Earlier this month the Central District Court handed down its decision on an appeal involving the taxation of an international sale of intellectual property by Gteko Ltd., an Israeli subsidiary of Microsoft Corporation.

About 10 years ago, Microsoft acquired 100% of Gteko’s shares in consideration for USD 90 million. Shortly after the acquisition, Gteko’s 150 employees were transferred to Microsoft Israel (another Microsoft subsidiary), and 9 months later, Gteko sold all of its intellectual property to Microsoft in consideration for USD 26.6 million. The consideration for the IP was determined by an external third party consulting company.

The Israeli Tax Authority (ITA) did not accept the consideration attributed by Microsoft to the IP, and by virtue of section 85A to the Income Tax Ordinance, dealing with transfer pricing in international transactions between related parties, argued that the IP sale should be taxed according to market terms. The ITA’s position was that the IP transaction was a de-facto sale of all of Gteko’s business, and that the real value of the IP was closer to USD 90 million, the consideration paid by Microsoft for the shares of Gteko, rather than the USD 26.6 million, the consideration which was reported by Gteko for the sale of its IP.

Microsoft challenged the ITA’s position and the matter was brought before the Court. In its decision, the court accepted the ITA’s position and determined that that the IP sale was in fact a broader transaction which included the sale of the vast majority of Gteko’s assets and not only its intellectual property, and that the consideration for the IP transaction should be approximately USD 80 million.

The Court further held that the synergy created by the acquisition is not an asset of the acquirer, that the transfer of all of the target’s employees as a whole as part of an acquisition can be deemed an asset of the target, and that the Israeli transfer pricing rules can be applied even if the underlying transaction does not reduce the tax liability (but actually increases the tax burden).

The Court’s decision underscores the importance of M&A tax structuring.

In light of this decision, potential acquirers, who are contemplating using, post-closing, the target’s intellectual property outside the scope of the target, may now consider shifting to asset purchase transactions, overriding the preference of target company shareholders to execute sales through share purchase deals.

At the very least, the decision emphasizes the need on the part of acquirers and targets alike, to carefully devise and design the structure of similar M&A transactions in order to ensure that separate identifiable values are provided as part of the share purchase deal and the subsequent sale of the target’s intellectual property.