YOUR TAXES: When is a sale not a sale?

The case is relevant to most Israeli merger and acquisition deals (“exits”).

money (photo credit: REUTERS)
(photo credit: REUTERS)
Where else can it happen? A taxpayer loses in the Supreme Court but goes on to win in a lower district court? And when is a sale not a sale? The Broadcom case was a roller coaster for the Israeli hi-tech sector (Broadcom Semiconductors Ltd vs. Kfar Saba (263423-01-16, 2268-04-17, December 9, 2019). We recently discussed the Supreme Court case, this is an update.
The case is relevant to most Israeli merger and acquisition deals (“exits”). Typically a foreign purchaser buys the shares of the Israeli company and then expects to transfer the intellectual property (IP) to a foreign company in the purchasing group. However, the IP transfer is subject to Israeli capital gains tax even though the shareholders just paid tax on the sale of their shares.
The facts of this case
In 2012 Broadcom Corporation of the US acquired all the shares of Broadlight Inc, another US corporation which had an Israeli subsidiary, for around $200 million. Three months later, the Israeli company sold its IP to a foreign affiliate for only $59.5 million. Then two companies in the Broadcom group signed agreements with the Israeli company for the supply of R&D, marketing and support services for a “cost plus” fee and for use of the old IP for a royalty.
The ITA felt that the $59.5-million figure was insufficient and assessed a shekel figure equivalent to $168.5 million based on FAR – functions, assets and risks – transferred, applying OECD transfer pricing guidelines.
The taxpayer went to the Supreme Court and claimed that the onus of proof was on the ITA to justify the $168.5 million according to Section 85A (transfer pricing) and Section 86 (artificial or fictitious transactions) of the Income Tax Ordinance.
The initial Supreme Court decision
The Supreme Court ruled that if the Israeli taxpayer company failed to report a sale of FAR to the Israeli Tax Authority (ITA) as the ITA claimed, the onus of proof that the transfer was adequately reported fell on the taxpayer.
Back to the district court
The parties found themselves back in the district court, and the ITA thought it was on to a winner. The same judge had ruled in a similar case in the ITA’s favor (the GTEKO case). In the GTEKO case, the purchaser (Microsoft) transferred IP out of Israel at a much lower value than the price just paid for shares in GTEKO. The court in the GTEKO case said that value cannot simply “evaporate” and ruled that the IP transfer should be taxed as a sale at a market value based on the price paid for the shares.
In the Broadcom case, there was a surprise. The court ruled in favor of the taxpayer because the facts were not the same as the GTEKO case.
The ITA claimed that the taxpayer shifted functions, assets and risks (FAR) out of Israel, thereby emptying the Israeli company of all substance. But the taxpayer in the Broadcom case proved the Israeli company was not emptied out.
• First and foremost, the Court ruled that changing the business model did not equate to a sale of FAR. It was done to increase activity in Israel – see below.
• Second, the IP wasn’t sold, instead there was an inter-company agreement allowing the group abroad to use the old IP for a royalty. The royalty rate of 14.5% of sales per a transfer pricing study wasn’t disputed
• Third, the Israeli company continued functioning, providing R&D and marketing services under local management for a “cost plus” fee, also not disputed.
• Fourth, the personnel headcount went up from 85 in 2009 to 210 by 2015
• Fifth, the Israeli company still incurred some risks, including the risk of reliance on a single customer.
• Sixth, there was no mention of any other hidden transaction, so the transfer was not artificial or fictitious.
• Seventh, the ITA did not properly respond to the danger of double taxation.
In short, the district court found that the transfer of IP out of Israel did not amount to a sale in the Broadcom case.
Concluding remarks
Israel lacks a section preventing double taxation of the shares and assets of a company (unlike Section 338 in the USA).
Purchasers should note this in their due diligence and be prepared to leave the IP in Israel. If you buy the assets instead of shares in the Israeli company, the Israeli sellers will incur higher taxes.
It remains to be seen if the Israeli Tax Authority (ITA) will lodge an appeal... back in the Supreme Court.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd.