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Yuval Navot
Herzog, Fox & Neeman, Tel Aviv
navoty@hfn.co.il

Amir Cooper
Herzog, Fox & Neeman, Tel Aviv
cooperam@hfn.co.il

 

Introduction

One of the 'hottest' tax topics in Israel in recent years has been the tax treatment of business restructuring within a multinational group. As an international startup hub, Israel sees its fair share of 'exit' deals in which a multinational group acquires the stock of a local startup company. More often than not, following the share acquisition, the multinational wishes to transfer the intellectual property (IP) of the newly acquired local company to its IP centre and/or transfer the local employees to another existing subsidiary of the multinational group. After these transactions, the newly acquired company continues to exist as a research and development (R&D) centre, at best.

These transactions have caught the attention of the Israel Tax Authority (ITA). The tax treatment of a transfer of IP from a newly acquired subsidiary is a matter that has been commonly raised in tax audits of multinational groups in recent years. The ITA argues in these cases that the transactions constitute taxable business restructuring pursuant to applicable transfer pricing rules and that the company's acquisition price is the proper benchmark for the value of the IP.

Recent Israeli court rulings that were issued in 2017 and 2019 shed important light on the subject and help to formulate a dos and don'ts list with respect to IP transfers.

The Gteko case and the ITA tax circular

The first court case to consider is Gteko – Microsoft.^[1] In the Gteko case, the ITA challenged a transaction that was reported by the taxpayer as an IP sale by an Israeli company that was acquired by Microsoft shortly before. In addition to the transfer of IP, the taxpayer also transferred its entire workforce into another Israeli subsidiary of Microsoft ('Microsoft Israel') in a transaction that was not reported as giving rise to a taxable event. Following the transfer of the workforce, Microsoft Israel provided services through a cost-plus arrangement to Gteko with respect to its existing clients.

The ITA argued that the transactions described above constitute business restructuring in which the taxpayer sold certain functions, assets and risks (FAR) associated with its business. The ITA assessed additional taxes on income that equals the difference between the reported value of the IP sold and the value of the taxpayer's enterprise based on the acquisition price of Gteko stock, with some minor adjustments.^[2]

The Gteko court confirmed the ITA's position, stating that the transfer of IP combined with the transfer of the workforce left the taxpayer as an 'empty corporate shell'. Gteko divested itself of all its assets for the benefit of Microsoft, lost existing clients and gained no new ones. The transaction was confirmed as a taxable FAR sale.

Following the Gteko ruling, the ITA issued in 2018 a tax circular^[3] in which it published guidance regarding the taxation of business restructuring. The tax circular is supposedly based on the Gteko ruling and the Organisation for Economic Co-operation and Development (OECD) transfer pricing guidelines^[4] (although arguably it deviates from OECD guidelines in some points). Very generally, the tax circular instructed the ITA assessing officers to examine the FAR transferred in a transaction and to adjust the transaction price if the parties had better business alternatives than transferring the FAR if they were acting at arm's length.^[5]

The Broadcom Semiconductor Ltd case^[6]

Soon after issuing the tax circular, the ITA was required to defend its position in another case, this time involving the Broadcom group. In Broadcom Semiconductor Ltd,^[7] it was the taxpayer that had the upper hand.

The Broadcom Corporation acquired the shares of a local Israeli company (Broadcom Semiconductor). Shortly after, Broadcom Semiconductor entered into several agreements with other entities in the Broadcom group. Pursuant to these agreements, Broadcom Semiconductor started providing marketing and technical support services to Broadcom Singapore Pte Ltd (in a cost-plus arrangement), providing R&D services to the Broadcom Corporation with respect to new IP to be developed (in a cost-plus arrangement), and licensing its legacy IP to Broadcom International Ltd, a Cayman company for a fixed royalty out of sales. However, Broadcom Semiconductor retained its workforce (and even increased the number of employees in subsequent years), and recorded an increase in income and revenue in subsequent years.       

The ITA viewed the combination of these transactions as a business restructuring transaction. The argument was that the restructuring resulted in Broadcom Semiconductor shifting from being a company engaged in R&D, manufacturing and sales into an R&D centre. This shift, as the ITA argued, should be considered as a sale of FAR by the taxpayer.

The court rejected the ITA's position based on the materially different facts in the Broadcom Semiconductor Ltd case compared with Gteko. It was ruled that the fact that the business operations and FAR of the taxpayer significantly changed is not sufficient to reclassify the combination of transactions as a FAR sale transaction. Broadcom Semiconductor was not left to become an 'empty corporate shell', but instead continued to grow, even if it was as a company that operated in a different field than in the past. In this respect, the court ruled that the taxpayer's argument that entering into the transactions was the best available option was not contradicted, considering the business success of the company in subsequent years.

The court further rejected the proposition that Broadcom Semiconductor divested of its FAR. It was ruled that the taxpayer retained its workforce function, even if it decided to put it to different use; retained significant business risks, although these risks changed in nature; and retained its main business asset – the legacy IP, which was sold in a taxable transaction to a related party in a later tax year.

Summary

The Gteko and Broadcom Semiconductor Ltd cases offer an important insight into the applicable tax rules in Israel with respect to business restructuring in a multinational group. A change in the business model of a newly acquired subsidiary can result in a hefty tax liability or go through relatively smoothly.

Multinationals that acquire an Israeli subsidiary and soon after transfer all assets and employees to a different entity will discover that the Gteko ruling applies in full force to them. However, where an Israeli company continues to grow following a share sale, and retains control over its most valuable assets – which is usually its IP and workforce with respect to high-tech companies – a change in its business model would not be treated as a taxable FAR transaction.

 

Notes

 

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