Exit pursued by Tax Authority

Foreign acquisitions of Israeli technology companies are often structured to avoid tax on the export of the main asset - the intellectual property. The Tax Authority is on the case.

Israeli technology companies that have made exits worth many millions now find themselves in the Tax Authority's sights. Several Israeli companies are in dispute with the Authority over how much tax they should pay in the case of what the Authority calls "a change of business model". According to the Authority, Israeli exits that take place in two stages a sale of shares in the company for a huge sum in the initial stage, followed by a sale of the company's intellectual property for a negligible amount in the second stage represent one sale, and will be taxed accordingly, and not according to the small amount in the second transaction.

Sources inform "Globes" that among the companies that have already felt the long arm of the Tax Authority reaching into their pockets and trying to extract big money are US semiconductors giant Broadcom, which in 2008 bought several Israeli high-tech companies, and eBay, in connection with its acquisition of Fraud Sciences, now part of PayPal, for $169 million in 2007.

PayPal stated in response: "The company pays taxes according to law. The matter is the subject of legal proceedings, and at this stage we do not wish to comment." No response was received from Broadcom.

Two-stage sale

Successful Israeli technology ventures being bought by global technology giants, particularly from the US, have become a common phenomenon, with dozens of Israeli companies making stirring exits in recent years, and hundreds of millions of dollars lining Israeli pockets. The most outstanding recent examples are the sale of navigation app company Waze to search giant Google, and the sale of Trusteer to global computing giant IBM.

However, after all the excitement, some of the Israeli companies have found themselves, and will find themselves, in difficult disputes with the Tax Authority, at the end of which they will have to pay millions of dollars more in tax. A Tax Authority source said that at least five such cases were currently before the courts.

The background to the disputes is the two-stage process by which acquisitions of Israeli companies by international companies are carried out. The international companies are generally interested in the Israeli company's intellectual property, in its technology, and not in its workforce. But tax considerations lead all those involved to construct the transaction as a sale of shares and not as a sale of intellectual property.

Selling the intellectual property alone would oblige the shareholders in the acquired company to distribute the proceeds as a dividend, or to liquidate the company, in order to benefit from the profits. In such a situation, the company would be liable to companies tax on the sale at 26.5% (the current rate) and then the shareholders would be taxed a further 25-30% on the distribution of profits. So instead of paying 26.5% tax, the company and the shareholders pay altogether about 50%, and are left with less money in hand. Shareholders in Israeli acquisition targets therefore generally insist upon a share purchase transaction.

Buying the shares means that the foreign company holds the Israeli company, which is where the sought-after intellectual property is. At this stage, the acquiring company's tax considerations come into play. It will want to transfer the know-how and technology from Israel to a tax shelter such as Luxembourg, Ireland, Cyprus or the Cayman Islands, where tax rates are extremely low.

Therefore, perhaps a few months after the original share purchase transaction, when the intellectual property in Israel is controlled by the international company, the Israeli company sells it for a pittance to one of the international company's other subsidiaries overseas. In order to justify the low price, the acquiring company equips itself with a valuation from experts in the field, who value the intellectual property and the technology at very low prices.

According to a high-tech epxert, "There is usually a gap of time between the share purchase and the sale of the assets and technology. The companies don't want it to be too blatant and set lights flashing at the Tax Authority."

But the lights have been flashing at the Tax Authority for a while. In July 2010, the Authority published a position paper making clear its stance on the tax consequences in these kinds of circumstances, which it terms "a change of business model", in which companies that own technology enterprises transfer intangible assets from the Israeli company to a connected party.

"We have recently encountered many companies in the Israeli economy, chiefly high technology companies, that have carried out, or that plan to carry out, a change in their business model. 'A change in business model' for these purposes includes the transfer of risks and intangible assets from the Israeli company to a connected party. In the cases that have come to our attention, a change in business model took place in the framework of a structural change within the group, and not through a transfer to unconnected third parties," the position paper states.

The position paper makes clear that the transferred intangible assets give the company that receives them a platform for continuing its activity and the right to cash flows from those assets. In the transfer, ownership rights in existing assets (know-how) change hands, including patent-protected or non patent-protected technologies, technological knowledge, technologies at various stages of development, and righs to future technologies, assets, markets, and so on.

The Tax Authority states that, in its view, a change in the business model could affect the tax liability of the transferring company on several levels:

a. The company could become liable to capital gains tax on the transferred assets: If in the change of business model any activity, or the business as a going concern, or tangible or intangible assets leave the Israeli company's possession, then this will considered a sale requiring the reporting of a capital gain, in accordance with the provisions of the tax ordinance.

b. The company could be liable for tax on royalties on assets not sold: If the Israeli company retains control of intangible assets that have not been transferred, and the Israeli company gives the receiving company or other connected companies in the group a right to use them, whether or not a contract exists, revenue from royalties will be credited to the Israeli company.

c. In addition, the Tax Authority will examine the company's liability to tax on a distribution of a dividend in kind: When the Israeli company relinquishes possession of assets, among them intangible assets, this transaction should be seen as a distribution of the assets of the Israeli company to its shareholders, which will be classed as dividend income in the hands of the shareholders.

Illegitimate tax planning

Under this position paper, the Tax Authority has issued tax assessments to the companies concerned that are far higher than the amounts the companies thought they would have to pay, which has led to disputes with the Authority, some of which, as mentioned, are currently before the courts.

A senior Tax Authority source told "Globes" that these transactions amounted to illegitimate tax planning as far as the Authority was concerned. "Initially they supposedly only sell shares, the tax is paid, and everything's fine, but in the second stage they in effect strip the Israeli company of economic content and technological know-how, extract it at laughable prices, in order to pay ridiculously low tax. For example, a deal can be at $100 million, and immediately afterwards they sell the intellectual property and all the company's know-how for $10 million to one of their overseas subsidiaries, a tenth of the price. These aren't market prices. The true market price is what there was before, in the sale of shares, when the shareholders conducted real negotiations. But what did the price of the shares reflect? The underlying assets, especially in high-tech companies, which means the intellectual property. There's nothing else there, and suddenly they're transferring it at a tenth of the price.

"In these cases," the senior official says, "the State of Israel loses twice over. It loses the real taxes, and it loses the economic activity, because once the intellectual property and the technology are taken out of Israel, employees here are laid off, factories are shut down, development companies are closed. This is the process we are seeing, and it's very painful, and very significant, amounting to hundreds of millions of dollars leaving the country."

The official says that the Tax Authority is therefore fighting to price the second-stage transaction, the sale of the intellectual property, at market value, and insisting that tax should be paid accordingly. "Of course we rule that the value should be according to full market value, and we are currently embroiled in these matters vis-a-vis several companies," he says.

Published by Globes [online], Israel business news - www.globes-online.com - on October 15, 2013

© Copyright of Globes Publisher Itonut (1983) Ltd. 2013

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