A recent Israeli Supreme Court case may have implications in many countries around the world that apply the UK concept of “central management and control” as a test of corporate residence.

A Bahamas trading company was found to be “controlled and managed” in Israel, and hence resident and taxable in Israel, in the case of Rachel Niago and Yitzhak Niago Dec’d vs Kfar Saba Assessing Officer (Civil Appeal 3102/12, Israeli Supreme Court, July 14, 2014).

The Israeli tax system is based on UK tax principles because the country was ruled by Britain from 1917 to 1948.

Main facts In 1987, two Israeli resident individuals (Yitzhak and Rahel Niago) set up an Israeli company to buy Israeli textile products and sell them to US customers, or to broker such deals. In 1990, the same individuals transferred the business activity relating to contacts with the customers to a Bahamas company. In 1993, ahead of an IPO on the Tel Aviv Stock Exchange, the Bahamas company sold the business activity back to the Israeli company for NIS 22.4 million ($7.8m.) and paid it as a dividend to the individuals.

The intended result was apparently a tax-free dividend from a foreign company for the parents under Israel’s territorial tax system before 2003.

The ITA’s contentions The Israel Tax Authority (ITA) considered the above moves aggressive. It claimed the payment by the Bahamas company was a taxable dividend because the Bahamas company was controlled and managed in Israel, making it Israeli resident. The ITA claimed that the Niagos’ sons, Doron and Eli, managed the Bahamas company, and they had relevant expertise in the textile trade.

Failing that, the ITA claimed that the way in which the transactions were carried out was artificial or fictitious and hence taxable under Israel’s general anti-avoidance rule (ITO Section 86).

The taxpayers’ riposte The central office of the Bahamas company was in Geneva and managed by the Swiss director and another employee. In addition, the company had an office in Amsterdam managed by the Dutch director.

The taxpayer claimed the Bahamas company was foreign resident because control and management were not exercised in Israel. The taxpayer claimed, among other things, that: the directors were foreign residents; the board met abroad and passed its resolutions autonomously without shareholder intervention; the daily management was conducted abroad; the formation of the Bahamas company represented an expansion of the overall activities; the directors had relevant knowledge in various areas, such as sales, finance, etc.

As for artificiality, the taxpayers claimed the moves were necessary under Bank of Israel exchange control rules, which were later abolished in 1998.

The Supreme Court’s judgment The Supreme Court upheld an earlier judgment in the District Court rejecting the taxpayers’ contentions.

First, the court found that in practice most of the business activity of the Bahamas company was handled by an independent sales agent in the United States. That presumably doesn’t make the company taxable in Israel, but read on.

Second, the court found that directors of the Bahamas company in Hong Kong, Geneva and Amsterdam played no substantive role, and their weight in the business activity was minimal. One was preoccupied with a different large American corporation.

Another helped on the administrative side, not the business side.

A third director had no real knowledge of the business activity.

Third, and most telling, was the undisputed fact that all the daily operations of the independent sales agent was conducted in Hebrew, which none of the directors spoke. Therefore, in practice, none of the directors had any practical way of conducting business activity with the sales agent.

Fourth, in the run-up to the IPO, none of the directors assisted in the preparation of the economic review needed. Instead the accountants and management of the Israeli company assisted an Israeli professor in producing this work.

Consequently, the court ruled that the control and management of the Bahamas company was exercised in Israel, making the company and the dividend payments taxable in Israel.

Comments This case was a clear victory for the Israel Tax Authority.

Others with offshore companies should check the reasonableness of their structure; that includes entities, operations ands documents.

Moving business activity to a foreign company may be a capital- gains tax event according to an ITA circular.

It is a shame that a case dating back to events in 1993 was only ruled upon 19 years later in the District Court in 2012 and 21 years later in the Supreme Court.

The strategy probably wouldn’t work today. Israel now has rules that deem “foreign professional companies” to be controlled and managed in Israel even if they aren’t. It is enough to be over 75 percent owned by Israeli residents and engaged in a prescribed service, such as agency.

To sum up The Israel Tax Authority spotted an Achilles’ heel in the offshore structure: The overseas directors couldn’t possibly manage the business because it was conducted behind their backs in Hebrew, not English. A veritable Tower of Babel.

As always, consult experienced tax advisers in each country at an early stage in specific cases.

leon@hcat.co Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax.

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