It is quite common for a taxpayer to acquire assets via another person who acts as a “front.” The front is an agent who is formally registered as the owner, using funds of the taxpayer for the acquisition. This may be done for a number of reasons such as asset protection or family considerations, as well as for fiscal considerations. The agency concept is widely used, but it may sometimes be labeled a nomineeship, an escrow account, bare trust or mere representation.
Facts of this case
In 2004, an Israeli resident taxpayer transferred $300,000 (NIS 1,317,000) to two Israeli accountants who had a tip from a Swiss banker. The money was used by the accountants to buy shares on the London Stock Exchange in an Israeli company, XTL Bio Pharma (“XTL”). The money was invested via an offshore investment company for the taxpayer’s benefit. Early in 2005, the taxpayer invested a second amount of NIS 600,000 in this way in XTL. Each investment was documented in memoranda of understanding which served as a power of attorney to the accountants. In his 2008 tax return, the taxpayer reported a massive loss of NIS 1,445,916, i.e. around 75% of his total investment of around NIS 1,917,000.
The taxpayer also filed capital declarations (hatsharot hon) listing his assets and liabilities as of December 31, 2004 and December 31, 2007. Many Israeli businessmen and investors routinely file capital declarations upon request from the ITA every few years. The taxpayer omitted the first investment in XTL in his 2004 capital declaration but listed both investments in his 2007 capital declaration.
The District Court allowed the taxpayer to use the entire 2008 capital loss. The ITA appealed to the Supreme Court on the grounds that the loss did not belong to the taxpayer, it may have belonged to the offshore company, if a loss was even realized. Quite a muddle. What was the legal relationship here? Whose loss was it?
The judgment
The Supreme Court ruled there was no trust relationship since the ITA and the taxpayer both said so. Instead, the Supreme Court judges decided there was an agency relationship that is governed by the Israeli Agency Law, 1965.
The accountants and the offshore company were the agent of the taxpayer. However, in this case the Supreme Court found there was an “undisclosed agency” concerning the shares of the first investment, and the ITA was a third party – because that investment wasn’t disclosed on the first capital declaration.
In order that the tax loss from the first investment could be attributed to the taxpayer given the undisclosed agency, the taxpayer had to adopt (or ratify) the investment and hence the right to utilize the tax loss.
The court ruled that the agent in this case was not entitled to use that loss under Israeli law, since the foreign investment company was not subject to Israeli taxation and so it would not be entitled to use the loss for Israeli tax purposes. Therefore, the adoption pre-condition for the Israeli taxpayer was not met and the Israeli taxpayer could not assume the tax loss.
Since the second investment was done under a disclosed agency arrangement and reported on the 2007 capital declaration to the ITA, the taxpayer was not required to meet the adoption pre-condition. Therefore, the taxpayer was entitled to use the tax loss as his own, pursuant to Section 2 of the Agency Law.
Comments
By not reporting the first investment on the first capital declaration, the taxpayer forfeited the right to later claim a loss on that investment. Only the loss on the second investment could be claimed as the investment was reported to the ITA.
The Supreme Court did not opine on the motives of the parties in this case. More recently, Know Your Customer (KYC) procedures and other anti-avoidance rules have become more relevant.
In short, using someone else to front a transaction may seem advantageous, but it is crucial to carefully characterize the relationship between the parties and consider how to present the relationship to third parties such as the ITA.
As always, consult experienced legal tax advisers in each country at an early stage in specific cases.Lilach Asherov is an Israeli tax attorney based in Ramat Gan, formerly a senior official at the ITA. Leon Harris is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd. lilach@asherov-taxlaw.co.il, leon@h2cat.com