Amnon Rafael Shlomi Lazar August 12 2011 Whose expense is it anyway? A Rafael & Co Law Offices | Corporate Tax - Israel Amnon Rafael, Shlomi Lazar Corporate Tax FactsDistrict Court decisionSupreme Court decisionComment FactsIn Hevrat Record CA Ltd (April 14 2011) three partners decided to liquidate their partnership. The liquidation agreement called for the division of the partnership into two distinct businesses, to be carried on by two companies whose shares were to be distributed between the partners. It was also agreed that if the division into companies did not result in an equal distribution, 'adjustment payments' would be made in order to make up for the difference.The partners failed to reach agreement on the amount of such payments. An appointed arbitrator made an award under which the director of the appellant company was to make adjustment payments to the other partners.The appellant classified the payments and its legal expenses as the cost of inventory and goodwill. The assessing officer classified the transaction as a withdrawal of a salary by the director from the appellant and a consequent payment of the adjustment payments by him. Therefore, when computing the appellant's taxable income, the assessing officer allowed the entire sum as a deduction, but applied a withholding tax for the amount withdrawn by the director, as the appellant had failed to deduct such amount. The withdrawn amount was therefore grossed up by the assessing officer, resulting in a hefty tax for the appellant.District court decisionThe appellant brought an appeal before the district court, which ruled in favour of the assessing officer. The court argued that focusing on the identity of the parties to the liquidation agreement and to the arbitration proceedings was a formalistic approach. It based its contention on the arbitration award, which provided that the adjustment payments:"At first blush - in accordance with the language of the [liquidation] agreement - [were] entered into personally between the parties [including the director of the appellant], however, as a practical matter adjustment payments between the companies are in order."The appellant argued that, even if the financial reports were imprecise with respect to the adjustment payments, they nonetheless reflected the legal expenses borne by it. It contended that this proved that the proceedings were not those of the director, but rather that it was itself a party to them. It further argued that if the director was liable for the adjustment payments, he should be regarded as having incurred them on the appellant's behalf and consequently the withdrawal of the funds constituted a payment of the sum owed to him. The assessing officer relied on the identity of the parties to the liquidation agreement and the arbitration proceedings, claiming that the director did not distinguish between the appellant and himself and treated the appellant's assets as his personal fund.Supreme Court decisionThe Supreme Court held in favour of the assessing officer. It agreed with the district court and stressed that the liability rested upon the director, even if the payment was made by the appellant. All legal documents that had been produced in evidence before the lower court, up to and including the arbitration award, indicated that the payment was due from the director and not from the appellant, which was not mentioned in these documents. The appellant was privy to one agreement signed in the course of events (execution proceedings) in which it was agreed that the responsibility for the adjustment payments rested with the director. It was therefore precluded from contending otherwise. The adjustment payments were required in order to strike a balance between the former partners, not between the new companies. The appellant undertook liabilities and received assets of the partnership and not of the other company - it had no right to these. Instead, the right was that of the director as a partner of the partnership. The payments made by the appellant were therefore held to have been made for the director. As such, they constituted remuneration from which withholding was due.CommentIf the partners had drafted a different agreement, then the result might have been favourable - had the director transferred his interest in the partnership to the company in a tax deferred transaction, then the company would have been the party to the liquidation agreement and subsequent proceedings. Under such circumstances, the adjustment payments would be classified as costs of inventory and goodwill, with the resulting tax benefits (lower profit from sale of inventory and amortisation of goodwill).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]).