Tax planning is legal, but within limits. What are those limits? Israel has a broad "general anti-avoidance rule" in Section 86 of the Income Tax Ordinance. This basically says that the Israeli Tax Authority may 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 in fact 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. So what does "artificial or fictitious" mean? Recently, the Israeli Supreme Court ruled on that question in the case of Doron Reuveni Holdings (1993) Ltd vs. Tel-Aviv 4 Assessing Officer (Civil Appeal judgement 4374/05 issued September 19, 2007). In the case insurance brokerage company Oldco owned by Mr R sold 40 percent of its goodwill to an investor for NIS 2.6 million in cash. Immediately afterwards, Oldco and the investor formed a new company Newco and contributed their respective shares of their goodwill (60:40) in return for shares of Newco in the same 60:40 ratio and elected a tax deferral under Section 104 of the Israeli Income Tax Ordinance. Newco continued the insurance brokerage business of Oldco, which became a transparent "family company" for Israeli tax purposes, i.e. the main shareholder is taxed instead of the company itself. All this apparently was meant to make the main shareholder of R Ltd (the individual) taxable on the NIS 2.6m. sale at around 10% instead of around 50% had he sold shares in R Ltd to the investor, according to the prevailing tax law at that time (it has since been amended). Not surprisingly, the assessing officer sought to reclassify the transaction as a sale of shares instead of goodwill, since a partial sale of goodwill is not possible. Alternatively, the assessing officer argued there was an artificial or fictitious transaction pursuant to Section 86 (see above) resulting in an improper reduction of tax with no commercial rationale The District Court and the Supreme Court accepted the assessing officer's alternative claim. They ruled that the taxpayer did not provide any real commercial rationale for inserting the Newco into the structure. The judgement also puts an artificial transaction into context: "A deal done by very smart people that absent tax considerations would be very stupid" (D. Hariton, "Symposium on Corporate Tax Shelters Part II: Commentary", 55 Tax L. Rev. 397 (2002)). Based on a review of the circumstances, it was ruled that the main purpose of the transaction in this case was tax avoidance, making the transaction artificial according to Section 86. To complement the picture, let's recap some significant earlier decisions regarding artificial or fictitious transactions. In the Promedico case, unrelated foreign companies supplied pharmaceutical products to an Israeli importer and paid a commission on each transaction to an offshore entity. The Israeli Supreme Court ruled that the commission transactions were artificial ( i.e. excessive), which is a civil matter. However, the commission transactions in this case were not fictitious (i.e. non-existent), which would have been a criminal offense. (Promedico Ltd. and others vs. The State of Israel, Aleph Pey 1182/99, 1493/99, 2606/99). In July 2003, in the Rubinstein Case (Large Enterprise Assessing Officer vs. Yoav Rubinstein & Co., Aleph Ayin 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. To sum up, the Israeli Tax Authority has broad authority under Section 86 of the Income Tax Ordinance to challenge an "artificial or fictitious" transaction that is tax efficient and lacks commercial purpose, especially if the transaction consists of a series of steps and/or does not follow normal patterns of behavior. The moral is when in Israel, stick to kosher-looking transactions. Now that we know what is an artificial or fictitious transaction, how will the Tax Authority find out about it? It is generally considered advisable to make full disclosure of relevant matters on annual tax returns. In addition, regulations have been issued listing a number of "reportable tax planning acts". Examples for the type of transactions that may be reportable in certain circumstances are: * Management or advice expenses of NIS 2m. or more in favor of a related party for management or advice or something similar, if it reduces tax payable. * Sale of an asset to a related party at a loss of NIS 2m. or more which is partly or wholly utilized within 24 months after the year of sale. * Sale of an asset received as a gift from a related party. If the gift was exempt in Israel, the sale takes place within three years and generates a loss of NIS 2m. or more. * Debts to others assumed by acquirer of an entity if within a period of 12 months the acquirer settles less than the full amount to the others. * Acquisition of 50% or more of the means of control of an entity with losses of at least NIS 3m. capable of utilization under the tax law. * Acquisition or holding by an Israeli resident of 25% of an entity resident in a country that has no tax treaty with Israel if any income is taxed there at a rate below 20%, or the receipt of NIS 1m. in the year from such an entity. * Contracting with the owner of a land interest to supply construction services where the consideration is based partly or wholly on the consideration from the sale of the land interest. The aim appears to be to uncover non-payment of real estate "acquisition tax" of up to 5%. * Contracting with the owner of a land interest to sell a real estate interest to a group of buyers organized to buy the interest and build thereon via an organizer. The aim appears to be to uncover possible non-payment of real estate "acquisition tax" of up to 5% and VAT of 15.5%. Once you report a tax planning act on your annual tax return,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 shortfall may be levied and additional fines and other sanctions are possible. As always, consult experienced tax and other advisors in each country at an early stage in specific cases. leon.harris@il.ey.com Leon Harris is an International Tax Partner at Ernst & Young Israel.

Your Taxes: When is Israeli tax planning off limits?

It is generally considered advisable to make full disclosure of relevant matters on annual tax returns.