





In
      February 2006, we introduced our active RFID technology, which utilizes active
      radio frequency communications to track people and objects. We developed this
      new technology to meet the growing market demand for asset and person tracking
      solutions. The new technology expands our wide
      range of products aimed to the homeland
      security market through a wireless asset tracking system. In
      order to focus
      on the growing market for this technology we established a new subsidiary in the U.S., VUANCE - RFID Inc.




30





Our
      “PureRF” movement detection solution can monitor and track a number of items
      simultaneously, providing an active set of different signals and alerts. The
      software and hardware solution employs small, low-powered RFID tags attached
      to
      an object or a person. License-free radio bands are used to track the RF
      identification band from a base transmitter that is programmable for periodic
      or
      event-driven transmissions.




Current
      activities in our active RF tracking business involve the development and
      marketing of a new product, the PureRF Suite, which is described below. We
      plan
      to market the PureRF Suite in the industrial, healthcare, security and homeland
      security sectors, and to further develop, improve and customize the PureRF
      Suite
      to meet customers’ needs in niche sectors.





***Product***





We
      expect
      our PureRF Suite, a complete location position (LP) system solution based on
      active RFID tag technology, to offer commercial customers and governmental
      agencies enhanced asset management capabilities. The system can be deployed
      in
      physical security applications. The basic components of our PureRF Suite
      include:





·
            an
                active tag, which contains a microchip equipped transponder, an antenna
                and a capacitor, attached to the item to be identified, located or
                tracked;




·
            a
                tag activator, which intermittently causes the active tag to transmit
                information via a wireless signal;




·
            a
                web-based management system, which captures and processes the signal
                from
                the active tag, and may be configured to provide an alert upon the
                occurrence of a trigger event;




·
            one
                or more wireless receivers; and




·
            the
                system initializer, which is used to configure the PureRF
                Suite.




The
      PureRF Suite provides a secure, precise and cost-effective means to positively
      identify, locate, track, monitor, count and protect people and objects,
      including inventory and vehicles. The ability to reliably identify and track
      the
      movement of people and objects in real-time will enable PureRF Suite customers
      to detect unauthorized movement of vehicles, trace packages and containers,
      control personnel and vehicle access to premises, and protect personnel in
      hazardous working environments and disaster management situations.





***Market
      Opportunity***





Radio
      frequency identification, or RFID, is a widely adopted technology in the
      auto-identification market, which addresses electronic identification and
      location of objects. Typically, an RFID tag or transponder is attached to or
      incorporated into a product or person. A handheld device that receives the
      radio
      frequency waves from these tags is used to determine their locations. Prior
      to
      the adoption of RFID, users identified and tracked assets manually as well
      as
      through the use of bar code technology. These solutions were limited because
      of
      the need for ongoing human intervention and the lack of instantaneous location
      capabilities. RFID technology possesses greater range, accuracy, speed and
      lower
      line−of−sight requirements than bar code technology.





Our
      PureRF Suite can track items simultaneously, providing an alert when a tagged
      item is removed from a pre-determined area, passes through a marked checkpoint
      or otherwise moves. We believe that potential customers for our PureRF Suite
      include the following:





·
            *Civil
                and Military Governments*.
                Our PureRF Suite can provide secure access control into restricted
                areas
                and map and track visitors throughout a facility. Many high security
                facilities, including governmental and industrial facilities, need
                access
                monitoring. For example, nuclear power plants, national research
                laboratories and correctional facilities need to accurately and securely
                monitor inbound and outbound activity. Line of sight identifiers,
                such as
                identification cards, suffer from problems that our RFID technology
                readily overcomes, including reliance on human visual identification,
                forgery and tampering. Our PureRF Suite also enables identification
                and
                location of individuals in restricted areas in real
                time.




·
            *Airport
                and Port Security Infrastructure Providers*.
                Our PureRF Suite can offer solutions for the transportation sector
                by
                enabling common carriers to monitor, track, locate and manage multiple
                baggage items simultaneously, thereby reducing risk of lost baggage,
                increasing customer service and improving
                security.




31




·
            *Businesses
                and Industrial Companies*.
                Our PureRF Suite can be used by businesses, shippers and warehouse
                operators to manage and track cartons, pallets, containers and individual
                items in order to facilitate movement, order picking, inventory
                verification and reduce delivery time. In addition, industrial companies
                can manage and track their mobile equipment and tools. We believe
                that our
                PureRF Suite can increase efficiency at every stage of asset, inventory
                and supply chain management by enabling long-range identification
                and
                location of products and removing the need for their human visual
                identification. Our products also work in conjunction with existing
                bar
                coding and warehouse systems to reduce the risk of loss, theft and
                slow
                speed of transfer.




·
            *Hospitals
                and Care Homes*.
                The healthcare sector has successfully utilized RFID technologies
                for the
                purposes of infant protection in maternity wards and wander prevention
                in
                care homes similar to our asset and personnel location and identification
                system targeted at the secure facility and hazardous business sectors.
                Our
                PureRF Suite can provide solutions for the healthcare sector for
                asset,
                staff, patient and medical record location and identification. We
                believe
                that as hospitals continue to upgrade their security measures, RFID
                technology will be utilized in real-time location systems that are
                designed to immediately locate persons, equipment and objects within
                the
                hospital.




·
            *Livestock
                Owners*.
                Our PureRF Suite can be used as a livestock identification and
                safeguarding system.




**Former
      E-ID Division**





From
      1988
      to 2006, our principal business was the design, development and marketing of
      advanced smart card and identification technologies and products for
      governmental and commercial customers in Europe, Asia and Africa. Our
      applications and solutions included e-passports, visas and other border entry
      documents, national identification and military, police and commercial access
      identification. As detailed above, in 2006, we decided to sell our E-ID division
      in order to focus on opportunities in the U.S. for our IRMS and active RFID
      tracking businesses.





In
      our
      E-ID Division, we developed a fully automated production line for picture
      identification contactless smart cards, and offered our customers raw materials
      and maintenance and service agreements. We provided identification solutions
      and
      contactless smart card production equipment for the governmental and commercial
      customers. The customers and contracts of our E-ID Division in 2004, 2005 and
      2006 included the following:





***Passports
      and ID Card—Africa***





In
      April
      2003, we entered into a five-year agreement with the Security, Immigration
      and
      Refugees Affaires Authority of an African country in connection with passports
      and other travel documentation for that country. The agreement required us
      to
      supply the customer with equipment and raw materials necessary for the
      production of passports and other travel documents from time to time. The
      agreement required the customer to pay us for the equipment and the raw
      materials supplied by us in the aggregate amount of $1.6 million. During 2004,
      2005 and 2006, we generated $261,000, $240,000 and $222,000 respectively, in
      revenues under this agreement.





***Passports
      and Id Smart Cards—Ukraine***




In
      September 1999, a consortium led by us was awarded a contract from the Ukrainian
      government for a national passport and ID smart card project. Over the course
      of
      the project from 1999 to 2005, we were engaged to supply technology, production
      equipment and raw materials for the issuance of passports and ID smart cards.
      We
      have been engaged in an arbitration proceeding concerning this contract, as
      further described under “—Legal Proceedings.” We did not have any revenues from
      this project in 2004, 2005 or 2006.




32


***National
      Documentation—Moldova***





In
      August
      1995, we entered into an agreement with Intercomsoft, which was subsequently
      amended on May 5, 1998 and July 22, 1998, in connection with a national
      documentation project in Moldova. The agreement had a term of ten years.
      Pursuant to the agreement, we supplied Intercomsoft with equipment and raw
      materials necessary for the production of passports, drivers' licenses, vehicle
      registrations, identification cards and other documents, as required from time
      to time under an agreement between Intercomsoft and the Ministry of Internal
      Affairs of Moldova (“MIAM”). Pursuant to the agreement, Intercomsoft was
      required to pay us for the equipment and raw materials that we supplied to
      Intercomsoft. In addition, we were entitled to 25% of Intercomsoft's gross
      profits from the sale of ID documentation to the MIAM. In addition, Trimol
      Group
      Inc., a publicly traded company in the United States and the parent company
      of
      Intercomsoft, issued 125,000 shares of Trimol Group, Inc. to us as partial
      consideration for the equipment supplied and the other undertakings. During
      the
      first and the second quarter of 2004 we sold all of our shares in Trimol Group,
      Inc. for the total amount of $2,500. In 2004 and 2005, we generated revenues
      of
      $1,610,000 and $559,000, respectively, pursuant to this agreement.




On
      March
      24, 2005, we terminated our agreement with Intercomsoft. Under the terms of
      the
      termination agreement, we supplied equipment, consumables and software directly
      to the Moldovan government until April 29, 2006 for which we expect we will
      be
      paid by the Moldovan government. We were paid by the Moldovan government per
      purchase order. During 2005, we generated $1,868,000 in revenues from the
      Moldovan government. (in addition to $559,000 revenues we generated under the
      agreement as mentioned above).





***Passports—Hong
      Kong***





In
      September 1996, SuperCom Asia Pacific Ltd., our wholly owned subsidiary, entered
      into an agreement with China Travel Service (Holdings) H.K. Ltd. (“CTSH”), which
      supplies passports to the Hong Kong government. Under the agreement, SuperCom
      Asia Pacific, as subcontractor, provides CTSH with all the equipment and raw
      materials required for the production of passports in Hong Kong. The agreement
      provides for payments for equipment and raw materials purchased plus annual
      fees
      for maintenance after the first 12 months. We renewed this agreement several
      times, most recently in March 2005 for an additional term of three years through
      June 30, 2007. In 2004, 2005 and 2006 we generated revenues of $758,000,
      $672,000 and $494,000 respectively, under this agreement.





***Hong
      Kong - China Re-Entry Cards***





In
      1996,
      SuperCom Asia Pacific entered into an agreement with China
      Travel Services (CHK) Ltd. (“CTS”),
      which is responsible for the supply of Hong Kong-China re-entry cards to the
      Hong Kong government. SuperCom Asia Pacific, as subcontractor, provides CTS
      with
      all the equipment and raw material necessary for the production of the Hong
      Kong-China re-entry cards. The agreement provides for payment of equipment
      and
      raw materials plus annual maintenance fees after the first 12 months. The term
      of the agreement is five years with a five-year renewal option and can be
      terminated for cause. In June 2001, the agreement was renewed through June
      29,
      2006, and CTS made a follow-on purchase order in 2007. In 2004, 2005 and 2006
      we
      generated revenues of $1,271,000, $900,000 and $898,000 respectively, under
      this
      agreement.





***Passports—United
      Kingdom***





In
      December 1997, we entered into an agreement with the Stationary Office Limited,
      an English company (“TSO”), which was awarded a ten-year agreement in June 1997
      to supply passports to the United Kingdom Passport Agency. We, as subcontractor,
      supplied TSO with equipment and training for the production of passports at
      TSO's central facility in Manchester, England and at six regional offices of
      the
      United Kingdom Passport Agency. In addition, TSO had the option to purchase
      raw
      materials from us at prices specified in the agreement. The TSO agreement
      provided for termination for cause and upon termination of TSO's agreement
      with
      the Passport Agency. In 2004, 2005 and 2006 we generated revenues of $129,000,
      $14,000 and $198,000 respectively, under this agreement.




33


***Biometric
      Visa*** ****** ***system
      to European Government***




In
      January 2005, we announced the execution of an agreement with the government
      of
      a European country to deploy a biometric visa issuance system in its embassies
      throughout the world. The project’s first stage has an estimated value of
      approximately $500,000.




The
      system was built on our proprietary platform technology, and was tailored to
      meet the customer’s specific requirements. To combat counterfeiting and fraud,
      the integrated system will capture the fingerprints of each visa applicant
      and
      store the images on a chip integrated in each visa, enabling automatic and
      positive identification of the person each time the visa is used. The system
      features an advanced and decentralized design that makes it fast and
      cost-effective to install while increasing its flexibility. The end-to-end
      solution meets all ICAO standards for visas and passports. In
      2005
      and 2006, we recognized revenues of $360,000 and $33,000, respectively, under
      this agreement.




***National
      ID card deal with African Governmental Agency***




In
      December 2004, we announced that we have entered into an agreement with an
      African governmental agency to provide an end-to-end “Magna” national
      identification system initially valued at approximately $2.5 million during
      the
      five-year term of the agreement. The solution was deployed in stages starting
      in
      the fourth quarter of 2004 and continued through the end of the fourth quarter
      of 2005. The
      comprehensive hardware and software-based solution consisted of a national
      population ID registry together with a document issuance system.




In
      2004,
      2005 and 2006, we generated revenues of $637,000, $1,918,000 and $399,000,
      respectively, under to this agreement.





***Automated
      Smart Card Production System to a European Government***




During
      the fourth quarter of 2004, we sold an automated smart card production system
      to
      the government of an European country. We recognized revenues from the sale
      in
      the amount of approximately $1.25 million during the forth quarter
      2004.




The
      system is designated to allow the production of secured documents and
      credentials issued by the government. We sold additional raw materials to this
      customer in 2006. During the years 2005 and 2006 our revenues from this project
      were $ 202,000 and $21,000, respectively. The automated production line is
      based
      on high-end technology and manufactures contactless smart cards and inlays
      with
      an antenna and chip.





***Biometric
      passport issuing and control system for a western European country***




During
      January 2006, we announced an award of a tender to provide the technology for
      a
      biometric passport issuing and control system for a country in Western Europe.
      The implementation of the project started during first quarter of
      2006.




The
      contract is for the implementation of a biometric passport issuing and control
      system, and includes a six-year contract for maintenance and support. In 2006,
      we recognized revenue of $453,000 under this agreement.





***E-Passport
      with a European Country***





In
      August
      2006, we entered into an agreement with a European country, estimated to
      generate approximately $1.5 million in
      revenues. Under the agreement we should supply
      our Magna end-to-end solution for the production, management and personalization
      of biometric passports. The 16-month pilot program will produce a personalized
      passport that includes personal details, photo identification, digital signature
      and biometric data. The electronic passport will be compliant with European
      and
      International Civil Aviation Authority (ICAO) standards. In 2006, we recognized
      revenue of $600,000 under this agreement.




34


***National
      Multi ID with a European Country***





In
      September 2006, we announced that we entered into an agreement with a European
      county which we estimate to be generate approximately $50 million in revenues
      during the 10-year term of the project. Under the agreement we
      should provide
      the end-to-end system for a national multi ID issuing and control system. There
      can be no assurance however that we will realize the full estimated value of
      this agreement.




The
      project, which commenced during the third quarter of 2006, involves the
      implementation of an end-to-end national ID issuing and control system based
      on
      our Magna system and includes the supply of digital enrollment and production
      equipment, software, maintenance and supply of secured raw material for the
      production of various National ID cards. In 2006, we recognized revenue of
      $4,569,000 under this agreement.




***Contracts
      for Commercial Applications-Generally***




From
      time
      to time we are party to agreements for the sale of our commercial applications,
      including DynaGate, SmartGate 2400, and SmartDSMS. Most, if not all, of our
      sales from these products are not recurring sales.





**Research
      and Development**


Our
      past
      research and development efforts helped us to achieve the goal of offering
      our
      customers a complete line of products and solutions. We spent $0.8 million,
      $1.2
      million and $1.4 million on research and development in 2004, 2005 and 2006,
      respectively. These amounts were spent on the development or improvement of
      our
      technologies and products, primarily in the areas of automatic contactless
      smart
      card production line, data capture, management software, population registry
      software packages, security printing, contactless smart cards, document
      authentication and active tracking and incident response management solutions.
      We will continue to research and develop new technologies for active RFID
      tracking and incident response management solutions. There can be no assurance
      that we can achieve any or all of our research and development
      goals.





**Sales
      and Marketing**




We
      sell
      our systems and products worldwide through distribution channels that include
      direct sales and traditional distributor or reseller sales. We have
      approximately 11 employees directly engaged in the sale, distribution and
      support of our products through centralized marketing offices in distinct world
      regions including, our employees of SuperCom Asia Pacific, which market our
      products in Asia, and SuperCom, Inc., which markets our products in the United
      States. We are also represented by several independent distributors and
      resellers with which we have distribution agreements.





Our
      distributors and resellers sell our systems and products to business enterprises
      and government agencies and act as the initial customer service contact for
      the
      systems and products they sell. We establish relationships with distributors
      and
      resellers through written agreements that provide prices, discounts and other
      material terms and conditions under which the reseller is eligible to purchase
      our systems and products for resale. These agreements generally do not grant
      exclusivity to the distributors and resellers and, as a general matter, are
      not
      long-term contracts, do not have commitments for minimum sales and could be
      terminated by the distributor. We do not have agreements with all of our
      distributors.





35


**Sales
      Analysis**





***Sales
      By Geographic Destination:***





The
      following table provides a breakdown of total revenue by geographic market
      (all
      amounts in thousands of dollars):





**Year
                ended December 31,****2004**
            
            **2005**
            
            **2006****Total**
            
            **Total**
            
            **Total****revenues**
            
            **revenues**
            
            **revenues**Europe
            
            $
            3,218
            
            $
            3,719
            
            $
            5,877Asia
                Pacific
            
            
            2,433
            
            
            2,173
            
            
            1,730Africa
            
            
            899
            
            
            2,158
            
            
            621United
                States
            
            
            386
            
            
            202
            
            
            373Israel
            
            
            320
            
            
            210
            
            
            194Other
            
            
            88
            
            
            -
            
            
            -$
            7,344
            
            $
            8,462
            
            $
            8,795





The
      following table provides a breakdown of total revenue by product category (all
      amounts in thousands of dollars):





**Year
                ended December 31,****2004**
            
            **2005**
            
            **2006**Raw
                materials and equipment
            
            $
            5,552
            
            $
            7,902
            
            $
            8,028SPPL
                1000
            
            
            1,210
            
            
            -
            
            
            -Maintenance
            
            
            582
            
            
            560
            
            
            767$
            7,344
            
            $
            8,462
            
            $
            8,795




**Customer
      Service**





We
      believe that customer support plays a significant role in our sales and
      marketing efforts and in our ability to maintain customer satisfaction, which
      is
      critical to our efforts to build our reputation and enable us to grow in our
      existing markets
      and to penetrate and grow in new markets.
      In addition, we believe that our interaction with
      our
      customer and the customers’ feedback
      involved in our ongoing support functions provide us with information on
      customer needs and contribute to our product development efforts. We generally
      provide maintenance services under a
      separate and tailor made agreements. We provide our service through customer training, local third-party
      service organizations, our subsidiaries, or our personnel, including appropriate
      personnel sent from our headquarters in Israel. We generally provide our
      customers with a warranty for our products varying in length from twelve to
      36
      months. Costs incurred annually by Vuance for product warranties have to date
      been insignificant; however, there can be no assurance that these costs will
      not
      increase significantly in the future.





36


**Manufacturing
      and Availability of Raw Materials**




Our
      manufacturing operations consist primarily of materials planning and
      procurement, quality control of components, kit assembly and integration, final
      assembly, and testing of fully-configured systems. A significant portion of
      our
      manufacturing operations consists of the integration and testing of
      off-the-shelf components. All of our products and systems, whether or not
      manufactured by us, undergo several levels of testing, including configuration
      to customer orders and testing with current release software, prior to
      delivery.





Certain
      components, such as printers and digital cameras, are purchased and then
      integrated by us into a data capture workstation. We contract with manufacturers
      to produce less technologically sensitive and complex features to our
      specifications.





In
      addition, for Existing
      Projects we
      purchase raw materials such as Teslin®, silicon, toners and certain security
      features, used by our customers in the production of ID documents from third
      parties. While third parties process many of the materials according to our
      specifications, we carry out the finishing and packaging of the consumable
      materials.





We
      do not
      have minimum supply commitments from our vendors and generally purchase
      components on a purchase order basis. Although we generally use standard raw
      materials and components for our systems, some of the key raw materials or
      components are available only from a single source or from limited sources.
      For
      example, Teslin®, which is a primary raw material used in our smart card
      products is only available from a single source. Similarly, many of our various
      chips and toners are only available from limited sources. Even where multiple
      sources are available, we typically obtain components and raw materials from
      only one vendor to ensure high quality, prompt delivery and low cost. If one
      of
      our suppliers were unable to meet our supply demands and we could not quickly
      replace the source of supply, it could have a material adverse effect on our
      business, operating results and financial condition, for reasons including
      a
      delay of receipt of revenues and damage to our business reputation. We have,
      however, identified alternate sources of supply for most of our components
      and
      raw materials. We believe that our open systems architecture facilitates the
      substitution of components when this becomes necessary or
      desirable.





**Competition**





We
      assess
      our competitive position from our experience and market intelligence and
      reviewing third party competitive research materials.




While
      many companies are active in the homeland security market, few companies offer
      products similar to IRMS in the area of access control/perimeter security
      designed for incident management. Additionally, there are many companies in
      the
      broader security market that may offer competing products, but these companies
      do not target governmental customers. We believe that Enterprise Air, Salamander
      Technologies, Johnson Controls, Kollsman, ADT, DMS, Raytheon and Corestreet
      may
      offer products that compete with IRMS in the governmental market, and that
      Wherenet, RF Code, Radiance, Axcess, Sovereign, Ekahau, Pango Networks and
      Aeroscout are potential competitors, in niche areas, to us with respect to
      our
      active RFID tracking products.




Our
      management expects competition to intensify as the markets in which our products
      and services compete continue to develop. Some of our competitors may be more
      technologically sophisticated or have substantially greater technical,
      financial, or marketing resources than we do, or may have more extensive
      pre-existing relationships with potential customers. Although we believe that
      our products combine technologies and features that provide customers with
      complete and comprehensive solutions, we cannot assure you that other companies
      will not offer similar products in the future or develop products and services
      that are superior to our products and services, achieve greater customer
      acceptance or have significantly improved functionality as compared to our
      products and services. Increased competition may result in our experiencing
      reduced margins, loss of sales or decreased market shares.





We
      also
      compete with system integrators such as Lockheed-Martin, Raytheon, L3 and
      Motorola, which act as prime integrators in connection with government
      agreements, or with companies that offer technology complementary to ours to
      the
      same target market.




Due
      to
      the developing nature of the markets for our IRMS and active RFID tracking
      products and the ongoing changes in this market, the above mention list might
      not constitute a full list of all of our competitors and additional companies
      may be considered our competitors.




37


**Intellectual
      Property**





Our
      ability to compete is dependent on our ability to develop and maintain the
      proprietary aspects of our technology. We rely on a combination of trademark,
      copyright, trade secret and other intellectual property laws, employee and
      third-party nondisclosure agreements, licensing and other contractual
      arrangements and have also applied for patent protection to protect our
      proprietary technology and intellectual property. These legal protections afford
      only limited protection for our proprietary technology and intellectual
      property.





In
      addition, the laws of certain foreign countries may not protect our intellectual
      property rights to the same extent as do the laws of Israel or the United
      States. Our means of protecting our intellectual property rights in Israel,
      the
      United States or any other country in which we operate may not be adequate
      to
      fully protect our intellectual property rights. For instance, the intellectual
      property rights of our Asian subsidiary, SuperCom Asia Pacific Ltd. may not
      be
      fully protected by the laws of Hong Kong and the People’s Republic of China.





***Patents***





As
      part
      of the OTI Transaction, we transferred our entire patents related to the E-ID
      Division to OTI.




Our
      patent portfolio currently consists of one patent application pending in the
      United States and an additional PCT application related to our IRMS and RFID
      technologies.





We
      intend
      to file additional patent applications when and if appropriate. There is no
      guarantee that patentable inventions will arise from our research and
      development efforts and, if we do apply for a patent protection for such
      inventions, there is no guarantee that it will be issued.





In
      addition, not all countries provide legal protection of proprietary technology
      to the same extent. There can be no assurance that the measures taken by us
      to
      protect our proprietary technologies are or will be sufficient to prevent
      misappropriation of our technologies or portions thereof by unauthorized third
      parties or independent development by others of similar technologies or
      products. In addition, regardless of whether our products infringe on
      proprietary rights of third parties, infringement or invalidity claims may
      be
      asserted or prosecuted against us and we could incur significant expenses in
      defending them. Our costs could also increase if we have to pay license fees
      as
      a result of these claims.





***Licenses***





We
      license technology and software, such as operating systems and database software
      from third parties for incorporation into our systems and products and we expect
      to continue to enter into these types of agreements for future products. Our
      licenses are either perpetual or for specific terms.





As
      part
      of the OTI Transaction, we received an irrevocable, worldwide, non-exclusive,
      non-assignable and non-transferable license to use in connection with the
      Existing Projects the intellectual property that we transferred to OTI as part
      of the OTI Transaction. Generally
      speaking, the
      license will be valid for the duration of all Existing
      Projects.





**Government
      Regulation**





We
      are
      subject to certain labor statutes and to certain provisions of collective
      bargaining agreements between the Histadrut (the General Federation of Labor
      in
      Israel) and the Coordinating Bureau of Economic Organizations, including the
      Industrialists’ Association, with respect to our Israeli employees. In addition,
      some of our Israeli employees are also subject to minimum mandatory military
      service requirements. Please refer to the discussion of “Employees” appearing
      under Section D of Item 6 for more information.





Generally,
      we are subject to the laws, regulations and standards of the countries in which
      we operate and/or sell our products, which vary substantially from country
      to
      country. The difficulty of complying with these laws regulations and standards
      may be more or less difficult than complying with applicable U.S. or Israeli
      regulations, and the requirements may differ.




38


**Employees**





As
      of
      December 31, 2006 and December 31, 2005, we had 56 and 57 full-time employees,
      respectively. Please refer to the section captioned “Employees” appearing under
      Item 6.D for more information about our employees.





As
      a
      result of the OTI Transaction we terminated the employment of certain employees
      that were employed by us in the e-ID Division (the above information includes
      also the employees of the E-ID Division which are not our employees since the
      beginning of 2007).





Our
      ability to succeed depends, among other things, upon our continuing ability
      to
      attract and retain highly qualified managerial, technical, accounting, sales
      and
      marketing personnel.





**Seasonality**




Our
      financial and operating results have fluctuated in the past and our financial
      and operating results could fluctuate in the future. The period
      between our initial contact with a potential customer and the purchase of our
      products and services is often long and subject to delays associated with the
      budgeting, approval and competitive evaluation processes that frequently
      accompany significant capital expenditures, particularly by governmental
      agencies. The typical sales cycle for our government customers has to date
      ranged from three to 36 months and the typical sales cycle for our commercial
      customers has ranged from one to six months. A lengthy sales cycle may have
      an
      impact on the timing of our revenue, which may cause our quarterly operating
      results to fall below investor expectations. We believe that a customer's
      decision to purchase our products and services is discretionary, involves a
      significant commitment of resources, and is influenced by customer budgetary
      cycles or federal and state grants. To successfully sell our products and
      services, we generally must educate our potential customers regarding their
      use
      and benefits, which can require significant time and resources. This significant
      expenditure of time and resources may not result in actual sales of our products
      and services.





The
      lead-time for ordering parts and materials and building many of our products
      can
      be many months. As a result, we must order parts and materials and build our
      products based on forecasted demand. If demand for our products lags
      significantly behind our forecasts, we may produce more products than we can
      sell, which can result in cash flow problems and write-offs or write-downs
      of
      obsolete inventory.





39


***C.    Organizational
      Structure***





The
      diagram below shows Vuance Ltd.'s holdings in its subsidiaries and affiliates
      as
      of June 25, 2007:




chart





*
      In
      February 2007, the Company purchased the remaining 20% from the minority and
      thus became the sole shareholder of the VUANCE - RFID Inc.





**SuperCom
      Asia Pacific Limited (''SuperCom Asia Pacific'')**




SuperCom
      Asia Pacific, incorporated in Hong Kong, is responsible for our sales and
      marketing efforts in the Far East. SuperCom Asia Pacific has been our wholly
      owned subsidiary since November, 2003.





**SuperCom
      Slovakia a.s. (''SuperCom Slovakia'')**




SuperCom
      Slovakia, incorporated in Slovakia, was established to implement a national
      documentation project in the Republic of Slovakia. SuperCom Slovakia is 66%
      owned by us and 34% owned by EIB Group a.s., a privately held Czech company.
      Despite our ownership of almost two-thirds or the economic interests of SuperCom
      Slovakia, our voting power in SuperCom Slovakia is 50%.




**SuperCom,
      Inc.**




SuperCom,
      Inc., incorporated in Delaware, is responsible for our sales and marketing
      efforts in the United States. SuperCom, Inc. is our wholly owned
      subsidiary.





**VUANCE
      - RFID Inc.**




VUANCE
      -
      RFID Inc., incorporated in Delaware in November 2005 under the name Pure RF
      Inc.
      Upon its incorporation we owned 80% of its shares. During January 2006 VUANCE
      -
      RFID Inc. established a wholly owned Israeli subsidiary . Pure RF Israel Ltd,
      which will develop new technology and solution for the tracking of people and
      assets. During February 2007, the Company purchased the remaining 20% from
      the
      minority for an amount of $100,000 whereupon VUANCE - RFID Inc. became our
      wholly owned subsidiary. In June 2007 Pure RF Inc. changed its name to VUANCE
      -
      RFID Inc.





**SBC
      Aviation Ltd.**




SBC
      Aviation Ltd., incorporated in Israel in the fourth quarter of 2006, is our
      wholly owned subsidiary, will commence operations in 2007, and will focus on
      executing information technology and security projects.




40


***D.    Property,
      Plants and Equipment***




We
      do not
      own any real estate property.





We
      lease
      approximately 2,224 square meters of facilities in Qadima, Israel. During the
      year 2006, our principal management, administration and marketing activities
      occupy approximately 682 square meters on the site. Our principal engineering,
      research and development and manufacturing activities occupy approximately
      1,542
      square meters on the site. As a result of the OTI Transaction, we leased to
      OTI
      certain portion of our leased facilities for a monthly fee of $11,000, for
      a
      period of one year, commencing on the closing date (December 31, 2006).
      According to our lease agreement with the owner of the facilities the lease
      is
      for a period of five years commencing on November 1, 2005. We have an option
      to
      renew the lease for an additional period of five years. According to the
      agreement, the monthly fee is approximately $16,000
      (for 2,224 square
      meters) .





SuperCom
      Asia Pacific leases approximately 200 square meters of office space in Hong
      Kong, and SuperCom, Inc. leases approximately 30 square meters of office space
      in Virginia. All of such leased properties in Hong Kong and the United States
      consist of office space for management, administrative and marketing
      activities.





The
      total
      annual rental fees for 2004, 2005 and 2006 were $386,821, $369,560 and $354,530,
      respectively. The total annual lease commitments for 2007 are
      $279,000





All
      assets are held in the name of Vuance Ltd. and its subsidiaries.





The
      following table details our fixed assets as of December 31, 2005 and
      2006:




**December
                31,****2005**
            
            **2006****(In
                thousands of US Dollars)****Cost:**Computers
                and peripheral equipment
            
            $
            1,055
            
            $
            300Machinery
                and peripheral equipment
            
            
            3575
            
            
            -Office
                furniture and equipment
            
            
            487
            
            
            211Leasehold
                improvements
            
            
            131
            
            
            755,248
            
            
            586**Accumulated
                depreciation:**Computers
                and peripheral equipment
            
            
            971
            
            
            259Machinery
                and peripheral equipment
            
            
            745
            
            
            -Office
                furniture and equipment
            
            
            245
            
            
            92Leasehold
                improvements
            
            
            77
            
            
            752,038
            
            
            426**Depreciated
                cost:**
            
            $
            3,210
            
            $
            160





Depreciation
      expenses for the years ended December 31, 2004, 2005 and 2006 were $238,000,
      $746,000 and $335,000, respectively.




During
      the fiscal 2005, the Company relocated its offices. As a result the Company
      wrote down the unamortized balance of leasehold improvement in the amount of
      $471,000. This expense was recorded in the statement of operations as part
      of
“Restructuring expenses”.





On
      December 31, 2006, as part of the OTI Transaction, all property and equipment
      related to the Division were transferred to OTI.




41


**ITEM
      4A.** ***Unsolved
      Staff Comments.***





Not
      applicable.





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




***A.    Operating
      results***




The
      following section should be read in conjunction with our consolidated financial
      statements and the related notes thereto, which have been prepared in accordance
      with U.S. GAAP and which are included in Item 18. Some of the statements
      contained in this section constitute “forward-looking statements.” These
      statements relate to future events or to our future financial performance and
      involve known and unknown risks, uncertainties and other factors that may cause
      our actual results, levels of activity, performance or achievements to be
      materially different from any future results, levels of activity, performance
      or
      achievements express or implied by such forward-looking statements. See “Note
      Regarding Forward Looking Statements” and “Risk Factors.”





**Overview**





We
      were
      established in 1988 in Israel. Our ordinary shares have been listed for trade
      on
      the Euronext Brussels stock market, under the symbol “SUP”, since October 23,
      2003. Since November 5, 2004, the Company’s ordinary shares have also traded on
      the OTC Bulletin Board under the symbol "SPCBF.OB". On April 29, 2007 our
      shareholders at the extraordinary general meeting of shareholders, approved
      to
      change the Company’s name to Vuance Ltd., as of May 14th, 2007 our current
      symbol on the OTC Bulletin Board is “VUNCF.OB” and on the Euronext Brussels
      stock market is “VUNC ” .





We
      develop and market incident response management and tracking solutions for
      public safety agencies, commercial customers and governmental organizations.
      We
      offer two principal products to our customers, both of which we developed
      recently:





·
            IRMS,
                an incident response management system, used to facilitate the
                authentication and flow of on-site personnel in disaster recovery
                operations, including police, fire and emergency medical service
                departments and other governmental agencies complying with U.S. Department
                of Homeland Security requirements, and


·
            PureRF
                Suite, an active radio frequency identification (RFID), system that
                utilizes radio frequency communications to track assets, people and
                objects for potential governmental agency and commercial
                customers.





In
      addition, we have several continuing projects relating to the advanced smart
      cards and identification technologies division we sold to OTI (please refer
      to
      the section captioned “The OTI Transaction” in Item 4.A and the section
      captioned “Former E-ID Division” in Item 4.B).





We
      sell
      our products through centralized marketing offices in different regions of
      the
      world. We have two wholly-owned marketing subsidiaries: SuperCom Asia Pacific
      Limited in Hong Kong and Supercom Inc. in the United States. Supercom Inc.,
      was
      established by the Company in 2003.





During
      the fourth quarter of 2005, we established a new Delaware subsidiary in which
      we
      initially owned 80% of the shares, VUANCE - RFID Inc., which began operations
      during the first quarter of 2006. During the first quarter of 2006 VUANCE -
      RFID
      Inc. established a wholly owned subsidiary. Pure RF Ltd, (Incorporated and
      operating in Israel), and focuses on new technology and solutions for active
      tracking of people and objects. During February 2007, we purchased the remaining
      20% of VUANCE - RFID from its minority shareholder for a purchase price of
      $100,000.





During
      the fourth quarter of 2006, we established a new wholly-owned Israeli
      subsidiary, S.B.C. Aviation Ltd., which will commence operations in 2007, and
      will focus on executing information technology and security
      projects.





On
      November 8, 2006, we announced the execution of the OTI Transaction(see full
      description in Item 4A above). As a result of the OTI Transaction, we recognized
      $10,536,000 as a capital gain on the sale of the e-ID Division in fiscal year
      2006. The capital gain was calculated based on OTI’s share price on the closing
      date, less a discount due to the lock up restrictions of the shares (based
      on an
      independent appraisal), the carrying value of the assets that were transferred
      to OTI and direct expenses (in an amount of $1,550) associated with the
      sale.




42




As
      a
      result of the OTI Transaction we terminated the employment of certain employees
      that were employed by us in the e-ID Division.





In
      connection with the completion of the OTI Transaction, during January 2007,
      a
      $2,500,000 loan was extended to us by a financial institution. In order to
      secure this loan , we deposited all of the we received from OTI in the OTI
      Transaction shares in escrow for the benefit of such financial
      institution.





***Revenues***





The
      primary products that we sell are smart card systems, smart card production
      machines and raw materials used for the production of smart cards and secure
      ID
      cards. We typically  derive
      the majority of our revenues during the first two years of an agreement with
      a
      customer. This revenue is generated by the delivery of the data collection
      and
      document production systems. Following delivery of such systems, the majority
      of
      revenues generated from the agreement results from ongoing deliveries of raw
      materials for use with the installed systems. We also typically generate
      additional revenues from maintenance fees and support, training and
      installation.





Our
      systems are tailored to meet the specific needs of our customers. In order
      to
      satisfy these needs, the terms of each agreement, including the duration of
      the
      agreement and prices for our products and services differ from agreement to
      agreement.





In
      the
      IRMS Division we generate our revenues from the sale of IRMS systems. The
      revenues from this Division derive from the initial sale of the system and
      recurring revenues from: system expansion and software upgrade





***Operating
      Expenses***





Our
      costs
      associated with a particular project may vary significantly depending on the
      specific requirements of the customer and the terms of the agreement, as well
      as
      on the extent of the technology licensing. As a result, our gross profits from
      each project may vary significantly.





Our
      research and development expenses consist of salaries, raw material and
      equipment costs, as well as financing research and development operations in
      subsidiaries.





***Net
      Income***





Our
      operating results are significantly affected by, among other things, the timing
      of contract awards and performance of agreements. As a result, our revenues
      and
      income may fluctuate substantially from quarter to quarter, and comparisons
      over
      longer periods of time may be more meaningful. The nature of our expenses
      (including cost of revenues) are mainly fixed or semi-fixed and any fluctuation
      in revenues will generate a significant variation in gross profit and net
      income.





**Critical
      Accounting Policies and Estimates**





The
      preparation of financial statements requires us to make estimates and
      assumptions that affect the reported amounts of assets and liabilities and
      the
      disclosure of contingent liabilities at the date of the financial statements
      and
      the reported amounts of revenues and expenses during the reporting period.
      On an
      ongoing basis, we evaluate our estimates and judgments, including those related
      to revenue recognition, allowance for bad debts, and valuation of inventories
      and impairment of long-lived assets.





We
      base
      our estimates and judgments on historical experience and on various other
      factors that we believe to be reasonable under the circumstances, the results
      of
      which form the basis for making judgments about the carrying values of assets
      and liabilities that are not readily apparent from other sources. Under
      different assumptions or conditions, actual results may differ from these
      estimates.





Our
      discussion and analysis of our financial condition and results of operations
      are
      based on our consolidated financial statements, which have been prepared in
      accordance with generally accepted accounting principles in the United States
      ("US GAAP"). Our significant accounting principles are presented within Note
      2
      to our Consolidated Financial Statements. While all the accounting policies
      impact the financial statements, certain policies may be viewed to be critical.
      These policies are those that are most important to the portrayal of our
      financial condition and results of operations. Actual results could differ
      from
      those estimates. Management believes that the significant accounting policies
      which affect its more significant judgments and estimates used in the
      preparation of the consolidated financial statements and are the most critical
      to aid in fully understanding and evaluating our reported results include the
      following:





A.  Revenue
      recognition




43




B.  Allowance
      for doubtful accounts




C.  Contingencies




D.  Stock
      Based Compensation





***Revenue
      Recognition***





We
      generate revenues primarily from governmental projects sales and commercial
      products sales. Some of
      our transactions include maintenance services, installation and integration
      consulting services.





Revenues
      are recognized when delivery has occurred and, where applicable, after
      installation has been completed, there is persuasive evidence of an agreement,
      the fee is fixed or determinable and collection of the related receivable is
      reasonably assured and no further obligations exist. In cases where delivery
      has
      occurred but the required installation has not been performed, the Company
      does
      not recognize the revenues until the installation is completed. The Company
      does
      not grant a right of return. Following are the main factors of our revenue
      recognition policies:




We
      recognize revenue from products generally upon shipment, unless contract terms
      call for a later date, net of an allowance for estimated returns, provided
      persuasive evidence of an arrangement exists, collection is probable, the fee
      is
      fixed or determinable, vendor-specific objective evidence exists to allocate
      the
      total fee to elements of the arrangement and assuming only inconsequential
      or
      perfunctory performance obligations remain. Revenue from some data security
      hardware products contains embedded software. However, the embedded software
      is
      considered incidental to the hardware product sale. We also act as a reseller
      of
      third-party hardware and software applications. Generally, we recognize such
      revenue upon shipment of the hardware or software application, unless contract
      terms call for a later date, provided that all other conditions above have
      been
      met.




As
      mentioned above we derive our revenues mainly from sale of hardware products
      that include embedded software that is considered to be incidental. However,
      in
      limited circumstances, we provide software upgrades in respect of the embedded
      software of hardware products sold in the past. Such revenues are recognized
      when all criteria outlined in Statement of Position No. 97-2 “Software Revenue
      Recognition” (“SOP No. 97-2) (as amended) are met: when persuasive evidence of
      an agreement exists, delivery of the product has occurred (i.e. the services
      have been provided), no significant obligations  under
      the
      agreement remain, the fee is fixed or determinable and collectibility is
      probable.




Service
      revenue includes payments under support and upgrade contracts and consulting
      fees. We recognize support and upgrade revenue ratably over the term of the
      contract, which typically is twelve months. Consulting revenue primarily relates
      to installation, integration and training services performed on a
      time-and-materials or fixed-fee basis under separate service arrangements.
      Fees
      from consulting are recognized as services are performed.




Revenues
      from arrangements that involve the delivery of multiple deliverables such as
      products, services or rights to use asset, are recognized in accordance with
      EITF Issue No. 00-21 “Revenue Arrangements with Multiple Deliverables”. For such
      arrangements, each element of the contract is accounted as a separate unit
      if
      the delivered items have value to the customer on a standalone basis and there
      is objective and reliable evidence of the fair value of the undelivered
      items.




We
      are
      entitled to royalties upon sales of smartcard systems. Such royalties are
      recognized when the sales are reported to the Company (mainly on a monthly
      basis).




Revenues
      from long-term contracts are recognized pursuant to the percentage of completion
      method. We measure the percentage of completion based on output criteria, such
      as the number of units delivered or based on contract milestones as applicable
      to each contract. Provisions for estimated losses on incomplete contracts are
      made during the period in which such losses are first identified, in the amount
      of the estimated loss on the entire contract. Cost
      estimates on percentage-of-completion contracts are reviewed periodically with
      adjustments recorded in the period in which the revisions are made. The
      complexity of the estimation process and factors relating to the assumptions,
      risks and uncertainties inherent with the application of the
      percentage-of-completion method of accounting affect the amounts of revenue
      and
      related expenses reported in our consolidated financial statements. A number
      of
      internal and external factors can affect our estimates, including labor rates,
      availability of qualified personnel and project requirement and/or scope
      changes. Billings on uncompleted contracts may be less than or greater than
      the
      revenues recognized and are recorded as either unbilled receivable (an asset)
      or
      deferred revenue (a liability) in the consolidated financial statements.




44




***Allowance
      for doubtful accounts***





The
      allowance for doubtful accounts is determined with respect to specific debts
      that the Company has determined to be doubtful of collection.





We
      perform ongoing credit evaluations of our customers' financial condition and
      we
      require collateral as deemed necessary. An allowance for doubtful accounts
      is
      determined with respect to those accounts that we have determined to be doubtful
      of collection. If the financial condition of our customers were to deteriorate,
      resulting in an impairment of their ability to make payments, additional
      allowances would be required. The
      allowance for doubtful accounts was $3,397,000 and $3,487,000 at December 31,
      2005 and 2006, respectively.





***Contingencies***





From
      time
      to time, we are the defendant or plaintiff in various legal actions, which
      arise
      in the normal course of business. We are required to assess the likelihood
      of
      any adverse judgments or outcomes to these matters as well as potential ranges
      of probable losses. A determination of the amount of reserves required for
      these
      contingencies, if any, which would be charged to earnings, is made after careful
      and considered analysis of each individual action together with our legal
      advisors. The required reserves may change in the future due to new developments
      in each matter or changes in circumstances, such as a change in settlement
      strategy. A change in the required reserves would affect our earnings in the
      period the change is made. Other than as described under the heading “Legal
      Proceedings” under Item 8, there are no material pending legal proceedings in
      which we are a party or of which our property is subject.





***Stock-Based
      Compensation***




Until
      December 31, 2005 we applied the intrinsic-value-based method of accounting
      prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting
      for Stock Issued to Employees,” and related interpretations including Financial
      Accounting Standards Board (FASB) Interpretation No. 44, “Accounting for Certain
      Transactions involving Stock Compensation,” an interpretation of APB Opinion No.
      25, issued in March 2000, to account for our employee stock options. Under
      this
      method, compensation expense was recognized only if the current market price
      of
      the underlying stock exceeded the exercise price on the date of grant. SFAS
      No.
      123, “Accounting for Stock-Based Compensation, (SFAS 123)” and FASB Statement
      No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” an
      amendment to FASB Statement No. 123, established accounting and disclosure
      requirements using a fair-value-based method of accounting for stock-based
      employee compensation plans. As permitted, through December 31, 2005, we elected
      to apply the intrinsic-value-based method of accounting described above, and
      have adopted only the disclosure requirements of SFAS No. 123, as amended.





However,
      as more fully described in note 2(v) to the accompanying financial statement,
      On
      January 1, 2006 we adopted SFAS No. 123R, “Share-Based Payment” (SFAS 123R), a
      revision of SFAS 123. Among other items, SFAS 123R eliminated the use of APB
      25
      and the intrinsic value method of accounting, and requires companies to
      recognize in their financial statements, the cost of employee services received
      in exchange for awards of equity instruments, based on the fair value of those
      awards at the grant date.





We
      adopted SFAS 123R, using the modified prospective method, as permitted under
      the
      standard. Accordingly, prior period amounts have not been restated. Under
      this method, the Company is required to record compensation expense for all
      awards granted after the date of adoption and for the unvested portion of
      previously granted awards that remain outstanding at the date of
      adoption.





45


***Warranties***





Based
      on
      past experience, the Company does not provide for warranty costs when revenue
      is
      recognized.





**Results
      of Operations**





The
      following table sets forth selected consolidated income statement data for
      Vuance for each of the three years ended December 31, 2004, 2005 and 2006
      expressed as a percentage of total revenues.





2004
            
            2005
            
            2006Revenues
            
            
            100
            %
            
            100
            %
            
            100
            %Cost
                of revenues
            
            
            50.8
            
            
            50.7
            
            
            39.7Inventory
                write-off
            
            
            —
            
            
            3.4
            
            
            —Gross
                profit
            
            
            49.2
            
            
            45.9
            
            
            60.3Operating
                expenses:Research
                and development
            
            
            11.5
            
            
            14.0
            
            
            15.5Selling
                and marketing, net
            
            
            33.3
            
            
            35.5
            
            
            63.9General
                and administrative
            
            
            26.6
            
            
            35.0
            
            
            31.1Restructuring
                expenses
            
            
            —
            
            
            5.9
            
            
            —Litigation
                settlement expenses
            
            
            —
            
            
            1.5
            
            
            1.2Total
                operating expenses
            
            
            71.4
            
            
            91.9
            
            
            111.7Capital
                gain from the sale of the e-ID Division
            
            
            —
            
            
            —
            
            
            119.7Operating
                income (loss)
            
            
            (22.2
            )
            
            (46.0
            )
            
            68.3Financial
                income (expenses), net
            
            
            (2.9
            )
            
            (0.3
            )
            
            (2.3
            )Other
                income (expenses), net
            
            
            (0.3
            )
            
            (0.4
            )
            
            (4.2
            )Income
                (loss) before income taxes
            
            
            (25.5
            )
            
            (46.7
            )
            
            61.8Equity
                in losses of affiliates andimpairment,
                net of taxes
            
            
            —
            
            
            —
            
            
            —Net
                income (loss) fromcontinuing
                operations
            
            
            (25.5
            )
            
            (46.7
            )
            
            61.8Loss
                from discontinued operations
            
            
            —
            
            
            —
            
            
            —Net
                income (loss)
            
            
            (25.5
            )
            
            (46.7
            )
            
            61.8





46





**Operating
      Results**





**Year
      Ended December 31, 2006 Compared to Year Ended December 31, 2005**





***Revenues***





Our
      revenues in 2006 were $8,795,000 compared to $8,462,000 in 2005, an increase
      of
      4%. We anticipate that our revenues in 2007 will be consistent with our mix
      of
      revenues in 2006. We believe that the Existing Projects are critical to our
      success in the short-term, we believe that both the IRMS and the active RFID
      will be critical to our long-term future success.





***Gross
      Profit***





Our
      gross
      profits in 2006 were $5,301,000 compared to gross profits of $3,882,000 in
      2005,
      an increase of 36.6%. The gross profit margin for the year 2006 increased by
      14.4% as compared to 46% in 2005. The incraese in our 2006 gross profit margin
      was primarily due to different mix of products, which carry higher margins.





***Expenses***





Our
      operating expenses in 2006 were $9,826,000 compared to $7,778,000 in 2005,
      an
      increase of 26%. The increase in operating expenses was mainly due to the
      increase in selling and marketing.




Selling
      and marketing expenses consist primarily of salaries and commission earned
      by
      sales and marketing personnel, trade show and promotional expenses, allocated
      rent and supplies and travel and entertainment costs. Our selling and marketing
      expenses in 2006 were $5,619,000 compared to $3,003,000 in 2005, an increase
      of
      87%. The increase in the sales and marketing expenses was primary due to the
      increase in sales promotion expenses related to the increase in revenues, labor
      expenses, an increase in sales and marketing activities in the United States
      and
      different mix of projects.




General
      and administrative expenses consist primarily of salaries, benefits, allocated
      rent and supplies, and related costs for our executive, finance, legal, human
      resource, information technology and administrative personnel, and professional
      service fees, including legal counsel insurance and audit fees. Our general
      and
      administrative expenses in 2006 were $2,737,000 compared to $2,968,000 in 2005,
      a decrease of 7.8%.




Research
      and development expenses consist primarily of salaries, benefits, allocated
      rent
      expense, supplies and equipment for software developers and architects, hardware
      engineers and program managers, as well as legal fees associated with our
      intellectual property. Our research and development expenses in 2006 were
      $1,362,000 compared to $1,182,000 in 2005, an increase of 15%. The increase
      in
      the research and development expenses was primarily due to research and
      development expenses associated with our new technologies, IRMS and active
      RFID.




Restructuring
      expenses contains certain financial measures related to expenses totaling
      $496,000 that are associated with cost-cutting measures implemented by us during
      year 2005.




Additionally,
      litigation settlement expenses consist one time expenses that relate to
      litigations that settled during the reported periods as described in legal
      proceeding. Our litigation settlement expenses in 2006 were $108,000 compared
      to
      $129,000 in 2005.





***Capital
      gain from the OTI Transaction***





As
      a
      result of the OTI Transaction, we recognized $10,536,000 as a capital gain
      on
      the sale of the e-ID Division in fiscal year 2006. The capital gain was
      calculated based on OTI’s share price on the closing date, less a discount due
      to the lock up restrictions of the shares (based on an independent appraisal),
      the carrying value of the assets that were transferred to OTI and direct
      expenses (in an amount of $1,550,000) associated with the sale.





The
      direct expenses included, inter alia, the fair value of 212,040 shares out
      of
      the shares we received y from OTI that will be transferred to consultants,
      as a
      finder and legal fee, in connection with the transaction (Our investment in
      OTI’s shares includes the shares held by us, net of the shares that will be
      transferred to the consultants).





47





***Financial
      Interest Expense, net***





Financial
      expense for the twelve months ended December 31, 2006, and 2005, was $204,000
      and $25,000, respectively. The increase in financial expense is mainly due
      to
      the financial expenses with respect to convertible bond.





***Other
      Expenses, Net***





Other
      expenses, net for the twelve months ended December 31, 2006, and 2005, was
      $
      367,000 and $30,000, respectively. Other expenses, net during the year 2006
      consisted write down of loan regarding an investment in an affiliated company
      and other trade receivables in the amount of $321,000 compared to $0 during
      the
      year 2005.





***Net
      Loss***





As
      a
      result of the factors described above, our net income in 2006 was $5,440,000
      compared to a net loss of $3,951,000 in 2005.





**Year
      Ended December 31, 2005 Compared to Year Ended December 31, 2004**





***Revenues***





Our
      revenues in 2005 were $8,462,000 compared to $7,344,000 in 2004, an increase
      of
      15%. The increase is primarily due to an increase in revenues from existing
      governmental customers, primarily in Europe and Africa. Although we believe
      that
      the government market is critical to our success in the short-term, we believe
      that both the government and commercial markets will be critical to our
      long-term future success.





***Gross
      Profit***





Our
      gross
      profits in 2005 were $3,882,000 compared to gross profits of $3,614,000 in
      2004,
      an increase of 7.4%. The gross profit margin for the year 2005 decreased by
      3.3%
      as compared to 49% in 2004. The decrease in our 2005 gross profit margin was
      primarily due to Inventory write-off in the amount of $287,000 related to the
      Ukraine project, and due to different mix of products, which carry lower
      margins.





***Expenses***





Our
      operating expenses in 2005 were $7,778,000 compared to $5,245,000 in 2004,
      an
      increase of 48%. The increase in operating expenses was due to the increase
      in
      selling and marketing expenses, general and administrative expenses, research
      and development expenses, restructuring expenses of $496,000 relating to
      cost-cutting measures that we implemented during the year 2005 and settlement
      expenses of $129,000.




Selling
      and marketing expenses consist primarily of salaries and commission earned
      by
      sales and marketing personnel, trade show and promotional expenses, allocated
      rent and supplies and travel and entertainment costs. Our selling and marketing
      expenses in 2005 were $3,003,000 compared to $2,445,000 in 2004, an increase
      of
      23%. The increase in the sales and marketing expenses was due to the increase
      in
      labor expenses and sales promotion expenses related to the increase in revenues.




General
      and administrative expenses consist primarily of salaries, benefits, allocated
      rent and supplies, and related costs for our executive, finance, legal, human
      resource, information technology and administrative personnel, and professional
      service fees, including legal counsel insurance and audit fees. Our general
      and
      administrative expenses in 2005 were $2,968,000 compared to $1,955,000 in 2004,
      an increase of 52%. The increase in the general and administrative expenses
      was
      primarily due to expenses related to the registration of our ordinary shares
      under the Exchange Act, the commencement of trading of our shares in the United
      States on the OTC Bulletin Board, and increases in our legal expenses related
      to
      our ID solutions for governmental markets activity.




Research
      and development expenses consist primarily of salaries, benefits, allocated
      rent
      expense, supplies and equipment for software developers and architects, hardware
      engineers and program managers, as well as legal fees associated with our
      intellectual property. Our research and development expenses in 2005 were
      $1,182,000 compared to $845,000 in 2004, an increase of 40%. The increase in
      the
      research and development expenses was primarily due to research and development
      expenses associated with our ID solutions for governmental markets and to new
      products development including SmartSMDS, E-Passport. We expect, that our
      research and development expenses will increase in 2006 due to research and
      development expenses associated with our SmartSMDS, E-Passport and new
      technology for active tracking solutions.




48




Restructuring
      expenses contains certain financial measures related to expenses totaling
      $496,000 that are associated with cost-cutting measures implemented by us during
      year 2005.




Additionally,
      in 2005, we paid settlement expenses totaling $129,000 relating to a litigation
      settlement that we entered into with Mr. Yaacov Pedhatzur in connection with
      the
      Yaacov Pedhatzur litigation. See section captioned “ *Legal
      Proceedings* ”
in
      Item
      8 below.





***Financial
      Interest Expense, net***




Financial
      interest expense for the twelve months ended December 31, 2005, and 2004, was
      $53,000 and $166,000, respectively. Interest expense during 2005 and 2004
      consisted of interest accrued from bank loans net of bank deposit.




***Other
      Expenses, Net***




Other
      expenses, net for the twelve months ended December 31, 2005, and 2004, was
      $
      30,000 and $27,000, respectively.





***Net
      Loss***





As
      a
      result of the factors described above, our net loss in 2005 was $3,951,000
      compared to a net loss of $1,872,000 in 2004, an increase of 111% in our net
      loss.





**Impact
      of Inflation and Currency Fluctuations**





Because
      the majority of our revenue is paid in or linked to the dollar, we believe
      that
      inflation and fluctuation in the NIS/dollar exchange rate has no material effect
      on our results of operations. However, a portion of the cost of our Israeli
      operations, mainly personnel, is incurred in NIS. Because some of our costs
      are
      in NIS, inflation in Israel/dollar exchange rate fluctuations do have some
      impact on expenses and, as a result, on net income. Our NIS costs, as expressed
      in dollars, are influenced by the extent to which any increase in the rate
      of
      inflation in Israel is not offset, or is offset on a delayed basis, by a
      devaluation of the NIS in relation to the dollar.





Historically,
      the New Israeli Shekel, the Israeli currency, has been devalued in relation
      to
      the U.S. dollar and other major currencies principally to reflect the extent
      to
      which inflation in Israel exceeds average inflation rates in western economies.
      Such devaluations in any particular fiscal period are never completely
      synchronized with the rate of inflation and therefore may lag behind or exceed
      the underlying inflation rate.





In
      2006,
      the rate of evaluation of the NIS against the U.S. dollar was 8.2% and the
      rate
      of deflation was 0.1%. It is unclear what the devaluation/evaluation rate will
      be in the future, and we may be materially adversely affected if inflation
      in
      Israel exceeds the devaluation of the NIS against the U.S. dollar, or if the
      timing of the devaluation lags behind increases in inflation in
      Israel.





We
      do not
      engage in any hedging or other transactions intended to manage risks relating
      to
      foreign currency exchange rate or interest rate fluctuations. At December 31,
      2006, we did not own any market risk sensitive instruments except for our
      revolving line of credit. However, we may in the future undertake hedging or
      other similar transactions or invest in market risk sensitive instruments if
      management determines that it is necessary or advisable to offset these
      risks.





**Seasonality**





Our
      quarterly operations are subject to fluctuations due to several factors,
      including the factors discused under the section captioned “Risk Factors—The
      time from our initial contact with a customer to a sale is long and subject
      to
      delays which
      could result in the postponement of our receipt of revenues from one accounting
      period to the next, increasing the variability of our results of operations
      and
      causing significant fluctuations in our revenue from quarter to quarter.” and
      the
      section captioned “Seasonality” appearing under Item 4, B. It is our experience
      that, as a general matter, a majority of our sales are made during the latter
      half of the calendar year consistent with the budgetary, approval and order
      processes of our governmental customers. Additionally, the period
      between our initial contact with a potential customer and the purchase of our
      products and services is often long and subject to delays associated with the
      budgeting, approval and competitive evaluation processes that frequently
      accompany significant capital expenditures, particularly for government
      organizations. A lengthy sales cycle may have an impact on the timing of our
      revenue, which may cause our quarterly operating results to fall below investor
      expectations. We believe that a customer's decision to purchase our products
      and
      services is discretionary, involves a significant commitment of resources,
      and
      is influenced by customer budgetary cycles. To successfully sell our products
      and services, we generally must educate our potential customers regarding their
      use and benefits, which can require significant time and resources. This
      significant expenditure of time and resources may not result in actual sales
      of
      our products and services, which could have an adverse effect on our results
      of
      operations.




49





**New
      Accounting Pronouncements**





In
      February 2006, the FASB issued FAS 155, “Accounting for Certain Hybrid Financial
      Instruments”, an amendment of FASB Statements No. 133 and 140. This Statement
      permits fair value measurement for any hybrid financial instrument that contains
      an embedded derivative that otherwise would require bifurcation.




This
      Statement becomes effective for all financial instruments acquired or issued,
      or
      subject to a re-measurement (new basis) after the beginning of an entity’s first
      fiscal year that begins after September 15, 2006. Earlier adoption is permitted
      as of the beginning of an entity’s fiscal year, provided that no interim period
      financial statements have been issued for the financial year.




Management
      is currently evaluating the impact of this Statement, if any, on the Company’s
      financial statements or its results of operations.





In
      June
      2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for
      Uncertainty in Income Taxes.” FIN 48 prescribes detailed guidance for the
      financial statement recognition, measurement and disclosure of uncertain tax
      positions recognized in an enterprise’s financial statements in accordance with
      FASB Statement No. 109, “Accounting for Income Taxes.” Tax positions must meet a
      more-likely -than- not recognition threshold at the effective date to be
      recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 is
      effective for fiscal years beginning after December 15, 2006 and the provisions
      of FIN 48 will be applied to all tax positions upon initial adoption of the
      Interpretation. The cumulative effect of applying the provisions of this
      Interpretation will be reported as an adjustment to the opening balance of
      retained earnings upon adoption.




The
      Company has not yet determined the impact, if any, that the adoption of FIN
      48
      will have on its financial position and results of operations.





In
      September 2006, the FASB issued FAS No. 157, "Fair Value
      Measurements". This Statement clarifies the definition of fair value,
      establishes a framework for measuring fair value, and expands the disclosures
      on
      fair value measurements. FAS No. 157 is effective for fiscal years
      beginning after November 15, 2007, and interim periods within those fiscal
      years.




The
      Company has not determined the impact, if any, the adoption of this Statement
      will have on its financial position and results of operations.




In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108,
“Considering the Effects of Prior Year Misstatements when Quantifying
      Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108
      provides interpretive guidance on the SEC’s views regarding the process of
      quantifying materiality of financial statement misstatements. SAB 108 was
      effective as of the year beginning January 1, 2006. The implementation of SAB
      108 had no impact on the Company’s consolidated financial
      statements.





In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option
      for Financial Assets and Financial Liabilities - Including an Amendment of
      FASB
      Statement No. 115” (“SFAS No. 159”). This pronouncement permits all
      entities to elect, at specified election dates, to measure eligible financial
      instruments at fair value. An entity shall report unrealized gains and losses
      on
      items for which the fair value option has been elected in earnings at each
      subsequent reporting date, and recognize upfront costs and fees related to
      those
      items in earnings as incurred and not deferred. SFAS No. 159 applies to
      fiscal years beginning after November 15, 2007, with early adoption
      permitted for an entity that has also elected to apply the provisions of SFAS
      No. 157. An entity is prohibited from retrospectively applying SFAS
      No. 159, unless it chooses early adoption. The Company is currently
      assessing the impact of SFAS No. 159 on its consolidated financial position
      and results of operations.




50




***B.    Liquidity
      and Capital Resources***





Net
      cash
      used in operating activities for the twelve months ended December 31, 2006
      was
      $3,047,000 compared to $2,954,000 during the period ended December 31, 2005,
      an
      increase of $93,000 or 3%. Our net income for the year 2006 was $5,440,000
      less
      capital gain from the OTI Transaction in the amount of $10,536,000 and other
      adjustments reached to net cash used in operating activities for the year 2006
      of $3,047,000 compared to a net loss of $3,951,000 during the year 2005 less
      other adjustment reached to net cash used in operating activities for the year
      2005 0f $2,954,000.




Net
      cash
      provided by investing activities during the period ended December 31, 2006
      was
      $476,000 compared to net cash used in investing activities of $635,000 during
      the period ended December 31, 2005, an increase of $1,111,000. This increase
      was
      primarily due to a proceeds from maturity of marketable debt securities of
      $
      650,000 during the year ended 2006 compared to investment in marketable debt
      securities of $650,000 during the year 2005, proceed from restricted cash
      deposit, net of $229,000 during the year ended 2006 compared to $41,000 during
      the year 2005. Also, during the year 2006 we purchased property and equipment
      in
      the amount of $ 93,000 compared to $ 315,000 during the year 2005. This was
      somewhat offset by the fact that during the year ended 2006 the amounts carried
      to deferred charges were $163,000 compared to $0 during the year ended 2005
      and
      Proceeds from disposal of short term deposits, net during the year 2006 were
      $0
      compared to $353,000 during the year 2005.




Net
      cash
      provided by financing activities during the period ended December 31, 2006
      was
      $2,721,000 compared to $2,989,000 during the period ended December 31, 2005,
      a
      decrease of $268,000. This decrease was primarily due to a payment of short
      term
      bank credit of $307,000 compared to an increase in short term bank credit of
      $120,000 in 2005, a decrease in issuance of share capital through a private
      placement, net of issuance costs of $183,000 compared to issuance of share
      capital through a private placement, net of issuance costs of $2,539,000. This
      was somewhat offset by the fact that during the year ended 2006, we had a
      proceeds from issuance of convertible bonds and warrants, of $3,139,000 compared
      to $0 during the year ended 2005.





As
      of
      December 31, 2006, our cash and cash equivalents, totaled $2,444,000, compared
      to $2,294,000 as of December 31, 2005. Restricted cash totaled $859,000 as
      of
      December 31, 2006 compared to $1,088,000 as of December 31, 2005. Restricted
      cash is invested in certificates of deposits, which mature within one year,
      and
      is used to secure agreements with a customer or a bank. Marketable securities
      totaled $11,077,000 as of December 31, 2006 compared to $650,000 as of December
      31, 2005. The majority of the increase in the marketable securities on December
      31, 2006 is due to OTI’s shares we received as part of the OTI Transaction.





We
      have
      accumulated net losses of approximately $18,625,000 from our inception through
      December 31, 2006, and we have continued to accumulate net losses since December
      31, 2006. Since May 1999, we have funded operations primarily through cash
      generated from our initial public offering on Nasdaq Europe in April 1999,
      which
      resulted in total net proceeds of approximately $23,600,000 (before offering
      expenses), our sale of shares of our former subsidiary, InkSure, and, to a lesser extent, borrowings from financial
      institutions, in 2004, private placements of our ordinary shares and warrants
      to
      purchase our ordinary shares, in 2005, private placements of our ordinary shares
      and warrants to purchase our ordinary shares and in 2006, Proceeds from issuance
      of convertible bonds and warrants and the sale of the E-ID Division to
      OTI. As of
      December 31, 2006, our principal source of liquidity was $2,444,000 of cash
      and
      cash equivalents. As of December 31, 2006, we had $668,000 of debt outstanding
      relating to obligations under our credit facility, $67,000 of debt outstanding
      relating to long-term loan, net of current maturities, an obligation for
      severance pay to Israeli employees of $744,000 of which $587,000 is provided
      by
      monthly deposits with severance pay funds, insurance policies and by an accrual
      and Convertible bonds of $2,255,000.





During
      June and July 2004, we received aggregate gross proceeds of $1,225,000 from
      a
      private placement of 265,001 ordinary shares and five-year warrants to purchase
      106,001 ordinary shares at an exercise price of $6.47 per share. In connection
      with the private placement, our placement advisors received warrants to purchase
      77,941 ordinary shares at an exercise price of $6.47 per share.




In
      August
      and September 2004, we received gross proceeds of $2,200,000 from a private
      placement to accredited investors of 420,000 ordinary shares and five-year
      warrants to purchase 168,000 ordinary shares at an exercise price of $6.47
      per
      share. In connection with the private placement, our placement agent received
      warrants to purchase 30,240 ordinary shares at an exercise price of $6.47 per
      share and 75,601 ordinary shares at an exercise price of $5.00 per share. All
      of
      such warrants issued in this private placement, except 75,601 warrants with
      an
      exercise price of $5.00, were called by us at a redemption price of $0.0588
      per
      warrant pursuant to our right to do so if the closing price (or closing bid
      price) of our ordinary shares on an U.S. stock exchange, Nasdaq or the OTC
      Bulletin Board was equal to or greater than $14.70 per share for 10 out of
      any
      15 consecutive trading days. The investors exercised warrants to purchase an
      aggregate of 194,627 ordinary shares. During the fourth quarter of 2004, 120,176
      warrants were exercised for an aggregate amount of approximately $778,000,
      and
      approximately $130,000 was received in respect of shares to be allotted in
      2005.
      During the year 2005, 54,451 warrants were exercised for an aggregate amount
      of
      approximately $ 352,000.




51




In
      November and December of 2005, we received aggregate gross proceeds of
      $3,050,000 from a private placement by certain investors of 836,292 ordinary
      shares (out of which, 150,807 shares were issued after December 31, 2005.)
      and
      five-year warrants to purchase 292,701 ordinary shares at an exercise price
      of
      $3.53 per share. The private placement was made to accredited investors pursuant
      to Rule 506 of Regulation D, promulgated under the Securities Act of 1933,
      as
      amended (the “Securities Act”) and to foreign private investors in offshore
      transactions in reliance on Regulation S promulgated under the Securities Act.
      In connection with the private placement, our placement agent received a cash
      fee of $150,000 and our placement advisors received five-year warrants to
      purchase 8,446 ordinary shares at an exercise price of $3.53 per share. The
      investors that participated in this private placement were granted the right,
      for one year following the closing of the private placement and subject to
      certain limitations, to participate in future issuances of our capital stock
      or
      securities (a “Subsequent Financing”) up to an amount which would permit each
      investor to maintain its fully diluted percentage equity ownership at the same
      level existing prior to the Subsequent Financing (after giving effect to such
      Subsequent Financing). The warrants are callable, subject to certain
      limitations, at our option if the closing bid price per ordinary share of our
      ordinary shares equals or exceeds $7.06 for 20 trading days during the term
      of
      the warrants. We may however only call, in any 3-month period, the lesser of
      (i)
      20% of the aggregate amount of the warrants initially issued to a warrant
      holder, or (ii) the total number of warrants then held by such
      holder.





In
      November 2006, we raised $3,156,500 through the issuance of Units consisting
      of
      convertible bonds and warrants (the “Convertible Bonds Transaction”). Units
      valued at $2,500,000 were issued to a single investor, and Units valued at
      $656,500 were issued to Special Situation Funds (SSF), who were our existing
      shareholders. The Convertible Bonds mature three years from the date of issuance
      and bears interest at an annual rate of 8%. Any withholding and other taxes
      payable with respect to the interest will be grossed up and paid by us
      (approximately 3% of the principal of the bond). Payment of interest will be
      net
      of any tax. Subject to certain redemption provisions, as described below, the
      Convertible Bonds may be converted at any time, at the option of the investors,
      into our ordinary shares at a conversion price of $5.00 per share. The
      purchasers of the Convertible Bonds were also granted warrants entitling them
      to
      acquire a total of 134,154 ordinary shares at an exercise price of $5.00 per
      share during the next five years. In respect of this transaction, we paid
      approximately $180,000 as expenses and granted an option to acquire up to 25,000
      shares of the Company to a third party, exercisable at $5 per share. The fair
      market value of this grant is $ 40,000.





If
      we
      fail to fulfill certain conditions, the purchasers of the Convertible Bonds
      Transaction may accelerate repayment of the principal amount of $3,156,500
      due
      under the of Convertible Bonds, in which case all interest payable at the
      Maturity Date will immediately become due and payable. As of December 31, 2006,
      we are in compliance with those conditions.





Between
      February 10, 2008 and February 16, 2008, we will have the option to call and
      redeem 100% of the Convertible Bonds at a price equal to (i) the aggregate
      principal amount of the bonds plus (ii) a redemption premium equal to fifteen
      percent (15%) of the aggregate principal amount plus (iii) any accrued but
      unpaid interest on the aggregate principal amount, calculated through the date
      of redemption.





The
      Convertible Bonds Transaction was accounted for in accordance with EITF 00-27,
      "
      Application of Issue No. 98-5 to Certain Convertible Instruments" and APB 14,
      "Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants".
      The fair market value of the Warrants was determined based on the fair
      value of the instruments issued using the Black-Scholes pricing model, assuming
      a risk free rate of 5%, a volatility factor of 78.21%, dividend yields of 0%
      and
      an expected life of 2 years. The expiration date of the Warrants is
      November 2011.





As
      a
      result of the Convertible Bonds Transaction, we recorded an amount of $282,000
      in respect of the Warrants and an amount of $632,000 as beneficial conversion
      feature in respect of the Convertible Bonds, as a credit to shareholders' equity
      (additional paid in capital).





On
      December 31, 2006, we concluded the OTI Transaction for 2,827,2000 restricted
      ordinary shares of OTI. One seventh of the restricted ordinary shares vest
      at
      the end of each calendar quarter, beginning with the quarter ended December
      31,
      2006.




As
      a
      result of the OTI Transaction, we recognized $10,536,000 as a capital gain
      on
      the sale of the e-ID Division in fiscal year 2006.





The
      capital gain was calculated based on OTI’s share price on the closing date, less
      a discount due to the lock up restrictions of the shares (based on an
      independent appraisal), the carrying value of the assets that were transferred
      to OTI and direct expenses (in an amount of $1,550,000) associated with the
      sale
      (the investment of the Company in OTI’s shares includes the shares held by the
      Company, net of the shares that will be transferred to the
      consultants).




52




The
      direct expenses included, inter alia, the fair value of 212,040 shares out
      of
      the shares received by us from OTI that will be transferred to consultants,
      as a
      finder and legal fee, in connection with the transaction.





In
      connection with the completion of the sale, during January 2007, a financial
      institution extended a $2,500,000 loan to us. In order to secure this loan
      we
      deposited OTI shares in favor of the financial institution.





Our
      budget relies on the Existing Projects for which OTI agreed to act as
      subcontractor and on estimated revenues from our new technologies.





As
      of
      December 31, 2006, we had credit lines from several banks in an aggregate amount
      of $830,000 including long-term loans (from time to time the bank may increase
      our credit line for a limited period), of which $585,000 is denominated in
      NIS
      and bears interest at the Prime rate plus an additional 0.5% to 2.5%, and $
      245,000 is denominated in dollars and bears interest at a rate of LIBOR plus
      2.5% to 2.9%. (As of December 31, 2006, the rates of the U.S LIBOR and Prime
      were 5.3% and 6% respectively) The weighted average interest rate on the credit
      lines as of December 31, 2005 and 2006 was approximately 5.9% and 7.85%,
      respectively.





We
      had an
      unused credit facility in the amount of approximately $95,000 as of December
      31,
      2006. There is no fee for the unused portion of the credit facility.





During
      the period from January 1, 2006 to December 31, 2006, our capital expenditures
      totaled approximately $93,000 (compared to $315,000 during 2005 and $1,087,000
      during 2004), of which approximately $69,000 (compared to $293,000 during 2005
      and $1,017,000 during 2004) was expended at or upon Vuance's facilities in
      Israel, and approximately $24,000 (compared to $22,000 during 2005 and $70,000
      during 2004) was expended upon various facilities of Vuance's subsidiaries
      outside Israel. During the first financial quarter of 2007, our capital
      expenditures totaled approximately $37,000.




We
      believe that our existing capital resources together with revenue from
      operations and amounts available under our credit facility will be sufficient
      to
      fund our planned operations through at least the next twelve months. We intend
      to consider other alternatives for financing, which may include public or
      private equity financings. There can be no assurance that such additional
      financing, if at all available, can be obtained on terms acceptable to us.
      If we
      are unable to obtain such additional financing, future operations will need
      to
      be scaled back further or discontinued.





***C.***
            ***Research
                and Development***




Our
      past
      research and development efforts have helped us to achieve our goal of offering
      our customers a complete line of products and solutions. As of December 31,
      2006
      the number of employees in our research and development activities was 17.
      Pursuant to the OTI Transaction we terminated the employment of certain
      employees that were employed by us in the E-ID Division and therefore we expect,
      in the short time, to see a reduce in the number of our research and
      developments employees,; On the other hand, due to our decision to focus on
      the
      new technology of our IRMS and Active RFID we expect to increase our research
      and development efforts. We spent $0.8 million, $1.2 million and $1.4 on
      research and development in 2004, 2005 and 2006, respectively. These amounts
      were spent on the development or improvement of our technologies and products,
      primarily in the areas of an automatic contactless smart card production line,
      data capture, management software, population registry software packages,
      security printing, contactless smart cards, document authentication, IRMS and
      Active RFID. We will continue to research and develop our IRMS and Active RFID.
      There can be no assurance that we can achieve any or all of our research and
      development goals.




***D.***
            ***Trend
                Information***




You
      can
      see more details under the section captioned “Results of operations” in Item
      5.




53




***Industry
      Trends***





The
      increased demand for better security systems and services has positively
      affected trends within the industry. Access Control and asset management are
      now
      leading security concerns in commercial and governmental enterprises. This
      has
      created an increasing demand, both for physical security access to buildings
      and
      logical security access to corporate networks combined with real time tracking
      and monitoring assets. Our mobile (IRMS) and fix access control solutions
      jointly with the RFID enabled security and asset management solutions to provide
      an optimal solution to these problems as they deliver stronger authentication
      of
      network users and they store personal data for highly secure physical access
      control.




***Market
      and Operational Trends***





Our
      quarterly operations results may be subject to significant fluctuations due
      to
      several factors. Some of these factors are based primarily on the timing of
      large orders, which represent a significant percentage of our revenues, customer
      budget cycles and impact on the timing for buying decisions, competitive
      pressures, the ability of our partners, distributors and system integrators
      to
      become effective in selling and marketing our products, as well as other
      factors.





During
      the twelve months ended December 31, 2006, we observed a slight increase in
      our
      production. We have also observed a considerable increase in marketing leads
      from our growing partnerships, distributions and systems integration network,
      and a particular interest by federal as well as local government customers
      in
      public safety or incident management. We expect to continue to benefit from
      marketing programs and leads generated by this network, as well as sales
      opportunities identified by them. We intend to expand our marketing and
      implementation capacity through these third parties, including vendors of
      complementary products and providers of service applications. By employing
      third
      parties in the marketing and implementation process, we expect to enhance sales
      by taking advantage of their market presence.





A
      significant portion of our 2006 revenues has been derived from our governmental
      projects and the remainder has been derived from commercial products.
      Historically, our revenues have been concentrated in a few large orders and
      in a
      relatively small number of customers, a trend that has been increasing over
      time
      and a trend that we expect to continue to influence our revenues.




Our
      revenues from the government market for 2006 and 2005 totaled $7,947,000 and
      $7,519,000, respectively. In comparison our revenues from the commercial market
      for 2006 and 2005 totaled $848,000 and $943,000, respectively. We anticipate
      that our mix of revenues from government and commercial markets for 2007 will
      be
      consistent with our mix of revenues in 2006.





For
      more
      information about our expectations regarding future cost of revenues, future
      operating expenses and liquidity and capital resources, please refer to the section
      captioned “Risk
      Factors” under Section D of Item 3 and the sections
      captioned “Results of Operations” and “Liquidity
      and Capital Resources” under
      Sections A and B, respectively, of Item 5 “Operating and Financial Review and
      Prospects ”.





Our
      development and marketing efforts for the solution and product platforms are
      aimed at addressing several systems and service trends that we see developing
      in
      the industry:




On
      December 2006 we concluded the sale of our E -ID Division to OTI. The sale
      allows management to focus primarily on the substantial market opportunities
      we
      have identified for our Incident Response Management Systems and Active RFID
      Solutions. Following September 11, and major disasters it has become apparent
      for agencies to track personnel, assets, and other objects on a local
      positioning basis, our IRMS solutions can fulfill critical homeland security
      requirements for public safety and emergency services agencies and local
      counter-terrorism task forces. In recent months, we have announced contracts
      for
      the deployment of our IRMS in a number of counties in the U.S., including Los
      Angeles, and we are currently discussing IRMS deployments with additional
      governmental agencies in North America.




54




As
      a
      result of these trends and combined with our core strengths, we are focusing
      on
      products and solutions that we believe will be significantly influential in
      the
      present and future markets. As
      of the
      date of this Annual Report, we expect
      that our 2007 revenues will be primarily derived from:





·
            Smart
                ID technologies;


·
            High
                security solution integration;


·
            IRMS
                systems





***Recent
      Developments and Outlook***





We
      expect
      revenues to continue to be derived from one-time sales and recurring fees,
      sales
      of high-end solutions, sales of products, consumables and technology. Sales
      are
      expected to continue through OEM partnerships and continual upgrades,
      maintenance and support will continue to be provided to customers. For more
      information see the section captioned “ *Recent
      Developments* ”
in
      Item
      4.




***E.***
            ***Off
                Balance Sheet
                Arrangements***





We
      do not
      have any off-balance sheet transactions that have or are reasonably likely
      to
      have a material effect on our current or future financial condition, changes
      in
      financial condition, revenues or expenses, results of operations, liquidity,
      capital expenditures or capital resources.





***F.***
            ***Tabular
                Disclosure of Contractual
                Obligations***





**Contractual
      Obligations**





The
      following table summarizes our contractual obligations and commitments as of
      December 31, 2006, which will require significant cash outlays in the
      future:





**Contractual
                Obligations**
            
            **Total**
            
            **Less
                than 1 year**
            
            **1-3
                years**
            
            **3-5
                years**
            
            **More
                than 5 years**Long-term
                debt obligations
            
            $
            354,000
            
            $
            287,000
            
            $
            67,000
            
            
            —
            
            
            —Capital
                (finance) lease obligations
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Operating
                lease obligations
            
            $
            826,000
            
            $
            279,000
            
            $
            547,000
            
            
            —
            
            
            —Unconditional
                purchase obligations
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Convertible
                bonds
            
            $
            3,156,566
            
            
            —
            
            $
            3,156,566
            
            
            —
            
            
            —Total
                contractual cash obligations
            
            $
            4,336,566
            
            $
            566,000
            
            $
            3,770,566
            
            
            —
            
            
            —





Long-term
      debt consists of amounts due to loans from banks, which is described in Item
      18,
      note 8 to the financial statements included in this Annual report. Operating
      lease obligations represent commitments under several lease agreements for
      our
      facilities and the facilities of certain subsidiaries. Convertible bonds
      represent the amount due to the investors under the convertible bonds assuming
      there will no conversion to shares, which is described in Item 18, Note 12
      to
      the financial statements included in this Annual report. Total contractual
      cash
      obligations represent outstanding commitments for loans from banks and lease
      agreement for facilities. We are not a party to any capital leases.




55




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




***A.    Directors
      and Senior Management.***




**Board
      of Directors**




We
      are
      managed by our Board of Directors that, pursuant to our Articles of Association,
      must be comprised of between two and eight members. Members are elected for
      a
      one year term ending at our next annual general meeting of shareholders, except
      for our external directors, who are elected for three year terms in accordance
      with the Israeli Companies Law. The Board of Directors elects one of its members to serve as
      the
      Chairman.





The
      Board
      of Directors is composed as follows (as of the date of this Annual Report):





********Name**
            
            **Age**
            
            **Position**Eli
                Rozen
            
            53
            
            Director,
                Chairman of the BoardAvi
                Landman
            
            53
            
            DirectorMichal
                Brikman
            
            37
            
            External
                Director (1)Ilan
                Horesh
            
            55
            
            External
                Director (1)Jaime
                Shulman
            
            64
            
            Director





(1)
      “External Director” as defined in the Israeli Companies Law (see explanation
      below)




***Eli
      Rozen*** is one
      of our co-founders and serves as a director and our Chairman of the Board of
      Directors. Mr. Rozen has served as the Chairman since 2000. From 1988 until
      2000, Mr. Rozen served as our Chief Executive Officer and President. Mr. Rozen
      has a B.S. in Industrial Engineering and Management from the Israel Institute
      of
      Technology.





***Avi
      Landman*** is one
      of our co-founders and serves as a member of the Board of Directors and as
      the
      Research Manager. Prior to joining us in 1988, Mr. Landman worked as a computer
      engineer at Gal Bakara Ltd. and prior to that as an electrical engineer at
      Eltam
      Ltd. Mr. Landman has a Bachelor of Science degree in Computer Engineering from
      the Israel Institute of Technology - the ''Technion''.





***Michal
      Brikman*** **,** an
      external Director, became a member of the Board of Directors on October 28,
      2004. Ms. Brikman is a Certified Public Accountant with extensive management
      and
      accounting experience. Since 2000, Ms. Brikman has been a business consultant
      at
      Daniel Doron Business Consulting. In addition to her appointment to Vuance’s
      Board of Director. Ms. Brikman received her Masters in Finance from Baruch
      College in New York City and later relocated to Israel.




***Ilan
      Horesh*** **,** an
      external Director, became a member of the Board of Directors on September 17,
      2006 and is a member of the audit committee. Mr. Horesh is also a board member
      of Retalix Ltd. From 1998 to 2006 Mr. Horesh was a department manager in
      Pelephone Communication Ltd. From 1997 to 1998 Mr. Horesh served as the Chief
      Executive Officer of "SHEFFA consumer club" a subsidiary of MACABI HEALTH
      SERVICES. From 1994 to 1997 Mr. Horesh was the manager of the Planning and
      Projects Department at PAZ OIL CORP. From 1994 to 1999 Mr. Horesh was a director
      of Hed-Artzi Ltd. Mr. Horesh holds B.A in Business Administration, B.A in
      History & Geography and M.A in Political Science.




***Jaime
      Shulman*** ,
      became
      a member of the Board of Directors on September 17, 2006. From 2001 to 2003
      Mr.
      Shulman was president and C.E.O of Logisticare,Ltd. From 1998 to 2000 Mr.
      Shulman was the president and C.E.O of the Amcor Group. From 1993 to 1997 Mr.
      Shulman was the president and C.E.O of the Magam Enterprises Group. From 1991
      to
      1998 Mr. Shulman was the active chairman of the board (part time) of Tana
      Industries. From 1991 to 1992 Mr. Shulman was a foreign Consultant to
      subsequently as C.E.O. in Metrometer, Inc. (New York). From 1978 to 1991 Mr.
      Shulman was in Electra Israel. From 1970 to 1977 Mr. Shulman was Production
      Manager in Tadiran, Plastic and Metal Plant. Mr. Shulman is an Electromechanical
      Engineer (equivalent to M.Sc. in Israel) from Buenos Aires University,
      Argentina.




56




**Executive
      Officers and Key Employees** ****





As
      of
      June 15, 2007, our executive officers and certain key employees who are not also directors are:




**Name******
              
              **Age******
              
              **Position**Eyal
                  Tuchman
              
              39
              
              Chief
                  Executive OfficerLior
                  Maza
              
              36
              
              Vice
                  President, Chief Financial OfficerMoshe
                  Wolfson
              
              55
              
              Vice
                  President, SalesRon
                  Peer
              
              57
              
              Vice
                  President, Business DevelopmentGali
                  Gana
              
              41
              
              Internal
                  Auditor


·
            Mr.
                Lior Maza was appointed Chief Financial Officer on June 14, 2007
                and
                replaced Mr. Yaron Shalom.





***Eyal
      Tuchman*** ,
      Chief
      Executive Officer. In April 2006, Mr. Tuchman became Vuance’s Chief Executive
      Officer, after 4 years of service as Vuance’s Chief Financial Officer and Chief
      Operational Officer. Mr. Tuchman brings to Vuance years of experience in
      business development finance and operational management in publicly traded
      companies. Prior to joining us in 2002, he served as Chief Financial Officer
      of
      Magam Group, a company traded on the Tel-Aviv Stock Exchange, from 1996 to
      2002,
      and before that, was a Senior Auditor at Kesselman & Kesselman (today,
      PriceWaterhouseCoopers). Mr. Tuchman holds a B.A. in Economics & Accounting
      from Ben Gurion University and is a certified public accountant.




***Lior
      Maza,***  Chief
      Finance Officer. Mr. Maza has over 10 years of financial management
      experience, having served as Director of Finance at PowerDsine, Ltd.
      (Nasdaq: PDSN), a pioneer in Power over Ethernet (PoE) solutions that was
      recently acquired by Microsemi Corporation (Nasdaq: MSCC). Prior to PowerDsine,
      Mr. Maza served for four years as the Corporate Controller of Invoke Solutions,
      a leading innovator of real-time, interactive research technology. Mr. Maza
      holds Masters in Business Administration, graduate with distinction, from
      Heriot-Watt University, Edinburgh Business School. Mr. Maza is a certified
      public accountant




***Moshe
      Wolfson,*** Chief
      Executive Officer & VP Sales of SuperCom Inc. Mr. Wolfson is responsible for
      SuperCom's Inc.business partnerships with system integrators and solution
      providers. Prior to joining SuperCom Inc in 2003, Mr. Wolfson was Vice President
      of Sales and Marketing at dsIT Technologies, a solution technology provider
      for
      real time military solutions. Prior to this, Mr. Wolfson was Executive
      Vice-President of Malam Systems, one of Israel’s major systems integration and
      software development companies and managed its IT Division. Mr. Wolfson has
      a
      M.B.A. from Tel Aviv University and a B.Sc. in Mathematics and Computer Science.
      He has been a lecturer in Information Technology since 1987. Mr. Wolfson served
      in the Israeli Army Computer Centre.




***Ron
      Peer*** **-** Senior
      VP, Business Development Mr. Peer has over 30 year's experience in the
      technology industry, holding top management positions. Mr. Peer has proved
      to be
      a successful leader in the Israeli and US Hi-Tech industries with broad and
      in-depth marketing and business vision. With proven experience and expertise
      in
      brand counterfeiting and document security solutions, he has directed startup
      and turnaround situations and also recruited and developed strong management
      teams. With his technological and operational experience foundations - rooted
      in
      the IDF as a Lieutenant Colonel - Mr. Peer maintains a successful international
      business and management career. Mr. Peer holds a B.Sc in Electronic Engineering,
      and Business and Marketing Diplomas from Tel-Aviv University.




***Gali
      Gana*** ,
      has
      been our internal auditor since August 2005. Mr. Gana has years of experience
      in
      internal audit and investigation audit. Since 1997 Mr. Gana is a partner in
      an
      accounting firm. Mr. Gana holds a B.A. in Business Administration &
Accounting from Hamichlala Leminhal, an M.A in Internal Audit and Public Administration from
      Bar-Ilan University, and he is a certified public accountant , as well as a
      C.I.A (certified internal auditor) and C.I.S.A (certified information system
      auditor).




57




***B.    Compensation***





The
      aggregate amount of compensation paid by us to our board members our President
      and Chief Executive Officer, Vice President, IPS Division, Vice President,
      Corporate Finance and Chief Financial Officer, and Vice President, Sales
      (collectively, the "Named Executive Officers") as a group for the twelve months
      ended December 31, 2006 was approximately $890,000 This sum includes amounts
      paid for salary and social benefit. In addition, we have provided automobiles
      to
      our executive officers at our expense.





In
      accordance with the requirements of Israeli law, we determine our directors’
compensation in the following manner. First, our audit committee reviews the
      proposal for compensation; second, provided that the audit committee approves
      the proposed compensation, the proposal is then submitted to our board of
      directors for review, except that a director who is the beneficiary of the
      proposed compensation does not participate in any discussion or voting with
      respect to such proposal; and finally, if our board of directors approves the
      proposal, it must then submit its recommendation to our shareholders, which
      is
      done in the forum of our shareholders’ general meeting. The approval of a
      majority of our shareholders is required for any such compensation
      proposal.





On
      January 26, 2003, at a special general meeting, our shareholders approved the
      grant to each of our directors who is not an external director, commencing
      on
      October 1, 2002, a monthly $1,000 fee and participation remuneration per meeting
      of the Board of Directors, provided however, that each of the directors who
      is
      not an external director shall be entitled to an aggregate sum of monthly
      remuneration and participation remuneration of not more than $18,000 per
      year.





As
      of
      December 31, 2006, we had set aside approximately $ 130,000 to provide pension,
      retirement or similar benefits for our board of directors and Named Executive
      Officers.





***Option/SAR
      Grants during the Year Ended December 31, 2006***





During
      the twelve months ended December 31, 2006, we granted options to purchase 63,750
      ordinary shares under our Employee Stock Option Plan two of our Named Executive
      Officers at an exercise price of $4.412. The expiration date of all such options
      is May 29, 2016.




Please
      refer to the Section captioned “Stock Option Plan” under Item 6, Section E below
      for a description of our Option Plans.




***C.    Board
      Practices***




Our
      Board
      of Directors and senior management consider good corporate governance to be
      central to our effective and efficient operations. The following table lists
      our
      directors, the positions they hold with us and the dates the directors were
      first elected or appointed:





**Name**
            
            **Position**
            
            **Period
                Served in Office**Eli
                Rozen
            
            Director
              Chairman
                of the Board
            
            1988-present
              July
                25, 2000-presentAvi
                Landman
            
            Director
            
            1988-presentMichal
                Brikman
            
            External
                Director
            
            October
                28, 2004-presentIlan
                Horesh
            
            External
                Director
            
            September
                17, 2006-presentJaime
                Shulman
            
            Director
            
            September
                17, 2006-present





Our
      Articles of Association provide that the minimum number of members of the Board
      of Directors is two and the maximum number is eight. The Board of Directors
      is
      presently comprised of five members, two of whom were elected as external
      directors under the provisions of the Israeli Companies Law (discussed below). All directors hold office until their
      successors are elected at the next annual general meeting of shareholders,
      except for our external directors Michal Brikman and Ilan Horesh, who shall
      hold
      office until October 2007 and September 2009, respectively.





Under
      the
      Israeli Companies Law and the regulations promulgated pursuant thereto, Israeli
      public companies, namely companies whose shares have been offered to the public,
      or that are publicly traded are required to appoint at least two natural persons
      as “external directors”. A person may not be appointed as an external director
      if the person, or a relative, partner or employer of the person, 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 an external director, any
      affiliation with the company to whose board the external director is proposed
      to
      be appointed, with the controlling shareholder of such company or with any
      entity controlling or controlled by such company or by the controlling
      shareholder of such 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 (which term includes a director).




58




In
      addition, no person may serve as an external 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 external director or interfere with the
      person’s ability to serve as an external director or if the person is an
      employee of the Israel Securities Authority or of an Israeli stock exchange.
      If,
      at the time of election of an external director, all other directors are of
      the
      same gender, the external director to be elected must be of the other gender.





Pursuant
      to the Israeli Companies Law, at least one of the external directors, as well
      as
      a number of the non-external directors to be determined by the board of
      directors, are required to have “accounting and financial expertise” and the
      other external directors are required to have "professional skills", as such
      terms are defined in regulations recently promulgated under the Israeli
      Companies Law.





Each
      committee of a company’s board of directors that has the authority to exercise
      powers of the board of directors is required to include at least one external
      director and its audit committee must include all external directors.





External
      directors are elected at the general meeting of shareholders by a simple
      majority, provided that the majority includes at least one-third of the
      shareholders who are not controlling shareholders, who are present and voting,
      or that the non-controlling shareholders who vote against the election hold
      one
      percent or less of the voting power of the company.





At
      our
      2003 Annual General Meeting held on June 30, 2003, Esther Koren and Avi Elkind
      were each re-elected to serve as external directors for an additional term
      of
      three years ending on June 30, 2006. However, Esther Koren resigned as a member
      of our Board of Directors due to personal reasons effective July 14, 2004.
      Ms.
      Michal Brikman was subsequently appointed to our Board of Directors as an
      External Director, which appointment was approved by our shareholders at a
      special general shareholder meeting on October 28, 2004. In addition, Ms.
      Brikman has been appointed to the audit committee. On September 17, 2006, our
      general meeting appointed Mr. Ilan Horesh as an External Director. In addition,
      Mr. Horesh has been appointed to the audit committee.




Under
      the
      Israeli Companies Law, an external director cannot be dismissed from office
      unless: (i) the board of directors determines that the external director no
      longer meets the statutory requirements for holding the office, or that the
      external director has breached the external director's fiduciary duties and
      the
      shareholders vote, by the same majority required for the appointment, to remove
      the external director after the external director has been given the opportunity
      to present his or her position; (ii) a court determines, upon a request of
      a
      director or a shareholder, that the external director no longer meets the
      statutory requirements of an external director or that the external director
      has
      breached his or her fiduciary duties to the company; or (iii) a court
      determines, upon a request of the company or a director, shareholder or creditor
      of the company, that the external director is unable to fulfill his or her
      duty
      or has been convicted of specified crimes.




We
      have
      the following committees:





**Audit
      Committee**





**** The
      Israeli **** Companies
      Law requires public companies to appoint an audit committee comprised of at
      least three directors, including all of the external directors, and further
      stipulates that the chairman of the board of directors of a public company,
      any
      director employed by or providing other services on a regular basis to the
      company and the controlling shareholder or any relative of the controlling
      shareholder of such company may not be members of the audit committee of the
      company. We have an audit committee (the "Audit Committee"), a majority of
      whose
      members, including the Chairman, satisfy the criteria of independence as
      required by Israeli law. In 2007 the Audit Committee adopted an audit committee
      charter which regulates its operations. According to our Audit Committee
      charter, the objective of the Audit Committee is to assist the Board of
      Directors’ oversight of: the Company’s accounting practices; the integrity of
      the Company’s financial statements; the Company’s accounting and financial
      reporting processes; the Company’s compliance with legal and regulatory
      requirements; the independent auditors’ qualifications, independence, and
      performance; audits of the Company’s financial statements; the internal audit
      function, and to locate deficiencies in the business management of the Company,
      among other things, in consultation with the Company’s independent auditors and
      internal auditors and to suggest to the Board of Directors the measures to
      be
      taken regarding such deficiencies. Ms. Michal Brikman, Mr. Ilan Horesh and
      Mr.
      Jaime Shulman are the members of the Audit Committee.




59




**Compensation** **(** **Remuneration)
      Committee**





**** We
      have a
      compensation committee (the "Compensation Committee"). In 2007 the Compensation
      Committee adopted a Compensation Committee charter, which regulates its
      operations. According to the Compensation Committee charter it is responsible
      for determining the compensation (including salaries, bonuses and equity
      incentive compensation awards) of executive officers, including the Chief
      Executive Officer, other senior management and members of the Board of
      Directors. Ms. Michal Brikman, Mr. Ilan Horesh and Mr. Jaime Shulman are the
      members of the Compensation Committee.




**Nominating
      and Corporate Governance Committee Charter**





On
      May
      15, 2007 our Board of Directors approved the establishment of a Nominating
      and
      Corporate Governance committee (the "Nominating and Corporate Governance
      Committee"). The Nominating and Corporate Governance committee is responsible
      for identifying individuals qualified to become board members, consistent with
      criteria approved by the Board of Directors, and recommending that the Board
      of
      Directors select the director nominees for election at the general meeting
      of
      shareholders. The Committee is also responsible for developing and recommending
      to the Board of Directors a set of corporate governance guidelines applicable
      to
      the Company, periodically reviewing such guidelines, recommending any changes
      thereto, and overseeing the evaluation of the Board of Directors. The Nominating
      and Corporate Governance Committee is comprised of Ms. Michal Brikman, Mr.
      Ilan
      Horesh and Mr. Jaime Shulman.





**Management** **Employment
      Agreements**





We
      maintain written employment agreements with substantially all of our key
      employees. These agreements provide, among other matters, for monthly salaries,
      our contributions to Managers’ Insurance and an Education Fund and severance
      benefits. All of our agreements with our key employees are subject to
      termination by either party upon the delivery of notice of termination as
      provided therein.





**** **Internal
      Auditor**





Under
      the
      Israeli Companies Law, the board of directors must appoint an internal auditor,
      proposed by the audit committee. The role of the internal auditor is to examine,
      among other matters, whether the company’s activities comply with the law and
      orderly business procedure. Under the Israeli Companies Law, the internal
      auditor may be an employee of the company but may not be an interested party
      or
      office holder, or a relative of any interested party or office holder, and
      may
      not be a member of the company’s independent accounting firm or its
      representative. We have appointed Mr. Gali Gana as our internal auditor in
      accordance with the requirements of the Israeli Companies Law.




60




***D.    Employees***




As
      of
      December 31, 2006 and December 31, 2005, we had 56 and 57 full-time employees,
      respectively. The following table describes our employees and the employees
      of
      our subsidiaries by department.





**Dec.
                31, 2004**
            
            **Dec.
                31, 2005**
            
            **Dec.
                31, 2006**Research,
                Development & Manufacturing
            
            
            28
            
            
            24
            
            
            26Marketing
                and Sales
            
            
            27
            
            
            23
            
            
            20Administration
            
            
            12
            
            
            10
            
            
            10**Total**
            
            
            **67**
            
            
            **57**
            
            
            **56**





Over
      the
      past three years, the number of our employees by geographic area was as follows:





**Dec.
                31, 2004**
            
            **Dec.
                31, 2005**
            
            **Dec.
                31, 2006**Israel
            
            
            46
            
            
            38
            
            
            38United
                states
            
            
            6
            
            
            5
            
            
            5Rest
                of the world
            
            
            15
            
            
            14
            
            
            13**Total**
            
            
            **67**
            
            
            **57**
            
            
            **56**





From
      time
      to time, we have engaged temporary employees to fill open positions. These
      temporary employees, however, historically have not comprised a material number
      of our employees.




As
      of
      December 31, 2006 all but 18 of our employees are located at our, Israel
      location.





As
      a
      result of the OTI Transaction we terminated the employment of approximately
      19
      employees that were employed by us in the e-ID Division (the above table
      includes also the employees of the E-ID Division). Our current total amount
      of
      employees is 41.




Vuance’s
      Israeli employees are not part of a collective bargaining agreement. However,
      in
      Israel we are subject to certain labor statutes, and to certain provisions
      of
      collective bargaining agreements between the Histadrut, the General Federation
      of Labor in Israel, and the Coordinating Bureau of Economic Organizations,
      including the Industrialists' Association. These are applicable to our employees
      by virtue of expansion orders of the Israeli Ministry of Labor and Welfare.
      These statutes and provisions principally concern the length of the workday,
      minimum daily wages for professional workers, procedures for dismissing
      employees, determination of severance pay, annual and other vacations, sick
      pay
      and other conditions for employment. In addition, by virtue of such expansion
      order all employees in Israel  are
      entitled to automatic adjustment of wages relative to increases in the Consumer
      Price Index in Israel. The amount and frequency of these adjustments are
      modified from time to time. We provide our employees with benefits and working
      conditions that comply with the required minimum.





Generally,
      all male adult citizens and permanent residents of Israel under the age of
      45
      are, unless exempt, obligated to perform up to 30 days of military reserve
      duty
      annually. Additionally, all such residents are subject to being called to active
      duty at any time under emergency circumstances. Some of our officers and
      employees are obligated to perform annual reserve duty. While we have operated
      effectively under these requirements since we began operations, no assessment
      can be made as to the full impact of such requirements on our workforce or
      business if conditions should change, and no prediction can be made as to the
      effect on us of any expansion of such obligations.





All
      of
      our employees have entered into confidentiality agreements. We have also granted
      certain employees options to purchase shares of our ordinary shares under our
      option plan. We consider our relationship with our employees to be good and
      have
      never experienced a strike or work stoppage.




61




***E.    Share
      Ownership***





The
      following table sets forth certain information regarding the beneficial
      ownership of our ordinary shares by our directors and Named Executive Officer as
      of May
      31, 2007. As of that date, we had 4,013,485 ordinary shares outstanding.




**Name**
            
            **Ordinary
                Shares held directly and beneficially**
            
            **%
                of Outstanding Ordinary Shares as of May 31, 2007**
            
            **Number
                of options outstanding**
            
            **Exercise
                price**
            
            **Expiration
                date**Eli
                Rozen
            
            658,128(1)
            
            15.45%
            
            109,817
              8,500
              42,500
              85,000
              51,000
            
            2.4706
              5.0000
              5.0000
              4.1180
              5.0000
            
            January
                26, 2013
              January
                11, 2015
              January
                11, 2015
              April
                27, 2012
              January
                19, 2017Avi
                Landman
            
            415,780(2)
            
            10.32%
            
            8,500
              8,500
              20,400
            
            2.4706
              5.0000
              5.0000
            
            January
                26, 2013
              January
                11, 2015
              January
                19, 2017Eyal
                Tuchman
            
            98,600
                (3)
            
            2.4%
            
            5,100
              12,750
              25,500
              21,250
              51,000
            
            2.4706
              2.4706
              14.8235
              5.000
              4.4118
            
            June
                19, 2012
              March
                28, 2014
              November
                11, 2014
              October
                4, 2014
              May
                29, 2016Directors
                and Named Executive Officers as a Group ([9] persons)(5)
            
            1,205,374(4)
            
            28.98%
            
            559,467
            
            2.4709
                - 14.8235
            
            January
                2013 - February 2017




(1)
      Includes (a) 412,311 shares held directly by Eli Rozen, and (b) options to
      purchase 245,817 ordinary shares which are currently exercisable or exercisable
      within 60 days of May 31, 2007, of which 118,317 ordinary shares are held by
      Finel Architecture and Engineering Ltd., a company owned solely by Mr. Rozen
      (“Finel”).





(2)
      Includes (a) 398,780 ordinary shares held by Avi Landman, of which 85,000 shares
      are held by Ashland Investments LLC, a limited liability company solely owned
      by
      Mr. Landman (“Ashland”), and (b) options to purchase 17,000 ordinary shares
      which are currently exercisable or exercisable within 60 days of May 31,
      2007.





(3)
      Includes options to purchase 98,600 ordinary shares which are currently
      exercisable or exercisable within 60 days of May 31, 2007.





(4)
      Includes options to purchase 394,283 ordinary shares which are currently
      exercisable or exercisable within 60 days of May 31, 2007.





(5)
      See
      notes 1, 2,3,4 and 5. Each
      of
      the directors and executive officers not separately identified in the above
      table beneficially own less than 1% of our outstanding ordinary shares
      (including options held by each such party, and which are exercisable or exercisable within
      60
      days of May
      31,
      2007 )
      and
      have therefore not been separately disclosed.




All
      of
      our ordinary shares have identical voting rights.




62




**Share
      Option Plans**





On
      February 14, 1999, the Board of Directors adopted, and our shareholders
      subsequently approved, the 1999 Employee Stock Option Plan Option Plan, which
      was amended and restated in March 2002 (the "1999 Option Plan"). We no longer
      use the 1999 Option Plan to issue stock options. In 2003, we adopted a new
      stock
      option plan under which we now issue stock options (the “Option Plan”). In
      December 2004, we filed a Registration Statement on Form S-8 with the SEC registering
      (i) 170,000 ordinary shares available for issuance upon exercise of stock
      options reserved for grant under the Option Plan, (ii) 594,034ordinary shares
      issued or issuable upon exercise of options previously granted under the Option
      Plan, and (iii) 109,412 ordinary shares issued or issuable upon exercise of
      options previously granted under the 1999 Option Plan. The Option Plan is
      intended to provide incentives to our employees, officers, directors and/or
      consultants by providing them with the opportunity to purchase our ordinary
      shares. The Option Plan is, subject to the provisions of the Israeli Companies
      Law, administered by the Compensation Committee, and is designed: (i) to comply
      with Section 102 of the Israeli Tax Ordinance or any provision which may amend
      or replace it and the rules promulgated thereunder and to enable us and grantees
      thereunder to benefit from Section 102 of the Israeli Tax Ordinance and the
      Commissioner’s Rules; and (ii) to enable us to grant options and issue shares
      outside the context of Section 102 of the Israeli Tax Ordinance. Options granted
      under the Option Plan will become exercisable ratably over a period of three
      to
      five years or immediately in certain circumstances, commencing with the date
      of
      grant. The options generally expire no later than 10 years from the date of
      grant. Any options, which are forfeited or canceled before expiration, become
      available for future grants. As of December 31, 2006, 853,752 ordinary shares
      are available for future grants of options, warrants, shares and other financial
      instruments.




As
      a
      result of an amendment to Section 102 of the Israeli Tax
      Ordinance as part of the 2003 Israeli tax reform, and pursuant to an election
      made by us thereunder, capital gains derived by optionees arising from the
      sale
      of shares issued pursuant to the exercise of options granted to them under
      Section 102 after January 1, 2003, will generally be subject to a flat capital
      gains tax rate of 25%. Previously, such gains were taxed as salary income at
      the
      employee’s marginal tax rate (which could be up to 50%). However, as a result of
      this election, we will no longer be allowed to claim as an expense for tax
      purposes the amounts credited to such employees as a benefit when the related
      capital gains tax is payable by them, as we had previously been entitled to
      do
      under Section 102. For certain information as to the Israeli tax reform, see
      “Taxation.”





On
      October 4, 2004, the Board of Directors approved a grant of options to acquire
      up to 128,351 ordinary shares of the Company to certain employees as
      compensation for their efforts in assisting the private placement completed
      during 2004, at an exercise price of $ 5 per share.





During
      2005, the Board of Directors approved a grant of options to acquire up to 15,300
      and 8,500 ordinary shares to certain employees at exercise prices of $5.24,
      and
      $4.18 per share, respectively. An additional 68,001 options were granted during
      2005 to related parties.





On
      December 29, 2005, our Board of Directors and Audit Committee approved the
      acceleration of the vesting schedule for certain of the stock options granted
      to
      our employees and officers as an incentive. As a result, options to purchase
      a
      total of 121,126 ordinary shares became exercisable at the date of the approval.
      The acceleration did not have any effect on the financial statements since
      the
      options had a zero intrinsic value at the original date of grant and at the
      date
      of acceleration.





On
      May
      30, 2006, the Board of Directors approved a grant of options to acquire up
      to
      93,501 ordinary shares to certain employees and officers. The exercise price
      of
      these options is $4.42 per share.




63




A
      summary
      of our stock option activity, and related information is as follows:





**Year
                ended December 31****2004**
            
            **2005**
            
            **2006****Number
                of**
              **options**
            
            **Weighted
                average exercise price**
            
            **Number
                of**
              **options**
            
            **Weighted
                average exercise price**
            
            **Number
                of**
              **options**
            
            **Weighted
                average exercise price**Outstanding
                at beginning of year
            
            
            260,868
            
            $
            6.89
            
            
            569,905
            
            $
            5.71
            
            
            595,971
            
            $
            5.77Granted
            
            
            345,101
            
            $
            7.24
            
            
            91,801
            
            $
            4.95
            
            
            93,501
            
            $
            4.42Exercised
            
            
            -
            
            $
            -
            
            
            (37,684
            )
            $
            2.48
            
            
            (43,152
            )
            $
            2.48Canceled
                and forfeited
            
            
            (36,064
            )
            $
            29.59
            
            
            (28,051
            )
            $
            5.53
            
            
            (92,418
            )
            $
            9.95Outstanding
                at end of year
            
            
            569,905
            
            $
            5.71
            
            
            595,971
            
            $
            5.77
            
            
            553,902
            
            $
            5.12Exercisable
                at end of year
            
            
            285,832
            
            $
            3.42
            
            
            515,504
            
            $
            6.06
            
            
            481,651
            
            $
            5.18




The
      weighted average fair value of options granted during the reported period was
      $5.58, $3.08 and $1.89, per option, for the years ended December 31, 2004,
      2005
      and 2006, respectively.


The
      fair
      value of these options was estimated on the date of grant using the Black &
Scholes option pricing model. The following weighted average assumptions were
      used for the 2006 grants: risk free rate of 5%, dividend yield of 0%, expected
      volatility factor of 57.14% and expected term of 3.09 years.




Regarding
      the assumptions used for the proforma information required under FAS 123 in
      2004
      and 2005 see Note 2x in the financial reports below.




The
      expected volatility was based on the historical volatility of our stock. The
      expected term was based on the historical behavior of the employees and based
      on
      Management estimate.





Compensation
      expenses recognized by us related to our share-based employee compensation
      awards were $9,000, $47,000 based on the provisions of APB 25 and $ 225,000
      based on the provisions of SFAS 123R for the years ended December 31, 2004,
      2005 and 2006, respectively.




The
      options outstanding as of December 31, 2006, have been separated into ranges
      of
      exercise price as follows:




**Range
                of exercise**
              **price**
            
            **Options
                outstanding as of**
              **December
                31, 2006**
            
            **Weighted
                average**
              **remaining**
              **contractual
                life (years)**
            
            **Weighted
                average**
              **exercise
                price**
            
            **Aggregate
                intrinsic value**
            
            **Options
                exercisable**
              **as
                of**
              **December
                31, 2006**
            
            **Weighted
                average**
              **exercise
                price**
            
            **Aggregate
                intrinsic value**$
                2.48 - $ 3.06
            
            
            202,093
            
            
            5.11
            
            $
            2.53
            
            $
            321
            
            
            202,093
            
            $
            2.53
            
            $
            321$
                4.18 - $ 5.00
            
            
            268,600
            
            
            5.59
            
            $
            4.83
            
            
            -
            
            
            196,349
            
            $
            4.89
            
            
            -$
                5.24 - $ 5.89
            
            
            23,800
            
            
            5.83
            
            $
            5.48
            
            
            -
            
            
            23,800
            
            $
            5.48
            
            
            -$11.77
                - $ 14.83
            
            
            57,801
            
            
            5.28
            
            $
            14.71
            
            
            -
            
            
            57,801
            
            $
            14.70
            
            
            -$
                23.53 - $ 33.06
            
            
            1,481
            
            
            0.22
            
            $
            26.36
            
            
            -
            
            
            1,481
            
            $
            26.36
            
            
            -$
                56.71
            
            
            127
            
            
            0.27
            
            $
            56.71
            
            
            -
            
            
            127
            
            $
            56.71
            
            
            -553,902
            
            
            
            
            $
            5.12
            
            
            
            
            
            481,651
            
            $
            5.18




The
      aggregate intrinsic value of the above table represents the total intrinsic
      value, based on our stock price of $4.12 as of December 31, 2006, less the
      weighted average exercise price per range. This represents the potential amount
      received by the option holders had all option holders exercised their options
      as
      of that date.




64




A
      summary
      of the status of the Entity’s non-vested options granted to employees as of
      December 31, 2006 and changes during the year ended December 31, 2006 is
      presented below:





**Options**
            
            **Weighted-average
                grant-date fair value**Non-vested
                at January 1, 2006
            
            
            80,467
            
            $
            2.771Granted
            
            
            59,501
            
            $
            2.000Vested
            
            
            (39,951
            )
            $
            2.777Forfeited
            
            
            (27,766
            )
            $
            2.353Non-vested
                at December 31, 2006
            
            
            72,251
            
            $
            2.289




As
      of
      December 31, 2006, there was $167,000 total unrecognized compensation cost
      related to non-vested share-based compensation arrangements granted under the
      stock option plans, of which, $147,000 is expected to be recognized during
      the
      year 2007.




**ITEM
      7.** ***Major
      Shareholders And Related Party Transactions.*** ****




***A.    Major
      shareholders***




The
      following table lists the beneficial ownership of our securities as of May
      31,
      2007 by each person known by us to be the beneficial owner of more than 5%
      of
      the outstanding shares of any class of our securities.





Beneficial
      ownership is determined in accordance with the rules of the SEC and generally
      includes voting or investment power with respect to securities. The principal
      address of our directors and executive officers listed below (all but Jacob
      Hassan, Special Situations Fund III, L.P., Special Situations Fund III, Q.P
      and
      Special Situations Cayman Fund, L.P.) is c/o Vuance Ltd., Sagid House “Hasharon
      Industrial Park” P.O.B 5039, Qadima 60920 Israel We believe that all persons
      named in the table have sole voting and sole investment power with respect
      to
      all shares beneficially owned by them. All figures include ordinary shares
      issuable upon the exercise of options or warrants exercisable within 60 days
      of
      May 31, 2007 and deemed to be outstanding and beneficially owned by the person
      holding those options or warrants for the purpose of computing the percentage
      ownership of that person, but are not deemed to be outstanding for the purpose
      of computing the percentage ownership of any other person. None of the following
      major shareholders have different voting rights from the other holders of our
      ordinary shares.








**Name
                of Beneficial Owner**
            
            **Number
                of Shares****Beneficially Owned**
            
            **Percentage
                of Shares****Outstanding**Jacob
                Hassan (1)
            
            
            398,881
            
            
            9.94
            %Avi
                Landman (2)
            
            
            415,780
            
            
            10.32
            %Eli
                Rozen (3)
            
            
            658,128
            
            
            15.45
            %Special
                Situations Fund III, L.P. (“SSF”)(4)
            
            
            1,390,524
            
            
            31.51
            %Special
                Situations Fund III, Q.P. (“SSFQP”)(5)
            
            
            1,390,524
            
            
            31.51
            %Special
                Situations Cayman Fund, L.P. (“Cayman”)(6)
            
            
            1,390,524
            
            
            31.51
            %Investor
                through convertible bond (7)
            
            
            606,250
            
            
            13.12
            %




(1)
            Mr.
                Hassan’s address is 21 Shnat Hayovel, Hod Hasharon ,
                Israel.


(2)
            Includes
                (a) 398,780 ordinary shares held by Avi Landman, of which 85,000
                shares
                are held by Ashland, and (b) options to purchase 17,000 ordinary
                shares
                which are currently exercisable or exercisable within 60 days of
                May 30,
                2007.****




65




(3)
            Includes
                (a) 412,311 shares held directly by Eli Rozen, and (b) options to
                purchase
                245,817 ordinary shares which are currently exercisable or exercisable
                within 60 days of May 30, 2007, of which 118,317 ordinary shares
                are held
                by Finel.


(4)
            Includes
                (a) 63,646 ordinary shares, (b) warrants to purchase 16,871 ordinary
                shares which are currently exercisable or exercisable within 60 days
                of
                May 30, 2007, (c) convertible bond which can be convert into 6,600
                ordinary shares (d) 727,599 shares held by its affiliate, SSFQP,
                (e)
                warrants held by SSFQP to purchase 197,292 ordinary shares which
                are
                currently exercisable or exercisable within 60 days of May 30, 2007,
                (f)
                convertible bond which can be convert into 98,000 ordinary shares
                (g)
                200,143 ordinary shares held by its affiliate, Cayman, (h) warrants
                held
                by Cayman to purchase 53,660 ordinary shares which are currently
                exercisable or exercisable within 60 days of May 30, 2007 and (i)
                convertible bond which can be convert into 26,713 ordinary
                shares.


(5)
            Includes
                (a) 727,599 ordinary shares, (b) warrants to purchase 197,292 ordinary
                shares which are currently exercisable or exercisable within 60 days
                of
                May 30, 2007, (c) convertible bond which can be convert into 98,000
                ordinary shares, (d) 63,646 shares held by its affiliate, SSF, (e)
                warrants held by SSF to purchase 16,871 ordinary shares which are
                currently exercisable or exercisable within 60 days of May 30, 2007,
                (f)
                convertible bond which can be convert into 6,600 ordinary shares,
                (g)
                200,143 ordinary shares held by its affiliate, Cayman, and (h) warrants
                held by Cayman to purchase 53,660 ordinary shares which are currently
                exercisable or exercisable within 60 days of May 30, 2007 and (i)
                convertible bond which can be convert into 26,713 ordinary
                shares..


(6)
            Includes
                (a) 200,143 ordinary shares, (b) warrants to purchase 53,660 ordinary
                shares which are currently exercisable or exercisable within 60 days
                of
                May 30, 2007, (c) convertible bond which can be convert into 26,713
                ordinary shares, (d) 727,599 shares held by its affiliate, SSFQP,
                (e)
                warrants held by SSFQP to purchase 197,292 ordinary shares which
                are
                currently exercisable or exercisable within 60 days of May 30, 2007,
                (f)
                convertible bond which can be convert into 98,000 ordinary shares,
                (g)
                63,646 ordinary shares held by its affiliate, SSF, and (h) warrants
                held
                by SSF to purchase 16,871 ordinary shares which are currently exercisable
                or exercisable within 60 days of May 30, 2007and (i) convertible
                bond
                which can be convert into 6,600 ordinary
                shares.


(7)
            Includes
                (a) warrants to purchase 106,250 ordinary shares which are currently
                exercisable or exercisable within 60 days of May 30, 2007, (b) convertible
                bond which could be convert into 500,000 ordinary
                shares.





To
      the
      best of our knowledge based on the information known to us, there has not been
      any significant change in the percentage ownership of the our major shareholders
      during the last three years other than changes resulting from our private
      placements in 2004 and 2005, the issuance of convertible bond during the
      November 2006, the exercise of warrants issued in those offerings, and the
      grant
      of options to Messrs. Rozen and Landman.




As
      of
      December 31, 2006, to the best of our knowledge based on the information
      available to us, we had approximately 23 registered holders of our ordinary
      shares.





To
      the
      best of our knowledge based on the information available to us, there are no
      existing arrangements that may at a future date result in a change of control
      of
      Vuance.





***B.***
            ***Related
                Party Transactions*******





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





On
      October 1, 2001, the we entered into a consulting agreement with a company
      owned
      by the Chairman of our Board of Directors who was one of our co-founders. In
      consideration of these consulting services, hawse have undertaken to pay $
      10,500 per month plus motor vehicle expenses. In addition, we pay $1,500 per
      month as a director’s fee. During 2006 we paid $ 144,000 pursuant to this
      agreement.





On
      January 21, 2007, the General Shareholders Meeting approved the grant of options
      to the Chairman of our Board of Directors to acquire up to 51,000 ordinary
      shares of the Company, at an exercise price of $5 per share under the Option
      Plan.




66




On
      April
      29, 2007, the General Shareholders Meeting approved the grant of options to
      the
      Chairman of our Board of Directors to acquire up to 85,000 ordinary shares
      of
      the Company, at an exercise price of $4.118 per share under the Option Plan.




On
      October 1, 2001, we entered into a consulting agreement with a company owned
      by
      a member of our Board of Directors, who was also one of our co-founders and
      a
      principal shareholder. On January 13 2005, the general shareholders meeting
      approved the following amendments to the consulting agreement:




·
            As
                of the date of the approval of the General Shareholders Meeting,
                to
                increase the consideration set forth in the said agreement to an
                amount of
                $ 7,000 per month.




·
            Upon
                the termination of the current car lease, to increase the car lease,
                to a
                price of up to NIS 4,200 (approximately $ 1,000 as of December 31,
                2006),
                (excluding tax) per month.




·
            To
                grant a one-time bonus of NIS 130,000 (approximately $ 30,000 as
                of
                December 31, 2005), including VAT.




In
      addition the Company pays $ 1,500 per month as a director’s fee. 2006 we paid
      $102,000 pursuant to this agreement. Also, on January 21, 2007, the General
      Shareholders Meeting approved the grant of options to acquire up to 20,400
      ordinary shares of the Company at an exercise price of $5 per share under the
      Option Plan.




On
      October 1, 2001, we entered into a consulting agreement with a company owned
      by
      one of the co-founders of the Company. In consideration for these services,
      we
      have undertaken to pay $ 4,600 per month plus motor vehicle expenses. During
      2006 we paid $72,000 pursuant to this agreement.




***C.***  ***Interests
      of Experts and Counsel***




Not
      applicable.




67




**ITEM
      8.** ***Financial
      Information.*** ****




***A.    Consolidated
      Statements and Other Financial Information (Audited)***




Refer
      to
      Item 18, which contains the following financial statements:




·
            
            Consolidated
                Balance Sheets




·
            
            Consolidated
                Statements of Operations




·
            
            Statements
                of Changes in Shareholders’ Equity





·
            
            Consolidated
                Statements of Cash Flows




·
            
            Notes
                to Consolidated Financial Statements





***Export
      Sales***





Sales
      in
      Israel during the year 2004, 2005 and 2006 was $ 320,000, $ 210,000 and
      $194,000, respectively. Export sales during the year 2004, 2005 and 2006 was
      $7,024,000 (96% of the total sales volume), $8,252,000 (98% of the total sales
      volume) and $8,601,000 (98% of the total sales volume),
      respectively.




***Legal
      Proceedings***





We
      are
      party to legal proceedings in the normal course of our business. Other than
      as
      described below, there are no material pending legal proceedings to which we
      are
      a party or of which our property is subject. Although the outcome of claims
      and
      lawsuits against us can not be accurately predicted, we do not believe that
      any
      of the claims and lawsuits described in this paragraph, individually or in
      the
      aggregate, will have a material adverse effect on our business, financial
      condition, results of operations and cash flows for any quarterly or annual
      period.





In
      April
      2004, the Department for Resources Supply of the Ministry of Ukraine filed
      with
      the International Commercial Arbitration Court at the Ukrainian Chamber of
      Commerce and Industry (the “Arbitration Court”) a claim to declare Contract No.
      10/82 (the “Contract”), dated April 9, 2002, between us and the Ministry of
      Internal Affairs of Ukraine, as void due to defects in the proceedings by which
      we were awarded the Contract. In July 2004 the Arbitration Court declared the
      Contract as void. On April 27, 2005 we appealed the decision in the High
      Commercial Court of Ukraine. In May 2005 the Department for Resources Supply
      of
      the Ministry filed with the Arbitration Court a new statement of claim for
      restitution of $1,047,740, paid to us by the Department for Resources Supply
      of
      the Ministry under the contract. On September 27, 2005, we received a negative
      award issued by the Arbitration Court in the second claim. On December 12,
      2005
      we were informed that the Supreme Court of Ukraine had dismissed our appeal
      regarding the July 2004 decision. On June 29, 2006, the Supreme Court of Ukraine
      held that the Arbitration Court award was valid and legal under applicable
      law.
      During February 2007, we received from the management body of the courts of
      Israel documents that were sent from the Ministry of Internal Affairs of Ukraine
      regarding the claim for restitution of $1,047,740. Our legal advisors have
      advised us that the documents were improperly sent and not in compliance with
      Israeli law. We intend to vigorously defend any motion to enforce the
      Arbitration Court award in Israel, and if necessary, to assert claims that
      the
      Ukrainian proceedings were legally defective and that no judgment based on
      these
      proceedings can be enforced in Israel.


Based
      on
      the opinion of our legal advisors, we believe that the above mentioned Ukraine
      Arbitration Court decision is incorrect, as a matter of law, that the Ukrainian
      government’s claim has no merit and that the Ukrainian Arbitration Proceedings
      were legally defective. Therefore no provision has been made in the financial
      statements in respect of the claim for restitution of $1,047,740. However,
      due
      to the developments described above, we wrote off inventory in an amount of
      approximately $287,000 in the fourth quarter of 2005, and took possession of
      the
      remaining inventory that was previously delivered to the customer. In 2003,
      we
      increased the allowance for doubtful accounts in an aggregate amount of
      $2,133,000 for the debt the Ukrainian government owes to us.




We
      did
      not have any revenues from this project in 2004, 2005 and 2006.




On
      October 30, 2003, SuperCom Slovakia, a subsidiary (66%) of Vuance Ltd., received
      an award from the International Arbitral Centre of the Austrian Federal Economic
      Chamber ("IAC"), in a case against the Ministry of Interior of the Slovak
      Republic relating to the agreement on delivery of Technology, Cooperation and
      Services signed on March 17, 1998. Upon the Arbitral Award, the Ministry of
      Interior of the Slovak Republic was ordered to pay SuperCom Slovakia the amount
      of SKK 80,000,000 (approximately $3,068,000 as of December 31, 2006) plus
      interest accruing from March, 1999. In addition, the Ministry of Interior of
      the
      Slovak Republic was ordered to pay the costs of arbitration in the amount of
      EUR
      42,716 (approximately $56,000 as of December 31, 2006) and SuperCom Slovakia's
      legal fees in the amount of EUR 63,611 (approximately $84,000 as of December
      31,
      2006). We have begun an enforcement proceeding to collect the arbitral award.
      The Ministry of Interior of the Slovak Republic filed a claim with the
      Commercial Court in Vienna, Austria on February 10, 2004, whereby it challenged
      and requested to set aside the arbitral award. During September 2005 the
      commercial court of Vienna dismissed the claim. On October 21, 2005 the Ministry
      of the Interior of the Slovak Republic filed an appeal. On August 25, 2006,
      the
      Austrian Appellate Court rejected the appeal and ordered the Ministry to
      reimburse Supercom Slovakia ́s costs of the appellate proceeding in the amount of
      EUR 6,688.50 within 14 days. On October 3, 2006, we were informed that the
      Ministry had decided not to file an extraordinary appeal to the Austrian Supreme
      Court’s decision rejecting its appeal. To date, our efforts to enforce the
      Commercial Court’s decision have been unsuccessful.




68




On
      July
      14, 2003, Mr. Yaacov Pedhatzur, filed a lawsuit against us, in the Magistrate’s
      Court in Tel Aviv, Israel, claiming the we owe him commissions in respect of
      transactions between us and certain third parties On September 29, 2005 we
      reached a settlement agreement with Mr. Yaacov Pedhatzur in which we agreed
      to
      pay Mr. Pedhatzur the NIS equivalent of $ 129,000. The settlement agreement
      has
      been approved by the court. This amount was recorded in the statement of
      operations of fiscal year 2005, as litigation settlement expenses.




On
      December 16, 1999, Secu-Systems Ltd. ("Secu-systems" or the "Plaintiff") filed
      a
      lawsuit with the District Court in Tel-Aviv-Jaffa jointly and severally against
      us and InkSure Ltd. (our former subsidiary, which became a subsidiary of InkSure
      Technologies, Inc., ("InkSure")) seeking a permanent injunction and damages
      arising from the printing method applied to certain products developed by
      Inksure. In its lawsuit, the plaintiff asserted claims of breach of a
      confidentiality agreement between the plaintiff and us, unjust enrichment by
      us
      and InkSure, breach of fiduciary duties owed to the plaintiff by us and InkSure,
      misappropriation of trade secrets by us and InkSure, and damage to the
      plaintiff’s property. On March 15, 2006, the Court denied the breach of contract
      claim, but upheld the claim for misappropriation of trade secrets and ordered
      InkSure and us to cease all activity involving the use of the confidential
      knowledge and/or confidential information of the plaintiff. In addition, the
      court ordered us and Inksure to provide a report certified by an accountant
      setting forth in full the income and/or benefit received by InkSure and us
      as a
      result of the misappropriation activity through the date of the judgment, and
      ordered us and Inksure, jointly and severally, to pay to the plaintiff
      compensation in the sum of NIS 100,000 ($24,000 as of December 31, 2006) and
      legal expenses as well as attorney’s fees in the sum of NIS 30,000 ($7,000 as of
      December 31, 2006). The plaintiff has filed an appeal, and we and InkSure filed
      a counter-appeal, on the ruling above. To date, no decision has been rendered
      on
      either appeal. At this point, we cannot estimate the outcome of such appeal.




On
      May 1,
      2006, Evilia Investments Ltd. ("Evilia") filed in the Magistrate's Court in
      Tel-Aviv-Jaffa a claim for damages against InkSure and against us, jointly
      and
      severally, for payment of NIS 2,366,868 (as of June 15, 2006, approximately
      $530,000) plus interest allegedly, due as rent payments and related management
      fees for a certain real estate property in Rehovot, leased to InkSure under
      a
      lease agreement entered into between Evilia and InkSure on October 10, 2000,
      as
      amended on May 25, 2001 (the "Agreement"), as to which we are a
      guarantor.




A
      motion
      for leave to defend the lawsuit was filed with the Court by both InkSure and
      us
      on June 15, 2006. On August 6, 2006, a settlement agreement was submitted to
      the
      Court, pursuant to which InkSure agreed to pay Evilia the amount of $130,000
      plus VAT. On August 13, 2006, the Court approved the settlement agreement.
      We
      agreed to pay (and paid) InkSure half of the settlement amount.




***Dividend
      Policy***





We
      have not distributed a cash dividend since August 27, 1997 and we do not
      anticipate any dividend distribution in the foreseeable future. Under
      the
      Israeli Companies Law, d ividends
      may only be paid out of profits legally available for distribution (the
      “Profits Criteria”) and
      provided that there is no reasonable concern that such payment will prevent
      us
      from satisfying our existing and foreseeable obligations as they become due.
      In
      addition, a competent court may approve, as per a motion to be filed by a
      company in accordance with the Israeli Companies Law requirements, a payment
      which does not meet the Profit Criteria, provided that the court was convinced
      that there is no reasonable concern that such payment will prevent the company
      from satisfying its existing and foreseeable obligations as they become due.




69




In
      accordance with our articles of association, a dividend shall be proposed by
      the
      board of directors and shall be payable only after the same has been approved
      by
      ordinary resolution of the shareholders meeting, but no such resolution shall
      provide for the payment of an amount exceeding the amount proposed by the board
      of directors.





Subject
      to the rights of the holders of shares as to dividends, any dividend paid by
      us
      shall be allocated among the members entitled thereto in proportion to the
      sum
      paid up or credited as paid up on account of the nominal value of their
      respective holding of the shares in respect of which such dividend is being
      paid, without taking into account the premium paid up for the shares.





***B.    Significant
      Changes***




There
      have not been any significant changes since the date of the annual financial
      statements included under Item 18 of this Annual Report.




**ITEM
      9.** ***The
      Offer And Listing.***




***A.***
            ***Offer
                and Listing Details***





The
                tables included below set forth information regarding the price history
                of
                the ordinary shares on the Euronext Brussels stock market and the
                OTCBulletin Board for the periods indicated.





We
      were
      traded on the NASDAQEurope stock market since April 19, 1999. On October 23,
      2003, following the closing of the NASDAQEurope stock market, we transferred
      the
      listing of our shares to Euronext Brussels stock market where we are currently
      traded under the symbol “VUNC”.





Our
      ordinary shares were quoted on the OTC Bulletin Board Market under the symbol
      “VUNC.OB”, from November 5, 2004.





The
      following table shows, for the periods indicated, the high and low closing
      prices of our ordinary shares in euros as reported on the NASDAQEurope stock
      market or the Euronext Brussels stock market, as applicable. (conversion to
      U.S.
      dollars is based on the exchange rate published by the Bank of Israel).. The
      following table also shows, for the periods indicated since November 5, 2004,
      the high and low closing prices of our ordinary shares on the OTC Bulletin
      Board
      Market.




70




The
      Company has not issued any securities in connection with a pre-emptive
      issue.





**Period**
            
            **European
                market (1)****Per
                share ($)**
            
            **US
                market (2)****High**
            
            **Low**
            
            **High**
            
            **Low****Annual**2002
            
            
            3.32
            
            
            0.59
            
            
            N/A
            
            
            N/A2003
            
            
            4.41
            
            
            1.65
            
            
            N/A
            
            
            N/A2004
            
            
            15.65
            
            
            3.24
            
            
            15.59
            
            
            12.592005
            
            
            16.41
            
            
            3.12
            
            
            15.06
            
            
            3.292006
            
            
            6.71
            
            
            3.18
            
            
            6.59
            
            
            3.24**Financial
                quarters****2005**First
                quarter
            
            
            16.41
            
            
            11.29
            
            
            15.06
            
            
            13.23Second
                quarter
            
            
            13.06
            
            
            4.41
            
            
            14.00
            
            
            4.00Third
                quarter
            
            
            4.82
            
            
            4.35
            
            
            5.59
            
            
            3.88Forth
                quarter
            
            
            4.65
            
            
            3.12
            
            
            5.24
            
            
            3.29**2006**First
                quarter
            
            
            5.12
            
            
            3.18
            
            
            6.47
            
            
            3.59Second
                quarter
            
            
            4.59
            
            
            3.29
            
            
            5.18
            
            
            3.53Third
                quarter
            
            
            6.71
            
            
            3.29
            
            
            6.59
            
            
            3.24Forth
                quarter
            
            
            6.00
            
            
            4.71
            
            
            5.88
            
            
            3.94**2007**First
                quarter
            
            
            5.24
            
            
            3.59
            
            
            5.41
            
            
            3.82**Most
                recent six months**December
                2006
            
            
            5.53
            
            
            4.71
            
            
            4.94
            
            
            3.94January
                2007
            
            
            5.27
            
            
            4.29
            
            
            4.59
            
            
            4.12February
                2007
            
            
            4.47
            
            
            4.29
            
            
            4.65
            
            
            4.12March
                2007
            
            
            5.18
            
            
            3.59
            
            
            5.41
            
            
            4.29April
                2007
            
            
            5.24
            
            
            4.24
            
            
            6.18
            
            
            5.41May
                2007
            
            
            5.28
            
            
            4.44
            
            
            6.06
            
            
            5.45





(1)
      Our
      shares were quoted on the NASDAQEurope stock market since April 19, 1999 and
      since October 23, 2003 **** on
      the
      Euronext Brussels stock market.




(2)
      Our
      ordinary shares were quoted on the OTC bulletin board from November 5,
      2004.




(3)
      Share
      prices are adjusted to give effect to our 1-for-5.88235 reverse share split
      effective for trading purposes on May 14, 2007.




On
      June
      26, 2007, the last reported sale price of our ordinary shares on the Euronext
      Brussels stock market was 3.5 Euro equivalent to 4.711$ per share and on the
      OTC
      bulletin board 5.1$ per share.




71




***B.***  ***Plan
      of Distribution***





Not
      applicable.





***C.    Markets***




Our
      ordinary shares are traded on the Euronext Brussels stock market under the
      symbol “VUNC” and on the OTC Bulletin Board under the symbol “VUNCF.OB”.





***D.    Selling
      Shareholders***





Not
      applicable.





***E.***
            ***Dilution***





Not
      applicable.





***F.***
            ***Expenses
                of the Issue***





Not
      applicable.




**ITEM
      10.** ***Additional
      Information.*** ****




***A.    Share
      Capital***





Not
      applicable.





***B.    Memorandum
      and Articles of Association***




Please
      refer to Item 10.B. of our Registration Statement on Form 20-F (File No.
      000-50790) filed with the U.S. Securities and Exchange Commission, as amended
      November 14, 2004, for a
      description of our memorandum of association and articles of association, the
      rights, preference and restrictions attaching to each class of our shares,
      and
      certain related matters, which we hereby incorporate into this Annual Report
      by
      reference.




72




***C.    Material
      Contracts***




Except
      for the material contracts described under the sections captioned “Employment
      Agreements, Termination of Employment and Change-In-Control Arrangements” and
“Share Option Plans” under Sections B and E, respectively, under Item 6, we are
      not a party to any other material contracts outside of the ordinary course
      of
      business.




***D.    Exchange
      Controls***




Pursuant
      to a general permit issued in 1998 by the Israeli Controller of Foreign Exchange
      under the Currency Control Law, 1978 (the "Currency Control Law"), there are
      virtually no restrictions on foreign exchange in the State of Israel, except
      for
      certain reporting obligations.




***E.    Taxation***




To
      the
      extent that the following discussion is based on new or existing tax or other
      legislation that has not been subject to judicial or administrative
      interpretation, there can be no assurance that the views expressed herein will
      be accepted by the tax or other authorities in question. This discussion is
      not
      intended, nor should it be construed, as legal or professional tax advice and
      it
      is not exhaustive of all possible tax considerations.




**Israeli
      Taxation**




The
      following is a summary of the current material Israeli tax laws applicable
      to
      companies in Israel with special reference to its effect on us. This section
      also contains a discussion of certain Israeli government programs from which
      we
      may benefit. This summary does not discuss all the acts of Israeli tax law
      that
      may be relevant to a particular investor in light of his or her personal
      investment circumstances or to some types of investors subject to special
      treatment under Israeli law. Some parts of this discussion are based on new
      tax
      legislation that has not been subject to judicial or administrative
      interpretation. Accordingly, we cannot assure you that the views expressed
      in
      the discussion will be accepted by the tax authorities in question. The
      discussion is not intended and should not be construed as legal or professional
      tax advice and does not cover all possible tax considerations.




Potential
      investors are urged to consult their own tax advisors as to the Israeli or
      other
      tax consequences of the purchase, ownership and disposition of our ordinary
      shares, including, in particular, the effect of any foreign, state or local
      taxes.




The
      following discussion describes the material Israeli tax consequences regarding
      ownership and disposition of Vuance’s ordinary shares applicable to non-Israeli
      shareholders, including U.S. shareholders.




***General
      Corporate Tax Structure***




Israeli
      companies are generally subject to corporate tax on their taxable income at
      a
      rate that is 34% for the 2005 tax year. This rate was 35% in the 2004 tax year
      and will be 31% in the 2006 tax year, 29% for the 2007 tax year, 27% for the
      2008 tax year, 26% for the 2009 tax year and 25% thereafter.




However,
      as discussed below, the rate is effectively reduced for income derived from
      an
“approved enterprise.”




**Special
      provisions relating to taxation under inflationary
      conditions**




The
      Income Tax Law (Inflationary Adjustments), 1985, generally referred to as the
      Inflationary Adjustments Law, represents an attempt to overcome the problems
      presented to a traditional tax system by an economy undergoing rapid inflation.
      The Inflationary Adjustments Law is highly complex. The provisions that are
      material to us, are summarized as follows:




·
            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 above 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.




73




·
            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.




·
            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.




Under
      the
      Inflationary Adjustments Law, results for tax purposes are measured in real
      terms, in accordance with changes in the Israeli consumer price index. We are
      taxed under this law. The difference between the change in the Israeli consumer
      price index and the exchange rate of Israeli currency in relation to the dollar
      may in future periods cause significant differences between taxable income
      and
      the income measured in dollars as reflected in our consolidated financial
      statements.




***Law
      for the Encouragement of Industry (Taxes), 1969***




Under
      the
      Law for the Encouragement of Industry (Taxes), 1969 (the “Industry Encouragement
      Law”), a company qualifies as an “Industrial Company” if it is a resident in
      Israel and at least 90% of its income in a given tax year (exclusive of certain
      income) is derived from Industrial Enterprises which was defined as an
      enterprise whose major activity in a particular tax year is industrial
      manufacturing. As of the date of this Annual
      Report ,
      we were
      qualified as such.




A
      qualifying Industrial Company is entitled to deduct expenses related to public
      offering in equal amounts over three years and is also entitled to amortization
      of the cost of purchased know-how and patents over an eight - year period for
      tax purposes. Additionally, under certain income tax regulations, Industrial
      Companies qualify for special accelerated depreciation rates. An Industrial
      Company owning an Approved Enterprise (see “Law for the Encouragement of Capital
      Investments, 1959” below) may choose between the above depreciation rates and
      the depreciation rules available to Approved Enterprises.




Qualification
      as an Industrial Company is not conditional upon the receipt of prior approval
      from any Israeli Government authority. No assurance can be given that we will
      continue to qualify as an Industrial Company or will in the future be able
      to
      avail itself of any benefits available to companies so qualifying.




***Taxation
      of Capital Gains Applicable to Israeli Shareholders and Non-Israeli
      Shareholders***




**General**




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.




**Israeli
      residents**




Individuals
      and corporations which are not subject to the provisions of the Inflationary
      Adjustments Law




**The
      law in effect until December 31, 2005**




Pursuant
      to the Tax Reform, generally, capital gains tax is imposed on Israeli residents
      at a rate of 15% on real gains derived on or after January 1, 2003, from the
      sale of shares in Israeli companies publicly traded on a recognized stock market
      in a country that has a treaty for the prevention of double taxation with
      Israel. (such as NASDAQ) or companies traded on both the TASE and NASDAQ or
      another recognized stock market. This tax rate is contingent upon the
      shareholder not claiming a deduction for financing expenses in connection with
      such shares, and does not apply to: (i) the sale of shares to a relative (as
      defined in the Tax Reform); (ii) the sale of shares by dealers in securities;
      (iii) the sale of shares by shareholders that report in accordance with the
      Inflationary Adjustments Law; or (iv) the sale of shares by shareholders who
      acquired their shares prior to an initial public offering (that are subject
      to a
      different tax arrangement). The tax basis of shares acquired prior to January
      1,
      2003 will be determined in accordance with the average closing share price
      in
      the three trading days preceding January 1, 2003. However, a request may be
      made
      to the tax authorities to consider the actual adjusted cost of the shares as
      the
      tax basis if it is higher than such average price.




74




**Corporations
      which are subject to the provisions of the Inflationary Adjustments
      Law**




In
      2006,
      the gain on the sale of securities is subject to tax at the date of sale, at
      the
      corporate tax law for that year (31%), on the entire increase in value in real
      terms from the date of purchase until the date of sale.




**The
      law, commencing January 1, 2006:**




**Individuals:**




Commencing
      in January 1, 2006, a real capital gain deriving to an individual will be taxed
      at a rate of 20%, on condition that the income is not classified as business
      income from the vantage point of the individual. This will apply to the entire
      real capital gain accrued since the date of purchase, or since January 1, 2003
      if the purchase preceded that date.




Notwithstanding
      the above, the real capital gain will be taxed at a rate of 25% in the following
      instances:




1.  The
      individual deducts interest expenses and linkage differentials.




2.  The
      seller is a "significant shareholder" at the date of the sale of the securities
      or at any time during the 12-month period preceding the sale. A "significant
      shareholder" is defined in general as shareholder who holds, either directly
      or
      indirectly, alone or together with another, at least 10% of any form of a means
      of control in a company. The term "together with another" means together with
      a
      relative, or together with someone who is not a relative with which the
      individual, either directly or indirectly, has a regular cooperative agreement
      regarding the affairs of the company.




**Companies
      not subject to the provisions of the Adjustment Law:**




Companies
      not subject to the provisions of the Adjustment Law in 2005, will be taxed
      at a
      rate of 25% upon the capital gain on the sale of securities in the period 2006
      -
      2009. In 2010 and thereafter, capital gains will be taxed at a corporate rate,
      which in 2010 is expected to be 25%.




**Companies
      subject to the provisions of the Adjustment Law:**




The
      real
      capital gain on the sale of securities by a company subject to the provisions
      of
      the Adjustment Law will be taxed at the corporate tax rate applicable during
      the
      year of sale, as follows: 2006 - 31%, 2007 - 29%, 2008 - 27%, 2009 - 26%, 2010
      -
      25%.




Non-Israeli
      residents:




Generally
      speaking, Non-residents of Israel will be exempt from capital gain tax in
      relation to the sale of ordinary shares traded in a stock exchange as long
      as
      (a) the capital gains are not accrued or derived by the non resident
      shareholder’s permanent establishment in Israel, (b) the ordinary shares in
      relation to which the capital gains are derived were acquired by the non
      resident after the initial listing of the ordinary shares and (c) neither the
      shareholder nor the capital gain is subject to certain sections of the Israeli
      income tax ordinance.




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
      addition, pursuant to the Income Tax Treaty between Israel and the United
      States, which we refer to as the Tax Treaty, gains derived from the sale,
      exchange or disposition of our ordinary shares by a person who qualifies as
      a
      resident of the United States within the meaning of the Tax Treaty and who
      is
      entitled to claim the benefits afforded to US residents under the Tax Treaty,
      referred to as a Treaty US Resident, would not be subject to Israeli capital
      gains tax, unless such Treaty US Resident owned, directly or indirectly, shares
      representing 10% or more of the voting power of our company at any time during
      the 12-month period preceding such sale, exchange or disposition.




75




In
      some
      instances where Vuance 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. 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.




***Income
      Taxes on Dividend Distribution to Israeli and Non-Israeli
      Shareholders***




According
      to the Israeli tax law, distribution of dividend from income attributed to
      an
“Approved Enterprise” will generally be subject to tax in Israel at the rate of
      15%.




Any
      distribution of dividend from income, which is not attributed to an “Approved
      Enterprise” will be subject to tax in Israel at the rate of 20%, except for
      dividend distributed, to Individual deemed “a substantial shareholder” which
      will be subject to tax at the rate of 25%.




Under
      the
      Tax Treaty, the maximum Israeli withholding tax on dividends paid to a holder
      of
      shares who is a Treaty US Resident is 25%. However, as mentioned above under
      “—Law for the Encouragement of Capital Investments, 1959”, dividends of an
      Israeli company paid out of income derived from an Approved Enterprise during
      the benefit period will generally still be subject to a reduced tax rate of
      15%.




The
      Tax
      Treaty further provides that a 12.5% Israeli withholding tax would apply to
      dividends paid to a US corporation owning 10% or more of an Israeli company’s
      voting stock during, in general, the current and preceding tax years of the
      Israeli company. The lower 12.5% rate applies only to dividends from income
      not
      derived from an Approved Enterprise in the applicable period and provided that
      not more than 25% of the Israeli company’s gross income consists of interest or
      dividend.




Generally
      speaking, a non-resident of Israel who has dividend income derived from or
      accrued in Israel, from which tax was withheld at source, is generally exempt
      from the duty to file tax returns in Israel in respect of such income, provided
      such income was not derived from a business conducted in Israel by the taxpayer
      and the non-resident has no other sources of income in Israel.




Residents
      of the United States generally will have withholding tax in Israel deducted
      at
      source. As discussed below, they may be entitled to a credit or deduction for
      United States federal income tax purposes in the amount of the taxes withheld,
      subject to detailed rules contained in United States tax
      legislation.




**United
      States Federal Income Taxation**





***General***





The
      following is a summary of the material U.S. federal income tax consequences
      of
      the ownership and disposition of our ordinary shares and warrants. The following
      discussion is not exhaustive of all possible tax considerations. This summary
      is
      based upon the Internal Revenue Code of 1986, as amended (the “Code”),
      regulations promulgated under the Code by the U.S. Treasury Department
      (including proposed and temporary regulations), rulings, current administrative
      interpretations and official pronouncements of the Internal Revenue Service
      (the
“IRS”), and judicial decisions, all as currently in effect and all of which are
      subject to differing interpretations or to change, possibly with retroactive
      effect. Such change could materially and adversely affect the tax consequences
      described below. No assurance can be given that the IRS would not assert, or
      that a court would not sustain, a position contrary to any of the tax
      consequences described below.





This
      discussion does not address state, local, or foreign tax consequences of the
      ownership and disposition of ordinary shares and warrants. (See “Israeli
      Taxation” above).





This
      summary is for general information only and does not address all aspects of
      the
      U.S. federal income taxation that may be important to a particular holder in
      light of its investment or tax circumstances or to holders subject to special
      tax rules, such as: banks; financial institutions; insurance companies; dealers
      in stocks, securities, or currencies; traders in securities that elect to use
      a
      mark-to-market method of accounting for their securities holdings; tax-exempt
      organizations; real estate investment trusts; regulated investment companies;
      qualified retirement plans, individual retirement accounts, and other
      tax-deferred accounts; expatriates of the United States; persons subject to
      the
      alternative minimum tax; persons holding ordinary shares or warrants as part
      of
      a straddle, hedge, conversion transaction, or other integrated transaction;
      persons who acquired ordinary shares or warrants pursuant to the exercise of
      any
      employee stock option or otherwise as compensation for services; persons
      actually or constructively holding 10% or more of our voting stock; and U.S.
      Holders (as defined below) whose functional currency is other than the U.S.
      dollar.




76




This
      discussion is not a comprehensive description of all of the U.S. federal tax
      consequences that may be relevant with respect to the ownership and disposition
      of our ordinary shares and warrants. We urge you to consult your own tax advisor
      regarding your particular circumstances and the U.S. federal income and estate
      tax consequences to you of owning and disposing of our ordinary shares and
      warrants, as well as any tax consequences arising under the laws of any state,
      local, or foreign or other tax jurisdiction and the possible effects of changes
      in U.S. federal or other tax laws.





This
      summary only addresses ordinary shares and warrants that are held as capital
      assets within the meaning of Section 1221 of the Code, which generally means
      as
      property held for investment, and were acquired upon original issuance at their
      initial public offering price. For purposes of this discussion, the term “U.S.
      Holder” means a beneficial owner of our ordinary shares and warrants that is any
      of the following:





·
            a
                citizen or resident of the United States or someone treated as a
                U.S.
                citizen or resident for U.S. federal income tax
                purposes;




·
            a
                corporation (or other entity taxable as a corporation for U.S. federal
                income tax purposes) created or organized in or under the laws of
                the
                United States, any state thereof, or the District of
                Columbia;




·
            an
                estate, the income of which is subject to U.S. federal income taxation
                regardless of its source;




·
            a
                trust if a U.S. court can exercise primary supervision over the trust’s
                administration and one or more U.S. persons are authorized to control
                all
                substantial decisions of the trust;
                or




·
            a
                trust in existence on August 20, 1996 that has a valid election in
                effect
                under applicable Treasury Regulations to be treated as a U.S.
                person.




The
      term
“Non-U.S. Holder” means a beneficial owner of our ordinary shares and warrants
      that is not a U.S. Holder. As described in “Taxation of Non-U.S. Holders” below,
      the tax consequences to a Non-U.S. Holder may differ substantially from the
      tax
      consequences to a U.S. Holder.





If
      a
      partnership (including for this purpose any entity treated as a partnership
      for
      U.S. federal income tax purposes) is a beneficial owner of our ordinary shares
      and warrants, the U.S. federal income tax consequences to a partner in the
      partnership will generally depend on the status of the partner and the
      activities of the partnership. A holder of our ordinary shares and warrants
      that
      is a partnership and the partners in such partnership should consult their
      own
      tax advisors regarding the U.S. federal income tax consequences of the ownership
      and disposition of our ordinary shares and warrants.





**Taxation
      of U.S. Holders**





The
      discussion in “Distributions on Ordinary Shares” and “Dispositions of Ordinary
      Shares or Warrants” below assumes that we will not be treated as a passive
      foreign investment company (“PFIC”) for U.S. federal income tax purposes. For a
      discussion of the rules that apply if we are treated as a PFIC, see the
      discussion in “Passive Foreign Investment Company” below.





***Distributions
      on Ordinary Shares***





General.
      Subject to the discussion in “Passive Foreign Investment Company” below, if you
      actually or constructively receive a distribution on ordinary shares, you must
      include the distribution in gross income as a taxable dividend on the date
      of
      your receipt of the distribution, but only to the extent of our current or
      accumulated earnings and profits, as calculated under U.S. federal income tax
      principles. Such amount must be included without reduction for any Israeli
      tax
      withheld. Dividends paid by us generally will not be eligible for the dividends
      received deduction allowed to corporations with respect to dividends received
      from certain domestic corporations. Dividends paid by us may or may not be
      eligible for preferential rates applicable to qualified dividend income, as
      described below.




77




To
      the
      extent a distribution exceeds our current and accumulated earnings and profits,
      it will be treated first as a non-taxable return of capital to the extent of
      your adjusted tax basis in the ordinary shares, and thereafter as capital gain.
      Preferential tax rates for long-term capital gain may be applicable to
      non-corporate U.S. Holders.





We
      do not
      intend to calculate our earnings and profits under U.S. federal income tax
      principles. Therefore, you should expect that a distribution will generally
      be
      reported as a dividend even if that distribution would otherwise be treated
      as a
      non-taxable return of capital or as capital gain under the rules described
      above.





Qualified
      Dividend Income. With respect to non-corporate U.S. Holders (i.e., individuals,
      trusts, and estates), for taxable years beginning before January 1, 2011,
      dividends that are treated as qualified dividend income (“QDI”) are taxable at a
      maximum tax rate of 15%. Among other requirements, dividends generally will
      be
      treated as QDI if either (i) our ordinary shares are readily tradable on an
      established securities market in the United States, or (ii) we are eligible
      for
      the benefits of a comprehensive income tax treaty with the United States which
      includes an information exchange program and which is determined to be
      satisfactory by the U.S. Treasury. It is expected that our ordinary shares
      will
      be “readily tradable” as a result of being listed on the OTC Bulletin
      Board.





In
      addition, for dividends to be treated as QDI, we must not be a PFIC (as
      discussed below) for either the taxable year in which the dividend was paid
      or
      the preceding taxable year. We do not believe that we will be a PFIC for our
      current taxable year. **** However,
      please see the discussion under “Passive Foreign Investment Company” below.
      Additionally, in order to qualify for QDI treatment, you generally must have
      held the ordinary shares for more than 60 days during the 121-day period
      beginning 60 days prior to the ex-dividend date. However, your holding period
      will be reduced for any period during which the risk of loss is
      diminished.





Moreover,
      a dividend will not be treated as QDI to the extent you are under an obligation
      (whether pursuant to a short sale or otherwise) to make related payments with
      respect to positions in substantially similar or related property. Since the
      QDI
      rules are complex, you should consult your own tax advisor regarding the
      availability of the preferential tax rates for dividends paid on ordinary
      shares.





Foreign
      Currency Distributions. We have the right to pay dividends in Israeli currency.
      A dividend paid in Israeli currency must be included in your income as a U.S.
      dollar amount based on the exchange rate in effect on the date such dividend
      is
      received, regardless of whether the payment is in fact converted into U.S.
      dollars. If the dividend is converted to U.S. dollars on the date of receipt,
      you generally will not recognize a foreign currency gain or loss. However,
      if
      you convert the foreign currency into U.S. dollars on a later date, you must
      include in income any gain or loss resulting from any exchange rate
      fluctuations. The gain or loss will be equal to the difference between (i)
      the
      U.S. dollar value of the amount you included in income when the dividend was
      received and (ii) the amount that you receive on the conversion of the foreign
      currency into U.S. dollars. Such gain or loss will generally be ordinary income
      or loss and U.S. source for U.S. foreign tax credit purposes.





In-Kind
      Distributions. Distributions to you of new ordinary shares or rights to
      subscribe for new ordinary shares that are received as part of a pro rata
      distribution to all of our shareholders will not be subject to U.S. federal
      income tax. The adjusted tax basis of the new ordinary shares or rights so
      received will be determined by allocating your adjusted tax basis in the old
      ordinary shares between the old ordinary shares and the new ordinary shares
      or
      rights received, based on their relative fair market values on the date of
      distribution. However, in the case of a distribution of rights to subscribe
      for
      ordinary shares, the adjusted tax basis of the new rights will be zero if the
      fair market value of the new rights is less than 15% of the fair market value
      of
      the old ordinary shares on the date of distribution and you do not make an
      election to determine the adjusted tax basis of the rights by allocation as
      described above. Your holding period for the new ordinary shares or rights
      will
      generally include the holding period for the old ordinary shares on which the
      distribution was made.





Foreign
      Tax Credits. Subject to certain conditions and limitations, including potential
      limitations under the U.S.-Israel Tax Treaty, Israeli taxes paid on or withheld
      from distributions from us and not refundable to you may be credited against
      your U.S. federal income tax liability or, alternatively, may be deducted from
      your taxable income. This election is made on a year-by-year basis and applies
      to all foreign taxes paid by you or withheld from you that year.





Distributions
      will constitute foreign source income for foreign tax credit limitation
      purposes. The foreign tax credit limitation is calculated separately with
      respect to specific classes of income. For this purpose, distributions
      characterized as dividends distributed by us will generally constitute “passive
      category income” or, in the case of certain U.S. Holders, “general category
      income.” Special limitations may apply if a dividend is treated as QDI (as
      defined above).




78




Special
      rules may apply to individuals whose foreign source income during the taxable
      year consists entirely of “qualified passive income” and whose creditable
      foreign taxes paid or accrued during the taxable year do not exceed $300 ($600
      in the case of a joint return).





Since
      the
      rules governing foreign tax credits are complex, you should consult your own
      tax
      advisor regarding the availability of foreign tax credits in your particular
      circumstances.





***Exercise
      or Lapse of Warrants***





Upon
      the
      exercise of our warrants, a U.S. Holder will not recognize gain or loss and
      will
      have a tax basis in the ordinary shares received equal to the U.S. Holder’s tax
      basis in the warrant plus the exercise price of the warrant. The holding period
      for the shares purchased pursuant to the exercise of a warrant will begin on
      the
      day following the date of exercise and will not include the period during which
      the U.S. Holder held the warrant. If a warrant lapses unexercised, a U.S. Holder
      will recognize a capital loss in an amount equal to its tax basis in the
      warrant. Such loss will be long-term if the warrant has been held for more
      than
      one year. See “Disposition of Ordinary Shares or Warrants” below for a
      discussion of capital gains tax rates and limitations on deductions for losses.
      The loss will generally be from U.S. sources, but the loss may be from a
      non-U.S. source under some circumstances under the U.S.-Israel Tax Treaty.
      U.S.
      Holders should consult their own independent tax advisors regarding the sourcing
      of any losses due to the lapse of our warrants before exercise.





***Dispositions
      of Ordinary Shares or Warrants***





Subject
      to the discussion in “Passive Foreign Investment Company” below, you generally
      will recognize taxable gain or loss realized on the sale or other taxable
      disposition of ordinary shares or warrants equal to the difference between
      the
      U.S. dollar value of (i) the amount realized on the disposition (i.e., the
      amount of cash plus the fair market value of any property received), and (ii)
      your adjusted tax basis in the ordinary shares or warrants. Such gain or loss
      will be capital gain or loss.





If
      you
      have held the ordinary shares or warrants for more than one year at the time
      of
      disposition, such capital gain or loss will be long-term capital gain or loss.
      Preferential tax rates for long-term capital gain (currently, with a maximum
      rate of 15% for taxable years beginning before January 1, 2011) will apply
      to
      non-corporate U.S. Holders. If you have held the ordinary shares or warrants
      for
      one year or less, such capital gain or loss will be short-term capital gain
      or
      loss taxable as ordinary income at your marginal income tax rate. The
      deductibility of capital losses is subject to limitations.





Generally,
      any gain or loss recognized will not give rise to foreign source income for
      U.S.
      foreign tax credit purposes, unless a different result is achieved under the
      U.S.-Israel Tax Treaty. You should consult your own tax advisor regarding the
      effect of such treaty on the source of income.





You
      should consult your own tax advisor regarding the U.S. federal income tax
      consequences if you receive currency other than U.S. dollars upon the
      disposition of ordinary shares or warrants.





***Passive
      Foreign Investment Company***





We
      generally will be a PFIC under Section 1297 of the Code if, for a taxable year,
      either (a) 75% or more of our gross income for such taxable year is passive
      income (the “income test”) or (b) 50% or more of the average percentage,
      generally determined by fair market value, of our assets either produce passive
      income or are held for the production of passive income (the “asset test”).
”Passive income” includes, for example, dividends, interest, certain rents and
      royalties, certain gains from the sale of stock and securities, and certain
      gains from commodities transactions.





Certain
      “look through” rules apply for purposes of the income and asset tests described
      above. If we own, directly or indirectly, 25% or more of the total value of
      the
      outstanding shares of another foreign corporation, we will be treated as if
      we
      (a) held directly a proportionate share of the other corporation’s assets, and
      (b) received directly a proportionate share of the other corporation’s income.
      In addition, passive income does not include any interest, dividends, rents,
      or
      royalties that are received or accrued by us from a “related person” (as defined
      in Section 954(d)(3) of the Code), to the extent such items are properly
      allocable to income of such related person that is not passive
      income.





Under
      the
      income and asset tests, whether or not we are a PFIC will be determined annually
      based upon the composition of our income and the composition and valuation
      of
      our assets, all of which are subject to change. In determining that we are
      not a
      PFIC, we are relying on our projected revenues and projected capital
      expenditures. If our actual revenues and capital expenditures do not match
      our
      projections, we may become a PFIC. For example, if we do not spend enough of
      the
      cash (a passive asset) we raise from any financing transactions we may
      undertake, the relative percentage of our passive assets will increase. In
      addition, our determination is based on a current valuation of our assets,
      including goodwill. In calculating goodwill, we have valued our total assets
      based on our market capitalization, determined using the market price of our
      ordinary shares. Such market price may fluctuate. If our market capitalization
      is less than anticipated or subsequently declines, this will decrease the value
      of our goodwill and we may become a PFIC. Furthermore, we have made a number
      of
      assumptions regarding the amount of value allocable to goodwill. We believe
      our
      valuation approach is reasonable. However, it is possible that the IRS will
      challenge the valuation of our goodwill, which may result in our being a
      PFIC.




79




We
      do not
      believe that we are currently a PFIC. We intend to use reasonable efforts to
      avoid PFIC status. However, because the PFIC determination is highly fact
      intensive and made at the end of each taxable year, there can be no assurance
      that we will not be a PFIC for the current or any future taxable year or that
      the IRS will not challenge our determination concerning our PFIC status. If
      we
      determine that we are a PFIC, we will take reasonable steps to notify
      you.





Default
      PFIC Rules under Section 1291 of the Code. If we are a PFIC, the U.S. federal
      income tax consequences to a U.S. Holder of the ownership and disposition of
      ordinary shares and warrants will depend on whether such U.S. Holder makes
      an
      election to treat us as a qualified electing fund (“QEF”) under Section 1295 of
      the Code (a “QEF Election”) or a mark-to-market election under Section 1296 of
      the Code (a “Mark-to-Market Election”). A U.S. Holder owning ordinary shares and
      warrants while we were or are a PFIC that has not made either a QEF Election
      or
      a Mark-to-Market Election will be referred to in this summary as a “Non-Electing
      U.S. Holder.”





If
      you
      are a Non-Electing U.S. Holder, you will be subject to the default tax rules
      of
      Section 1291 of the Code with respect to:





·
            any
                “excess distribution” paid on ordinary shares and warrants, which means
                any distribution received by you which, together with all other
                distributions received in the current taxable year, exceeds 125%
                of the
                average distributions received by you during the three preceding
                taxable
                years (or during your holding period for the ordinary shares and
                warrants,
                if shorter); and




·
            any
                gain recognized on the sale or other taxable disposition (including
                a
                pledge) of ordinary shares and
                warrants.




Under
      these default tax rules:





·
            any
                excess distribution or gain will be allocated ratably over your holding
                period for the ordinary shares and
                warrants;




·
            the
                amount allocated to the current taxable year and any period prior
                to the
                first day of the first taxable year in which we were a PFIC will
                be
                treated as ordinary income in the current
                year;




·
            the
                amount allocated to each of the other years will be treated as ordinary
                income and taxed at the highest applicable tax rate in effect for
                that
                year; and




·
            the
                resulting tax liability from any such prior years will be subject
                to the
                interest charge applicable to underpayments of
                tax.




In
      addition, notwithstanding any election you may make, dividends that you receive
      from us will not be eligible for the preferential tax rates applicable to QDI
      (as discussed above in “Distributions on Ordinary Shares”) if we are a PFIC
      either in the taxable year of the distribution or the preceding taxable year,
      but will instead be taxable at rates applicable to ordinary income.





Special
      rules for Non-Electing U.S. Holders will apply to determine U.S. foreign tax
      credits with respect to withholding taxes imposed on distributions on ordinary
      shares.





If
      we are
      a PFIC for any taxable year during which you hold ordinary shares or warrants,
      we will continue to be treated as a PFIC with respect to you for all succeeding
      years during which you hold ordinary shares or warrants, regardless of whether
      we actually continue to be a PFIC. You may terminate this deemed PFIC status
      by
      electing to recognize gain (which will be taxed under the default tax rules
      of
      Section 1291 of the Code discussed above) as if your ordinary shares or warrants
      had been sold on the last day of the last taxable year for which we were a
      PFIC.




80




If
      we are
      a PFIC in any year with respect to you, you will be required to file an annual
      return on IRS Form 8621 regarding distributions received on ordinary shares
      and
      any gain realized on the disposition of ordinary shares or
      warrants.





QEF
      Election. If you make a QEF Election, you generally will not be subject to
      the
      default rules of Section 1291 of the Code discussed above. Instead, you will
      be
      subject to current U.S. federal income tax on your pro rata share of our
      ordinary earnings and net capital gain, regardless of whether such amounts
      are
      actually distributed to you by us. However, you can make a QEF Election only
      if
      we agree to furnish you annually with certain tax information, and we currently
      do not intend to prepare or provide such information.





Mark-to-Market
      Election. U.S. Holders may make a Mark-to-Market Election, but only if the
      ordinary shares are marketable stock. The ordinary shares will be “marketable
      stock” as long as they remain listed on the OTC Bulletin Board or become listed
      on NASDAQ (if our NASDAQ Listing Application is approved), and are regularly
      traded. Stock is “regularly traded” for any calendar year during which it is
      traded (other than in de minimis quantities) on at least fifteen days during
      each calendar quarter. There can be no assurances, however, that our ordinary
      shares will be treated, or continue to be treated, as regularly
      traded.





If
      the
      ordinary shares are marketable stock you make a Mark-to-Market Election, you
      generally will not be subject to the default rules of Section 1291 of the Code
      discussed above. Rather, you generally will be required to recognize ordinary
      income for any increase in the fair market value of the ordinary shares and
      warrants for each taxable year that we are a PFIC. You will also be allowed
      to
      deduct as an ordinary loss any decrease in the fair market value to the extent
      of net marked-to-market gain previously included in prior years. Your adjusted
      tax basis in the ordinary shares and warrants will be adjusted to reflect the
      amount included or deducted.





The
      Mark-to-Market Election will be effective for the taxable year for which the
      election is made and all subsequent taxable years, unless the ordinary shares
      and warrants cease to be marketable stock or the IRS consents to the revocation
      of the election. You should consult your own tax advisor regarding the
      availability of, and procedure for making, a Mark-to-Market
      Election.





Since
      the
      PFIC rules are complex, you should consult your own tax advisor regarding them
      and how they may affect the U.S. federal income tax consequences of the
      ownership and disposition of ordinary shares and warrants.





***Information
      Reporting and Backup Withholding***





Generally,
      information reporting requirements will apply to distributions on ordinary
      shares or proceeds on the disposition of ordinary shares and warrants paid
      within the United States (and, in certain cases, outside the United States)
      to
      U.S. Holders other than certain exempt recipients, such as corporations.
      Furthermore, backup withholding (currently at 28%) may apply to such amounts
      if
      the U.S. Holder fails to (i) provide a correct taxpayer identification number,
      (ii) report interest and dividends required to be shown on its U.S. federal
      income tax return, or (iii) make other appropriate certifications in the
      required manner. U.S. Holders who are required to establish their exempt status
      generally must provide such certification on IRS Form W-9.





Backup
      withholding is not an additional tax. Amounts withheld as backup withholding
      from a payment to you may be credited against your U.S. federal income tax
      liability and you may obtain a refund of any excess amounts withheld by filing
      the appropriate claim for refund with the IRS and furnishing any required
      information in a timely manner.





**Taxation
      of Non-U.S. Holders**





***Distributions
      on Ordinary Shares***





Subject
      to the discussion in “Information Reporting and Backup Withholding” below, as a
      Non-U.S. Holder, you generally will not be subject to U.S. federal income tax,
      including withholding tax, on distributions received on ordinary shares, unless
      the distributions are effectively connected with a trade or business that you
      conduct in the United States and (if an applicable income tax treaty so
      requires) attributable to a permanent establishment that you maintain in the
      United States.





If
      distributions are effectively connected with a U.S. trade or business and (if
      applicable) attributable to a U.S. permanent establishment, you generally will
      be subject to tax on such distributions in the same manner as a U.S. Holder,
      as
      described in “Taxation of U.S. Holders - Distributions on Ordinary Shares”
above. In addition, any such distributions received by a corporate Non-U.S.
      Holder may also, under certain circumstances, be subject to an additional
“branch profits tax” at a 30% rate or such lower rate as may be specified by an
      applicable income tax treaty.




81




***Dispositions
      of Ordinary Shares and Warrants***





Subject
      to the discussion in “Information Reporting and Backup Withholding” below, as a
      Non-U.S. Holder, you generally will not be subject to U.S. federal income tax,
      including withholding tax, on any gain recognized on a sale or other taxable
      disposition of ordinary shares and warrants, unless (i) the gain is effectively
      connected with a trade or business that you conduct in the United States and
      (if
      an applicable income tax treaty so requires) attributable to a permanent
      establishment that you maintain in the United States, or (ii) you are an
      individual and are present in the United States for at least 183 days in the
      taxable year of the disposition, and certain other conditions are
      present.





If
      you
      meet the test in clause (i) above, you generally will be subject to tax on
      any
      gain that is effectively connected with your conduct of a trade or business
      in
      the United States in the same manner as a U.S. Holder, as described in “Taxation
      of U.S. Holders - Dispositions of Ordinary Shares and Warrants” above.
      Effectively connected gain realized by a corporate Non-U.S. Holder may also,
      under certain circumstances, be subject to an additional “branch profits tax” at
      a 30% rate or such lower rate as may be specified by an applicable income tax
      treaty.





If
      you
      meet the test in clause (ii) above, you generally will be subject to tax at
      a
      30% rate on the amount by which your U.S. source capital gain exceeds your
      U.S.
      source capital loss.





***Information
      Reporting and Backup Withholding***





Payments
      to Non-U.S. Holders of distributions on, or proceeds from the disposition of,
      ordinary shares and warrants are generally exempt from information reporting
      and
      backup withholding. However, a Non-U.S. Holder may be required to establish
      that
      exemption by providing certification of non-U.S. status on an appropriate IRS
      Form W-8.





Backup
      withholding is not an additional tax. Amounts withheld as backup withholding
      from a payment to you may be credited against your U.S. federal income tax
      liability and you may obtain a refund of any excess amounts withheld by filing
      the appropriate claim for refund with the IRS and furnishing any required
      information in a timely manner.




***F.    Dividends
      and Paying Agent***





Not
      applicable.





***G.    Statement
      by Experts***





Not
      applicable.





***H.    Documents
      on Display***




We
      are subject to the informational requirements of the Exchange Act, applicable
      to
      foreign private issuers. We, as a “foreign private issuer,” are exempt from the
      rules under the Exchange Act prescribing certain disclosure and procedural
      requirements for proxy solicitations, 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
      purchases and sales of shares. In addition, we are not required to file annual,
      quarterly and current reports and financial statements with the SEC as
      frequently or as promptly as United States companies whose securities are
      registered under the Exchange Act. However, we will file with the SEC, within
      180 days after the end of each fiscal year, an annual report on Form 20-F
      containing financial statements audited by an independent accounting firm.
      We
      will also furnish quarterly reports on Form 6-K containing unaudited interim
      financial information for the first three quarters of each fiscal year, within
      60 days after the end of such quarter.





You
      may read and copy any document we file or furnish with the SEC at reference
      facilities at 450 Fifth Street, NW, Washington, DC 20549. You may also obtain
      copies of the documents at prescribed rates by writing to the Public Reference
      Section of the SEC at 450 Fifth Street, NW, Washington, DC 20549. Please call
      the SEC at 1-800-SEC-0330 for further information on the operation of the public
      reference facilities. You can review our SEC filings and the registration
      statement by accessing the SEC’s internet site at
      http://www.sec.gov.




82




***I.  Subsidiary
      Information***





Not
      applicable.





**ITEM
      11.** ***Quantitative
      and Qualitative Disclosures About Market Risk.*** ****





*Quantitative
      and Qualitative Information about Market Risk*




The
      primary objective of our investment activities is to preserve principal while
      at
      the same time maximizing the income we receive from investments without
      significantly increasing risk. Some of the securities in which we may invest
      may
      be subject to market risk. This means that a change in prevailing interest
      rates
      and foreign currency rates against the NIS may cause the value of the investment
      to fluctuate. For example, if we purchase a security that was issued with a
      fixed interest rate and the prevailing interest rate later rises, the value
      of
      our investment will probably decline. To minimize this risk, we intend to
      maintain our portfolio of cash equivalents and short-term investments in a
      variety of securities, including U.S. dollars, NIS bank deposits, money market
      funds and government and non-government debt securities. In general, money
      market funds are not subject to market risk because the interest paid on such
      funds fluctuates with the prevailing interest rate.





Our
      financial market risk includes risks related to international operations and
      related foreign currencies. We anticipate that sales outside of North America
      will continue to account for a significant portion of our consolidated revenue
      in 2006. To date, most of our sales have been valued in dollars. In future
      periods, we expect our sales to be principally valued in dollars, eliminating
      foreign currency exchange risk.





We
      value
      expenses of some of our international operations, such as Israel and Hong Kong,
      in each country's local currency and therefore are subject to foreign currency
      exchange risk. However, through December 31, 2005, we have not experienced
      any
      significant negative impact on our operations as a result of fluctuations in
      foreign currency exchange rates, although we have incurred a loss of $48,000
      in
      the year ended December 31, 2005 due to fluctuations in foreign exchange rates.
      We do not use financial instruments to hedge operating expenses in Israel or
      Hong Kong that are valued in local currency. We intend to continue to assess
      the
      need to utilize financial instruments to hedge currency exposures on an ongoing
      basis.





We
      do not
      use derivative financial instruments for speculative trading purposes, nor
      do we
      hedge our foreign currency exposure to offset the effects of changes in foreign
      exchange rates.





Our
      exposure to market risks for changes in interest rates relates primarily to
      our
      credit facility. At December 31, 2005, our financial market risk related to
      this
      debt was immaterial. Our general policy is to limit the risk of principal loss
      and ensure the safety of invested funds by limiting market and credit
      risk.





**Foreign
      currency risk**




Most
      of our sales are denominated in U.S. dollars, and we incur most of our expenses
      in U.S. dollars, Euros and Israeli Shekels. According to the salient economic
      factors indicated in SFAS No. 52, “Foreign Currency Translation,” our cash flow,
      sale price, sales market, expense, financing and inter-company transactions
      and
      arrangement indicators are predominantly denominated in U.S. dollars. In
      addition, the U.S. dollar is the primary currency of the economic environment
      in
      which we operate, and thus the U.S. dollar is our functional and reporting
      currency.




In
      our balance sheet, we remeasure into U.S. dollars all monetary accounts
      (principally cash and cash equivalents and liabilities) that are maintained
      in
      other currencies. For this remeasurement we use the foreign exchange rate at
      the
      balance sheet date. Any gain or loss that results from this remeasurement is
      reflected in the statement of income as financial income or financial expense,
      as appropriate.




We
      measure and record non-monetary accounts in our balance sheet (principally
      fixed
      assets, prepaid expenses and share capital) in U.S. dollars. For this
      measurement we use the U.S. dollar value in effect at the date that the asset
      or
      liability was initially recorded in our balance sheet (the date of the
      transaction).





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





Not
      applicable.




83




**PART
      II**




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





A.
            None.





B.
            None.





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





A.
            None.





B.
            None.





C.
            Not
                applicable.





D.
            No
                changes.





E.
            None.





**ITEM
      15. Controls and Procedures.**





**Disclosure
      Controls and Procedures**





Within
      90
      days prior to the date of this Annual Report, we performed an evaluation of
      the
      effectiveness of our disclosure controls and procedures that are designed to
      ensure that the material financial and non-financial information required to
      be
      disclosed on Form 20-F and filed with the Securities and Exchange Commission
      is
      recorded, processed, summarized and reported as and when required. There
      are
      inherent limitations to the effectiveness of any system of disclosure controls
      and procedures, including the possibility of human error and the circumvention
      or overriding of the controls and procedures. Accordingly, even effective
      disclosure controls and procedures can provide only reasonable assurance of
      achieving their control objectives .
      Based
      on our evaluation, which was performed under the supervision and with the
      participation of our management including the Chief Executive Officer (“CEO”)
      and Chief Financial Officer (“CFO”), the CEO and CFO have concluded that our
      disclosure controls and procedures (as defined in Exchange Act Rules 13(a)-15(e)
      and 15(d)-15(e) of the Exchange Act of 1934, as amended) as of the end of the
      period covered by this Annual Report are
      effective to provide reasonable assurance that information required to be
      disclosed on
      Form
      20-F and filed with the Securities and Exchange Commission is recorded,
      processed, summarized and reported as and when required. The CEO and CFO have
      indicated that there have been no significant changes in the internal controls
      or other factors that could significantly affect internal controls subsequent
      to
      the above-mentioned evaluation, Pursuant
      to Section 404 of the Sarbanes-Oxley Act of 2002, we expect that beginning
      with our annual report on Form 20-F for the fiscal year ended
      December 31, 2007, we will be required to furnish a report by management on
      our internal control over financial reporting, which report must also contain
      a
      statement that our auditors have issued an attestation reporton our
      management's assessment of such internal controls.





**ITEM
  16.**  ***Reserved***




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





Our
      board
      of directors has determined that Ms. Michal Brikman, who chairs our audit
      committee, is an “audit committee financial expert.” Ms. Brikman is an
      independent director under Nasdaq Market Place Rule 4200(a)(15).





**ITEM
      16B.**  ***Code
      of Ethics***





Our
      board
      of directors adopted a code of ethics that applies to our chief executive
      officer, chief financial officer, director of finance, controller, and other
      persons performing similar functions a copy of which is filed as Exhibit 11.1
      to
      this Annual Report. A copy of our code of ethics will be provided, without
      charge, upon written request of any person delivered as follows: Sagid House
      “Ha’Sharon Industrial Park” P.O.B 5039, Qadima 60920 Israel.




84




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





The
      following table presents the fees to our external auditors for professional
      services rendered in the years ended December 31, 2006 and 2005:




**2006**
            
            **2005**Audit
                Fees
            
            
            60,000
            
            
            45,000Audit-Related
                Fees
            
            
            52,500
            
            
            28,000Tax
                Fees
            
            
            5,000
            
            
            5,000All
                other Fees
            
            
            -
            
            
            5,000**Total**
            
            
            117,500
            
            
            83,000




*Pre-Approval
      Policies for Non-Audit Services*




The
      Audit
      Committee has adopted policies and procedures relating to the approval of all
      audit and non-audit services that are to be performed by our independent
      auditors. These policies generally provide that we will not engage our
      independent auditors to render audit or non-audit services unless the service
      is
      specifically approved in advance by the Audit Committee or the engagement is
      entered into pursuant to the pre-approval procedure described
      below.




From
      time
      to time, the Audit Committee may pre-approve specified types of services that
      are expected to be provided to us by our independent auditors during the next
      12
      months. Any such pre-approval is detailed as to the particular service or type
      of services to be provided and is also generally subject to a maximum dollar
      amount.





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





Not
      applicable.





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





None.





**PART
      III**




**ITEM
      17.** ***Financial
      Statements.***





Not
      applicable.





**ITEM
      18.** ***Financial
      Statements.***




85




Report
      of
      the Independent Registered Public Accounting Firm




**To
      the Board of Directors of**


**SuperCom
      Asia Pacific Limited**




We
      have
      audited the accompanying balance sheets of SuperCom Asia Pacific Limited (the
      “Company”) as of December 31, 2006 and 2005, and the related statements of
      income, stockholders’ deficit and cash flows for the years ended December 31,
      2006 and 2005. 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 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 the financial
      statements are free of material misstatement. The Company is not required to
      have, nor were we engaged to perform, an audit of its internal control over
      financial reporting. Our audits include consideration of internal control over
      financial reporting as a basis for designing audit procedures that are
      appropriate in the circumstances, but not for the purpose of expressing an
      opinion on the effectiveness of the Company’s internal control over financial
      reporting. Accordingly, we express no such opinion. Our audit also includes
      examining, on a test basis, evidence supporting the amounts and disclosures
      in
      the financial statements, assessing the accounting principles used and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the financial position of the Company as of December 31,
      2006
      and 2005 and the results of its operations and cash flows for the years ended
      December 31, 2006 and 2005 in conformity with accounting principles generally
      accepted in the United States of America.




**BDO
      McCabe Lo Limited**


**Certified
      Public Accountants**




**Hong
      Kong, March 22, 2007**




86




SUPERCOM
      LTD. AND ITS SUBSIDIARIES




CONSOLIDATED
      FINANCIAL STATEMENTS




AS
      OF
      DECEMBER 31, 2006




IN
      U.S.
      DOLLARS




INDEX




PageReport
                of Independent Registered Public Accounting Firm
            
            88Consolidated
                Balance Sheets
            
            89-90Consolidated
                Statements of Operations
            
            91Statements
                of Changes in Shareholders' Equity
            
            92Consolidated
                Statements of Cash Flows
            
            93-94Notes
                to Consolidated Financial Statements
            
            95-130




87




**Certified
        Public Accountants**Grant Thornton logo


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




**TO
      THE SHAREHOLDERS OF**




**SUPERCOM
      LTD.**




We
      have
      audited the accompanying consolidated balance sheets of Supercom Ltd. (the
      "Company") and its subsidiaries as of December 31, 2005 and 2006, 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,
      2006. These financial statements are the responsibility of the Board of
      Directors and management of the Company. Our responsibility is to express an
      opinion on these financial statements based on our audits.




We
      did
      not audit the financial statements of Supercom Asia Pacific Limited, a
      subsidiary, whose assets included in the consolidation constituted approximately
      4% and 2% of total consolidated assets as of December 31, 2005 and 2006,
      respectively, and whose revenues included in the consolidation constituted
      approximately 33%, 26% and 20% of total consolidated revenues for the years
      ended December 31, 2004, 2005 and 2006, respectively. The financial
      statements of this subsidiary were audited by another independent registered
      public accounting firm, whose report has been furnished to us. Our opinion,
      insofar as it relates to the amounts included in respect of this subsidiary,
      is
      based solely on the report of the other independent registered public accounting
      firm.




We
      conducted our audits in accordance with auditing standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance as to whether the financial
      statements are free of material misstatements. The Company is not required
      to
      have, nor were we engaged to perform an audit of its internal control over
      financial reporting. Our audit included consideration of internal control over
      financial reporting as a basis for designing audit procedures that are
      appropriate in the circumstances, but not for the purpose of expressing an
      opinion on the effectiveness of the Company’s internal control over financial
      reporting. Accordingly, we express no such opinion. An audit also includes
      examining, on a test basis, evidence supporting the amounts and disclosures
      in
      the financial statements, assessing the accounting principles used and
      significant estimates made by the Board of Directors and management, as well
      as
      evaluating the overall financial statement presentation. We believe that our
      audits and the report of the other independent registered public accounting
      firm
      provide a reasonable basis for our opinion.




In
      our
      opinion, based on our audits and the report of the other independent registered
      public accounting firm, the consolidated financial statements referred to above
      present fairly, in all material respects, the consolidated financial position
      of
      the Company and its subsidiaries as of December 31, 2005 and 2006, and the
      consolidated results of their operations, and their cash flows for each of
      the
      three years in the period ended December 31, 2006, in conformity with
      accounting principles generally accepted in the United States.




Fahn
      Kanne & Co.


Certified
      Public Accountants (Isr.)




Tel-Aviv,
      ISRAEL


April
      18,
      2007


(Except
      for Note 18d, for which the date is June 27,2007)




Head
        Office:
 Levinstein
        Tower
 23
        Menachem Begin Road
 Tel-Aviv,
        66184 ISRAEL
 P.O.B.
        36172, 61361
 Tel . 972-3-7106666
 Fax
        972-3-7106660
 info@gtfk.co.il
 www.gtfk.co.il




88




**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**





**U.S.
      dollars in thousands**








**December
                31,****2005**
            
            **2006**ASSETSCURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            2,294
            
            $
            2,444Restricted
                cash deposits
            
            
            1,088
            
            
            859Marketable
                securities
            
            
            650
            
            
            11,077Trade
                receivables (net of allowance for doubtful accounts of $ 3,397 and$ 3,487
                as of December 31, 2005 and 2006, respectively)
            
            
            1,053
            
            
            2,625Other
                accounts receivable and prepaid expenses
            
            
            733
            
            
            717Inventories
            
            
            2,205
            
            
            270Totalcurrent assets
            
            
            8,023
            
            
            17,992INVESTMENTS
                AND LONG-TERM RECEIVABLES:Investment
                in restricted marketable securities of other company
            
            
            -
            
            
            4,431Long-term
                trade receivables
            
            
            209
            
            
            79Investment
                in an affiliated company
            
            
            275
            
            
            -Severance
                pay fund
            
            
            492
            
            
            239Totalinvestments and long-term receivables
            
            
            976
            
            
            4,749PROPERTY
                AND EQUIPMENT, NET
            
            
            3,210
            
            
            160INTANGIBLE
                ASSETS AND DEFERRED CHARGES
            
            
            67
            
            
            197Totalassets
            
            $
            12,276
            
            $
            23,098




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




89




**SUPERCOM
          LTD. AND ITS SUBSIDIARIES**
 **CONSOLIDATED
        BALANCE SHEETS**
 
 **U.S.
        dollars in thousands, except share data**





**December
                31,****2005**
            
            **2006**LIABILITIES
                AND SHAREHOLDERS' EQUITYCURRENT
                LIABILITIES:Short-term
                bank credit and current maturities of long-term loan
            
            $
            855
            
            $
            668Trade
                payables
            
            
            770
            
            
            823Employees
                and payroll accruals
            
            
            322
            
            
            533Accrued
                expenses and other liabilities
            
            
            1,271
            
            
            3,428Totalcurrent liabilities
            
            
            3,218
            
            
            5,452LONG-TERM
                LIABILITIES:Convertible
                bonds
            
            
            -
            
            
            2,255Long-term
                loan, net of current maturities
            
            
            195
            
            
            67Accrued
                severance pay
            
            
            616
            
            
            323Totallong-term liabilities
            
            
            811
            
            
            2,645COMMITMENTS
                AND CONTINGENT LIABILITIESSHAREHOLDERS'
                EQUITY:Share
                capital:
              Ordinary
                shares of NIS 0.0588235 par value -Authorized
                6,800,000 shares as of December 31, 2005 and 2006;Issued
                and outstanding: 3,807,167 and 4,001,126 shares as of December 31,
                2005 and 2006, respectively
            
            
            61
            
            
            64Additional
                paid-in capital
            
            
            31,702
            
            
            33,562Deferred
                stock compensation
            
            
            (15
            )
            
            -Receipt
                on account of shares
            
            
            564
            
            
            -Accumulated
                deficit
            
            
            (24,065
            )
            
            (18,625
            )Totalshareholders' equity
            
            
            8,247
            
            
            15,001Totalliabilities and shareholders' equity
            
            $
            12,276
            
            $
            23,098




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




90




**SUPERCOM
            LTD. AND ITS SUBSIDIARIES**
 **CONSOLIDATED
          STATEMENTS OF OPERATIONS**
 
 **U.S.
          dollars in thousands, except share data**




**Year
                ended**
              **December
                31,****2004**
            
            **2005**
            
            **2006**Revenues
            
            $
            7,344
            
            $
            8,462
            
            $
            8,795Cost
                of revenues
            
            
            3,730
            
            
            4,293
            
            
            3,494Inventory
                write-off
            
            
            -
            
            
            287
            
            
            -Gross
                profit
            
            
            3,614
            
            
            3,882
            
            
            5,301Operating
                expenses:Research
                and development
            
            
            845
            
            
            1,182
            
            
            1,362Selling
                and marketing
            
            
            2,445
            
            
            3,003
            
            
            5,619General
                and administrative
            
            
            1,955
            
            
            2,968
            
            
            2,737Restructuring
                expenses
            
            
            -
            
            
            496
            
            
            -Litigation
                settlement expenses
            
            
            -
            
            
            129
            
            
            108Total
                operating expenses
            
            
            5,245
            
            
            7,778
            
            
            9,826Capital
                gain from the sale of the e-ID Division
            
            
            -
            
            
            -
            
            
            10,536Operating
                income (loss)
            
            
            (1,631
            )
            
            (3,896
            )
            
            6,011Financial
                expenses, net
            
            
            (214
            )
            
            (25
            )
            
            (204
            )Other
                expenses, net
            
            
            (27
            )
            
            (30
            )
            
            (367
            )Net
                income (loss)
            
            $
            (1,872
            )
            $
            (3,951
            )
            $
            5,440Earnings
                (loss) per share:Basic
                earnings (loss) per share
            
            $
            (0.75
            )
            $
            (1.25
            )
            $
            1.37Diluted
                earnings (loss) per share
            
            $
            (0.75
            )
            $
            (1.25
            )
            $
            1.31Weighted
                average number of Ordinary shares used in computing basic earnings
                (loss)
                per share
            
            
            2,480,361
            
            
            3,155,872
            
            
            3,969,212Weighted
                average number of Ordinary shares used in computing diluted earnings
                (loss) per share
            
            
            2,480,361
            
            
            3,155,872
            
            
            4,212,791




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




91




SUPERCOM
      LTD. AND ITS
      SUBSIDIARIES


**STATEMENTS
      OF CHANGES IN SHAREHOLDERS' EQUITY**





**U.S.
      dollars in thousands, except share amounts**




**Ordinary
                  shares****Number
                  of Shares**
              
              **Share
                  capital**
              
              **Additional
                  paid-in capital**
              
              **Deferred
                  stock compensation**
              
              **Accumulated
                  Deficit**
              
              **Receipt
                  on account of shares**
              
              **Total
                  comprehensive income (loss)**
              
              **Total
                  shareholders' equity**Balance
                  as of January 1, 2004
              
              
              2,194,170
              
              
              40
              
              
              25,814
              
              
              -
              
              
              (18,242
              )
              
              -
              
              
              -
              
              
              7,612Deferred
                  stock compensation
              
              
              -
              
              
              -
              
              
              68
              
              
              (68
              )
              
              -
              
              
              -
              
              
              -
              
              
              -Conversion
                  of loan to ordinary shares, net
              
              
              10,201
              
              
              1
              
              
              24
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              25Issuance
                  of shares in a private placement, net
              
              
              685,001
              
              
              9
              
              
              2,451
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              2,460Exercise
                  of warrants
              
              
              120,176
              
              
              1
              
              
              737
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              738Receipt
                  on account of share to be allotted
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              143
              
              
              -
              
              
              143Amortization
                  of stock compensation
              
              
              -
              
              
              -
              
              
              -
              
              
              9
              
              
              -
              
              
              -
              
              
              -
              
              
              9Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (1,872
              )
              
              -
              
              $
              (1,872
              )
              
              (1,872
              )Total
                  comprehensive loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              (1,872
              )Balance
                  as of December 31, 2004
              
              
              3,009,548
              
              
              51
              
              
              29,094
              
              
              (59
              )
              
              (20,114
              )
              
              143
              
              
              -
              
              
              9,115Deferred
                  stock compensation
              
              
              -
              
              
              -
              
              
              11
              
              
              (11
              )
              
              
              
              
              -
              
              
              -
              
              
              -Issuance
                  of shares in a private placement, net
              
              
              685,485
              
              
              9
              
              
              2,047
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              2,056Exercise
                  of warrants and options
              
              
              112,134
              
              
              1
              
              
              550
              
              
              -
              
              
              -
              
              
              (129
              )
              
              -
              
              
              422Receipt
                  on account of shares to be allotted
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              550
              
              
              -
              
              
              550Amortization
                  of stock compensation
              
              
              -
              
              
              -
              
              
              -
              
              
              55
              
              
              -
              
              
              -
              
              
              -
              
              
              55Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (3,951
              )
              
              -
              
              $
              (3,951
              )
              
              (3,951
              )Total
                  comprehensive loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              (3,951
              )Balance
                  as of December 31, 2005
              
              
              3,807,167
              
              $
              61
              
              $
              31,702
              
              $
              (15
              )
              $
              (24,065
              )
              $
              564
              
              
              -
              
              $
              8,247Reclassification
                  upon adoption of SFAS 123(R)
              
              
              -
              
              
              -
              
              
              (15
              )
              
              15
              
              
              -
              
              
              -
              
              
              -Issuance
                  of shares in a private placement, net
              
              
              150,807
              
              
              2
              
              
              455
              
              
              -
              
              
              -
              
              
              (550
              )
              
              -
              
              
              (93
              )Exercise
                  of warrants and options
              
              
              43,152
              
              
              1
              
              
              105
              
              
              -
              
              
              -
              
              
              (14
              )
              
              -
              
              
              92Amounts
                  attributed to warrants issued in connection with convertible
                  bonds
              
              
              -
              
              
              -
              
              
              282
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              282Beneficial
                  conversion feature on convertible bonds
              
              
              -
              
              
              -
              
              
              632
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              632Stock
                  based compensation
              
              
              -
              
              
              -
              
              
              401
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              401Net
                  income
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              5,440
              
              
              -
              
              $
              5,440
              
              
              5,440Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              5,440Balance
                  as of December 31, 2006
              
              
              4,001,126
              
              $
              64
              
              $
              33,562
              
              $
              -
              
              $
              (18,625
              )
              $
              -
              
              
              
              
              $
              15,001




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




92




SUPERCOM
      LTD. AND ITS
      SUBSIDIARIES


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**





**U.S.
      dollars in thousands**




**Year
                  ended December 31,****2004**
              
              **2005**
              
              **2006**Cash
                  flows from operating activities:Net
                  Income (loss)
              
              $
              (1,872
              )
              $
              (3,951
              )
              $
              5,440Adjustments
                  to reconcile net income (loss) to net cash used in operating
                  activities:Depreciation
                  and amortization
              
              
              338
              
              
              772
              
              
              355Accrued
                  severance pay
              
              
              128
              
              
              52
              
              
              128Stock
                  based compensation
              
              
              9
              
              
              55
              
              
              361Decline
                  in market value below cost of marketable debt securities
              
              
              7
              
              
              -
              
              
              -Capital
                  gain from the sale of the e-ID Division
              
              
              -
              
              
              -
                  -
              
              
              (10,536
              )Amortization
                  of discount on convertible bonds
              
              
              -
              
              
              -
              
              
              30Amortization
                  of deferred charges
              
              
              -
              
              
              -
              
              
              6Write
                  down of loan regarding an investment in an affiliated
                  company
              
              
              -
              
              
              -
              
              
              275Decrease
                  (increase) in trade receivables
              
              
              (398
              )
              
              448
              
              
              (1,442
              )Decrease
                  (increase) in other accounts receivable and prepaid
                  expenses
              
              
              (403
              )
              
              517
              
              
              254Decrease
                  (Increase) in inventories
              
              
              814
              
              
              (40
              )
              
              212Increase
                  (decrease) in trade payables
              
              
              (31
              )
              
              (365
              )
              
              53Increase
                  (decrease) in employees and payroll accruals
              
              
              51
              
              
              (35
              )
              
              211Increase
                  (decrease) in accrued expenses and other liabilities
              
              
              747
              
              
              (407
              )
              
              1,586Loss
                  on sale of property and equipment
              
              
              1
              
              
              -
              
              
              8Exchange
                  differences on principle of long-term loan
              
              
              -
              
              
              -
              
              
              12Net
                  cash used in operating activities
              
              
              (609
              )
              
              (2,954
              )
              
              (3,047
              )Cash
                  flows from investing activities:Purchase
                  of property and equipment
              
              
              (1,087
              )
              
              (315
              )
              
              (93
              )Increase
                  in severance pay fund
              
              
              (95
              )
              
              (64
              )
              
              (95
              )Proceeds
                  from restricted cash deposits, net
              
              
              234
              
              
              41
              
              
              229Proceeds
                  from disposal of short term deposits, net
              
              
              344
              
              
              353
              
              
              -Proceeds
                  from (investment in) marketable securities
              
              
              110
              
              
              (650
              )
              
              650Amounts
                  carried to deferred charges
              
              
              -
              
              
              -
              
              
              (163
              )Cash
                  paid in respect of sale of the e-ID Division
              
              
              -
              
              
              -
              
              
              (52
              )Acquisition
                  of intangible assets
              
              
              (37
              )
              
              -
              
              
              -Net
                  cash provided by (used in) investing activities
              
              
              (531
              )
              
              (635
              )
              
              476Cash
                  flows from financing activities:Short-term
                  bank credit, net
              
              
              (1,122
              )
              
              120
              
              
              (307
              )Proceeds
                  from issuance of convertible bonds and warrants, net
              
              
              -
              
              
              -
              
              
              3,139Issuance
                  of share capital through a private placement, net of issuance
                  costs
              
              
              3,517
              
              
              2,539
              
              
              (183
              )Proceeds
                  from exercise of options and warrants, net
              
              
              84
              
              
              422
              
              
              92Long-term
                  loan received
              
              
              400
              
              
              500
              
              
              204Principal
                  repayment of long-term loan
              
              
              (574
              )
              
              (592
              )
              
              (224
              )Net
                  cash provided by financing activities
              
              
              2,305
              
              
              2,989
              
              
              2,721Increase
                  (decrease) in cash and cash equivalents
              
              
              1,165
              
              
              (600
              )
              
              150Cash
                  and cash equivalents at the beginning of the year
              
              
              1,729
              
              
              2,894
              
              
              2,294Cash
                  and cash equivalents at the end of the year
              
              $
              2,894
              
              $
              2,294
              
              $
              2,444




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




93




**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS (Cont.)**


**U.S.
      dollars in thousands**





**Year
                ended**
              **December
                31,****2004**
            
            **2005**
            
            **2006**Supplemental
                disclosure of cash flows information:Cash
                paid in respect of sale of the e-ID DivisionAssets
                and Liabilities of the division, at the date of sale:Working
                Capital, net
            
            
            -
            
            
            -
            
            
            2,073Fixed
                assets, net
            
            
            -
            
            
            -
            
            
            2,800Intangible
                assets
            
            
            -
            
            
            -
            
            
            47Fair
                value of marketable securities received as proceeds, net
            
            
            -
            
            
            -
            
            
            (15,508
            )Capital
                gain from the sale of the e-ID Division
            
            
            -
            
            
            -
            
            
            10,536-
            
            
            
            
            
            -
            
            
            (52
            )Cash
                paid during the year for:Interest
            
            $
            128
            
            $
            87
            
            $
            76Supplemental
                disclosure of non-cash investing and financing
                activities:Transfer
                of inventory to property and equipment
            
            $
            1,117
            
            $
            -
            
            $
            -Transfer
                of trade receivable to inventory
            
            $
            860
            
            $
            -
            
            $
            -Conversion
                of loan to ordinary shares
            
            $
            25
            
            $
            -
            
            $
            -Accrued
                issuance costs
            
            $
            176
            
            $
            109
            
            $
            19Issuance
                of warrants to service provider
            
            $
            -
            
            $
            -
            
            $
            40




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




94




**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands (except exercise price per share)**


**NOTE
                1:-**
            **GENERAL**





a.
            SuperComLtd. ("the Company") was established in 1988 in Israel. The Company’s
                ordinary shares have been listed for trade on the Euronext Brussels
                stock
                market, under the symbol “SUP”, since October 23, 2003. Since November 5,
                2004, the Company’s ordinary shares have also traded on the OTC Bulletin
                Board under the symbol "SPCBF.OB".





The
                Company develops and markets incident response management and assets
                tracking solutions for public safety agencies, commercial customers
                and
                governmental organizations. The Company offers two principal products
                to
                its customers, both of which were developed recently: SmartDSMS,
                an
                incident response management system, or IRMS, used to facilitate
                the
                authentication and flow of on-site personnel in disaster recovery
                operations, including policy, fire and emergency medical service
                departments and other governmental agencies complying with U.S. Department
                of Homeland Security requirements, and the PureRF Suite, an active
                radio
                frequency, or active RF, system that utilizes bi-directional radio
                frequency communications to track people and objects for potential
                governmental agency and commercial customers. Regarding the e-ID
                activity
                after the closing of the sale of the e-ID Division to OTI, see
                below.





The
      Company sells its products through centralized marketing offices in different
      regions of the world. The Company has two wholly-owned marketing subsidiaries:
      SuperCom Asia Pacific Limited in Hong Kong and Supercom Inc. in the United
      States. Supercom Inc., was established by the Company in 2003.




During
      the fourth quarter of 2005, the Company established a new subsidiary (80%),
      Pure
      RF Inc., (incorporated in Delaware) which began operations during the first
      quarter of 2006. During the first quarter of 2006 Pure RF Inc established Pure
      RF Ltd (100%) (Incorporated and operating in Israel), and focuses on new
      technology and solutions for active tracking of people and objects. During
      February 2007, the Company purchased the remaining 20% from the minority for
      an
      amount of $100.




During
      the fourth quarter of 2006, the Company established a new wholly-owned
      subsidiary, S.B.C. Aviation Ltd., (incorporated in Israel) which will commence
      operations in 2007, and will focus on executing information technology and
      security projects.




95




**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                1:-**
            **GENERAL
                (Cont.)**





On
      November 8, 2006, the Company announced that it had entered into an agreement
      with On Track Innovations Ltd. ("OTI") (NASDAQ: OTIV ),
      under
      which OTI agreed to acquire the assets of the Company’s e-ID Division
      (including, inventory, fixed assets and intangible assets) for consideration
      consisting of 2,827,200 restricted ordinary shares of OTI. The transaction
      was
      completed on December 31, 2006. At the closing, the parties entered into a
      service and supply agreement pursuant to which the Company agreed to continue
      to
      provide services and receive revenues under certain existing ID and e-ID
      contracts for governmental and commercial projects in Europe, Asia and Africa.
      OTI will serve as a subcontractor for these projects. The 2,827,200 ordinary
      shares issued to the Company are subject to a lock-up agreement, where
      one-seventh of the shares (403,885 ordinary shares) will be released from the
      lock-up restrictions every three months beginning on the closing date, December
      31, 2006, for an aggregate period of eighteen months. The Company executed
      an
      irrevocable proxy appointing an OTI person, to vote the 2,827,200 ordinary
      shares issued to the Company in connection with the transaction. Under the
      terms
      of the Agreement, OTI committed to file with the SEC a registration statement
      covering these ordinary shares no later than the Filing Deadline, as defined
      in
      the Agreement. If such registration statement is not filed with the SEC by
      the
      Filing Date, OTI will be subject to Liquidated Damages, as detailed in the
      Agreement. As a result of the sale of the e-ID Division, the Company recognized
      $10,536 as a capital gain on the sale of the e-ID Division in fiscal year
      2006.




The
      capital gain was calculated based on OTI’s share price on the closing date, less
      a discount due to the lock up restrictions of the shares (based on an
      independent appraisal), the carrying value of the assets that were transferred
      to OTI and direct expenses (in an amount of $1,550) associated with the
      sale.




The
      direct expenses included, inter alia, the fair value of 212,040 shares out
      of
      the shares received by the Company from OTI that will be transferred to
      consultants, as a finder and legal fee, in connection with the transaction
      (The
      investment of the Company in OTI’s shares includes the shares held by the
      Company, net of the shares that will be transferred to the
      consultants).




As
      a
      result of the transaction the Company terminated the employment of certain
      employees that were employed by the Company in the e-ID Division.




In
      connection with the completion of the sale, during January 2007, a $2,500 loan
      was extended to the Company by a financial institution. In order to secure
      this
      loan the Company deposited OTI shares in favor of the financial institution.
      See
      Note 18b.




Regarding
      indemnity to OTI, see Note 10b4.





b.
            Concentration
                of risk that may have a significant impact on the
                Company:





The
      Company derives most of its revenues from several major customers. (As of
      December 31, 2006, an amount of $2,019 out of the $2,625 trade receivables
      balance consists of one customer) See also Note 15c.





The
      Company purchases certain raw materials used in its products from a sole
      supplier. Although there are only a limited number of manufacturers of those
      particular raw materials, management believes that other suppliers could provide
      similar raw materials on comparable terms without affecting operating
      results.





Profitability
      of the Company’s investment in OTI’s ordinary shares will depend on the share
      price and the ability to sell the OTI ordinary shares. See Note 1a above.




96




**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**




**NOTE
                1:-**
            **GENERAL
                (Cont.)**





c.
            On
                November 21, 2006 the Company announced that it had raised $3,156.5
                through the issuance of Units consisting of Convertible Bonds and
                Warrants. See Note 12





**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES**





The
                consolidated financial statements have been prepared in accordance
                with
                accounting principles generally accepted in the United States.





a.
            Use
                of estimates:





The
                preparation of financial statements in conformity with generally
                accepted
                accounting principles requires management to make estimates and
                assumptions that affect the amounts reported in the financial statements
                and accompanying notes. Actual results could differ from those
                estimates.





b.
            Financial
                statements in U.S. dollars:





Most
      of
      the revenues of the Company and its subsidiaries are received in U.S. dollars.
      In addition, a substantial portion of the costs of the Company and its
      subsidiaries are incurred in U.S. dollars. Therefore, management believes that
      the dollar is the currency of the primary economic environment in which the
      Company and its subsidiaries operate. Thus, the functional and reporting
      currency of the Company and its subsidiaries is the U.S. dollar.





Accordingly,
      monetary accounts maintained in currencies other than the U.S. dollar are
      re-measured into U.S. dollars in accordance with Statement No. 52 of the
      Financial Accounting Standards Board ("FASB") "Foreign Currency Translation"
      (“SFAS No. 52”). All transaction gains and losses from the re-measurement of
      monetary balance sheet items are reflected in the statements of operations
      as
      financial income or financial expense as appropriate.




c.
            Principles
                of consolidation:





The
      consolidated financial statements include the accounts of the Company and its
      subsidiaries (unless the minority shareholders have certain approval or veto
      rights) in Israel, the United States and Hong-Kong. Material intercompany
      transactions and balances were eliminated upon consolidation. Material profits
      from intercompany sales, not yet realized outside the group, were also
      eliminated.





d.
            Cash
                equivalents:





The
      Company considers unrestricted short-term highly liquid investments originally
      purchased with maturities of three months or less to be cash
      equivalents.





e.
            Restricted
                cash deposits:





Restricted
      cash is invested in certificates of deposit, which mature within one year,
      and
      is used to secure agreements with customers or banks.




97




**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





f.
            Marketable
                securities:





The
      Company accounts for investments in marketable securities
      in accordance with Statement of Financial Accounting Standard No. 115,
      "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No.
      115"). Management determines the appropriate classification of its investments
      in marketable securities
      and commercial paper at the time of purchase and reevaluates such determinations
      at each balance sheet date.


As
      of
      December 31, 2005, all securities covered by SFAS No. 115 were designated by
      management as trading securities.





Trading
      securities are stated at market value. The changes in market value are carried
      to financial income or expenses.





Trading
      gains for the years 2005 and 2006 amounted to approximately $15 and $3,
      respectively, in respect of trading securities held by the Company in the
      reporting periods. All securities designated as trading securities were sold
      during 2006.





The
      entire balance of marketable securities as of December 31, 2006, consists of
      marketable securities received in connection with the OTI transaction. Such
      securities which are not considered restricted according to the provisions
      of
      SFAS No. 115, were classified as available-for-sale and are stated at fair
      value, with unrealized gains and losses reported in accumulated other
      comprehensive income in a separate component of shareholders’ equity, net of
      taxes. Realized gains and losses on the sale of such securities, as determined
      on a specific identified basis, are included in the consolidated statement
      of
      operations. Since all OTI securities were received by the Company on December
      31, 2006, no unrealized gains or losses were recognized during fiscal
      2006.




Marketable
      securities of OTI that are considered to be restricted, because the sale of
      such
      securities is prohibited for a period longer than 12 months, are accounted
      at
      cost net of write down for any permanent decrease in value. These securities
      are
      presented in the balance sheets as “Investment in restricted marketable
      securities of other company. See Note 1a.





g.
            Allowance
                for doubtful accounts:





The
      allowance for doubtful accounts is determined with respect to specific amounts
      the Company has determined to be doubtful of collection. In determining the
      allowance for doubtful accounts, the Company considers, among other things,
      its
      past experience with such customers and the information available regarding
      such
      customers.





h.
            Inventories:





Inventories
      are stated at the lower of cost or market value. Inventory write-offs are mainly
      provided to cover risks arising from slow-moving items or technological
      obsolescence. Cost is determined as follows:





Raw
      materials, parts and supplies - using the moving "average cost"
      method.





Work-in-progress
      and finished products - on the basis of direct manufacturing costs, with the
      addition of allocable, indirect manufacturing costs.




98




**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**




**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





i.
            Investment
                in an affiliated company and a certain majority owned
                subsidiary:





The
      investment in an affiliated company, over which the Company can exercise
      significant influence over operating and financial policies of the investee
      (generally, entities in which the Company holds 20% to 50% of ownership or
      voting rights), is presented using the equity method of accounting in accordance
      with Accounting Principle Bulletin No. 18, “The Equity Method of Accounting for
      Investments in Common Stock”.





The
      investment in a certain majority-owned company is presented using the equity
      method of accounting due to substantive participation rights held by the
      minority, which impact the Company’s ability to exert control over the
      subsidiary. See Note 5.





j.
            Property
                and equipment:





Property
      and equipment (including self construction equipment) are stated at cost, net
      of
      accumulated depreciation.




Self-construction
      equipment costs represent the incremental direct costs that are identifiable
      with, and related to, the construction and installation of the equipment and
      that are necessary to get it ready for its intended use. These costs include
      amounts paid to outside contractors and payroll-related costs of employees
      that
      are engaged in the construction and installation of the equipment.




Depreciation
      is computed using the straight-line method, over the estimated useful lives,
      at
      the following annual rates:





%Computers
                and peripheral equipment
            
            
            33Machinery
                and peripheral equipment
            
            
            6
                - 20Office
                furniture and equipment
            
            
            6
                - 15Leasehold
                improvements
            
            
            Over
                the shorter of the term of the lease or the life of the
                asset




k.
            Impairment
                of long-lived assets and intangible
                assets:





The
      Company's long-lived assets and certain identifiable intangible assets are
      reviewed for impairment in accordance with Statement of Financial Accounting
      Standard No. 144, "Accounting for the Impairment or Disposal of Long-Lived
      Assets" ("SFAS No. 144") 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
      asset. If such asset is considered to be impaired, the impairment to be
      recognized is measured by the amount by which the carrying amount of the asset
      exceeds the fair value of the asset. Assets to be disposed of by sale are
      reported at the lower of the carrying amount or fair value less costs to sell.




99




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





l.
            Beneficial
                conversion feature:





The
      Company applies Emerging Issues Task Force Issue No. 00-27
      (EITF 00-27). “Application of EITF Issue No. 98-5, Accounting for
      Convertible Securities with Beneficial Conversion Features or Contingency
      Adjustable Conversion Ratios, to Certain Convertible Instruments,” which is
      effective for all such instruments. This EITF Issue clarified the accounting
      for
      instruments with beneficial conversion features or contingency adjustable
      conversion ratios.





The
      beneficial conversion feature has been calculated by allocating the proceeds
      received in financing transactions to the convertible instrument and to any
      detachable warrants included in the transaction, and by measuring their
      intrinsic value based on the effective conversion price as a result of the
      allocated proceeds.





The
      amount of the beneficial conversion feature with respect to convertible bonds
      was recorded as a discount on the convertible bonds with a corresponding amount
      credited directly to shareholders’ equity as additional paid in capital. After
      initial recognition the discount on the convertible bonds is amortized as
      interest expenses over the term of the bonds (3 years).





m.
            Long-term
                trade receivables:





Long-term
      receivables represent amounts expected to be collected 12 months or more after
      the balance sheet date. Such amounts are initially recorded at fair value
      (present value of the face amount to be received). The difference between the
      present value and the face amount are treated as a discount and amortized as
      interest expense over the life of the receivables.





n.
            Issuance
                costs of convertible bonds - deferred
                charges:





Costs
      incurred in respect of obtaining financing through issuance of convertible
      bonds
      are deferred and expensed as financing expenses over the contractual life of
      the
      bonds (3 years).





o.
            Accrued
                severance pay:





The
      liabilities of the Company for severance pay are 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 portion thereof.
      The Company's liability for all its employees is fully covered by monthly
      deposits with severance pay funds, insurance policies and by an accrual. The
      value of these policies is presented as an asset on the Company's balance
      sheet.





The
      deposited funds include accrued income up to the balance sheet date. The
      deposited funds may be withdrawn only upon the fulfillment of the Company’s
      obligation pursuant to Israel's Severance Pay Law or labor agreements. The
      value
      of the deposited funds is based on the cash surrender value of these policies
      and includes immaterial profits.


100




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





Severance
      expenses for the years ended December 31, 2004, 2005 and 2006 amounted to $151,
      $115 and $ 159, respectively.





As
      of
      December 31, 2006, the severance pay balance and fund relating to employees
      whose employment was terminated due to the OTI transaction, were presented
      as a
      current liability and a current asset, as applicable.





p.
            Intangible
                assets:





Intangible
      assets, are amortized over their useful lives using a method of amortization
      that reflects the pattern in which the economic benefits of the intangible
      assets are consumed or otherwise used up, in accordance with SFAS No. 142,
      “Goodwill and Other Intangible Assets.





q.
            Revenue
                recognition:





The
      Company and its subsidiaries generate their revenues from the sale of products,
      maintenance, training and installation. The sale of products involves the sale
      of the Smartcard System, IRMS system and raw materials. The Company sells its
      products through centralized marketing offices in different regions of the
      world.





Product
      sales of smartcard systems, contactless smart card Production Line 1000 (SPPL
      1000) IRMS system and raw materials are recognized in accordance with Staff
      Accounting Bulletin No. 104, “Revenue Recognition” (“SAB No. 104”),
      when persuasive evidence of an agreement exists, delivery of the product has
      occurred, the fee is fixed or determinable, collectability is probable, and
      inconsequential or perfunctory performance obligations remain. If the product
      requires specific customer acceptance, revenue is deferred until customer
      acceptance occurs or the acceptance provision lapses.




The
      Company does not provide a right of return to its customers.





Based
      on
      past experience, the Company does not provide for warranty costs when revenue
      is
      recognized.





The
      Company applied the provisions of EITF Issue No. 00-21 “Revenue Arrangements
      with Multiple Deliverables” for multiple element arrangements entered into after
      June 15, 2003. EITF Issue No. 00-21 provides guidance on how to account for
      arrangements that involve the delivery or performance of multiple products,
      services and/or rights to use assets. For such arrangements, each element of
      the
      contract is accounted for as a separate unit when it provides the customer
      value
      on a stand-alone basis and there is objective evidence of the fair value of
      the
      related unit.





Maintenance
      and support revenues included in multiple-element arrangements are deferred
      and
      recognized on a straight-line basis over the term of the maintenance and support
      agreement. For these multiple element arrangements, the Company accounts for
      each unit of the contract (maintenance, support and services) as a separate
      unit, when each unit provides value to the customer on a stand-alone basis
      and
      there is objective evidence of the fair value of the stand-alone unit.


101




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





The
      Company is entitled to royalties upon sales of smartcard systems. Such royalties
      are recognized when the sales are reported to the Company (mainly on a monthly
      basis).





Deferred
      revenues and customer advances include amounts received from customers for
      which
      revenues have not been recognized.





The
      Company recognizes certain long-term contract revenues, in accordance with
      Statement of Position (“SOP”) 81-1, “Accounting for Performance of
      Construction-Type and Certain Production Type Contracts”.




Pursuant
      to SOP 81-1, revenues from these contracts are recognized under the percentage
      of completion method. The Company measures the percentage of completion based
      on
      output or input criteria, such as contract milestones or number of units
      shipped, as stipulated in each contract.




Provisions
      for estimated losses on uncompleted contracts are made during the period in
      which such losses are first identified, in the amount of the estimated loss
      on
      the entire contract. As of December 31, 2006, no such estimated losses were
      identified.




The
      Company believes that the use of the percentage of completion method is
      appropriate, as the Company has the ability to make reasonably dependable
      estimates of the extent of progress towards completion, contract revenues and
      contract costs. In addition, contracts executed include provisions that clearly
      specify the enforceable rights of the parties to the contract, the consideration
      to be exchanged and the manner and terms of settlement. In all cases, the
      Company expects to perform its contractual obligations and the parties are
      expected to satisfy their obligations under the contract.




In
      contracts that do not meet all the conditions mentioned above, the Company
      utilizes zero estimates of profits; equal amounts of revenue and cost are
      recognized until results can be estimated with sufficient accuracy.




Revenues
      and costs recognized pursuant to SOP 81-1 on contracts in progress are subject
      to management estimates. Actual results could differ from these
      estimates.





The
      Company derives its revenues mainly from sale of hardware products that include
      embedded software that management considers to be incidental. Such revenues
      are
      recognized in accordance with SAB No. 104, as mentioned above.





However,
      in limited circumstances, the Company provides software upgrades in respect
      of
      the embedded software of hardware products sold to its customers in the past.
      Such revenues are recognized when all criteria outlined in Statement of Position
      No. 97-2 “Software Revenue Recognition” (“SOP No. 97-2”) (as amended) are met:
      when persuasive evidence of an agreement exists, delivery of the product has
      occurred (i.e. the services have been provided), no significant obligations
      under the agreement remain, the fee is fixed or determinable and collectability
      is probable.


102




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





r.
            Shipping
                and handling costs:




Shipping
      and handling fees billed to customers are reflected as revenues while the
      related shipping and handling costs are included in cost of revenues. To date,
      shipping and handling costs have not been material.





s.
            Research
                and development costs:





Research
      and development costs are expensed as incurred.





Research
      and development costs incurred in the process of software production before
      establishment of technological feasibility, are charged to expenses as incurred.
      Costs of the production of a product master incurred subsequent to the
      establishment of technological feasibility are capitalized according to the
      principles set forth in SFAS No. 86, "Accounting for the Costs of Computer
      Software to be Sold, Leased or Otherwise Marketed". Based
      on
      the Company's product development process, technological feasibility is
      established upon completion of a detailed program design or a working
      model.





Capitalized
      software development costs are amortized on a product-by-product basis
      commencing with general product release by the greater of the amount computed
      using: (i) the ratio that current gross revenues from sales of the software
      product bear to the total of current and anticipated future gross revenues
      from
      sales of that software, or (ii) the straight-line method over the estimated
      useful life of the software product (three years).





t.
            Income
                taxes:





The
      Company and its subsidiaries account for income taxes in accordance with
      Statement of Financial Accounting Standard (SFAS) 109, "Accounting for Income
      Taxes". This Statement prescribes the use of the liability method whereby
      deferred tax asset and liability account balances are determined based on
      differences between the 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 and its
      subsidiaries provide a valuation allowance, if necessary, to reduce deferred
      tax
      assets to their estimated realizable value.





u.
            Concentrations
                of credit risk:





Financial
      instruments that potentially subject the Company to concentrations of credit
      risk consist principally of cash and cash equivalents, restricted cash deposits,
      marketable securities and trade receivables. The Company's trade receivables
      are
      derived from sales to customers located primarily in Europe (including Eastern
      Europe), Asia Pacific, Africa, the United States and Israel. The Company
      performs ongoing credit evaluations of its customers' financial conditions.
      The
      allowance for doubtful accounts is determined with respect to specific debts
      that the Company has determined to be doubtful of collection. See Note 2g
      above.


103




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





Cash
      and
      cash equivalents, restricted cash deposits and marketable securities are
      deposited with major banks in Israel, Hong-Kong and the United States.
      Management believes that the financial institutions are financially sound and,
      accordingly, minimal credit risk exists with respect to these financial
      instruments.





Regarding
      marketable securities received in connection with the OTI transaction. See
      Note
      1b.





The
      Company has no significant off-balance-sheet concentration of credit risk,
      such
      as foreign exchange contracts, option contracts or other foreign hedging
      arrangements. See Note 8a regarding bank credit denominated in currencies other
      than U.S. dollars.





v.
            Basic
                and diluted earnings (loss) per
                share:





Basic
      earnings (loss) per share are computed based on the weighted average number
      of
      ordinary shares outstanding during each year. Diluted earnings (loss) per share
      are computed based on the weighted average number of ordinary shares outstanding
      during each year, plus the dilutive potential of stock options and warrants
      outstanding during the year using the treasury stock method and the dilutive
      potential of convertible bonds using the “if-converted method”, in accordance
      with FASB Statement No. 128, "Earnings Per Share".





The
      net
      income (loss) and the weighted average number of shares used in computing basic
      and diluted earning per share for the reported periods are as follows:





Year
                ended December 31,2004
            
            2005
            
            2006Net
                income (loss) used for the computation of basic earnings per
                share
            
            
            (1,872
            )
            
            (3,951
            )
            
            5,440Interest
                expenses on convertible bond
            
            
            -
            
            
            -
            
            
            75Net
                income (loss) used for the computation diluted earnings per
                share
            
            
            (1,872
            )
            
            (3,951
            )
            
            5,515





Year
                ended December 31,2004
            
            2005
            
            2006Weighted
                average number of shares used in the computation of basic earnings
                per
                share
            
            
            2,480,361
            
            
            3,155,872
            
            
            3,969,212Add:Additional
                shares from the assumed exercise of employee stock options and warrants,
                net
            
            
            -
            
            
            -
            
            
            164,016Weighted
                average number of additional shares issued upon the assumed conversion
                of
                convertible bonds
            
            
            -
            
            
            -
            
            
            79,563Weighted
                average number of shares used in the computation of diluted earnings
                per
                share
            
            
            2,480,361
            
            
            3,155,872
            
            
            4,212,791




104


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





All
      outstanding stock options and warrants have been excluded from the calculation
      of the diluted net loss per share for the years ended December 2004 and 2005
      since the Company reported losses for those years




The
      number of options and warrants that have been excluded from the calculation
      were
      864,071, 1,121,083 and 795,279 for the years ended December 31, 2004, 2005
      and
      2006.





w.
            Fair
                value of financial instruments:





The
      following methods and assumptions were used by the Company and its subsidiaries
      in determining their fair value disclosures for financial
      instruments:





At
      December 31, 2006 and 2005, the carrying amounts of cash and cash equivalents,
      restricted cash deposits, m arketable
      securities current
      trade receivables, other accounts receivable, trade payables, short-term bank
      credit and other accounts payable approximate their fair value due to the
      short-term maturity of such instruments. The fair value of marketable securities
      is generally based on quoted market prices. Regarding the fair value of
      marketable securities received from the OTI transaction, see Notes 2f and
      1a.





The
      carrying value of convertible bonds, does not approximate their fair value,
      since the proceeds received in respect to the issuance of these bonds was
      allocated to the convertible bonds and to the detachable warrants that were
      included in that issuance. In addition the carrying value of the convertible
      bonds was reduced in order to reflect the beneficial conversion feature, in
      accordance with the provisions of EITF 00-27. See also Note 2l.





x.
            Accounting
                for stock-based compensation:




Until
      December 31, 2005, the Company accounted for its employee stock option
      plans using the intrinsic value based method of accounting prescribed by
      APB 25, “Accounting for Stock Issued to Employees” and related
      interpretations.  Accordingly, the compensation cost relating to stock
      options, measured as the excess of the fair value of the underlying stock over
      the exercise price on the date of grant, if any, was charged on the date of
      grant of such options, to shareholders’ equity, under deferred compensation, and
      was thereafter amortized by the straight-line method and charged against income
      over the vesting period.




The
      Company applied SFAS No. 123 and Emerging Issue Task Force (“EITF”)
      No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than
      Employees for Acquiring, or in Conjunction with Selling, Goods or Services” with
      respect to options issued to non-employees.




105




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





In
      December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” (SFAS 123R),
      a revision of SFAS No. 123, “Accounting for Stock Based Compensation (SFAS 123).
      Among other things, SFAS 123R eliminates the use of APB 25 and the intrinsic
      value method of accounting, and requires companies to recognize in their
      financial statements, the cost of employee services received in exchange for
      awards of equity instruments, based on the fair value of those awards at the
      grant date. The effective date of SFAS 123R is the first reporting fiscal year
      period beginning after June 15, 2005, which is the first quarter 2006 for the
      Company.





SFAS
      123R
      allowed companies to adopt its requirements using either a “modified
      prospective” method, or a “modified retrospective” method. Under the “modified
      prospective” method, compensation cost is recognized in the financial statements
      beginning with the effective date, based on the requirements of SFAS 123R for
      all share-based payments granted after that date, and based on the requirements
      of SFAS 123 for all unvested awards granted prior to the effective date of
      SFAS
      123R. Under the “modified retrospective” method, the requirements are the same
      as under the “modified prospective” method, except that it permits entities to
      restate financial statements of previous periods based on pro forma disclosures
      made in accordance with SFAS 123.





In
      March
      2005, the SEC issued Staff Accounting Bulletin 107 (“SAB 107”). In particular,
      SAB 107 provides supplemental implementation guidance on SFAS 123R, including
      guidance on valuation methods, classification of compensation expense, inventory
      capitalization of share-based compensation cost, income statement effects,
      disclosures and several other issues.





On
      January 1, 2006, the Company adopted FAS 123R (and the relevant principles
      of
      SAB 107) using the modified prospective method, as permitted under
      FAS 123R.  Accordingly, prior period amounts have not been restated.
      Under this method, the Company is required to record compensation expense for
      all awards granted after the date of adoption and for the unvested portion
      of
      previously granted awards that remain outstanding at the date of
      adoption.





As
      a
      result of adopting SFAS123(R), the Company’s net income for 2006 is $216 less,
      than if it had continued to account for share-based compensation under APB
      25.
      Upon adoption of SFAS 123(R), the remaining balance of the Additional Paid-In
      Capital and the offsetting amount in Deferred Stock-Based Compensation ($15),
      that are both reflected in shareholders’ equity at December 31, 2005, were
      reversed, as required by SFAS123 (R). There was no net effect on total
      shareholders’ equity.


106




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**





The
      following table summarizes relevant information for the years ended December
      31,
      2004 and 2005 (prior to the adoption of SFAS 123R), under the Company's
      intrinsic value method of accounting for stock awards, with supplemental
      information as if the fair value recognition provisions of SFAS No. 123 had
      been
      applied:





Pro
      forma
      information under SFAS 123:




**Year
                ended December 31,****2004**
            
            **2005**Net
                loss as reported
            
            $
            (1,872
            )
            $
            (3,951
            )Stock
                based compensation expensesdetermined
                under fair value based method
            
            
            (766
            )
            
            (1,475
            )Stock
                based compensation expenses included in reported net loss
            
            
            9
            
            
            55Pro
                forma net loss
            
            $
            (2,629
            )
            $
            (5,371
            )Basic
                and diluted net loss per share as reported
            
            $
            (0.75
            )
            $
            (1.25
            )Pro
                forma basic and diluted net loss
            
            $
            (1.06
            )
            $
            (1.70
            )





The
      fair
      value of these options is amortized over their vesting period and estimated
      at
      the date of grant using a Black-Scholes option pricing model with the following
      weighted-average assumptions for 2004 and 2005: risk-free interest rates of
      4.2%
      and 3.68%, respectively, with a dividend yield of 0% for each year, volatility
      factors of the expected market price of the Company's ordinary shares of 113.9%
      and 101.9%, respectively, and a weighted-average expected life of the option
      of
      five years for each year.





y.
            Advertising
                costs:





The
      Company expenses advertising costs as incurred. Advertising expenses for the
      years ended December 31, 2004, 2005 and 2006, were approximately $ 10,
      $ 21 and $ 18, respectively.





z.
            Comprehensive
                Income:





The
      Company has no comprehensive income components other than net income (loss)
      in
      the reporting periods.





z.a.
            Recently
                issued accounting pronouncements:





FAS
      155
“accounting for certain Hybrid Financial Instruments”




In
      February 2006, the FASB issued FAS 155, Accounting for Certain Hybrid Financial
      Instruments, an amendment of FASB Statements No. 133 and 140. This Statement
      permits fair value measurement for any hybrid financial instrument that contains
      an embedded derivative that otherwise would require bifurcation.




This
      Statement becomes effective for all financial instruments acquired or issued,
      or
      subject to a re-measurement (new basis) after the beginning of an entity’s first
      fiscal year that begins after September 15, 2006. Earlier adoption is permitted
      as of the beginning of an entity’s fiscal year, provided that no interim period
      financial statements have been issued for the financial year.


107




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                2:-**
            **SIGNIFICANT
                ACCOUNTING POLICIES
                (Cont.)**




Management
      is currently evaluating the impact of this Statement, if any, on the Company’s
      financial statements or its results of operations.





In
      June
      2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for
      Uncertainty in Income Taxes.” FIN 48 prescribes detailed guidance for the
      financial statement recognition, measurement and disclosure of uncertain tax
      positions recognized in an enterprise’s financial statements in accordance with
      FASB Statement No. 109, “Accounting for Income Taxes.” Tax positions must meet a
      more-likely -than- not recognition threshold at the effective date to be
      recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 is
      effective for fiscal years beginning after December 15, 2006 and the provisions
      of FIN 48 will be applied to all tax positions upon initial adoption of the
      Interpretation. The cumulative effect of applying the provisions of this
      Interpretation will be reported as an adjustment to the opening balance of
      retained earnings upon adoption.




The
      Company has not yet determined the impact, if any, that the adoption of FIN
      48
      will have on its financial position and results of operations.





In
      September 2006, the FASB issued FAS No. 157, "Fair Value
      Measurements". This Statement clarifies the definition of fair value,
      establishes a framework for measuring fair value, and expands the disclosures
      on
      fair value measurements. FAS No. 157 is effective for fiscal years
      beginning after November 15, 2007, and interim periods within those fiscal
      years.




The
      Company has not determined the impact, if any, the adoption of this Statement
      will have on its financial position and results of operations.




In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108,
“Considering the Effects of Prior Year Misstatements when Quantifying
      Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108
      provides interpretive guidance on the SEC’s views regarding the process of
      quantifying materiality of financial statement misstatements. SAB 108 was
      effective as of the year beginning January 1, 2006. The implementation of SAB
      108 had no impact on the Company’s consolidated financial
      statements.





In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option
      for Financial Assets and Financial Liabilities - Including an Amendment of
      FASB
      Statement No. 115” (“SFAS No. 159”). This pronouncement permits all
      entities to elect, at specified election dates, to measure eligible financial
      instruments at fair value. An entity shall report unrealized gains and losses
      on
      items for which the fair value option has been elected in earnings at each
      subsequent reporting date, and recognize upfront costs and fees related to
      those
      items in earnings as incurred and not deferred. SFAS No. 159 applies to
      fiscal years beginning after November 15, 2007, with early adoption
      permitted for an entity that has also elected to apply the provisions of SFAS
      No. 157. An entity is prohibited from retrospectively applying SFAS
      No. 159, unless it chooses early adoption. The Company is currently
      assessing the impact of SFAS No. 159 on its consolidated financial position
      and results of operations.




108




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
              3:-**
            **OTHER
                ACCOUNTS RECEIVABLE AND PREPAID
                EXPENSES**





**December
                31,****2005**
            
            **2006**Prepaid
                expenses
            
            $
            428
            
            $
            178Government
                authorities
            
            
            96
            
            
            74Advance
                payment to suppliers
            
            
            86
            
            
            16Severance
                pay fund - current (*)
            
            
            -
            
            
            348Others
            
            
            123
            
            
            101$
            733
            
            $
            717





(*)
      The
      severance pay fund related to employees that were employed in the e-ID Division.
      See Note 1a.




**NOTE
              4:-**
            **INVENTORIES**





**December
                31,****2005**
            
            **2006**Raw
                materials, parts and supplies
            
            $
            1,632
            
            $
            270Finished
                products
            
            
            573
            
            
            -$
            2,205
            
            $
            270





During
      2005, due to developments, as more fully described in Note 10c1, the Company
      wrote-off inventory in an amount of $287.





On
      December 31, 2006, as part of the sale of the e-ID Division to OTI, all
      inventory related to the Division was transferred to OTI. See Note
      1a.




**NOTE
                5:-**
            **INVESTMENT
                IN AFFILIATED COMPANY AND
                OTHERS**





a.
            During
                2004, the Company sold its entire holding (40%) in an affiliated
                company
                for an amount of $0.001. The affiliated company served as a regional
                office responsible for marketing in the former Soviet territories
                (excluding the Ukraine and Moldova). During 2003, the affiliated
                company
                downsized all of its operations, and the Company decided to write-off
                its
                entire investment in that company in an amount of approximately $48.





b.
            In
                December 1997, the Company established SuperComSlovakia
                , owned equally with another unrelated investor, in order to execute
                a
                transaction with the Ministry of Interior of the Slovak
                Republic.


109




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                5:-**
            **INVESTMENT
                IN AFFILIATED COMPANY AND OTHERS
                (Cont.)**





In
      March
      2000, the Company purchased an additional 16% of SuperCom  Slovakia,
      at a nominal value of $1, and granted such unrelated investor a loan in an
      amount of $275, bearing interest of 0.7% per month, for any amounts outstanding.
      Interest is compounded on the outstanding principal balance of the loan and
      is
      to be repaid under the same conditions as the outstanding principal
      balance.





The
      unrelated investor has an option to buy back 16% of the shares, for $1, upon
      repayment of the loan to the Company.





The
      Company currently owns 66% of SuperCom  Slovakia's
      outstanding shares. The Company has accounted for this investment using the
      equity method of accounting, due to the substantive participation rights held
      by
      the minority, which
      impacts the Company’s ability to exert control over the subsidiary .


During
      the fourth quarter of 2006, the Company wrote down the investment in an
      affiliate due to litigation developments regarding this subject and, due to
      low
      probability of collection. See Note 10c2.





**NOTE
                6:-**
            **PROPERTY
                AND EQUIPMENT**





**December
                31,****2005**
            
            **2006**Cost:Computers
                and peripheral equipment
            
            $
            1,055
            
            $
            300Machinery
                and peripheral equipment
            
            
            3,575
            
            
            -Office
                furniture and equipment
            
            
            487
            
            
            211Leasehold
                improvements
            
            
            131
            
            
            755,248
            
            
            586Accumulated
                depreciation:Computers
                and peripheral equipment
            
            
            971
            
            
            259Machinery
                and peripheral equipment
            
            
            745
            
            
            -Office
                furniture and equipment
            
            
            245
            
            
            92Leasehold
                improvements
            
            
            77
            
            
            752,038
            
            
            426Depreciated
                cost
            
            $
            3,210
            
            $
            160





Depreciation
      expenses for the years ended December 31, 2004, 2005 and 2006, were $ 238,
      $ 746
      (including write down of leasehold improvements, See below) and $ 335,
      respectively.





During
      fiscal 2005, the Company relocated its offices. As a result, the Company wrote
      down the unamortized balance of leasehold improvement in the amount of $471.
      This expense was recorded in the statement of operations as part of
“Restructuring expenses”.





On
      December 31, 2006, as part of the sale of the e-ID Division to OTI, all property
      and equipment related to the Division were transferred to OTI. See Note
      1a.




110
 
 **SUPERCOM
          LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
          dollars in thousands**


**NOTE
                7:-**
            **INTANGIBLE
                ASSETS AND DEFERRED
                CHARGES**





On
      November 17, 2003, the Company purchased 20% of the remaining shares of
      SuperCom  Asia
      Pacific from the minority shareholder for $ 70. The acquisition was accounted
      for under the purchase method of accounting. Accordingly, the consideration
      of $
      70 was attributed to customer-related intangible assets that will be amortized
      based on their estimated useful life which, according to management, was
      determined to be five years.





The
      deferred charges were incurred in respect of issuance of convertible bonds
      during 2006. See Note 12





**December
                31,****2005**
            
            **2006**Deferred
                charges
            
            $
            -
            
            $
            197Customer-related
                intangible assets
            
            
            42
            
            
            -Patent
                - registration expenses
            
            
            25
            
            
            -$
            67
            
            $
            197





Amortization
      of intangible assets amounted to $ 100, $ 26 and $ 20 for the years ended
      December 2004, 2005 and 2006, respectively.





On
      December 31, 2006, as part of the sale of the e **-** ID
      Division to OTI, all the intangible assets related to the Division were
      transferred to OTI. See Note 1a.





**NOTE
                8:-**
            **BANK
                CREDIT**





a.
            As
                of December 31, 2006, the Company had credit lines from several banks
                in
                an aggregate amount of $ 830 including long-term loans (from time to
                time the banks may increase the Company’s credit line for a limited
                period), of which $ 585 is denominated in NIS and bears interest at
                the prime rate plus an additional 0.5% - 2.5%, and $ 245 is
                denominated in U.S. dollars and bears interest at a rate of LIBOR
                plus
                2.5% -2.9%. As of December 31, 2006, the U.S. LIBOR and prime rates
                were
                5.3% and 6% respectively.





The
      weighted average interest rates on the credit lines as of December 31, 2005
      and
      2006, were approximately 5.9% and 7.85%, respectively.





The
      Company had an unused credit facility in an amount of approximately $ 95 as
      of December 31, 2006, for which there is no fee.


111




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                8:-**
            **BANK
                CREDIT (Cont.)**





b.
            Long-term
                loans:





**December
                31,****2005**
            
            **2006**Banks
            
            $
            362
            
            $
            354Less
                - current maturities of long-term loans
            
            
            167
            
            
            287$
            195
            
            $
            67
            (*)





As
      of
      December 31, 2006, a loan in the amount of $ 195 bears annual average interest
      at a rate of LIBOR + 2.875% and a loan in the amount of $159 bears annual
      average interest at a rate of PRIME + 2.75%.





(*)Repayment
      of the principal amount of the long-term loans is during 2008.





c.
            Regarding
                guarantees and liens - see Note
                10b.








**NOTE
                9:-**
            **ACCRUED
                EXPENSES AND OTHER
                LIABILITIES**





**December
                31,****2005**
            
            **2006**Customer
                advances
            
            $
            38
            
            
            310Deferred
                revenues
            
            
            571
            
            
            285Accrued
                expenses
            
            
            577
            
            
            (*)2,261Accrued
                severance pay - current (**)
            
            
            -
            
            
            421Other
            
            
            85
            
            
            151$
            1,271
            
            $
            3,428





(*)
                As of December 31, 2006 includes $450 related to the transaction
                with OTI
                and $1,376 related to marketing expenses.





**(**)**The
                accrued severance pay related to employees that were employed in
                the e-ID
                Division. See Note 1a.




112




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                10:-**
            **COMMITMENTS
                AND CONTINGENT LIABILITIES**





a.
                  Leasecommitments:





The
      Company's facilities and those of certain subsidiaries are rented under several
      operating lease agreements for periods ending in 2007 - 2010.





On
      April
      18, 2005, the Company signed a lease for new offices in Kadima. The lease is
      for
      a period of five years commencing on November 1, 2005. The Company has an option
      to extend the lease period for an
      additional five
      years on similar terms. According to the lease, the monthly fee is
      $16.




As
      a
      result of the sale of the e-ID Division to OTI, the Company leased to OTI
      certain portion of its leased facilities for a monthly fee of $11, for a period
      of one year, commencing on the closing date.




Future
      minimum lease commitments under non-cancelable operating leases (including
      the
      portion leased to OTI as describe above) for the years ended December 31, are
      as
      follows:





2007
            
            $
            2792008
            
            
            1932009
            
            
            1932010
            
            
            161$
            826





Rent
      expenses for the years ended December 31, 2004, 2005 and 2006, were
      approximately $ 387, $ 369 and $ 355, respectively.





b.
            Guarantees,
                indemnity and liens:





1.
            The
                Company issued bank guarantees in the amount of $54 to secure the
                Company's lease and additional bank guarantees in the amount of $13
                to
                secure other obligations. As a condition of those guarantees, the
                Company
                deposited $ 58, which is included as part of the restricted cash
                deposits.





2.
            In
                order to secure bank credit and covenants to the bank, the Company
                pledged
                deposits in the amount of $442 in favor of Bank Otsar Ha-Hayal Ltd.
                and
                the amount of $ 312 in favor of the Bank of Jerusalem, which are
                included
                as part of restricted cash
                deposits.


Certain
                loan agreements and debentures contain restrictive covenants, mainly
                the
                requirement to maintain certain financial ratios. As of December
                31, 2006,
                the Company was in compliance with all of its financial covenants.





3.
            In
                order to secure an agreement with a customer, the Company provided
                bank
                guarantees in the amount of $ 78. As a condition of this guarantee,
                the
                Company deposited $ 47 in the bank, which is included as part of
                restricted cash. The Company has granted a pledge in favor of Bank
                Otzar
                Ha-Hayal Ltd. on the funds and rights that are generated from the
                Ethiopian immigration.


113




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**




**NOTE
                10:-**
            **COMMITMENTS
                AND CONTINGENT LIABILITIES
                (Cont.)**





4.
            Under
                the sale agreement of the e-ID Division to OTI, the Company agreed
                to
                indemnify OTI for any breaches of the Company’s representations,
                warranties, covenants and obligations for twelve months from the
                closing
                date (December 31, 2007). The indemnification also covers any claim
                based
                on the Company’s alleged infringement on the intellectual property of any
                third party.




5.
            See
                Note 18b.





c.
            Litigation:




1.
            In
                April 2004, the Department for Resources Supply of the Ministry of
                Ukraine
                filed with the International Commercial Arbitration Court at the
                Ukrainian
                Chamber of Commerce and Industry (the “Arbitration Court”) a claim to
                declare Contract No. 10/82 (the “Contract”), dated April 9, 2002, between
                the Company and the Ministry of Internal Affairs of Ukraine, as void
                due
                to defects in the proceedings by which the Company was awarded the
                Contract. In July, 2004, the Arbitration Court declared the Contract
                as
                void. On April 27, 2005, the Company appealed the decision in the
                High
                Commercial Court of Ukraine. In May 2005, the Department for Resources
                Supply of the Ministry filed with the Arbitration Court a new statement
                of
                claim for restitution of $1,048 paid to the Company by the Department
                for
                Resources Supply of the Ministry under the Contract. On September
                27,
                2005, the Company received a negative award issued by the Arbitration
                Court in the second claim. On December 12, 2005, the Company was
                informed
                that the Supreme Court of Ukraine had dismissed its appeal regarding
                the
                July 2004 decision. On June 29, 2006, the Supreme Court of Ukraine
                held
                that the Arbitration Court award was valid and legal under applicable
                law.




During
      February 2007, the Company received from the management body of the courts
      of
      Israel documents that were sent from the Ministry of Internal Affairs of Ukraine
      regarding the claim for restitution of $1,048. The Company’s legal advisors have
      advised the Company that the documents were improperly sent and not in
      compliance with Israeli law. The Company intends to vigorously defend any motion
      to enforce the Arbitration Court award in Israel, and if necessary, to assert
      claims that the Ukrainian proceedings were legally defective and that no
      judgment based on these proceedings can be enforced in Israel.




Based
      on
      the opinion of its legal advisors, the Company believes that the above mentioned
      Ukraine Arbitration Court decision is incorrect, as a matter of law, that the
      Ukrainian government’s claim has no merit and that the Ukrainian Arbitration
      Proceedings were legally defective. Therefore no provision has been made in
      the
      financial statements in respect of the claim for restitution of $1,048. However,
      due to the developments described above, the Company wrote off inventory in
      an
      amount of approximately $287 in the fourth quarter of 2005, and took possession
      of the remaining inventory that was previously delivered to the customer. In
      2003, the Company increased the allowance for doubtful accounts in an aggregate
      amount of $2,133 for the debt the Ukrainian government owes to the Company.




The
      Company did not have any revenues from this project in 2004, 2005 and 2006.




114




**SUPERCOM
      LTD. AND ITS SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**U.S.
      dollars in thousands**


**NOTE
                10:-**
            **COMMITMENTS
                AND CONTINGENT LIABILITIES
                (Cont.)**





2.
            On
                October 30, 2003, SuperCom Slovakia, a subsidiary (66%) of SuperCom
                Ltd.,
                received an award from the International Arbitral Center of the Austrian
                Federal Economic Chamber, in a case against the Ministry of Interior
                of
                the Slovak Republic relating to the Agreement on Delivery of Technology,
                Cooperation and Services signed on March 17, 1998. Upon the Arbitral
                Award, the Ministry of Interior of the Slovak Republic was ordered
                to pay
                SuperCom Slovakia the amount of SKK 80,000,000 (approximately $3,068
                as of
                December 31, 2006) plus interest accruing from March 1999. In addition,
                the Ministry of Interior of the Slovak Republic was ordered to pay
                the
                costs of arbitration in the amount of EUR 42,716 (approximately $56
                as of
                December 31, 2006) and SuperCom Slovakia’s legal fees in the amount of EUR
                63,611 (approximately $84 as of December 31, 2006). The Company has
                begun
                an enforcement proceeding to collect the arbitral awards. The Ministry
                of
                Interior of the Slovak Republic filed a claim with the Commercial
                Court in
                Vienna, Austria on February 10, 2004, whereby it challenged and requested
                to set aside the arbitral award. During September 2005, the Commercial
                Court of Vienna dismissed the claim. On October 21, 2005, the Ministry
                of
                the Interior of the Slovak Republic filed an appeal. On August 25,
                2006,
                the Austrian Appellate Court rejected the appeal and ordered the
                Ministry
                to reimburse Supercom Slovakia ́s costs of the appellate proceeding in the
                amount of EUR 6,688.50 within 14 days. On October 3, 2006, the Company
                was
                informed that the Ministry had decided not to file an extraordinary
                appeal
                to the Austrian Supreme Court’s decision rejecting its appeal. To date,
                the Company’s efforts to enforce the Commercial Court’s decision have been
                unsuccessful.




3.
            On
                July 14, 2003, Mr. Yaacov Pedhatzur, filed a lawsuit against the
                Company
                in the Magistrate’s Court in Tel Aviv, Israel, claiming that the Company
                owes him commissions in respect of transactions between the Company
                and
                certain third parties. On September 29, 2005, the Company reached
                a
                settlement agreement with Mr. Pedhatzur in which the Company agreed
                to pay
                Mr. Pedhatzur the NIS equivalent of $129. The settlement agreement
                has
                been approved by the court. This amount was recorded in the statement
                of
                operations of fiscal year 2005, as litigation settlement expenses.




4.
            On
                December 16, 1999, Secu-Systems Ltd. filed a lawsuit with the District
                Court in Tel-Aviv-Jaffa jointly and severally against the Company
                and its
                former subsidiary, InkSure Ltd. (“InkSure”), seeking a permanent
                injunction and damages arising from the printing method applied to
                certain
                products developed by InkSure. In its lawsuit, Secu-Systems asserted
                claims of breach of a confidentiality agreement between Secu-Systems
                and
                the Company, unjust enrichment of the Company and InkSure, breach
                of
                fiduciary duties owed to Secu-Systems by the Company and InkSure
                and
                misappropriation of trade secrets and damage to Secu-Systems’ property. On
                March 15, 2006, the Court denied the breach of contract claim, but
                upheld
                the claim for misappropriation of trade secrets and ordered InkSure
                and
                the Company to cease all activity involving the use of the confidential
                knowledge and/or confidential information of Secu-Systems. In addition,
                the court ordered the Company and Inksure to provide a report certified
                by
                an accountant setting forth in full the income and/or benefit received
                by
                InkSure and the Company as a result of the infringing activity through
                the
                date of the judgment, and ordered the Company and Inksure, jointly
                and
                severally, to pay to Secu-Systems compensation in the sum of NIS
                100,000
                ($24 as of December 31, 2006) and legal expenses as well as attorney’s
                fees in the sum of NIS 30,000 ($7 as of December 31, 2006). Secu-Systems
                has filed an appeal, and the Company and InkSure filed a counter-appeal,
                on the ruling above. To date, no decision has been rendered on either
                appeal. At this point, the Company cannot estimate the outcome of
                such
                appeal.




115


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                10:-**
            **COMMITMENTS
                AND CONTINGENT LIABILITIES
                (Cont.)**




5.
            On
                May 1, 2006, Evilia Investments Ltd. (“Evilia”) filed in the Magistrate’s
                Court in Tel-Aviv-Jaffa a claim for damages against InkSure Ltd.
                and
                against the Company, jointly and severally, for payment of NIS 2,366,868
                (as of June 15, 2006, approximately $530) plus interest allegedly
                due as
                rent payments and related management fees for a certain real estate
                property in Rehovot, leased to InkSure under a lease agreement entered
                into between Evilia and InkSure on October 10, 2000, as amended on
                May 25,
                2001 (the “Agreement”), as to which SuperCom is a guarantor. A motion for
                leave to defend the lawsuit was filed with the Court by both InkSure
                and
                the Company on June 15, 2006. On August 6, 2006, a settlement agreement
                was submitted to the Court, pursuant to which InkSure agreed to pay
                Evilia
                the amount of $130 plus VAT. On August 13, 2006, the Court approved
                the
                settlement agreement. The Company agreed to pay (and paid) InkSure
                half of
                the settlement amount.




**NOTE
                11:-**
            **TAXES
                ON INCOME**





a.
            Tax
                benefits under the Israeli Law for the Encouragement of Industry
                (Taxation), 1969 (“the law”):





The
                Company is an "industrial company", as defined by the law and, as
                such, is
                entitled to certain tax benefits, mainly accelerated depreciation
                of
                machinery and equipment, the right to claim public issuance expenses
                and
                the right to amortize patents and other intangible property rights
                for tax
                purposes.





b.
            Measurement
                of results of operations for tax purposes under the Israeli Income
                Tax Law
                (Inflationary Adjustments), 1985.





Results
                of operations for tax purposes are measured in terms of earnings
                in NIS
                after adjustments for changes in Israel's 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 Israel's CPI
                and in
                the NIS/dollar exchange rate causes a further difference between
                taxable
                income and 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 above difference between the
                functional currency and the tax bases of assets and
                liabilities.





c.
            Reduction
                in corporate tax rates:





On
      July
      25, 2005, the Israeli Parliament passed an amendment to the Income Tax Ordinance
      (No. 147) - 2005, gradually reducing the tax rate applicable to the Company
      as
      follows: in 2006 - 31%, in 2007 - 29%, in 2008 - 27%, in 2009 - 26% and in
      2010
      and thereafter - 25%.




According
      to a previous amendment to the Income Tax Ordinance (No. 140) 2004, the tax
      rates were reduced as follows: in 2004 - 35% and in 2005 - 34%.





d.
            Non-Israeli
                subsidiaries:





Non-Israeli
      subsidiaries are taxed according to the tax laws of the country in which they
      are located.


116


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                11:-**
            **TAXES
                ON INCOME (Cont.)**





e.
            Deferred
                income taxes:





Deferred
                income taxes reflect the net tax effects of temporary differences
                between
                the carrying amounts of assets and liabilities for financial reporting
                purposes and the amounts used for income tax purposes. Significant
                components of the deferred tax assets of the Company and its subsidiaries
                are as follows:





**December
                31,****2005**
            
            **2006****Tax
                Benefits:**Operating
                loss carryforward
            
            $
            4,626
            
            $
            4,958Reserves
                and allowances
            
            
            805
            
            
            930Net
                deferred tax asset before valuation allowance
            
            
            5,431
            
            
            5,888Valuation
                allowance
            
            
            (5,431
            )
            
            (5,888
            )Net
                deferred tax asset
            
            $
            -
            
            $
            -Deferred
                income taxes consist of the following:Domestic
            
            $
            4,643
            
            $
            4,820Valuation
                allowance
            
            
            (4,643
            )
            
            (4,820
            )Foreign
            
            
            788
            
            
            1,068Valuation
                allowance
            
            
            (788
            )
            
            (1,068
            )$
            -
            
            $
            -




As
                of December 31, 2006, the Company and its subsidiaries have provided
                valuation allowances of $ 5,988 in respect of deferred tax assets
                resulting from tax loss carryforward and other temporary differences.
                Management currently believes that since the Company and its subsidiaries
                have a history of losses, the deferred tax assets are not considered
                more
                likely than not to be realized in the foreseeable
                future.


117


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**





**NOTE
                11:-**
            **TAXES
                ON INCOME (Cont.)**





f.
            Net
                operating loss carryforward and loss on marketable
                securities:





SuperCom
                Ltd. has accumulated losses for tax purposes as of December 31, 2006,
                in
                an amount of approximately $ 15,200, which may be carried forward and
                offset against taxable income in the future for an indefinite period.
                SuperComLtd.
                also has a loss on marketable securities in an amount of $ 1,780
                which may be carried forward and offset against gains on marketable
                securities for an indefinite
                period.





As
      of
      December 31, 2006, SuperCom's subsidiaries in the United States, Hong Kong
      and
      Israel have estimated total available carryforward tax losses of $ 2,654,
      $ 758 and $386, respectively. In Hong-Kong tax losses are available to
      offset against taxable income, if any, for an indefinite period. In the U.S.,
      tax losses can be carried forward for 20 years.





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





g.
            SuperCom
                Ltd has received final assessment until the tax year ended December
                31,
                2001.


Supercom’s
                subsidiaries in the United States and Israel haven’t received final
                assessment from their incorporation.


Supercom’s
                subsidiary in Hong-Kong has assessment that is considered to be final
                until the tax year ended December 31, 1999.


118


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                11:-**
            **TAXES
                ON INCOME (Cont.)**





h..
            Net
                income (loss) before taxes on incomeconsists
                of the following:




**Year
                ended December 31,****2004**
            
            **2005**
            
            **2006**Domestic
            
            $
            (1,446
            )
            $
            (2,787
            )
            $
            6,250Foreign
            
            
            (426
            )
            
            (1,164
            )
            
            (810
            )$
            (1,872
            )
            $
            (3,951
            )
            $
            5,440





i.
            Reconciliation
                of the theoretical tax expense (benefit) to the actual tax expense
                (benefit):


A
                reconciliation of theoretical tax expense, assuming all income is
                taxed at
                the statutory rate applicable to the income of companies in Israel,
                and
                the actual tax expense, is as
                follows:




**Year
                ended December 31,****2004**
            
            **2005**
            
            **2006**Net
                income (loss) before taxes on income, as reported in the consolidated
                statements of operations
            
            $
            (1,872
            )
            $
            (3,951
            )
            
            5,440Statutory
                tax rate in Israel
            
            
            35
            %
            
            34
            %
            
            31
            %Theoretical
                tax expenses (benefit)
            
            $
            (655
            )
            $
            (1,343
            )
            
            1,686Carryforward
                losses and other deferred taxes for which a full valuation allowance
                was
                recorded
            
            
            525
            
            
            1,021
            
            
            384Decrease
                in taxes resulting from utilization of carryforward tax losses for
                which
                deferred taxes were not created in the past
            
            
            -
            
            
            -
            
            
            (2,402
            )Differences
                in taxes resulting from Approved Enterprise benefits and from rate
                applicable to foreign subsidiary and others
            
            
            130
            
            
            322
            
            
            332Actual
                income tax
            
            $
            -
            
            $
            -
            
            $
            -





119


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                12:-**
            **CONVERTIBLE
                BONDS**





In
      November 2006, the Company raised $3,156.5 through the issuance of Units
      consisting of Convertible Bonds and Warrants. Units valued at $2,500 were issued
      to a single investor, and Units valued at $656.5 were issued to Special
      Situation Funds (SSF), who are existing shareholders of the Company. The
      Convertible Bonds mature three years from the date of issuance and bears
      interest at an annual rate of 8%. Any withholding and other taxes payable with
      respect to the interest will be grossed up and paid by the Company
      (approximately 3% of the principle of the bond). Payment of interest will be
      net
      of any tax. Subject to certain redemption provisions, as described below, the
      Convertible Bonds may be converted at any time, at the option of the investors,
      into the Company's ordinary shares at a conversion price of $5 per share. The
      investors were also granted Warrants entitling them to acquire a total of
      134,154 ordinary shares at an exercise price of $5 per share during the next
      five years. In respect of this transaction, the Company paid approximately
      $180
      as expenses and granted an option to acquire up to 25,000 shares of the Company
      to a third party, exercisable at $5 per share. The fair market value of this
      grant is $ 40.





If
      the
      Company fails to fulfill certain conditions, the investors may accelerate
      repayment of the principal amount of $3,156.5 principal amount of Convertible
      Bonds, in which case all interest payable at the Maturity Date will immediately
      become due and payable. As of December 31, 2006, the Company is in compliance
      with those conditions.




Between
      February 10, 2008 and February 16, 2008, the Company has the option to call
      and
      redeem 100% of the Convertible Bonds at a price equal to (i) the aggregate
      principal amount of the bonds plus (ii) a redemption premium equal to fifteen
      percent (15%) of the aggregate principal amount plus (iii) any accrued but
      unpaid interest on the aggregate principal amount, calculated through the date
      of redemption.





This
      transaction was accounted for in accordance with EITF 00-27, " Application
      of
      Issue No. 98-5 to Certain Convertible Instruments" and APB 14, "Accounting
      for
      Convertible Debt and Debt Issued with Stock Purchase Warrants". The fair market
      value of the Warrants was determined based on the fair value of the
      instruments issued using the Black-Scholes pricing model, assuming a risk free
      rate of 5%, a volatility factor of 78.21%, dividend yields of 0% and an expected
      life of 2 years. The expiration date of the Warrants is November 2011.





As
      a
      result, the Company recorded an amount of $282 in respect of the Warrants and
      an
      amount of $632 as beneficial conversion feature in respect of the Convertible
      Bonds, as a credit to shareholders' equity (additional paid in
      capital).




120


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**





**NOTE
              13:-**
            **SHARE
                CAPITAL**





a.
            The
                Company’s ordinary shares have been listed for trade on the Euronext
                Brussels stock market, under the symbol “SUP”, since October 23, 2003.
                Since November 5, 2004, the Company’s ordinary shares have also traded on
                the OTCBulletin
                Board under the symbol "SPCBF.OB".





b.
            During
                2005, the Company increased its authorized share capital to
                6,800,000ordinary shares.





c.
            Shareholders'
                rights:





The
      ordinary shares confer upon the holders the right to receive notice to
      participate and vote in the general meetings of the Company, and the right
      to
      receive dividends, if declared.





d.
            Stock
                options:





1.
            On
                February 14, 1999, the Board of Directors adopted, and the Company’s
                shareholders subsequently approved, the 1999 Employee Stock Option
                Plan,
                which was amended and restated in March 2002 (the “1999 Option Plan”). The
                Company no longer uses the 1999 Option Plan. In 2003, the Company
                adopted
                a new stock option plan under which the Company issues stock options
                (the
                “Option Plan”). The Option Plan is intended to provide incentives to the
                Company’s employees, officers, directors and/or consultants by providing
                them with the opportunity to purchase ordinary shares of the Company.
                The
                Option Plan is, subject to the provisions of the Israeli Companies
                Law,
                administered by the Remuneration Committee, and is designed: (i)
                to comply
                with Section 102 of the Israeli Tax Ordinance or any provision which
                may
                amend or replace it and the rules promulgated thereunder and to enable
                the
                Company and grantees thereunder to benefit from Section 102 of the
                Israeli
                Tax Ordinance and the Commissioner’s Rules; and (ii) to enable the Company
                to grant options and issue shares outside the context of Section
                102 of
                the Israeli Tax Ordinance. Options granted under the Option Plan
                will
                become exercisable ratably over a period of three to five years or
                immediately in certain circumstances, commencing with the date of
                grant.
                The options generally expire no later than 10 years from the date
                of
                grant. Any options, which are forfeited or canceled before expiration,
                become available for future grants. As of December 31, 2006 853,752
                ordinary shares are available for future grants of options, warrants,
                shares and other financial instruments.




As
      a
      result of an amendment to Section 102 of the Israeli Tax Ordinance as part
      of
      the 2003 Israeli tax reform, and pursuant to an election made by the Company
      thereunder, capital gains derived by optionees arising from the sale of shares
      issued pursuant to the exercise of options granted to them under Section 102
      after January 1, 2003, will generally be subject to a flat capital gains tax
      rate of 25%. Previously, such gains were taxed as salary income at the
      employee’s marginal tax rate (which could be up to 50%). However, as a result of
      this election, the Company will no longer be allowed to claim as an expense
      for
      tax purposes the amounts credited to such employees as a benefit when the
      related capital gains tax is payable by them, as the Company had previously
      been
      entitled to do under Section 102.




121


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                13:-**
            **SHARE
                CAPITAL (Cont.)**





2.
            On
                October 4, 2004, the Board of Directors approved a grant of options
                to
                acquire up to 128,351 ordinary shares of the Company to certain employees
                as compensation for their efforts in assisting the private placement
                completed during 2004, at an exercise price of $5 per
                share.





During
      2005, the Board of Directors approved a grant of options to acquire up to 15,300
      and 8,500 ordinary shares to certain employees at exercise prices of $5.24,
      and
      $4.18 per share, respectively. An additional 68,001 options were granted
      during 2005 to related parties. See Note 14d.





On
      December 29, 2005, the Board of Directors and the Audit Committee approved
      the
      acceleration of the vesting schedule for certain of the stock options granted
      to
      employees and officers as an incentive. As a result, options to purchase a
      total
      of 121,126 ordinary shares became exercisable at the date of the approval.
      The
      acceleration did not have any effect on the financial statements since the
      options had a zero intrinsic value at the original date of grant and at the
      date
      of acceleration.





On
      May
      30, 2006, the Board of Directors approved a grant of options to acquire up
      to
      93,501 ordinary shares to certain employees and officers. The exercise price
      of
      these options is $ 4.42 per share.





Regarding
      options granted to related parties, subsequent the balance sheet date, see
      Note
      18a.





3.
            A
                summary of the Company's stock option activity, and related information
                is
                as follows:





**Year
                ended December 31****2004**
            
            **2005**
            
            **2006****Number
                of**
              **options**
            
            **Weighted
                average exercise price**
            
            **Number
                of**
              **options**
            
            **Weighted
                average exercise price**
            
            **Number
                of**
              **options**
            
            **Weighted
                average exercise price**Outstanding
                at beginning of year
            
            
            260,868
            
            $
            6.89
            
            
            569,905
            
            $
            5.71
            
            
            595,971
            
            $
            5.77Granted
            
            
            345,101
            
            $
            7.24
            
            
            91,801
            
            $
            4.95
            
            
            93,501
            
            $
            4.42Exercised
            
            
            -
            
            $
            -
            
            
            (37,684
            )
            $
            2.48
            
            
            (43,152
            )
            $
            2.48Canceled
                and forfeited
            
            
            (36,064
            )
            $
            29.59
            
            
            (28,051
            )
            $
            5.53
            
            
            (92,418
            )
            $
            9.95Outstanding
                at end of year
            
            
            569,905
            
            $
            5.71
            
            
            595,971
            
            $
            5.77
            
            
            553,902
            
            $
            5.12Exercisable
                at end of year
            
            
            285,832
            
            $
            3.42
            
            
            515,504
            
            $
            6.06
            
            
            481,651
            
            $
            5.18




122


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                13:-**
            **SHARE
                CAPITAL (Cont.)**





The
      weighted average fair value of options granted during the reported period was
      $5.58, $3.08 and $1.89, per option, for the years ended December 31, 2004,
      2005
      and 2006, respectively.




The
      fair
      value of these options was estimated on the date of grant using the Black &
Scholes option pricing model. The following weighted average assumptions were
      used for the 2006 grants: risk free rate of 5%, dividend yield of 0%, expected
      volatility factor of 57.14% and expected term of 3.09 years.




Regarding
      the assumptions used for the proforma information required under FAS 123 in
      2004
      and 2005 see Note 2x above.




The
      expected volatility was based on the historical volatility of the Company’s
      stock. The expected term was based on the historical behavior of the employees
      and based on Management estimate.





Compensation
      expenses recognized by the Company related to its share-based employee
      compensation awards were $9, $47 based on the provisions of APB 25 and $ 225
      based on the provisions of SFAS 123R for the years ended December 31, 2004,
      2005 and 2006, respectively.





The
      options outstanding and exercisable as of December 31, 2006, have been separated
      into ranges of exercise prices as follows:





**Range
                of exercise**
              **price**
            
            **Options
                outstanding as of**
              **December
                31, 2006**
            
            **Weighted
                average**
              **remaining**
              **contractual
                life (years)**
            
            **Weighted
                average**
              **exercise
                price**
            
            **Aggregate
                intrinsic value**
            
            **Options
                exercisable**
              **as
                of**
              **December
                31, 2006**
            
            **Weighted
                average**
              **exercise
                price**
            
            **Aggregate
                intrinsic value**$
                2.48 - $ 3.06
            
            
            202,093
            
            
            5.11
            
            $
            2.53
            
            $
            321
            
            
            202,093
            
            $
            2.53
            
            $
            321$
                4.18 - $ 5.00
            
            
            268,600
            
            
            5.59
            
            $
            4.83
            
            
            -
            
            
            196,349
            
            $
            4.89
            
            
            -$
                5.24 - $ 5.89
            
            
            23,800
            
            
            5.83
            
            $
            5.48
            
            
            -
            
            
            23,800
            
            $
            5.48
            
            
            -$11.77
                - $ 14.83
            
            
            57,801
            
            
            5.28
            
            $
            14.71
            
            
            -
            
            
            57,801
            
            $
            14.71
            
            
            -$
                23.53 - $ 33.06
            
            
            1,481
            
            
            0.22
            
            $
            26.36
            
            
            -
            
            
            1,481
            
            $
            26.36
            
            
            -$
                56.71
            
            
            127
            
            
            0.27
            
            $
            56.71
            
            
            -
            
            
            127
            
            $
            56.71
            
            
            -553,902
            
            
            
            
            $
            5.12
            
            
            
            
            
            481,651
            
            $
            5.18





The
      aggregate intrinsic value of the above table represents the total intrinsic
      value, based on the Company’s stock price of $4.12 as of December 31, 2006, less
      the weighted average exercise price per range. This represents the potential
      amount received by the option holders had all option holders exercised their
      options as of that date.


123


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                13:-**
            **SHARE
                CAPITAL (Cont.)**





A
      summary
      of the status of the Entity’s non-vested options granted to employees as of
      December 31, 2006 and changes during the year ended December 31, 2006 is
      presented below:





**Options**
            
            **Weighted-average
                grant-date fair value**Non-vested
                at January 1, 2006
            
            
            80,467
            
            $
            2.771Granted
            
            
            59,501
            
            $
            2.000Vested
            
            
            (39,951
            )
            $
            2.777Forfeited
            
            
            (27,766
            )
            $
            2.353Non-vested
                at December 31, 2006
            
            
            72,251
            
            $
            2.289





As
      of
      December 31, 2006, there was $167 total unrecognized compensation cost related
      to non-vested share-based compensation arrangements granted under the stock
      option plans, of which, $147 is expected to be recognized during the year 2007.





e.
            Private
                placements and warrants





1.
            In
                2004, the Company completed private placements of an aggregate of
                685,001
                of its ordinary shares to institutional and private investors at
                an
                aggregate purchase price of approximately $3.5 million at a price
                of $5
                per share. In addition, such investors were issued warrants
                exercisable for five years from the closing date of the purchase
                of an
                aggregate of up to 274,001 ordinary shares at an exercise price of
                $6.47
                per share.





Additionally,
      warrants exercisable for a period of 5 years were issued as follows: 75,601
      ordinary shares issuable upon the exercise of warrants having an exercise price
      of $5 per share to consultants and 30,240 ordinary shares issuable upon the
      exercise of warrants having an exercise price of $6.47 per share that were
      issued to Broadband Capital LLC as a portion of the placement agent fee issued
      in connection with a private placement completed on September 10, 2004; 12,751
      ordinary shares issuable upon the exercise of warrants having an exercise price
      of $6.47 per share that were issued to Meitav Capital Ltd. as a portion of
      the
      placement agent fee issued in connection with a private placement completed
      on
      July 15, 2004; and 500 ordinary shares issuable upon the exercise of warrants
      having an exercise price of $6.47 per share that were issued to Max Tech Ltd.
      as
      a portion of the placement agent fee issued in connection with a private
      placement completed on July 15, 2004.




As
      part
      of the private placement, two consultants received warrants exercisable for
      up
      to four years for the purchase of an aggregate of up to 4,251 and 17,001
      ordinary shares, respectively at an exercise price of $5 per share.




The
      warrants granted to the consultants as describe above were fully vested on
      the
      date of grant. The fair value of the warrants is $ 340 as computed using the
      Black & Scholes pricing model with the following weighted average
      assumptions: risk free interest of 4.1%, dividend yield of 0, volatility factor
      of the excepted market price of the Company’s ordinary shares of 98.3%, and
      expected term of 2 years of the warrants. The Company recorded the issuance
      costs that resulted from the issuance of warrants to consultants during the
      reported periods, directly to additional paid in capital.


124


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
              13:-**
            **SHARE
                CAPITAL (Cont.)**





During
      the fourth quarter of 2004, 120,176 warrants were exercised for an aggregate
      amount of approximately $ 778 and approximately $ 130 was received in respect
      of
      20,000 shares that were issued in 2005.




During
      2005, 54,451 warrants were exercised for an aggregate amount of approximately
      $
      352.





2.
            In
                November and December of2005,the Company received aggregate gross proceedsof
                $3,050 from a private placement of 836,292 ordinary shares (out of
                which
                150,807 shares were issued after December 31, 2005) and five-year
                warrants
                to purchase 292,701 ordinary shares at an exercise price of $3.53
                per
                share. The private placement was made to accredited investors pursuant
                to
                Rule 506 of Regulation D, promulgated under the Securities Act of
                1933, as
                amended (the “Securities Act”) and to foreign private investors in
                offshore transactions in reliance on Regulation S promulgated under
                the
                Securities Act. In connection with the private placement, the Company’s
                placement agent received a cash fee of $150 and the Company’s placement
                advisors received five-year warrants to purchase 8,446 ordinary shares
                at
                an exercise price of $3.53 per share. The investors that participated
                in
                this private placement were granted the right, for one year following
                the
                closing of the private placement and subject to certain limitations,
                to
                participate in future issuances of the Company’s capital stock or
                securities (a “Subsequent Financing”) up to an amount which would permit
                each investor to maintain its fully diluted percentage equity ownership
                at
                the same level existing prior to the Subsequent Financing (after
                giving
                effect to such Subsequent Financing). The warrants are callable,
                subject
                to certain limitations, at the option of the Company if the closing
                bid
                price per ordinary share of the Company's ordinary shares equals
                or
                exceeds $7.06 for 20 trading days during the term of the warrants.
                The
                Company may only call, in any 3-month period, the lesser of (i) 20%
                of the
                aggregate amount of the warrants initially issued to a warrant holder,
                or
                (ii) the total number of warrants then held by such
                holder.





The
      warrants granted to the placement advisors as described above were fully vested
      on the date of grant. The fair value of the warrants is $ 15 as computed using
      the Black & Scholes pricing model with the following weighted average
      assumption: risk free interest of 4%, dividend yield of 0, volatility factor
      of
      the excepted market price of the Company’s ordinary shares of 74%, and expected
      term of 2 years of the warrants. The Company recorded the issuance costs
      directly to additional paid in capital.





3.
            During
                2005, 4,251 warrants were issued to a consultant. The fair value
                of the
                warrants is $ 13 as computed using the Black & Scholes pricing model
                with the following assumption: risk free interest of 3.5%, dividend
                yield
                of 0, volatility factor of the excepted market price of the Company’s
                ordinary shares of 117.03%, and expected term of the warrants of
                2 years.
                During the years 2005 and 2006, the Company recognized $8 and $5,
                respectively, as compensation expenses.


125


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
              13:-**
            **SHARE
                CAPITAL (Cont.)**





4.
            During
                2006, the Board of Directors approved a grant of options to acquire
                up to
                75,651 shares to certain consultants. The exercise prices under the
                terms
                of the options are at a range of $ 3.42 to $ 5.47 per share. The
                fair
                market value of the warrants is $ 162 as computed using the Black
&
                Scholes pricing model with the following weighted average assumption:
                risk
                free interest of 4.25%, dividend yield of 0, volatility factor of
                the
                excepted market price of the Company’s ordinary shares of 73.46%, and
                expected term of the warrants of 2.47 years. During 2006, the Company
                recognized $131, as compensation
                expenses.





5.
            A
                summary of the Company's warrants activity to consultant, investors
                (including warrants issued in connection with convertible bonds),
                and
                related information is as follows:





**Year
                ended December 31****2004**
            
            **2005**
            
            **2006****Number
                of**
              **options**
            
            **Weighted
                average exercise price**
            
            **Number
                of**
              **options**
            
            **Weighted
                average exercise price**
            
            **Number
                of**
              **options**
            
            **Weighted
                average exercise price**Outstanding
                at beginning of year
            
            
            -
            
            
            -
            
            
            294,165
            
            $
            6.00
            
            
            525,111
            
            $
            4.53Granted
            
            
            414,341
            
            $
            6.12
            
            
            305,397
            
            $
            3.53
            
            
            234,805
            
            $
            4.95Exercised
            
            
            (120,176
            )
            $
            6.48
            
            
            (74,451
            )
            $
            6.48
            
            
            -
            
            
            -Canceled
                and forfeited
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Outstanding
                at end of year
            
            
            294,165
            
            $
            6.00
            
            
            525,111
            
            $
            4.53
            
            
            759,916
            
            $
            4.65Exercisable
                at end of year
            
            
            288,500
            
            $
            6.00
            
            
            519,446
            
            $
            4.48
            
            
            737,250
            
            $
            4.65





The
      warrants to consultant, investors (including warrants issued in connection
      with
      convertible bonds), outstanding and exercisable as of December 31, 2006, have
      been separated into ranges of exercise prices as follows:




**Range
                of exercise**
              **price**
            
            **Options
                outstanding as of**
              **December
                31, 2006**
            
            **Weighted
                average**
              **remaining**
              **contractual
                life (years)**
            
            **Weighted
                average**
              **exercise
                price**
            
            **Aggregate
                intrinsic value**
            
            **Options
                exercisable**
              **as
                of**
              **December
                31, 2006**
            
            **Weighted
                average**
              **exercise
                price**
            
            **Aggregate
                intrinsic value**$
                3.42 - $ 3.53
            
            
            306,246
            
            
            3.88
            
            $
            3.53
            
            $
            180
            
            
            306,246
            
            $
            3.53
            
            $
            180$
                4.42 - $ 4.71
            
            
            27,200
            
            
            6.74
            
            $
            4.59
            
            
            -
            
            
            27,200
            
            $
            4.59
            
            
            -$
                5
                - $ 5.48
            
            
            303,604
            
            
            3.70
            
            $
            5.06
            
            
            -
            
            
            280,938
            
            $
            5.00
            
            
            -$
                6.48
            
            
            122,866
            
            
            2.69
            
            $
            6.48
            
            
            -
            
            
            122,866
            
            $
            6.48
            
            
            -759,916
            
            
            3.72
            
            $
            4.65
            
            
            
            
            
            737,250
            
            $
            4.65





6.
            The
                fair value of all the warrants granted as described above was measured
                based on the fair value of the instruments issued, since that based
                on
                Company Management opinion, such measurement is more reliable than
                the
                fair value of services.





(*) **** All
      data
      in Note 13 was restated to reflect the numbers of ordinary shares issuable
      upon
      the exercise of options and warrants, as a result of the reverse share split.
      See note 18d below.




126


**SUPERCOM
          LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
          dollars in thousands**


**NOTE
              13:-**
            **SHARE
                CAPITAL (Cont.)**





f.
            Dividends:





In
      the
      event that cash dividends are declared in the future, such dividends will be
      paid in NIS. The Company does not intend on paying cash dividends in the
      foreseeable future.





g.
            Convertible
                bonds and warrants - see Note 12.





**NOTE
                14:-**
            **RELATED
                PARTY TRANSACTIONS**





a.
            On
                October 1, 2001, the Company entered into a consulting agreement
                with a
                company owned by the Chairman of the Board of Directors, who was
                one of
                the co-founders of the Company.





In
      consideration of these consulting services, the Company has undertaken to pay
      $
      10.5 per month plus motor vehicle expenses. In addition the Company pays $
      1.5
      per month as a director’s fee. During 2004, 2005 and 2006, the Company paid
      $144, each year, pursuant to this agreement.





On
      January 21, 2007, the General Shareholders Meeting approved the grant of options
      to the Chairman of the Board of Directors to acquire up to 51,000 ordinary
      shares of the Company, at an exercise price of $5 per share under the Option
      Plan. See Note 18a.





b.
            On
                October 1, 2001, the Company entered into a consulting agreement
                with a
                company owned by a member of the Company's Board of Directors, who
                was one
                of the Company's co-founders and a principal shareholder. On January
                13
                2005, the General Shareholders Meeting approved the following amendments
                to the consulting agreement:


·
            As
                of the date of the approval of the General Shareholders Meeting,
                to
                increase the consideration set forth in the said agreement to an
                amount of
                $ 7 per month.


·
            Upon
                the termination of the current car lease, to increase the car lease,
                to a
                price of up to NIS 4,200 (approximately $ 1 as of December 31, 2006),
                (excluding tax) per month.


·
            To
                grant a one-time bonus of NIS 130,000 (approximately $ 30 as of December
                31, 2005), including VAT.





In
      addition the Company pays $ 1.5 per month as a director’s fee. During 2004, 2005
      and 2006, the Company paid $ 73, $ 132 and $ 102, pursuant to this
      agreement.





Also,
      on
      January 21, 2007, the General Shareholders Meeting approved the grant of options
      to acquire up to 20,400 ordinary shares of the Company at an exercise price
      of
      $5 per share under the Option Plan. See Note 18a.





c.
            On
                October 1, 2001, the Company entered into a consulting agreement
                with a
                company owned by one of the co-founders of the Company.





In
      consideration for these services, the Company has undertaken to pay $ 4.6 per
      month plus motor vehicle expenses. During 2004, 2005 and 2006, the Company
      paid
      $ 69, $ 71 and $ 72, pursuant to this agreement.




127


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                14:-**
            **RELATED
                PARTY TRANSACTIONS (Cont.)**





d.
            On
                January 13, 2005, the General Shareholders Meeting approved among
                other
                things the Board of Directors’ decision dated October 4, 2004, to grant
                options to acquire up to 51,001 ordinary shares of the Company to
                the
                Chairman of the Board of Directors and 8,500 ordinary shares of the
                Company to each of the two directors of the Company, who are not
“outside
                directors”. The exercise price of the options is $ 5 per share. Those
                options were granted as compensation for their efforts in completing
                a
                private placement during 2004.





e.
            As
                of December 31, 2005 and 2006, the balance of the debts of related
                parties
                were $ 0 (net of allowance $55).




**NOTE
              15:-**
            **SEGMENTS,
                MAJOR CUSTOMERS AND GEOGRAPHIC
                INFORMATION**





a.
            Summary
                information about geographic areas:





The
      Company manages its business on the basis of one reportable segment (see Note
      1
      for a brief description of the Company's business) and follows the requirements
      of SFAS 131, "Disclosures about Segments of an Enterprise and Related
      Information".





The
                following is a summary of operations within geographic areas, based
                on the
                location of customers and data regarding long-lived
                assets:




**Year
                ended December 31,****2004**
            
            **2005**
            
            **2006****Total**
            
            **Long-lived**
            
            **Total**
            
            **Long-lived**
            
            **Total**
            
            **Long-lived****revenues**
            
            **assets**
            
            **revenues**
            
            **assets**
            
            **revenues**
            
            **assets**Europe
            
            $
            3,218
            
            $
            -
            
            $
            3,719
            
            $
            -
            
            $
            5,877
            
            $
            -Asia
                Pacific
            
            
            2,433
            
            
            20
            
            
            2,173
            
            
            16
            
            
            1,730
            
            
            18Africa
            
            
            899
            
            
            -
            
            
            2,158
            
            
            -
            
            
            621
            
            
            -United
                States
            
            
            386
            
            
            65
            
            
            202
            
            
            61
            
            
            373
            
            
            54Israel
            
            
            320
            
            
            3,556
            
            
            210
            
            
            3,133
            
            
            194
            
            
            88Other
            
            
            88
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -$
            7,344
            
            $
            3,641
            
            $
            8,462
            
            $
            3,210
            
            $
            8,795
            
            $
            160





b.
            Summary
                of operations based on products and
                services:





**Year
                ended December 31,****2004**
            
            **2005**
            
            **2006**Raw
                materials and equipment
            
            $
            5,552
            
            $
            7,902
            
            $
            8,028SPPL
                1000
            
            
            1,210
            
            
            -
            
            
            -Maintenance
            
            
            582
            
            
            560
            
            
            767$
            7,344
            
            $
            8,462
            
            $
            8,795




128


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
              15:-**
            **SEGMENTS,
                MAJOR CUSTOMERS AND GEOGRAPHIC INFORMATION
                (Cont.)**





c.
            Major
                customer data as a percentage of total
                sales:





**Year
                ended December 31,****2004**
            
            **2005**
            
            **2006**Customer
                A
            
            
            22
            %
            
            *
            
            
            -Customer
                B
            
            
            *
            
            
            23
            %
            
            *Customer
                C
            
            
            17
            %
            
            11
            %
            
            10
            %Customer
                D
            
            
            10
            %
            
            *
            
            
            *Customer
                E
            
            
            16
            %
            
            *
            
            
            *Customer
                F
            
            
            *
            
            
            10
            %
            
            -Customer
                G
            
            
            -
            
            
            22
            %
            
            59
            %




*)  Less
      than
      10%.





**NOTE
                16:-**
            **FINANCIAL
                EXPENSES, NET**




**Year
                ended December 31,****2004**
            
            **2005**
            
            **2006**Financial
                expenses:Interest,
                bank charges and fees (*)
            
            $
            (194
            )
            $
            (119
            )
            $
            (178
            )Exchange
                differences
            
            
            (48
            )
            
            -
            
            
            (109
            )Total
                financial expenses
            
            
            (242
            )
            
            (119
            )
            
            (287
            )Financial
                income:Exchange
                differences
            
            
            -
            
            
            28
            
            
            -Interest
            
            
            28
            
            
            66
            
            
            83Total
                financial income
            
            
            28
            
            
            94
            
            
            83Net
                total
            
            $
            (214
            )
            $
            (25
            )
            $
            (204
            )





*
      In
      2006, includes $75 expenses related to convertible bonds




129


**SUPERCOM
        LTD. AND ITS SUBSIDIARIES**
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **U.S.
        dollars in thousands**


**NOTE
                17:-**
            **OTHER
                EXPENSES, NET**




**Year
                ended December 31,****2004**
            
            **2005**
            
            **2006**Write
                down of loan regarding an investment in an affiliated company and
                other
                trade receivables
            
            $
            -
            
            $
            -
            
            $
            (321
            )Loss
                on sale of property and equipment, net
            
            
            (1
            )
            
            -
            
            $
            (8
            )Decline
                in market value of held-to-maturity securities
            
            
            (7
            )
            
            -
            
            
            -Other
            
            
            (19
            )
            
            (30
            )
            
            (38
            )$
            (27
            )
            $
            (30
            )
            $
            (367
            )




**NOTE
              18:-**
            **SUBSEQUENT
                EVENTS**





a.
            During
                January 2007, the General Shareholders Meeting approvedamong
                other things, the grant of options to acquire up to 51,000 ordinary
                shares
                of the Company to the Chairman of the Board of Directors and options
                to
                acquire up to 20,400 shares of the Company to a director of the Company.
                The exercise price of the options is $ 5 per share.





b.
            On
                January 2, 2007 the Company received a $2,500 loan from a financial
                institution bearing interest at a rate of Libor + 1.5%. As part as
                the
                transaction of the sale of the Company’s e-ID Division to OTI. The Company
                pledged its restricted ordinary shares of OTI as security for the
                loan.
                The proceeds of any sale of the OTI ordinary shares shall be applied
                first
                to pay off any payments due under the loan. Until the loan (including
                any
                applicable interest and fees) is paid in full, any remaining proceeds
                from
                the sale of the OTI ordinary shares shall be held by the financial
                institution (up to an amount equal to the unpaid principal amount
                plus any
                accrued but unpaid interest on the loan) as security for the loan,
                OTI has
                agreed to guarantee the loan on behalf of the Company. The fair value
                of
                the guarantee was estimated by Company Management as insignificant.
                See
                Note 1a.





c.
            During
                February 2007, the Company purchased the remaining 20% of its subsidiary
                (Pure RF) from the minority for an amount of $
                100.





d.
            Reverse
                share split.





On
      May,
      14 2007 a 1 for 5.88235 reverse split of the Company ordinary shares became
      effective for trading purpose. Pursuant to this reverse share split each 5.88235
      ordinary shares of Nis 0.01 par value became 1 ordinary share of Nis 0.0588235
      par value. Unless otherwise noted, all share and per share amounts for all
      periods presented (including numbers of options, warrants and convertible bonds)
      have been retroactively restated to give effect to this reverse
      split.


130


**ITEM
      19.    Exhibits.**





1.1*
            Memorandum
                of Association.





1.2*
            Articles
                of Association.





1.3*
            Amendment
                to Articles of Association.





2.1*
            Forms
                of Stock Certificates Representing Ordinary
                Shares.





4.1*
            The
                SuperCom Ltd. 1999 Employee Stock Option Plan (as Amended and Restated
                in
                2002).





4.1(a)**
            The
                SuperCom Ltd. 2003 Israeli Share Option
                Plan




4.2*
            Stock
                Purchase Agreement between SuperCom and Elad Ink, dated as of March
                4,
                2002.





4.3*
            Stock
                Purchase Agreement between SuperCom and ICTS BV, dated as of April
                29,
                2002.





4.4*
            Stock
                Purchase Agreement between SuperCom and ICTS-USA, Inc., dated as
                of
                September 27, 2002.





8
            List
                of Subsidiaries of SuperCom Ltd.





11.1
            Code
                of Ethics




12.1
            Certification
                pursuant to Section 302 of the Sarbanes-Oxley
                Act.





12.2
            Certification
                pursuant to Section 302 of the Sarbanes-Oxley
                Act.




13.1
            Certification
                pursuant to Section 906 of the Sarbanes-Oxley
                Act.





15.1
            Consent
                of Fahn, Kanne & Co., a member of Grant Thornton, dated June 29,
                2006.





15.2
            Consent
                of BDO McCabe Lo & Company, independent public accountants, dated June
                29, 2006.








*
                Previously filed as exhibits to, and incorporated herein by reference
                from, the Company’s Registration Statement on Form 20-F (File No.: 0-50790
                filed on September 14, 2004).**
                Previously filed as Exhibit 99.2 to, and incorporated herein by reference
                from, the Company’s Registration Statement on Form S-8 (File No.
                333-121231filed on December 14, 2004).


131


**SIGNATURE**




SuperCom
      Ltd. 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.




**SUPERCOM
                LTD.****By:**
            /s/
                Eyal Tuchman**Eyal
                Tuchman****Its:**
            **Chief
                Executive Officer**




Date: June 28 ,
      2007


132


Exhibit
      8




**Subsidiaries
      of Vuance Ltd. as of June 20, 2007**


**Name
                  of Subsidiary**
              
              **Jurisdiction
                  of Organization**
              
              **Percent
                  Owned**SuperCom,
                  Inc.
              
              United
                  States
              
              100%SuperCom
                  Asia Pacific Ltd.
              
              Hong
                  Kong
              
              100%SuperCom
                  Slovakia A.S.
              
              Slovakia
              
              66%VUANCE
                  - RFID Inc.
              
              United
                  States
              
              100%*S.B.C.
                  Aviation Ltd
              
              Israel
              
              100%


*
      VUANCE
      - RFID Inc has an Israeli wholly-owned subsidiary Pure RF Ltd.,
      (100%)




133




Exhibit
      11.1





**SUPERCOM
      LTD.**


**CORPORATE
        CODE OF CONDUCT AND ETHICS**




This
      Corporate Code of Conduct and Ethics, referred to as the “Code,” is intended to
      provide our associates, as defined below, with a clear understanding of the
      principles of business conduct and ethics that are expected of them and to
      ensure:




·
            the
                ethical handling of conflicts of interest between personal and
                professional relationships;


·
            full,
                fair, accurate, timely and understandable disclosure in the reports
                required to be filed by the company with the Securities and Exchange
                Commission and in other public communications made by the company;
                and


·
            compliance
                with applicable governmental laws, rules and
                regulations.




The
      standards set forth in the Code apply to us all. Every associate of the company
      has to comply with the Code as a condition of his or her relationship with
      the
      company. The term “associate” means every full and part-time employee of the
      company and its subsidiaries, all members of the company’s senior management,
      including the company’s Chief Executive Officer and Chief Financial Officer, and
      every member of the company’s Board of Directors, even if such member is not
      employed by the company.




It
      is our
      responsibility to conduct ourselves in an ethical business manner and also
      to
      ensure that others do the same. If any one of us violates these standards,
      he or
      she can expect a disciplinary response, up to and including termination of
      any
      employment or other relationship with the company, and possibly other legal
      action. If any breach of the Code is known to you, you are encouraged to report
      it to the Corporate Compliance Officer. By doing so, we ensure that the good
      faith efforts of all of us to comply with the Code are not
      undermined.




The
      Chief
      Financial Officer is designated by the Board and can be nominated and changed
      with a Board resolution. The Board has designated the Chief Financial Officer
      the Corporate Compliance Officer.




The
      standards set forth in this Code are guidelines that should govern our conduct
      at all times. If you are confronted with situations not covered by this Code,
      or
      have questions regarding the matters that are addressed in the Code, you are
      urged to consult with the Corporate Compliance Officer.




The
      provisions of the Code regarding the actions the company will take are
      guidelines which the company intends to follow. There may be circumstances,
      however, that in the company’s judgment require different measures or actions
      and in such cases it may act accordingly while still attempting to fulfill
      the
      principles underlying this Code




I
              **CONFLICTS
                  OF INTEREST**




Associates
      should avoid any situation that may involve, or even appear to involve, a
      conflict between their personal interests and the interests of the company.
      In
      dealings with current or potential customers, suppliers, contractors, and
      competitors, each associate should act in the best interests of the company
      to
      the exclusion of personal advantage. Associates and their immediate family
      members are prohibited from any of the following activities which could
      represent an actual or perceived conflict of interest:




·
            Having
                a significant financial interest in, or obligation to any outside
                enterprise which does or seeks to do business with the company or
                which is
                an actual or potential competitor of the
                company.




134




·
            Serving
                as a director, officer or in any other management or consulting capacity
                for any actual or potential competitor of the company or engaging
                in
                activities that are directly competitive with those in which the
                company
                is engaged.




·
            Conducting
                a significant amount of business on the company’s behalf with an outside
                enterprise which does or seeks to do business with the company if
                an
                immediate family member of the associate is a principal, officer
                or
                employee of such enterprise.




·
            Using
                any company property or information or his or her position at the
                company
                for his or her personal gain or diverting a business opportunity
                from the
                company for personal benefit.




·
            Receiving
                any loan or advance from the company, or be the beneficiary of a
                guarantee
                by the company of a loan or advance from a third party, except for
                customary advances or corporate credit in the ordinary course of
                business
                or approved by the Audit Committee and the Corporate Compliance
                Officer.




·
            In
                addition, the Audit Committee of the Board will review and approve
                all
                related-party transactions, as required by the Securities and Exchange
                Commission, any exchange or market upon which the Company’s securities are
                listed or quoted, or any other regulatory body to which the company
                is
                subject.




II
              **FULL
                  AND FAIR DISCLOSURE**





Because
      the integrity of the company’s external reports to shareholders and authorities
      such as the Securities and Exchange Commission depends on the integrity of
      the
      company’s internal reports and record-keeping, all associates must adhere to the
      highest standards of care with respect to our internal records and reporting.
      The company is committed to full, fair, accurate, timely, and understandable
      disclosure in the periodic reports required to be filed by it with authorities
      such as the Securities and Exchange Commission, and it expects each associate
      to
      work diligently towards that goal.




**A**
            **Accurate
                Records and Reporting**




Under
      law, the company is required to keep books, records and accounts that accurately
      and fairly reflect all transactions, dispositions of assets and other events
      that are the subject of specific regulatory record keeping requirements,
      including generally accepted accounting principles and other applicable rules,
      regulations and criteria for preparing financial statements and for preparing
      periodic reports filed with authorities such as the Securities and Exchange
      Commission. All company reports, accounting records, sales reports, expense
      accounts, invoices, purchase orders, and other documents must accurately and
      clearly represent the relevant facts and the true nature of transactions.
      Reports and other documents should state all material facts of a transaction
      and
      not omit any information that would be relevant in interpreting such report
      or
      document. Under no circumstance may there be any unrecorded liability or fund
      of
      the company, regardless of the purposes for which the liability or fund may
      have
      been intended, or any improper or inaccurate entry knowingly made on the books
      or records of the company. No payment on behalf of the company may be approved
      or made with the intention, understanding or awareness that any part of the
      payment is to be used for any purpose other than that described by the
      documentation supporting the payment. In addition, intentional accounting
      misclassifications (e.g., expense versus capital) and improper acceleration
      or
      deferral of expenses or revenues are unacceptable reporting practices that
      are
      expressly prohibited.





The
      company has developed and maintains a system of internal controls to provide
      reasonable assurance that transactions are executed in accordance with
      management’s authorization, are properly recorded and posted, and are in
      compliance with regulatory requirements. The system of internal controls within
      the company includes written policies and procedures, budgetary controls,
      supervisory review and monitoring, and various other checks and balances, and
      safeguards such as password protection to access certain computer systems.
      The
      company has also developed and maintains a set of disclosure controls and
      procedures to ensure that all of the information required to be disclosed by
      the
      company in the reports that it files or submits under the Securities Exchange
      Act is recorded, processed, summarized and reported within the time periods
      specified by the Securities and Exchange Commission’s rules and forms.
      Associates are expected to be familiar with, and to adhere strictly to, these
      internal controls and disclosure controls and procedures.




135




**B**
            **Document
                Retention**




Applicable
      laws and regulations require the proper retention of many categories of records
      and documents that are commonly maintained by companies. In consideration of
      those legal requirements and the company’s business needs, all associates must
      maintain records in accordance with the legal requirements.




In
      addition, any record, in paper or electronic format, relevant to a threatened,
      anticipated or actual internal or external inquiry, investigation, matter or
      lawsuit may not be discarded, concealed, falsified, altered, or otherwise made
      unavailable, once an associate has become aware of the existence of such
      threatened, anticipated or actual internal or external inquiry, investigation,
      matter or lawsuit. Associates must handle such records in accordance with the
      legal requirements.




When
      in
      doubt regarding retention of any record, an associate must not discard or alter
      the record in question and should seek guidance from the Corporate Compliance
      Officer.





III
            **FAIR
                DEALING WITH CUSTOMERS, SUPPLIERS, COMPETITORS, AND
                ASSOCIATES**





The
      company does not seek to gain any advantage through the improper use of favors
      or other inducements. Good judgment and moderation must be exercised to avoid
      misinterpretation and adverse effect on the reputation of the company or its
      associates. Offering, giving, soliciting or receiving any form of bribe to
      or
      from an employee of a customer or supplier to influence that employee’s conduct
      is strictly prohibited.




**A.**
            **Giving
                Gifts**




Cash
      or
      cash-equivalent gifts must not be given by an associate to any person or
      enterprise. Gifts, favors and entertainment may be given to non-governmental
      employees if what is given:




·
            is
                consistent with customary business
                practice;




·
            is
                not excessive in value and cannot be construed as a bribe or
                pay-off;




·
            is
                not in violation of applicable law or ethical standards;
                and




·
            will
                not embarrass the company or the associate if publicly
                disclosed.





See
      also
      subsection E below for considerations relating to gifts to foreign officials
      and
      Section IV. B below for considerations relating to gifts to government
      employees.





**B.**
            **Receiving
                Gifts**




Gifts,
      favors, entertainment or other inducements may not be accepted by associates
      or
      members of their immediate families from any person or organization that does
      or
      seeks to do business with, or is a competitor of, the company, except as common
      courtesies usually associated with customary business practices. If the gift
      is
      of more than token value, the Corporate Compliance Officer must approve its
      acceptance. An especially strict standard applies when suppliers are involved.
      If a gift unduly influences or makes an associate feel obligated to “pay back”
the other party with business, receipt of the gift is unacceptable. It is never
      acceptable to accept a gift in cash or cash equivalent.




136




**C.**
            **Unfair
                Competition**





Applicable
      laws and regulations dictate what can and what cannot be done in a competitive
      environment. The following practices can lead to liability for “unfair
      competition” and should be avoided. They are violations of the
      Code.





Disparagement
      of Competitors. It is not illegal to point out weaknesses in a competitor’s
      service, product or operation; however, associates may not spread false rumors
      about competitors or make misrepresentations about their businesses. For
      example, an associate may not pass on anecdotal or unverified stories about
      a
      competitor’s products or services as the absolute truth (e.g., the statement
      that “our competitors’ diagnostic testing procedures have poor quality
      control”).





Disrupting
      a Competitor’s Business. This includes bribing a competitor’s employees, posing
      as prospective customers or using deceptive practices such as enticing away
      employees in order to obtain secrets or destroy a competitor’s organization. For
      example, it is not a valid form of “market research” to visit a competitor’s
      place of business posing as a customer.





Misrepresentations
      of Price and Product. Lies or misrepresentations about the nature, quality
      or
      character of the company’s services and products are both illegal and contrary
      to company policy. An associate may only describe our services and products
      based on their documented specifications, not based on anecdote or his or her
      belief that our specifications are too conservative.





**D.**
            **Antitrust
                Concerns**




The
      company is subject to antitrust laws and regulations in the jurisdictions where
      it does business that are intended to ensure that competition is the primary
      regulator of business activity. These laws and regulations prohibit many kinds
      of formal or informal understandings, agreements, and plans which involve
      prices, territories, market share or customers to be served. As a result, every
      corporate decision that involves customers, competitors, and business planning
      with respect to output, sales and pricing raises antitrust issues. Compliance
      with applicable antitrust laws is in the public interest, in the interest of
      the
      business community at large, and in our company’s interest.





Failing
      to recognize antitrust risk is costly. Antitrust litigation can be very
      expensive and time-consuming. Moreover, violations of the antitrust laws can,
      among other things, subject you and the company to the imposition of
      injunctions, treble damages, and heavy fines. Criminal penalties may also be
      imposed, and individual employees can receive heavy fines or even be imprisoned.
      For this reason, antitrust compliance should be taken seriously at all levels
      within the company.




**E.**
            **Unfair
                Practices in International Business**




Applicable
      laws and regulations prohibit associates from making certain gifts to foreign
      officials. “Foreign officials” may include not only persons acting in an
      official capacity on behalf of a foreign government, agency, department or
      instrumentality, but also representatives of international organizations,
      foreign political parties and candidates for foreign public office. A gift
      may
      be prohibited if it is made for the purpose of:





·
            Influencing
                any act or decision of a foreign official in his official capacity;





·
            Inducing
                a foreign official to do or omit to do any act in violation of his
                lawful
                duty;





·
            Inducing
                a foreign official to use his position to affect any decision of
                the
                government; or





·
            Inducing
                a foreign official to secure any improper
                advantage.


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A
      gift is
      still prohibited even when paid through an intermediary. Any associate who
      has
      any questions as to whether a particular gift might be prohibited, please
      contact the Corporate Compliance Officer.




**IV.**
            **GOVERNMENT
                RELATIONS**




Associates
      must adhere to the highest standards of ethical conduct in all relationships
      with government employees and must not improperly attempt to influence the
      actions of any public official.




A.
            **Government
                Procurement**





Many
      national and local governments have adopted comprehensive laws and regulations
      governing their purchases of products from private contractors. These laws
      and
      regulations are intended to assure that governmental entities receive pricing,
      terms, and conditions equivalent to those granted to the company’s most favored
      commercial customers and that there is full and open competition in contracting.
      When selling products or services to government procurement agencies, the
      company is accountable for complying with all applicable procurement laws,
      regulations, and requirements. Certifications to, and contracts with, government
      agencies are to be signed by a company associate authorized by the Managing
      Board to sign such documents, based upon knowledge that all requirements have
      been fully satisfied.




B.
            **Payments
                to Officials**





Payments
      or gifts shall not be made directly or indirectly to any government official
      or
      associate if the gift or payment is illegal under the laws of the country having
      jurisdiction over the transaction, or if it is for the purpose of influencing
      or
      inducing the recipient to do, or omit to do, any act in violation of his or
      her
      lawful duty. Under no circumstances should gifts be given to employees of the
      United States Government.




**C.**
            **Political
                Contributions**




Company
      funds, property or services may not be contributed to any political party or
      committee, or to any candidate for or holder of any office of any government.
      This policy does not preclude, where lawful, company expenditures to support
      or
      oppose public referendum or separate ballot issues, or, where lawful and when
      reviewed and approved in advance by the Corporate Compliance Officer, the
      formation and operation of a political action committee.





**V.**
            **COMPLIANCE
                WITH LAWS, RULES AND
                REGULATIONS**




**A.**
            **Insider
                Trading Policy**




The
      company expressly forbids any associate from trading on material non-public
      information or communicating material non-public information to others in
      violation of the law. This conduct is frequently referred to as “insider
      trading.” This policy applies to every associate of the company and extends to
      activities both within and outside their duties to the company, including
      trading for a personal account. An associate may also become a temporary insider
      of another company with which our company has a contractual relationship, to
      which it has made a loan, to which it provides advice or for which it performs
      other services.





Trading
      on inside information is not a basis for liability unless the information is
      material. This is information that a reasonable investor would consider
      important in making his or her investment decisions, or information that is
      likely to have a significant effect on the price of a company’s
      securities.





Information
      is non-public until it has been effectively communicated to the marketplace.
      Tangible evidence of such dissemination is the best indication that the
      information is public. For example, information found in a report filed with
      the
      Securities and Exchange Commission or appearing in a national newspaper would
      be
      considered public. Each associate should be familiar with and abide by the
      company’s Insider Trading Policy. A copy of this policy is available from the
      Human Resources Department or on the Company’s intranet site.




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**B.**
            **Equal
                Employment Opportunity**




The
      company makes employment-related decisions without regard to a person’s race,
      color, religious creed, age, sex, sexual orientation, marital status, national
      origin, ancestry, present or past history of mental disorder, mental
      retardation, learning disability or physical disability, including, but not
      limited to, blindness and genetic predisposition, or any other factor unrelated
      to a person’s ability to perform the person’s job. “Employment decisions”
generally mean decisions relating to hiring, recruiting, training, promotions
      and compensation, but the term may encompass other employment actions as well.
      The company encourages its associates to bring any problem, complaint or concern
      regarding any alleged employment discrimination to the attention of the Human
      Resources Department. Associates who have concerns regarding conduct they
      believe is discriminatory should also feel free to make any such reports to
      the
      Corporate Compliance Officer.





**C.**
            **Sexual
                Harassment Policy**




The
      company is committed to maintaining a collegial work environment in which all
      individuals are treated with respect and dignity and which is free of sexual
      harassment. In keeping with this commitment, the company will not tolerate
      sexual harassment of associates by anyone, including any supervisor, co-worker,
      vendor, client or customer, whether in the workplace, at assignments outside
      the
      workplace, at company-sponsored social functions or elsewhere. Each associate
      should contact the Human Resources Department if he requires further
      information.





**D.**
            **Health,
                Safety & Environment
                Laws**




Health,
      safety, and environmental responsibilities are fundamental to the company’s
      values. Associates are responsible for ensuring that the company complies with
      all provisions of the health, safety, and environmental laws of the United
      States and of other countries where the company does business. The penalties
      that can be imposed against the company and its associates for failure to comply
      with health, safety, and environmental laws can be substantial, and include
      imprisonment and fines.





**VI.**
            **REPORTING
                VIOLATIONS UNDER THE CODE: NON-RETALIATION
                POLICY**




Any
      associate of the company having any information or knowledge regarding the
      existence of any violation or suspected violation of the Code may report the
      violation or suspected violation to the Corporate Compliance Officer. The
      Company will endeavor to keep reports confidential to the fullest extent
      practicable under the circumstances.




Any
      associate who reports a suspected violation under the Code by the company,
      or
      its agents acting on behalf of the company, to the Corporate Compliance Officer,
      may not be fired, demoted, reprimanded or otherwise harmed for, or because
      of,
      the reporting of the suspected violation, regardless of whether the suspected
      violation involves the associate, the associate’s supervisor or senior
      management of the company.




In
      addition, any associate who reports a suspected violation under the Code which
      the associate reasonably believes constitutes a violation of a federal statute
      by the company, or its agents acting on behalf of the company, to a federal
      regulatory or law enforcement agency, may not be reprimanded, discharged,
      demoted, suspended, threatened, harassed or in any manner discriminated against
      in the terms and conditions of the associate’s employment for, or because of,
      the reporting of the suspected violation, regardless of whether the suspected
      violation involves the associate, the associate’s supervisor or senior
      management of the company.





139


**VII.**
            **QUESTIONS
                UNDER THE CODE AND WAIVER
                PROCEDURES**




Associates
      are encouraged to consult with the Corporate Compliance Officer about any
      uncertainty or questions they may have under the Code. If any situation should
      arise where a course of action would likely result in a violation of the Code
      but for which the associate thinks that a valid reason for the course of action
      exists, the associate should contact the Corporate Compliance Officer to obtain
      a waiver **prior
      to the time the action is taken. No waivers will be granted after the fact
      for
      actions already taken.** Except
      as noted below, the Corporate Compliance Officer will review all the facts
      surrounding the proposed course of action and will determine whether a waiver
      from any policy in the Code should be granted.





*Waiver
      Procedures for Executive Officers and Directors* .
      Waiver
      requests by an executive officer or member of the Board shall be referred by
      the
      Corporate Compliance Officer, with his or her recommendation, to the Board
      or a
      committee thereof for consideration. If either (i) a majority of the independent
      directors on the Board, or (ii) a committee comprised solely of independent
      directors agrees that the waiver should be granted, it will be granted. The
      company will disclose the nature and reasons for the waiver on its next Form
      20-F to be filed with the Securities and Exchange Commission or otherwise as
      required by the Securities and Exchange Commission. If the Board denies the
      request for a waiver, the waiver will not be granted and the associate may
      not
      pursue the intended course of action.





**It
      is the company’s policy only to grant waivers from the Code in limited and
      compelling circumstances.**





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