Your Taxes: Should technology companies go offshore?

The Israel Tax Authority has issued a position paper which takes aim fair and square at the offshore option.

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.
Then, if 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 market price.
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”).
Many additional 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 company.
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 nothing.
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 (= future clientele).
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 sold.
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 assets.
• But a transfer of risks may reduce the value of any parallel asset transferred.
• 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.
A subcontract need not be an IP sale or royalty transaction if properly worded.
• If 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 offshore.
• 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 terms.
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 cases. Leon Harris is an international tax specialist at Harris Consulting & Tax Ltd.