In May 2022, the Tel Aviv District Court issued an important ruling in the Medingo Ltd case on the tax aspects of business restructuring. This ruling joins a series of previous rulings, in the Gteko case and the Broadcom case, dealing with the same tax issue.
Business restructuring refers to actions made by related parties in multinational groups reorganizing their commercial relations. Business restructuring may have extensive legal and tax implications. In some instances, such restructuring involves transfers of FARs (functions, assets and risks) from one company to related parties, but not necessarily.
The OECD discussed business restructuring and the associated tax implications comprehensively in it’s guidelines pertaining to transfer pricing. In addition, the Israel Tax Authority (ITA) published a circular that analyzed the issue and presented its position regarding instances when transactions between related parties should be deemed as FAR transfer event.
Medingo, Roche, and Intellectual Property
In 2010, pharmaceutical giant Roche acquired Medingo’s entire share capital for about USD 160 million.
During 2010, Medingo and Roche signed, subsequent to the acquisition, four intercompany agreements. The agreements were in effect until December 31, 2013:
- An R&D services agreement, according to which Medingo was to provide R&D services to Roche and any new intellectual property developed as of the date of this agreement was to belong to Roche.
- A service agreement, according to which Medingo was to provide marketing, technical support, and administrative services to Roche. Medingo was also to provide advice and support pertaining to the use of patents.
- A manufacturing agreement, according to which Medingo was to provide manufacturing and packaging services to Roche.
- A license agreement, under which Medingo was to grant Roche a license to use Medingo’s old intellectual property developed up until this time. This license enables, inter alia, the manufacture, use, sale, commercial utilization, and continuing development of related products and the granting of sublicenses to related entities in the Roche Group.
In respect of the first three intercompany agreements (the service agreements), the companies determined a transfer pricing model according to the cost plus method. The transfer pricing for the license agreement was in the form of royalties at a fixed rate of product sales.
In 2013, Medingo discontinued its operations in Israel and an asset purchase agreement between Medingo and Roche was signed. According to the agreement, Medingo sold all its rights and obligations, including its patents and rights with respect to the old intellectual property, in consideration for about ILS 166 million. Medingo reported the capital gain deriving from such agreement to the ITA.
The ITA did not accept Medingo’s argument, as presented in the capital gain report it filed, whereby it sold the old intellectual property in 2013. The ITA’s order stated that the majority of the FARs pertaining to Medingo’s activity were already transferred in 2010, upon the signing of the intercompany agreements, in a transfer constituting a taxable capital gain event.
The ITA also did not accept the sum of the consideration as reported by Medingo in its capital gain report. Instead, it ruled that since this is a transfer between related parties, and thus should be on an arm’s length basis, the FAR value is to be derived from the value of the Medingo share acquisition transaction signed in 2010, subject to various adjustments. Accordingly, the ITA issued an order imposing on Medingo a taxable income in respect of the FAR transfer totaling about ILS 481 million. This total reflects a tax liability of approximately ILS 120 million. Medingo opposed the ITA’s position and appealed to the district court.
The Court’s Decision
Judge Yardena Seroussi accepted the appeal and Medingo’s position. After an in-depth analysis and deliberation, she ruled that, under the circumstances, the business restructuring Medingo performed subsequent to its acquisition, as reflected in the intercompany agreements signed between Medingo and Roche in 2010, does not constitute the sale of Medingo’s activity.
For the purpose of analyzing the case, the court relied on the guiding principles set in earlier rulings with essentially similar circumstances as this case (the Broadcom case and the Gteko case). It also examined the transaction according to the OECD Transfer Pricing Guidelines, considering the fact that the intercompany agreements constitute transactions between related parties.
In its ruling, the court addressed two key questions:
Do the intercompany agreements, per se, and without taking into account they are agreements between related parties, constitute a sale of the activity?
The court ruled the intercompany agreements, per se, do not constitute a sale of the activity, after analyzing the FAR elements.
Following its examination of the transfer of functions, the court ruled that Medingo’s activity continued and many functions remained in Medingo between 2010 and 2013, such as the R&D, marketing, and manufacturing functions.
Following its examination of the transfer of assets, the court denied the ITA’s claim that the old intellectual property cannot be separated from the new intellectual property. The Court ruled that the old intellectual property, including the patents developed with it, were registered and remained under Medingo’s ownership between 2010 and 2013, while only the new patents were registered under Roche’s name.
The court ruled, Following its examination of the risks, that even if some of the risks were transferred gradually, Medingo retained a significant portion of the risks. The ruling also stated it is indisputable a change in the fabric of Medingo’s activity began subsequent to the signing of the intercompany agreements. However, while this change may perhaps indicate that the price paid in the intercompany agreements in respect of the services provided was not commensurate with their value, it does not necessarily indicate the transfer or sale of Medingo’s activity. That being the case, the ensuing question revolves around the pricing of the transaction, rather than a change in its classification.
Does the fact the parties are related affect the classification of the intercompany agreements to the point that such agreements should be deemed the sale of activity between the parties?
The court noted that the OECD Transfer Pricing Guidelines state a transaction between related parties should be examined in relation to two separate issues while applying the arm’s length principle: the classification of the transaction and the pricing of the transaction.
Initially, the classification of the transaction should be examined in order to ascertain whether it would also have been executed between unrelated parties. If the examination finds that unrelated parties would have engaged in the transaction in the same situation, then the examination should proceed with checking if the price paid reflects the arm’s length principle.
The court stated that its examination of the classification of the transaction found no fault in it and ruled that unrelated parties also execute transactions of similar classification.
The court added that its examination of the ITA’s arguments found that the underlying issue in the arguments is actually the price of the transaction and not its classification. However, since the ITA did not refer to the pricing of the transaction, the court had no choice but to allow Medingo’s position.
The court also referred to the ITA’s argument that Roche’s intentions to close operations in Israel and transfer the entire activity abroad already existed back in 2010. The court did not accept this position. Instead, it stated in response that, firstly, intentions can be reconsidered and as long as the activity and the old intellectual property were not actually transferred, then no tax event occurred. Secondly, even if there had been a real intention to transfer the old intellectual property at some point, since the old intellectual property was returned to Medingo upon the expiry of the license agreement, Roche would still have to purchase it in order to make use thereof, as actually happened in 2013.
Planning Prior to an Acquisition Transaction
In light of the above, it is essential to plan intercompany transactions and business restructurings in an optimal manner. To the extent possible, it is also prudent to take into account the purchaser’s needs even before consummating the acquisition transaction. Such planning ensures more successful transactions and helps avoid superfluous post-acquisition tax events.