Last week, the Jerusalem District Court rendered its decision in the Barazani case, which dealt with the distinction (and the different tax treatment) between a “capital note” and an intercompany loan, which was provided by an Israeli parent company to its foreign subsidiary. The District Court ruled in favor the Israel Tax Authority (ITA), accepting its approach that in the case at hand, the intercompany financing arrangement did not qualify as a capital note, resulting in deemed interest income for the Israeli parent company and, in addition, a deficit fine. The District Court ruled further that the method of determining the interest rate by the taxpayer did not comply with applicable transfer pricing rules, accepting the ITA’s position regarding the deemed interest that should be charged in connection with the intercompany loan.

To set the background, it is possible, subject to meeting certain conditions, for a parent company to provide interest-free financing to its subsidiary via a so-called “capital note”, which is a hybrid debt-equity instrument. Among other qualification requirements, the financing must not be linked to an index and does not carry any interest or yield, there is a minimum 5-year maturity period and its repayment is subordinate to all other obligations of the company receiving the financing.

Often times, companies don’t pay sufficient attention to intercompany financing arrangements, despite the fact that these are subject to the arm’s length principle stipulated by Section 85A of the Israeli Income Tax Ordinance. That is, any intercompany transaction (financing included) must be documented in accordance with applicable transfer pricing rules, and the terms of the transaction (interest rate, loan terms, etc.) must be supported by transfer pricing documentation (study).

In many cases, parent-to-subsidiary financing is conducted without documenting the nature of the transaction, leaving room for various classifications, such as loans, capital contributions or capital notes. The Barazani ruling emphasizes the importance of determining and documenting, in advance, the nature of such financing and its terms, including being able to show that the applicable interest rates are in line with market conditions.

Capital Note or Loan?

In the Barzani case, the ITA claimed that despite the taxpayer’s position, the parent company did not transfer funds through a capital note to its affiliated companies in Romania, but rather an intercompany, interest-bearing, loan, thus requiring the parent Israeli company that granted the loan to recognize, and pay taxes, on the interest income that accrued to its favor. In order to qualify as a “capital note”, the terms and conditions of the note must be decided on and documented in advance in order to show that the note meets the said requirements (duration not less than 5 years, does not bear interest, is subordinated to other debt, etc.). The District Court ruled in favor of the ITA, noting that that the mere use of the title “capital note” is not sufficient if the document does not meet the essential conditions for defining the financing itself as an actual “capital note”, and most of the alleged capital notes did not meet the arm’s length principles required under Section 85A of the Israeli Income Tax Ordinance.

In the financial statements of the Romanian affiliated companies, the financings were described as short term loans. The taxpayer’s claims that the loan agreements were executed by mistake, and that the intention was to use capital notes in advance, were rejected for several factual reasons, in addition to the fact that local Romanian law does not recognize such an intercompany financing instrument.

Alternative Assessment under Section 85A – Higher Interest Rate

The District Court adopted the ITA’s position, not only with regard to the amounts in question being a loan and not a capital note, but also with respect to the interest rate that should apply to the loan. The District Court ruled that market research study that was conducted for loans granted in 2008 was not sufficient and could not be applied to interest rates on loans granted at a later stage. The District Court further held that the amount of interest chosen by the taxpayer in the transfer pricing study provided, did not correspond to the jurisdiction in which the affiliated companies were located, and that the transactions selected for comparison were not appropriate. As such, the District Court upheld the ITA’s position of setting a higher interest rate, noting that even such higher interest rate was favorable to the taxpayer as in the District Court’s view, a higher interest rate than that claimed by the ITA could have been imposed.

Deficit Fine

As part of the assessment issued to the taxpayer, the ITA charged the taxpayer a deficit fine, claiming that the taxpayer was negligent in filing tax returns in the manner filed. The taxpayer, on the other hand, argued that a deficit fine should only be imposed in cases where a taxpayer knowingly submits tax returns with slim chances of them being accurate. The District Court rejected the taxpayer’s claims holding that the taxpayer’s conduct amounts to negligence. Indeed, this is the first case in which a deficit fine is upheld as part of a court ruling in the field of transfer pricing.

Key Takeaways

Interest rate on related party financing should be supported by a transfer pricing study in accordance with the OECD guidelines for intercompany financing, and interest rates should be set accordingly. The interest rate must reflect, among other things, the grant and maturity dates of the loan, the risk inherent in the loan, any applicable thin capitalization rules, and the question whether an unrelated third party would, under the circumstances, grant a loan to the subsidiary. The provision of a guarantee by the parent company is also subject to arm’s length rules and should come with appropriate consideration. The possibility of issuing a capital note must be examined in advance, before granting the loan, and the conditions of Section 85A of the Israeli Income Tax Ordinance must be met.

We note that the ruling was rendered by the District Court and is subject to change by the Supreme Court to the extent an appeal is in fact submitted.