In the Israeli technology world, money is often in short supply, and
“boot-strapping” (making do with less) is the order of the day. So in the first
year or two, a seed technology firm typically operates in someone’s home and
develops a product in the hi-tech, cleantech or biotech field.
all goes well, sales revenues begin and a question suddenly arises – what about
tax planning for the expected profits? One possibility is to claim tax breaks
for approved enterprises or privileged enterprises under the Law for the
Encouragement of Capital Investments.
Another possibility is to go
offshore – or is it? The Israel Tax Authority (ITA) has issued a position paper
which takes aim fair and square at the offshore option (“Position of the Tax
Authority Regarding Tax Consequences In The Case Of a Change in The Business
Model In Companies That Own an Enterprise in the Technological Field” of July 8,
2010). This paper is mandatory reading for every Israeli technology firm, online
operation and patent attorney.
The offshore option According to the ITA
position paper, companies in Israel decide to move over to a business model in
which they provide services to foreign resident companies for a fee calculated
on a “cost plus” basis – costs plus a fixed profit mark-up (typically, cost plus
10 percent). Before the change, the Israeli company held and managed risks and
intellectual property (IP).
After the change in the business model, the
risks and IP are owned or used by a related party for consideration below the
In many cases, the change may not be immediately visible:
the same employees continue to work in the same offices and carry out the same
functions in the same areas of activity.
A change in business model is
sometimes accompanied by a change of parent company, sometimes known as a “flip”
or in Hebrew, a “Hipuch Sharvul” (“sleeve switch”).
indicators of a change of business model are listed in the position paper. These
include the behavior in practice of the parties, in particular, in which company
control is exercised over the transferred IP (decisions regarding investment,
development and hiring of employees and experts, etc); in which company has the
economic ability to bear any risk; and whether the IP is located in a company in
which any unrelated parties are involved.
Further indicators include: the
existence of related party transactions; a change in the method of intercompany
accounting; de-registering IP in Israel; reducing the number of employees
engaged in Israel in development, marketing, sales, support or production;
decrease in revenues in Israel; material changes in the gross profit and
operating profit in Israel; reduction in deferred revenues from sales or
ancillary support services; decrease in cash flow of the Israeli
What are the tax consequences? According to the ITA position
paper, a change in a business model triggers a series of taxable events. First,
a transfer of IP is liable to Israeli capital gains tax. Just because IP is an
intangible (invisible) asset, it is no less taxable when it is sold or
transferred. According to the Israeli Income Tax Ordinance, a sale includes any
action or event which results in an asset leaving the possession of a person.
Currently, the tax rate is 25%.
Second, if any IP is not sold but is used
by another company, the ITA thinks the other company should pay an arm’s length
royalty for the use of the IP.
The ITA will deem the royalty to be
taxable income to the IP owner, presumably each year.
Currently, the tax
rate is 25%. So don’t move only part of the IP – it’s all or
Third, according to the position paper, if assets leave Israel,
the process may be deemed to be an in-kind dividend distribution to the
company’s shareholders and taxed as such. Subject to any tax treaty, 20% tax
applies to a shareholder who holds under 10% of the company, or 25% tax if the
shareholder holds 10% or more.
Fourth, if the Israeli operation was an
approved or privileged enterprise, which elected an exemption from company tax
on undistributed profits, deeming a dividend will also trigger company tax on
those profits at rates of up to 25%.
Fifth, the ITA may disregard
transactions that are artificial or fictitious and aimed at achieving an
improper reduction of tax, for example if the foreign recipient company is
incapable of bearing the risks or managing the IP. The ITA is also considering
whether to make a change in the business model a reportable tax planning event
and may issue a further announcement on the subject.
What the ITA will do
The ITA position paper tells assessing officers how to proceed. First, they will
check which assets were transferred even if they are not recorded in the books
or reported to the ITA, such as knowhow, technology still under development,
future technological rights, brand names, trade marks, client lists, goodwill (=
Next, the ITA will review what type of transaction( s)
can be deemed to occur. Then, the ITA will determine the market value of assets
deemed to have been sold. This is done by asking the company to produce transfer
pricing studies according to Section 85A of the Income Tax Ordinance.
Thereafter, the ITA will identify the royalty value of IP not deemed to be
What tips can we offer? • Always visit your tax advisor when you
visit your patent/IP attorney. Ask them to work together. IP registration can
have decisive tax consequences, good or bad.
• Tax planning is legitimate
if done for legitimate business reasons. Always check the business rationale for
your tax planning.
• Always do your tax planning before developing any
IP. It cannot be taxed if it doesn’t yet exist.
• A transfer of business
risks is a key indicator of a change in the business model, according to the
position paper and according to recent OECD guidance.
• A transfer of
functions and risks is arguably not a taxable transaction, only a transfer of
• But a transfer of risks may reduce the value of any parallel
• Make IP supplies subject to termination clauses. If
done properly, termination may not be taxable.
• If the intention is to
develop IP in Israel and subcontract the production to somewhere cheap like
China, check the transaction is appropriately structured.
need not be an IP sale or royalty transaction if properly worded.
the intention is to enter into an international joint venture (e.g. a cost and
revenue sharing arrangement), these may be recognized and respected by the ITA
if properly structured, according to a published ITA tax ruling. Other joint
ventures may be problematic.
• Israel offers excellent tax breaks for
privileged and approved enterprises for productive and technology enterprises,
especially if they have international competitive appeal. And the regime may
soon be upgraded. Check out these tax breaks as an alternative to going
• Fundraising is usually the quickest indicator of market
value. For example, if there was recently a fundraising in which new investors
injected cash of $10 million and received 10% of the company’s equity on a
post-money basis, the company and its IP must be worth around $100m. The ITA
position paper forgot to point this out, but it is well known.
• Have a
transfer pricing study ready at all times to demonstrate that ongoing
transactions between related parties in your group are on market
This is like a Kashrut certificate for those transactions and is
required by law.
• Multinational corporations that acquire an Israeli
technology company should not export its technology without first checking the
Israeli tax consequences.
Israel has no rule for “stepping up” the cost
of technology although one has been proposed.
As always, consult
experienced tax advisors in each country at an early stage in specific
Leon Harris is an international tax specialist at
Harris Consulting & Tax Ltd.