By Assaf Hasson, Assaf Hasson & Co.
The Israeli Jerusalem District Court ruled in favor of the Israel Tax Authority (the ITA) in a transfer pricing case, Sephira & Offek Ltd. and Israel Daniel Amram, dated August 16. The case involved the reclassification of a trademark transaction between a new immigrant and his company and the arm’s length principle with respect to research and development (R&D) services.
The court supported the ITA’s main contentions. First, a transaction in which the appellant sold a trademark to a company owned by him was a negative tax planning event which is not covered by section 97(b)(1) of the Israeli Tax Ordinance (New Version), 5721-1961 (the Tax Ordinance). Second, income from R&D which exceeded the amount to be considered as arm’s length as ordinary income must be reclassified. Third, such income is not entitled to the tax incentives under the Israeli Encouragement of Capital Investments Law, 5719-1959 (the Encouragement Law).
Facts
Israel Daniel Amram (the appellant) is an engineer who was employed until 1998 by the French Ministry of Health and, as part of his work, was involved in a national project aimed at issuing every French citizen a medical card that includes a memory chip containing his or her relevant medical information. Following his involvement in this project, the appellant developed a unique and efficient computerized interface that would link French insurance companies and physicians and facilitate financial accounting between medical service providers and patients.
In 1999, the appellant registered the trademark SEPHIRA in France and established a French company bearing the name SEPHIRA SAS. Sephira provided services to medical service providers, including, among other things, leasing the dedicated device required to read smart medical cards.
In 2003, the appellant made Aliya, immigrating from France to Israel, and, in the same year, he established Sephira Israel. In the initial years following its establishment, Sephira Israel mainly provided foreign non-Israeli companies with R&D services and operated a call center.
As of 2011, Sephira Israel reported its income from R&D services as preferred income in accordance with the provisions of section 51Z of the Encouragement Law.
Over the years, the scope of Sephira France’s activities expanded until it employed about 150 workers and provided services to approximately 33,000 medical service providers, which constituted about 20% of the medical services market in France.
In 2009, the appellant renewed his ownership of the trademark to Sephira in France.
On July 2011, the appellant signed an agreement with Sephira Israel for the sale of his rights in the trademark Sephira in exchange for an amount equal to EUR 8.4 million, which was determined in accordance with a valuation made around the date of the transaction. The agreement stipulates that the consideration for the trademark will be paid in semi-annual payments, with each semi-annual payment being not less than EUR 150,000. Sephira Israel transferred the consideration to the appellant within a period of four years, with the last payment being made in May 2015.
In December 2011, following Sephira Israel’s acquisition of the trademark, it entered into an agreement with Sephira France pursuant to which Sephira France would pay Sephira Israel royalties for the use of the trademark.
In 2017, the ITA claimed that the transaction of sale of the trademark was an artificial transaction that must be ignored for the purposes of determining the tax applicable to the appellants. It also claimed that the appellant’s profit rate from the R&D activity exceeds the standard profit rate in the industry. Therefore, the ITA determined that the appellant’s taxable income which was in excess of the usual profit from the R&D activity should be classified as ordinary income that is taxable at the regular corporate tax rate and not as preferred income under the Encouragement Law.
Ruling
The court ruled that the trademark sale transaction was artificial under Section 86 of the Tax Ordinance and should therefore be ignored along with its implications (including the royalty income at the level of Sephira Israel).
On the basis of the arguments made by the ITA, the court also stated that the appellant took advantage of tax benefits that he was entitled to as an Oleh, New Immigrant, by selling his trademark to his own company in an artificial manner, and that the appellants failed to demonstrate the commercial reasons for the transaction. Further, the court agreed with the ITA that the individual earned the royalty income and therefore should be taxed at his marginal rate.
The court addressed the appellants’ contention that, in the proceedings, the ITA changed its position on transfer pricing matters from a position based on section 85A of the Tax Ordinance to a position relying on the grounds of “reclassification”. The court, based on the Supreme Court’s ruling in the “Shawarma A.S. Ltd.” case, rejected the appellant’s contention regarding an invalid change in its position by the ITA and argued that during the appeal the appellant was given a reasonable opportunity to deal with the ITA’s position.
At this point, the court rejected the appellants’ contention that the transaction should be assessed on the basis of section 85A of the Tax Ordinance, which deals with transfer pricing since such section applies to an international transaction in which the price is set for services only “if the price were determined for the conditions between parties with whom there is no special relationship[…]”. The court agreed with the ITA that when providing the R&D services, the appellant generated more profits than would be expected in an arm’s length transaction between parties with no special relationship. In addition, with the court accepting this contention, there were no issues with the ITA’s conclusion regarding reclassification.
According to the court, the ITA was indeed entitled to reclassify the appellant’s income from R&D services to related companies and determine that the amount of income reported by the appellant in respect of such R&D services exceeded the operating margin at market value and should be classified as ordinary income and not as preferred income.
Nevertheless, the court did partially uphold one part of the appellant’s appeal that the ITA should have calculated the amount of the deviation not according to the operating profit based on the median rate determined in the market research (18.67%) but according to the highest rate found in the market research on transactions between unrelated companies (40%).
Conclusion
The court ruling has significant tax implications for New Immigrants or returning residents and their companies, prior to and following their Aliya. With respect to transfer pricing matters, multinational companies should examine the use and reference to their transfer pricing studies to determine that income exceeding the arm’s length amount should be regarded as ordinary income. Aligning the amount of income and profit recognition for preferred activities and the related transfer pricing studies may avoid the reclassification of income that is eligible for ordinary income tax incentives and the subjection of such income to the corporate income tax rate.
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