by Jacky Houlie, Managing Partner; Shlomo Hubscher, Partner
In a recent decision by the Israeli District Court in Tel Aviv, the court rejected the Israeli tax authorities’ (ITA) argument that a post-acquisition amendment to the appellant business model necessarily implies a sale of business.
In light of the common scenario of Israeli technology companies undergoing acquisitions by multi-national enterprises (MNE), the ITA has been increasingly aggressive claiming ‘business restructuring exposures’ of deemed transfers of functions, assets, and risks (FAR) from the Israeli taxpayer to the acquiring MNE.
A brief history of business restructuring attention in Israel is outlined as follows:
- In June 2017, Gteko Ltd. vs. Kfar Saba Assessing Officer, Ruling 49444-01-13 (the Gteko Ruling) the Israeli 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.
- In November 2018, the ITA published Tax Circular No. 15/2018: Business Restructuring within a Multinational Group, clarifying the ITA’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, acceptable methodologies for assessing the FAR that have been transferred or ceased, as well as the tax implications thereof.
- In December 2019, the landmark ruling, Broadcom Semiconductor Ltd. vs. Kfar Saba Assessing Officer, Tax Appeal 26342-01-16 (the “Broadcom Ruling) concluded that a transition of an Israeli company from a principal and owner of intellectual property position to a service provider role on a cost-plus basis does not necessarily trigger a capital gain tax event by means of sale of an asset.
Taking the variance of the Gteko and Broadcom rulings into consideration, it is of particular note to review and understand the implications of the latest Israeli court ruling in May 2022, Medingo, Ltd. vs. Afula Assessing Officer, Tax Appeal 53528-01-16, (the Medingo Ruling).
Main facts: An Israeli taxpayer, Medingo Ltd. (Medingo), that had developed a proprietary insulin pump had been acquired in 2010 by the Roche pharmaceutical group (Roche). Thereupon, the parties established intercompany agreements for Medingo to provide R&D, manufacturing, and related services, all on a contract basis to Roche going forward, as well a license agreement between the parties with respect to Medingo’s legacy IP. The legacy IP was eventually sold to the licensee (Roche) a few years later, in 2013.
The ITA characterized the intercompany arrangements as a transfer of FAR, retroactive to 2010 and applied the initial acquisition price as reference to determine the value of said FAR ILS 481 million (roughly $138.5 million) subject to capital gains tax.
The District Court, however, continued in the direction of the Broadcom Ruling (cited multiple times in the Medingo Ruling) and dismissed the ITA’s far-reaching approach to transfers of FAR following a business restructuring.
With reference to the OECD Guidelines, the court ruled that only in exceptional circumstances, tax authorities are required to intervene in the nature of the transaction agreed by the parties. More specifically, it should only intervene in cases where such transaction is clearly unreasonable or where it is impractical to determine an arm’s length price for the agreed transaction.
In addition, the court emphasized that in accordance with the arm’s length principle, realistically available options are referred to as a business alternative, which is a clearly preferred alternative without a doubt and not one of a number of theoretical options, with the benefit of hindsight. As such, the realistically available options should be examined from the perspective of both sides.
At the case at hand, the court concluded that the intercompany agreements were found to be acceptable in this industry and, considering the circumstances of the case (e.g. the considerable obstacles faced by Medingo and significant business risks in is operations), there was logic in establishing such. Therefore, the intercompany arrangements (and the parties’ behavior thereof) should be respected, and there is no room for recharacterization of the agreements. The court indicated that the post-acquisition agreements were not necessarily influenced by the fact that Medingo and Roche were now related parties.
In addition, the court distinguished between legacy IP (subject to the license arrangement) and new IP (developed by Medingo on a contract basis) and indicated that Roche’s license to use the legacy IP was for a fixed period and Roche acquired said IP at the end of that period. Further, the fact that Roche was not entitled to transfer said IP without Medingo’s consent supports this distinction.
Finally, the court ruled that businesses can change their business mix, such as Medingo’s reduction in risks (e.g. from IP owner to a licensor and contract service provider) and such does not necessarily entail a sale of business activity.
JH Law provides a full range of transfer pricing services that address the challenges of international commerce and business operations. This alert is provided solely for informational and educational purposes and is not a full or complete analysis of the matters presented and should not be construed as legal advice.
by Jacky Houlie, Managing Partner; Shlomo Hubscher, Partner
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