Increased Tax Certainty for Multinational Investors in Israel – Bloomberg Tax

Posted By on July 12, 2022

The judiciary in Israel, for a third time in four years, has considered whether value had been taken overseas in the changed business functioning of a local company after an international group acquired it, and whether tax was due. A sigh of relief came from the finance teams of many a multinational group, active in Israel, when the Tel-Aviv District Court published its decision in the Medingo case on May 8.

Since the early 1960s, Israel has encouraged the growth of industry to increase national product, offering support ranging from monetary grants to tax benefits for innovative enterprises.

Israels tax authority started to ramp up their efforts to patrol the fiscal borders in 2010 to catch the flight of technology from Israel-based tech companies acquired by multinational groups. The ITA would, during the next 12 years, insist on hefty assessments and claimsometimes even frivolouslythat assets had been extracted covertly from Israel right after a foreign takeover. Tax bills were issued on the basis that the value of the intangibles the ITA claimed had been smuggled out must be equal, or at least close, to the amount paid for the shares in the takeover. A substantial 2017 court win by the ITA caused serious unrest within the tax management of international groups that had substantially bought into Israel.

Shortly after the Organization for Economic Cooperation and Developments 2010 publication on cross-border value transfers in changes in business models, the ITA issued an internal decree relating to post-merger escape of value, explaining for its tax assessors the tell-tale signs of this phenomenon.

These matters were at the heart of some high-profile disputes, among which was the Giteck case in June 2017. After Microsoft Corp. purchased Giteck in 2006 for $90 million, Giteck in 2007 reported the sale of its IP to a foreign group company for $26 million, after the companys staff had been transferred. The tax authorities argued that the value of the IP transferred was equal to the $90 million paid for Gitecks shares. The court rejected Gitecks explanations that Microsoft had paid a premium for the integration advantage and synergy benefits, ensuring full control. The district court ruled in favor of the ITA and agreed that compensation for the IP could not have been less than the amount that had been paid for the shares (with some room for downward adjustment) in 2006.

On a winning streak, the ITA hastened to publish Circular 2018/15 laying out the tell-tale signs of intangible exports to related parties by post-acquisition changes in intergroup functioning. In that circular, the ITA based its views on Chapter IX of the OECDs Transfer Pricing Guidelines regarding cross-border reorganizations. Tax assessors were sent checklists of what to look out for, and recently acquired companies knew to expect a change of business model tax audit within one to two years.

Many multinational enterprises invested in Israels high-tech sector were left wondering how they could manageif at allthe particular tax risk resulting from these developments in relation to their Israeli acquisitions. Since 2010, foreign conglomerates would wrestle to prevent the expression in their consolidated financials of substantial, unpredictable, tax risk in their Israel acquisitions. Public companies subject to securities law and financial reporting rules would have to disclose tax risks that the ITAs position could create and the disclosure of which could impact investor relationships or, on the other hand, even alert the Israel tax authorities. They were damned if they did and damned if they didnt.

Finally, initial relief arrived with the 2019 decision in Broadcom (Case 2454/19). In this case, the Dune company had produced and marketed components for broadband communications since its inception. After the Broadcom Group bought Dune for $185 million, Broadcom obtained the required permissions from Israels innovation authority to take the government funded IP overseas, and paid the regulatory penalties to allow the export of Dunes IP. Later on, however, Broadcom decided not to take the IP abroad. Instead, Dune would provide research and development services and would give Broadcom the right to use its IP for a royalty of around 14%. This had all been set out in detailed agreements and reported accordingly.

The ITA believed the nature of Dunes business had changed from an independent enterprise to a mere service provider and, therefore, it must have waived the rights to its original business and allowed its IP out. The tax assessment was set on close to 150 million Israeli shekels ($44 million).

In its decision, the court asserted that the use of the term changes in business models is not a magic wand. There would not necessarily be a tax relevant change of business model just because the tax assessor argued that there was oneespecially when a company remained active, continued to hold assets, and ran risk. Also, the fact that risk on the company had been reduced, to a certain extent, did not support a claim that assets had been transferred. The court also rejected the ITAs claim of artificiality, and prevented a shift of the burden of proof to Broadcom.

It should be noted that the court that put the taxpayer in the right this time around was the same court that had dealt with the Giteck case.

However, great concern continued to guide multinational enterprises in relation to their Israeli acquisitions, as the ITA persisted in keeping many similar cases pending for objection or appeal.

So now, the outcome of the Medingo case in May 2022 has boosted foreign investors confidence in Israels tax transparency, and proved that the positive Broadcom decision had not been an isolated incident.

In 2010, the Roche pharmaceutical group paid $160 million for Medingo, which owned the technology to a wireless insulin pump. Medingos activities were integrated into the Roche group by it providing R&D and support, such as marketing, administration, and technological services, as well as manufacturing and packaging for Roche. Roche also received a license to Medingos IP allowing development, production, and commercialization for a 2% royalty. All of this was set out in signed agreements.

The number of Medingos employees initially increased after 2010, as did its turnover. However, Medingo then experienced economic hardship and was heavily over-financed by Roche. Early in 2012, it announced it would cease operations by the end of 2013 and, in November 2013, Roche bought the IP out of Israel for $46 million.

The ITA was convinced that all post-acquisition transactions were part of a long-term intentional process conceived right after the takeoverto move Medingos IP out of Israel at a discount. The tax assessments the ITA issued were again based on the $160 million acquisition price, as in the case of Giteck. Medingo had no choice but to appeal; a company losing money is unable, in most cases, to pay tax on income never earned, and definitely not 145 million Israeli shekels in tax.

The court decided that the constellation of facts and agreements did not actually imply a transfer of value right after the acquisition, as Medingo had remained active after its takeover. The fact that important management decisions came from the Roche group did not change that. Also, the rights of Roche to the outcome of Medingos continued R&D work did not change the views of the judge Yardena Sarousy, a former senior tax policymaker with Israels Ministry of Finance.

The court disagreed with the ITA that the new IP resulting from Medingos R&D work could not be distinguished from the original IP, because new patents had been registered in Roches name after 2010. Medingos original IP had not left, the court said, because the license given had been for a limited period and reminded the tax assessor that a license agreement is not by definition suspicious. As opposed to Giteck, Medingo had not been relieved from economic risk: when the sale of products based on its IP failedwhich is indeed what happenedMedingos existence was at risk. The court then referred, in its turn, to the same OECD Transfer Pricing Guidelines the ITA quotes, that characterization of transactions can only differ from written agreements between the parties in rare cases: only when agreements are fundamentally unfounded or lack an arms length price.

The post-acquisition intercompany model had actually increased the companys chances for economic survival. Substantial (over-)financing by Roche of the local company, by way of loans, merely testifies to the obvious uncertainty of most large high-tech acquisitions. Until the IP will have, maybe, one day proven itself commercially, there is no certainty. Had the company rejected a clearly more attractive (intercompany) model, as the OECD Guidelines say, then recharacterization of relationships may be appropriate. At the most in the case at hand, explained the court, the ITA could have challenged the pricing of the actual transactions. And even if assets, functions or risks had been transferred, opined the court, that had not happened right after the 2010 acquisition, as claimed by the ITA, but only on the date of a real (contractual) transfer.

The Medingo case confirms that precise and careful post-acquisition integration of the activities and capabilities of an Israeli tech company should not automatically result in claims by the tax authorities pertaining to an extraction of value. When prudently guided and secured, including inter-group contracts and transfer pricing guidance, foreign investors can secure the time needed to work on the integration and discover whether the technological product in the acquisition can succeed.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Henriette Fuchs is international tax partner at Yaron-Eldar, Paller, Schwartz & Co in Tel Aviv.

The author may be contacted at: fuchsh@yetax.co.il

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Increased Tax Certainty for Multinational Investors in Israel - Bloomberg Tax

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