This is an important update for multinational groups with business activities or affiliates in Israel, and is particularly relevant for groups contemplating a change of their business model affecting Israeli subsidiaries or the purchase of an Israeli company.
- The Israel Tax Authority (the "ITA") published a comprehensive circular, number 15/2018 (the "Circular"), addressing the Israeli income tax aspects of business model restructuring by multinational groups. A change of a business model refers mainly to circumstances under which functions, assets or risks (so called "FAR") of an entity are transferred or terminated.
- This matter is commonly raised in tax audits of Israeli companies that are acquired by multinational groups, and following the closing of the acquisition, the intellectual property ("IP") of the Israeli acquired company is transferred, or deemed transferred, to a non-Israeli affiliate, or the entrepreneurial aspects of the acquired company (such as sales functions) are terminated.
- The Circular addresses two major aspects of a business model change: (a) the identification and characterisation of such change in the business model; and (b) valuation concepts and methodologies of the FAR transferred in the course of such business model change.
- The Circular states that it follows the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations from 2017 (the “OECD Guidelines”). The Circular also adopts certain determinations of a District Court's decision regarding Gteko vs. Tax Assessor of Kfar Sava (the “Gteko Decision”), published June, 2017, although some deviations from both of these authorities are apparent.
- We should note that the Circular represents the ITA's interpretation of the law and accordingly, its position on said matters. The Circular does not, however, have any legal binding status and therefore, courts are not bound by it.
2. Business Model Restructuring – Identification and Characterisation
Identification of business model restructuring is based on an analysis and comparison of the FAR at the taxpayer before and after the purported change.The Circular notes that inter-company agreements are the starting point but certainly not the last stop. Rather, the facts and circumstances together with the parties' de facto behavior and intentions are determinative.
Transactions Involving IP
An important section of the Circular is dedicated to differentiate between (a) a capital gain event that usually occurs upon the sale of IP by an Israeli company to a non-Israeli affiliate; and (b) ongoing profits of an Israeli company, which are more common upon the granting of a license or right of use to other companies in the group.The ITA emphasises in the Circular its view that economic ownership trumps legal ownership. Moreover, the Circular goes on and sets forth a list of examinations that should be taken into consideration in order to determine whether or not an event should be considered as a business model restructuring disregarding whether or not a legal sale was conducted, as follows:
What is the economic life expectancy of the asset being transferred and whether it corresponds to the period of the license granted?
Does the recipient receive rights in future developments of the transferred asset?
Who manages and controls functions related to the development and maintenance of the assets?
Who is responsible for the risk and costs associated with conservation and development of transferred intangibles?
Which entity makes business decisions regarding risks, development and retention of the transferred intangibles?
The Circular emphasises that under certain circumstances, the aforementioned examinations constitute greater indicators of business model restructuring than criteria such as a legal contract between the parties defining the transaction as a grant of a right of use or a form of payment, which can be a single payment or recurring payments.
3. Valuation Concepts and Methodologies
- The Circular provides guidelines on the ITA's views for valuing the FAR transferred. The Circular notes that to the extent that there is an equity transaction at stake, the acquisition price in the transaction (subject to certain adjustments) serves as the proper benchmark for the value of such company. Most commonly, under this approach, the acquisition cost of a company by a multinational group serves to valuate such company's FAR for purposes of determining the post-closing value of the transferred IP.
- In determining the acquisition price of a company, the Circular notes the following positions:
- Consideration held back pending completion of a certain post-closing employment term by key employees should be taken into account as part of the acquisition price.
- Unvested options and RSUs assumed by the acquirer that vest over a post-closing period should also be taken into account as part of the acquisition price.
- Earn-out payments should also be taken into account as part of the acquisition price.
- The acquisition price should not be discounted due to attribution of a portion of such price to control premium.
- The Circular provides guidelines on the adjustments that should be made to the acquisition price such as upward adjustments to account for financial liabilities of the acquired company. Interestingly, an upward adjustment is required to be made to employees' transaction bonuses (contrary to the Gteko Decision). Downward adjustments are allowed on account of tax-assets, cash and certain investments.
- The Circular further notes the following points with respect to the valuation of the FAR remaining with the Israeli company post-change in its business model:
- The PPA prepared by the acquirer in connection with an acquisition should not be relied upon in assigning value to assets.
- Generally, neither goodwill nor going concern value can be separated from other assets.
- Synergy is not considered an asset of the company to which value should be assigned.
- Workforce-in-place is considered an asset of the company to which value should be assigned.
4. Secondary Adjustments
According to the Circular, insofar as additional income is required to be recorded resulting from an assessment in connection with a business model restructuring, this may result in in a secondary adjustment, namely, in viewing the additional income as a separate and additional dividend or loan transaction. Thus, special attention should be given to this subject.
5. Information Requests – Tax Audits
Here you can find the Circular's model for an information document request that the ITA's tax inspectors are instructed to send out as part of audits of companies in the course of an examination whether a change of business model took place.
Putting aside the question of legal authority of the ITA to request such information, it is very useful for potential buyers of Israeli target companies to be mindful of this list in preparation of such various documents in connection with an acquisition of the an Israeli target company.