What can you do with the shell of a failed company? Sell it to someone else so they can use its past tax losses?
By LEON HARRIStaxes good 88(photo credit: )
What can you do with the shell of a failed company? Sell it to someone else so they can use its past tax losses? Israeli tax law doesn't expressly allow this, but the Israel Tax Authority generally disallows it under Section 86 of the Income Tax Ordinance. However, a recent Supreme Court decision shed new light on the existing legislation and case law.
First, what does Section 86 say? This Section enables the Tax Authority to disregard a transaction if it is "artificial or fictitious" and it is liable to reduce the amount of tax payable; if a disposition is not carried out; or if a principal objective is improper avoidance or reduction of tax - even if it is not contrary to law. The assessing officer may then issue his own assessment accordingly.
In July 2003, in the Rubinstein Case (Large Enterprise Assessing Officer vs Yoav Rubinstein & Co, civil appeal 3415/97), a failed fish-rearing company with no assets or activity was acquired by new owners who changed its name, turned it into a construction company and tried to offset past fish-rearing losses against its construction profits.
The Supreme Court found this altogether fishy - and ruled it involved an "artificial" series of acts that amounted to an artificial transaction. This was because the transaction was intended to reduce tax, had no commercial purpose and did not follow normal patterns of behavior. It is necessary to balance the right of the taxpayer to carry out tax planning with the public interest in having an equitable and fair tax system.
However, another Supreme Court case recently ruled in favor of the taxpayer, at least in part (Ben Ari Shin Insurance Agencies (1968) Ltd vs Jerusalem 1 Assessing Officer, civil appeal 7387/06 of May 29, 2008).
In this case, Ben Ari had acquired 32 percent of the shares of an automobile repair company in 1994. The company made losses until 1997 when it stopped repairing automobiles and dismissed its employees. The following year, Ben Ari acquired the remaining shares (68%) of the company and in 1999 moved insurance activities into the company from another he owned and changed the company's name. The company became profitable and tried to offset the past automobile repair losses against the insurance-related profits. The Assessing Officer denied the loss offset on the grounds that the above process was artificial.
The Supreme Court took a more lenient view. It ruled there was no commercial reason for Ben Ari's acquisition of the remaining 68% of the company's shares, but developed a new rule for cases where there is a change in control of a company: If the new shareholder was not a shareholder when the company incurred losses, the company should not be allowed to offset losses incurred under the previous ownership (as ruled in the Rubinstein case). However, if the new majority shareholder was a minority shareholder when the company incurred losses, a pro rata portion of such past losses may be offset by the company against profits under the new control.
Therefore, since Ben Ari held a 32% minority shareholding when the losses were incurred, the company was allowed to offset 32% of those losses against income of the company after he acquired control.
The court went on to rule that if there is no change in control of the company, past losses may be offset in full. The term "control" is taken to mean the main economic interest in a company and the ability to steer its activity. Therefore, a control will be seen to exist where a party held, or has the right to hold, alone or together, directly or indirectly, 50% of the means of control of a company.
Nevertheless, the court ruled it seems appropriate to allow the tax authorities a degree of discretion in determining whether control exists in special cases where this definition may lead to a distorted economic or business result.
It should also be noted that under regulations dealing with reportable tax planning acts, certain types of "aggressive tax planning" must be reported on Form 1213 and attached to your annual tax return. One such reportable act is the acquisition of 50% or more of the means of control of an entity with tax losses of at least NIS 3 million, alone or together with a related party in one or several transactions over a period of 24 months.
The assessing officer may then issue a partial best-judgment assessment of your income and tax due, disregarding the act. If the act was considered to be artificial or fictitious, a deficiency fine of 30% of the tax shortfall may be levied, among other things. However, no such exposure arises if you obtain an advance tax ruling from the Tax Authority.
As always, consult experienced tax advisors in each country at an early stage in specific cases.
leon.harris@il.ey.comLeon Harris is an international tax partner at Ernst & Young Israel.
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