Unlike the taxing authorities in many other countries, the tax authorities of Israel – managing the tax system of one of the world's leading innovation incubators – actively 'patrol the border' keeping a close watch on related-party transactions that may involve intangibles.
Bolstered by the 2010 transfer pricing guidelines of the OECD's 'changes in business models', the Israel tax authorities (ITA) booked a first victory in 2017 at the district court in the case of Giteck. With the confidence gained from that case, the ITA then proceeded, in 2018, with the publication of a circular explaining when and how the export of values from (often typically IP-driven) Israeli companies can be identified and will be taxed. Circular 15/2018 focuses on international exports of functions, assets and risks (FAR), and is especially aimed at taxing fleeing FAR elements oftentimes following the acquisition of control in an Israel based company by a foreign investor.
In the Giteck case, the shares of an Israeli company were purchased in 2006 for some $90 million by Microsoft Corporation US. After its inception in 1992, Giteck had developed a piece of successful software (IP) used as its platform to provide automated technical support for manufacturers of electronic equipment. On the eve of the take-over by the Microsoft group, Giteck employed close to 150 staff supporting its customers and a small number running its IP. As often happens after acquisition by an MNE, Microsoft transferred Giteck's staff to its local existing subsidiary, while Giteck – not long after – reported having sold its IP to the US Microsoft company at a price of $26.6 million.
Once the tax audit was launched, the ITA argued that because the most substantial asset of a technology company is its IP, Giteck's income reported from the IP transaction should have been close to the $90 million paid for its shares. The court refereeing the dispute, after making its own detailed assessment of domestic transfer pricing and relevant OECD guidelines, in particular rejected the 'synergy' argument raised by Giteck, explaining the higher share price paid by Microsoft included, inter alia, a significant appreciation of the expected benefits of Giteck's joining the existing abilities of the Microsoft group. The honourable court believed that "value does not disappear or evaporate" and that Giteck had not succeeded in arguing why the total FAR value in Giteck should not be equal the $90 million share price paid and the taxpayer had not succeeded in meeting the burden of proof.
In a similar case, after a two-year arbitration around an IP extraction following the acquisition of Israel-based Mercury Interactive by HP, HP agreed – in July 2017 – to pay an additional NIS 3.1 billion ($877 million) in tax in relation to the IP transaction after it had acquired the shares in Mercury for $4.5 billion. Initially, the ITA had actually demanded NIS 4 billion.
Recently, at the beginning of September 2019, the Israel Supreme Court also issued an intermediate decision in the district court-heard case regarding the Broadcom group and regarding the integration of its 2012 acquired Israeli subsidiary, Broadlight. After the Broadlight share purchase for $200 million, the Broadcom group chose to transfer the intellectual property and other assets out of Broadlight at a reported a price of $59.5 million for the IP. The tax authorities insisted that Broadlight's research and development (R&D) and its marketing capabilities – in effect the balance of its FAR – were also no longer with Broadlight. Broadlight insists that no transfer of economic ownership of the balance of the FAR functions had taken place and showed two 2012 agreements by the companies to support the inter-company arrangement that governed the relationship between Broadlight and its related companies.
The district court, where the case is currently pending, supports the ITA's claim that the tax assessor may actually re-classify the nature of the inter-company relationship regarding the relevant bits of Broadlight FAR, and roll out the 'anti-artificiality' chapter of the Israel Tax Ordinance, section 86. This particular anti-avoidance tool allows the tax assessor to ignore the legal appearance of a transaction, or even a transaction altogether, when an economic base for the transaction – or for the way in which it was executed – is absent in his eyes. This is a surprising new use of section 86, in light of the fact that the purpose, goal and background of this piece of anti-abuse legislation bears no connection to transfer pricing legislation and was born to redirect cases of apparent abuse. The Supreme Court, in an indirect way, did not halt the district court in supporting the tax assessor that the burden to disprove the impression of the tax assessor rests on the taxpayer absolving the tax assessor from having to prove why the contractual intentions of Broadlight are incorrect. Interestingly, the impact of this particular court supported discussion regarding classification of the transaction may, in the long run, backfire and actually limit the future freedom of the tax authorities to re-classify or classify certain agreements.
It is estimated that the ITA is running well over 20 pending FAR discussions in connection with acquisitions that have occurred in recent years. Tax experts accompanying multinationals acquiring control in Israeli companies confirm that a new perception of the share price negotiations is imperative, and that the highly uncertain outcome of a future gains tax discussion regarding relevant IP should be at the centre of the negotiating table. If not, the alternative is to leave the IP and other FAR aspects of the acquired company untouched. This will often pose challenges from an implementation and technical perspective leaving finance management of the acquiring group with substantial tax uncertainties when re-classification of inter-company transactions is sprung upon them.