Control and Management beaten Tower of Babel

Your Taxes: Israeli court case could have implications in other countries modeled after UK tax principles.

Your Taxes_311 (photo credit: Thinkstock/Imagebank)
Your Taxes_311
(photo credit: Thinkstock/Imagebank)
A recent Israeli court case could have implications in many other countries 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 Yitzhak Niago and Rachel Niago vs Kfar Saba Assessing Officer (Income Tax Appeal 1029/8, Tel Aviv District Court, January 12, 2012).
The Israeli tax system is based on UK tax principles, which were in force during the British Mandate in 1917-1948.
Main facts
In 1987, two Israeli resident individuals (Yitzhak and Rachel 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.
In practice, there was some financial chicanery. The Bahamas company transferred NIS 22.4m. in cash to the Israeli company (apparently in lieu of the business), which lent it straight back to the Bahamas company. But in its books, the Israeli company offset this loan to the Bahamas company against an amount owed for shares in the Israeli company by the individuals’ sons (Doron and Eli) ahead of the IPO.
The intended result was apparently a tax-free dividend from a foreign company for the parents (under Israel’s territorial tax system before 2003) and a paid-up stake for the sons in an Israeli company that went public.
The Israel Tax Authority’s contentions
The Israel Tax Authority (ITA) found 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 taxpayer’s sons, Doron and Eli, managed the sons who had decades of relevant experience and expertise in the textile trade.
Failing 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 taxpayer’s riposte
The taxpayer claimed the Bahamas company was foreign resident because control and management were not exercised in Israel. It was 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. One director was resident in Hong Kong and dealt with finding clients. Another director, the CEO, was resident in the Netherlands and dealt with sales and finance and had contacts with the banking system. The third director, a Swiss resident, dealt with administration and was in contact with Israeli suppliers and with the banks;
• 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 and an office managed by Yaron Mendler, a sales agent, not a director.
As for artificiality, the taxpayer claimed the moves were necessary under Bank of Israel exchange-control rules (later abolished in 1998).
The court’s judgement
The court ruled against the taxpayer for a number of reasons, including:
• The Hong Kong director did not take part in the daily activity of the Bahamas company, as he was preoccupied with a separate US corporation with revenues over $1.2 billion;
• According to the judgment and the company’s prospectus, all the activity with foreign buyers and Israeli manufacturers was done via an independent sales agency managed by Mendler in New York. Given modern means of communication, the agency activities of the Bahamas company would not have been harmed if the company had never been formed;
• Doron, the Israeli resident son, admitted acting as agent for the Bahamas company and even signing agreement in its name;
• Doron admitted corresponding with Mendler in Hebrew and only afterward reporting on business done to the directors of the Bahamas company in English. He stated that “99 percent of the letters of Mendler were discussed orders received, how to make samples and buyers’ requests. Critical things about contracting or not contracting with a particular client were handled in writing with the owners” (apparently he meant with the directors);
• There was no change in Mendler’s mode of operation after the Israeli company acquired the business of the Bahamas company;
• The Dutch director and CEO was apparently unable to recall the names of any of the names of the Israeli manufacturers that the company had links with, but thought they were from the Far East;
• The Dutch director and CEO also claimed the Bahamas company hired advisers to help them decide about selling the company’s business, but no evidence of this could be produced. The minutes were short and laconic and made no reference to this;
• Daily financing actions of the Swiss director with the banks constituted daily administration, not substantial management of the company.
Therefore, the court concluded that “the business of the company was conducted in a language that was strange to its directors and/or employees, and in practice they were reliant on business information that was or was not transferred to them by the Israeli company... this behavior supports the conclusion that the directors and employees of the company had no real interest in the company’s business, and those presented by the appellants as directors served as a platform lacking any business substance. Also, decisions about policy and contractual commitments were taken by them, not by the directors.”
The judgement goes on to describe those directors as “an artificial platform... certainly not the “brain” behind the textile marketing business that the appellants conducted.” Consequently, the court ruled that the control and management of the Bahamas company was exercised in Israel and that the payments to the appellants are taxable in Israel as dividends.
• This case was a victory for the Israel Tax Authority.
• Others with offshore companies should check the reasonableness of their structure.
• Always check what is stated in prospectuses and other documents.
• Always check whether documents that should exist (e.g., economic studies) do exist.
• It is not clear whether the ITA also sought to impose Israeli company tax on the profits of the Bahamas company.
• Moving business activity to a foreign company may be a capital-gains tax event according to a an ITA circular.
• It is a shame that a case dating back to events in 1993 was only ruled upon nearly 19 years later, as a court appeal against an assessment issued in 1999.
• The strategy probably would not work in 2012. Israel now has rules that deem “foreign professional companies” to be controlled and managed in Israel even if they are not. It is enough to be over 75% owned by Israeli residents and engaged in a prescribed service, such as agency.
• It remains to be seen whether an appeal will be submitted to the Israeli Supreme Court.
To sum up
The Israel Tax Authority spotted an Achilles heel in the offshore structure: The overseas directors could not possibly manage the business, as 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 Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.