Section 86 of the Income Tax Ordinance grants the assessing officer the power to disregard a transaction that is likely to decrease the amount of tax payable by a taxpayer where such a transaction is, among other things, considered 'artificial'. The boundaries of this artificiality were considered in the Supreme Court decision in Signon on June 26 2011.


Signon was a simple case of dividend stripping (ie, the transfer of shares immediately prior to dividends distribution). The taxpayer, an Israeli company, invested its reserves in shares of companies that had declared dividends prior to the purchase. The dividends were received tax free, as under Section 126 of the Income Tax Ordinance intercompany dividends are not subject to additional tax.

Subsequent to receipt of the dividends, the taxpayer sold the shares at a loss, reflecting the difference between the pre-dividend purchase price and the post-dividend lower price. The taxpayer invoked a special provision of the law dealing with the taxation of inflationary profits, as then in force, allowing it to offset the capital loss from the sale of the shares against its profits.

The tax authorities argued that the loss was in effect a virtual loss, as the taxpayer, having received the dividend, suffered no real loss. The tax authorities also contended that the transaction was an "improper reduction of taxes" - one of the four causes on which the assessing officer may rely, in accordance with Section 86, to deny the taxpayer the fiscal result sought.

The taxpayer contended that, among other things, it legitimately made use of the statutory provisions and that denying the set-off would de facto annul the tax regime applicable to intercompany dividends.


The court determined that tax relief may be denied on the basis of either an "improper reduction of taxes" or an "artificial transaction". It focused on the latter and acknowledged that its task was to strike a balance between the legitimate right of the taxpayer to plan its affairs and the constitutional protection of property on the one hand, and the payment of taxes that were rightfully due on the other.

The court additionally distinguished between positive and negative tax planning. The former applies to obtaining fiscal results previewed by the legislature, even in the absence of a commercial reason for obtaining them. The latter considers whether the legislature would have amended the statute in light of the tax planning undertaken by the taxpayer. In the case under consideration, the law was indeed amended, but the court decided that such amendment did not rule out the possibility that the transaction was prior to the amendment and therefore artificial.

In determining what constitutes an artificial transaction, the court broke new ground. Previously, common wisdom regarded a transaction as 'artificial' where it lacked a commercial purpose - that is, if the transaction was not entered into solely for fiscal reasons, it was held to be viable and the desired tax results were obtained. In departing from the criterion of a commercial purpose, the court chose the criterion of the 'fundamentality of the commercial purpose' - namely, the commercial purpose must be so fundamental that if it were lacking then the taxpayer would not have entered into the transaction. The fundamentality of the commercial purpose is determined by taking into consideration all the circumstances surrounding the transaction. Three factors are helpful in this regard:

  • the credibility of the commercial reason - that is, the evidence must be brought to show that in the absence of a specific commercial purpose the transaction would not have come about;
  • a comparison of the profit to be derived from implementation of the commercial purpose and that to be derived as a result of the fiscal law; and
  • the risk factor - the greater the risk being hedged by the tax motive of the transaction, the greater the indication of an artificial transaction.

Finally, the court reviewed the famous Compaq and IES decisions rendered in the United States. It seems to have been persuaded by the critics of these decisions, but in any event ruled that in the case at hand, contrary to Compaq and IES, the taxpayer did not exercise any discretion in order to derive a profit from the transactions. The transactions were entered into solely in order to gain a fiscal advantage.


A new criterion will now distinguish between natural tax saving transactions and artificial transactions, which will fail to achieve their desired tax goals. Interestingly, the proof of a profit motive will not suffice to prevent the application of Section 86 of the Income Tax Ordinance. The taxpayer is now required to show that such a profit motive was a fundamental commercial purpose of the transaction. Transactions geared to tax avoidance will not accomplish their objective.

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]).