By Jacky Houlie, JH & Co. Law Office, and Shlomo Hubscher JH Consulting Ltd.
In a landmark ruling, Israel’s Lod District Court last week (December 9) rejected the Israeli tax authorities’ position on the classification of a business restructuring from a tax and transfer pricing perspective.
In Broadcom Semiconductor Ltd. vs. Kfar Saba Assessing Officer, the court ruled that an Israeli company that transitions from a principal and owner of intellectual property to a service provider on a cost-plus basis does not necessarily trigger a tax event from the sale of an asset.
The ruling is particularly significant in contrast to the 2017 Gteko-Microsoft decision, which was issued by the same judge, The Honorable Dr. Samuel Bornstein.
Broadcom Israel
Broadcom Semiconductors, Ltd is an Israeli company, established in 2001 as “Dune Semiconductors, Ltd.” and engaged in the development, production, and supply of fast switches and router components. Dune Semiconductors had rights to certain intellectual property, both those licensed in from related affiliates as well as internally developed.
The Dune companies were acquired by the Broadcom Corporation in November 2009. To complete this acquisition, Broadcom Israel applied to the Office of Chief Scientist (known as the Israel Innovation Authority since 2016), a division of Israel’s Ministry of Economy and Industry, for a transfer of its developed intellectual property.
The application was in accordance with the Knesset’s 1984 (5744) law, the Law for the Encouragement of Industrial Research and Development and was approved by the Office of Chief Scientist, subject to a payment of 60 million Israeli shekel (approximately USD 17 million) due to Dune Semiconductors’ status as beneficiary of its grants.
Following the acquisition, Broadcom Israel entered into agreements to provide marketing and support services to a related Broadcom affiliate under a cost+ 10% structure, to provide development services to a related Broadcom affiliate, under a cost+ 8% structure, and a license agreement with another Broadcom affiliate to employ Broadcom Israel’s intellectual property in consideration for royalties in the range of approximately 14% of the latter affiliate’s turnover.
Israeli tax authorities’ position
The Israeli tax authorities argued that, as a result of the new agreements, the functions, assets, and risks that had been undertaken in Israel were transferred outside this jurisdiction, thereby constituting a business restructuring, leaving an ‘empty shell’ in Israel.
As a result, the Israeli tax authorities demanded 100 million Israeli shekel (approximately USD 29 million) in additional taxes, claiming that the value of functions, assets, and risks transferred should be based on the purchase price and that the change in the business model should be reclassified as a sale of an asset.
Broadcom Israel’s position
According to Broadcom Israel, the applicability of business restructuring and transfer of functions, assets, and risks would only have been appropriate had Broadcom Israel been emptied of its activity after the acquisition.
However, in this case, Broadcom Israel continued as an operational company both as a licensor and as a service provider and its financial situation actually improved following the acquisition and new business arrangement.
Moreover, several years following the license transaction, Broadcom Israel eventually sold its intellectual property and was taxed for the realized capital gain. Therefore, Broadcom Israel argued that it should not be subject to tax on the transfer of functions, assets, and risks prior to that sale as well.
The ruling
As background, in 2017, an Israeli district court issued the first ruling addressing transfer pricing aspects of the transfers of intangibles. To summarize Gteko Ltd. vs. Kfar Saba Assessing Officer, Ruling 49444-01-13, Judge Bornstein and the court ruled that post-M&A transfers of human and capital assets, including IP, should be considered as a sale of an entire business and therefore the IP value should generally be aligned with the initial acquisition price.
The Gteko Ruling emphasized that the focal question should be what the essence of the transaction(s) is and not the ‘dressing’ around it (what is widely referred to as ‘substance over form’). Moreover, the Israeli district court demonstrated its stance on the potential benefits of synergies. Although synergies may have influenced the initial acquisition price, that does not necessarily prove that an independent party would not identify another benefit that would similarly influence the acquisition price.
In this light, the court ruled that the value of the intangibles should not be further reduced by the synergy value. Finally, Microsoft Corp., the acquiring foreign MNE in the case at hand, transferred human capital (also known as workforce in place) from Gteko Ltd. to Microsoft’s other Israeli subsidiaries.
The court’s view is that a workforce’s professional know-how and possession of commercial secrets related to the technology represents additional substantial value beyond the ‘listed value’ of the technology itself.
In 2018, the Israeli tax authorities published Tax Circular No. 15/2018: Business Restructuring within a Multinational Group, clarifying the Israeli government’s stance on the tax and transfer pricing aspects of changes in business models.
Circular 15/2018, heavily based on the Gteko Ruling, outlines techniques for identification and characterization of restructuring (including required disclosures), acceptable methodologies for assessing the functions, assets, and risks that have been transferred or ceased, as well as the tax implications of the restructuring.
Broadcom Israel versus Gteko
Judge Bornstein explained that the Broadcom Case is very different from the Gteko Ruling. For Gteko, the economic value was enjoyed by Microsoft while the Israeli entity became an ‘empty corporate shell’, seeing a dramatic collapse in Gteko business after its acquisition.
Broadcom, on the other hand, has witnessed increased activity within Israel due to the aforementioned agreements, renting more office space, and hiring more workforce. Moreover, the court emphasized that the Israeli tax authorities did not take into consideration realistically available alternatives at the time of the suggested restructuring, which is one of the primary elements found in Circular No. 15/2018.
While the court recognized that, in principle, it is correct that a business model change may in some cases constitute a functions, assets, and risks sale, it cannot be assumed and automatic. In the words of the ruling, the term “business restructuring” does not ‘magically’ change the classification of the transaction between the parties. Further, to determine that a business restructuring constitutes the sale of functions, assets, and risks property for tax purposes, it must be demonstrated that not only that the change occurred, but also that the change would not meet the arm’s length principle, assuming unrelated parties engaged in similar circumstances.
Accordingly, Broadcom Israel’s business activities are regarded to have evolved naturally. It should be noted that the arm’s length principle should still be applied in a thorough analysis of the functions, assets, and risks to determine the appropriate remuneration mechanism, but such should be done in a deliberate and measured analysis and not an automatic conclusion.
In contrast to Broadcom Israel’s position, however, the court did confirm that the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, as well as its approach to business restructuring, found in Chapter IX thereof, may be used as a reference for Israeli tax purposes.
Relevant take-aways
As Israel is often referred to as the “startup nation” with many technology companies being acquired by foreign conglomerates, the transfer pricing aspects of such exits and other restructurings, including implementation thereof, have increasingly appeared on the radar of the Israeli tax authorities.
Taking into account the aforementioned regulations such as Chapter IX of the OECD guidelines, Circular No. 15/2018, Israeli tax incentive structures, and the differences between the Broadcom and Gteko rulings, it is important for local taxpayers and/or their acquiring parents to be prepared to prove business reasons behind such changes to mitigate business restructuring exposure.
-Jacky Houlie is Founder/Managing Partner at JH & Co. Law Office.
-Shlomo Hubscher is Partner at JH Consulting Ltd.
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