In Golan v Assessing Officer Kfar Sava(1) the Tel-Aviv District Court held that a dividend paid exclusively on shares that were subsequently sold to the corporation constituted part of the consideration paid for the shares, and was therefore to be taxed as part of the capital gain achieved on the sale.
Facts
The taxpayer and her brothers inherited the shares of a corporation in equal parts. The heirs did not get along and later entered into negotiations in order to allow the taxpayer to part from the corporation. After lengthy discussions, the parties agreed that:
- the taxpayer's shares would be converted into Class A shares and the taxpayer only would receive a dividend of IS3,485,000; and
- after the distribution of the exclusive dividend, the taxpayer's Class A shares would be sold to the corporation for IS1,681,000.
The articles of association of the corporation were altered to allow for the conversion of the shares and the distribution of the exclusive dividend. Once the two-step transaction had been carried out, proper returns were filed.
Assessing officer's position
The assessing officer contended that the dividend received by the taxpayer before the sale formed part and parcel of the consideration paid on the shares. It was therefore to be added to the consideration of IS1,681,000 and taxed in accordance with the capital gains tax regime. This argument was based on the true 'economic substance' of the transaction or, in the alternative (in view of the series of coordinated transactions), on the Income Tax Ordinance's provisions entitling the assessing officer to disregard artificial transactions whose primary purpose is to unduly decrease tax.
Taxpayer's position
The taxpayer claimed that the dividend had been lawfully distributed in accordance with the Companies Law, and therefore the assessing officer could not characterise it differently. The profits of the corporation had not been distributed in the past because the other shareholders who controlled the corporation vetoed such a distribution. The dividend paid out constituted the profits to which the taxpayer would have been entitled had they been timely paid out. Moreover, the dividend represented past earnings which were paid to the taxpayer in order to compensate her for the investment risk inherent in the shares while the consideration for the shares was paid in return for a waiver of any future rights in the corporation. Finally, the taxpayer claimed that the assessing officer's assessment brought about a tax of 68% - comprised of the company tax levied on the company's income and her personal capital gains tax - but at the time the maximum capital gains tax stood at 50%.
Decision
The court held for the assessing officer. It found that the dividend could not be re-characterised on the basis of corporate law. It therefore examined the applicability of the provisions dealing with an 'artificial transaction' to the case at hand.
The court held that during their negotiations, the parties had negotiated with respect to one sum payable for the shares. The dissection of the sum into a dividend and the consideration for the shares was an afterthought. The parties did not negotiate the value of the shares cum dividend.
The judge then concluded that:
"I must comment with all due respect, that in the circumstances of this appeal, the use of the terminology 'legitimate' impairs the contention raised and is harms the notion of 'legitimate tax planning'. This is not a case of choosing a tax savings course as opposed to a fully taxable course in a transaction which enjoys true economic reasons… The taxpayer did not choose a tax savings course but rather the construction of a detour which required the alteration of the corporation's articles of associations…
The parties chose a course lacking any commercial reason and it is therefore a far cry from 'legitimate tax planning'… To create on the eve of the transaction calling for an exit of a shareholder, discrimination amongst the shareholders, so that only one shareholder, the taxpayer, who one moment later sells her shares to the corporation, will be entitled to the dividend, this action is one whose illegitimacy colors its entirety as such."
The court further held that an 'artificial transaction' could not be justified by the taxpayer's desire to achieve a result similar to one denied by the provisions of the Income Tax Ordinance. The court referred to Section 94B of the ordinance, which mitigates the tax on that part of the consideration representing retained earnings of the seven-year period preceding the sale liable to capital gains tax. In the case at hand, the seven-year limitation barred full enjoyment of the relief under consideration. The taxpayer could not overcome this bar by means of an artificial transaction according her an exclusive dividend.
Comment
Golan does not stand for the proposition that all sales of shares subsequent to a dividend distribution are 'artificial'. This result was attained because the dividend distribution was made uniquely to the taxpayer. Had the other shareholders enjoyed the dividend distribution, had the shares been originally allotted to all the shareholders as class shares with an economic motive, or had more time elapsed between the distribution to the taxpayer and the sale of the shares, the results could have been very different. Golan did not mention Ramsay, but it is reminiscent of its holding that a preordained series of transactions designed to achieve a tax savings will not attain its ultimate aim.
For further information on this topic please contact Amnon Rafael or Shlomi Lazar at A Rafael & Co Law Offices by telephone (+972 3 696 6999), fax (+972 3 696 1444) or email ([email protected] or [email protected]).
Endnotes
(1) TA 1110-06, January 31 2012.