In April 2019, the authors of this article published in the International Transfer Pricing Journal an article that addressed, inter alia, OECD and Israeli principles of Business Restructuring, focusing on the various resulting models, such as outright sale and licensing structures. Since then, however, an Israeli tax court have reached a legal decision that change the landscape and revisit certain transfer pricing aspects of Business Restructuring in Israel.
Despite the global economic effects of the coronavirus pandemic, significant investment in Israeli technologies continues to be alive and kicking. The first half of 2020 witnessed over 300 deals involving Israel companies. The following graphic demonstrates the increase in deals and value compared to previous quarters:[1]
For example, during 2020, NVIDIA completed the planned acquisition of Yokneam-based Mellanox Technologies for approximately U.S. Dollars (“USD”) $7b, Hellman & Friedman bought Israeli cyber security company, Checkmarx for over $1b and Intel Corp. pulled the trigger on yet another Israeli investment, acquiring the Israeli mobility as a service solutions company, Moovit for $900 million.
In light of the many technology companies being acquired by foreign conglomerates, the transfer pricing aspects of such exits and other restructurings, including implementation thereof, has increasingly appeared on the radar of the Israeli tax authorities (“ITA”), the Israeli court systems and the Israeli government.
As detailed herein, a recent court ruling by Israel’s Lod District Court for Broadcom Semiconductor Ltd. vs. Kfar Saba Assessing Officer, Tax Appeal 26342-01-16 addressed the classification of a business restructuring from a tax and transfer pricing perspective.
In this respect, is it worthwhile to mention an additional recent publication by the ITA. On June 2, 2020, the ITA published Tax Circular No. 1/2020: Transfer Pricing Section 85A of the Israeli Tax Ordinance (“Circular 1/2020”).[2] This circular formally replaces section 2.5 of Tax Circular No. 3/2008: Transfer Pricing (“Circular 3/2008”),[3] which states:
After the taxpayer has submitted the above documents and the documents required by the regulations, the burden of proof will now apply to the assessing officer if he/she arrived at determinations that differ from those agreements reached by the parties of the transaction.
Circular 1/2020 clarifies the ITA’s position as to when a transfer pricing information package provided by a taxpayer is sufficient in quality and content in order to shift the burden of proof to the assessing officer. More specifically, the ITA asserts that the submittal of the transfer pricing study does not necessarily move the burden of proof from the taxpayer to the ITA. Rather, the ITA will first review the transfer pricing study and other documents submitted by the taxpayer to verify its compliance with Israeli transfer pricing regulations. In the event that the ITA rejects the information package presented by the taxpayer, Circular 1/2020 empowers the ITA to set its tax assessment, based on its general experience and past assessments, without being required to substantiate such with its own transfer pricing analysis.
The high priority that transfer pricing issues have taken in Israel is reflected, inter alia, in these court rulings and circulars.
- Initial Israeli Approach to Business Restructuring
The authors of this article published an article entitled “Migration of Intellectual Property from Israeli Technology Companies” in volume 26, no. 3 of the International Transfer Pricing Journal, which addressed certain business restructuring issues, from the perspective of the Organization for Economic Cooperation and Development Guidelines[4] (“OECD Guidelines”) as well as based on recent Israeli transfer pricing publications. The article highlighted the upswing of foreign investment in Israel through various forms such as mergers and acquisitions and consideration of business, operational and tax consequences of such acquisitions. As mentioned above, such inbound investment has continued despite the current period of economic uncertainty during the global coronavirus crisis.
In its revised version of chapter IX of the OECD guidelines, the OECD reaffirms that MNEs are free to organize their commercial operations as they see fit and should not be instructed by tax authorities on how to design the location of business operations. In addition to synergies, economies of scale and streamlining the efficiency of a supply chain, the OECD recognizes that tax considerations may also be a contributing factor to a business restructuring, albeit subject to the application of the arm’s length principle and article 9 of the OECD
Model Tax Convention (2017). In relevance to the common scenario of Israeli companies undergoing acquisition by MNEs, chapter IX addresses the transfer of intangibles or rights thereof within the context of a restructuring. A transfer of intangibles may raise challenges, for both the identification as well as an arm’s length valuation of intangibles, as not all intangibles are legally protected or recognized for accounting purposes.
It is common that intangibles developed and owned by an Israeli target company, which are migrated to a foreign MNE, post-acquisition, continue to be enhanced for the most part by the in-house Israel-based R&D team. Under the post-acquisition business model, the Israeli company is no longer exploiting the intangibles for its own purpose, but rather doing so on a contract or license basis in cooperation with the new IP owner, thereby making the determination of which entity is mostly involved in the DEMPE functions[5] more critical.
In the Gteko Ltd. vs. Kfar Saba Assessing Officer, Ruling 49444-01-13 (the “Gteko Ruling,”),[6] the court ruled that post-M&A transfers of human and capital assets, including IP, should be considered as a sale of an entire business and therefore the IP value should generally be aligned with the initial acquisition price. The Gteko Ruling emphasized focus on ‘substance over form’, potential benefits of synergies and the transfer of human capital (also known as workforce in place).
In 2018, the ITA published Tax Circular No. 15/2018: Business Restructuring within a Multinational Group, clarifying the ITA’s stance on the tax and transfer pricing aspects of changes in business models. Circular 15/2018, heavily based on the Gteko Ruling, outlines techniques for identification and characterization of restructuring (including required disclosures), acceptable methodologies for assessing the functions, assets, and risks (“FAR”) that have been transferred or ceased, as well as the tax implications thereof.
- Update based on recent Israeli District Court Ruling
In a landmark ruling in December 2019 (after the publication of the initial article), Israel’s Lod District Court rejected the ITA’s position on the classification of a business restructuring from a tax and transfer pricing perspective under the circumstances detailed below. The ruling is particularly significant since the court distinguishes between the Broadcom Semiconductor facts and circumstances from those of the Gteko Ruling (2017), which was issued by the same judge, the Honorable Dr. Samuel Bornstein.
In Broadcom Semiconductor Ltd. vs. Kfar Saba Assessing Officer, Tax Appeal 26342-01-16 (the “Broadcom Ruling”),[7] the court ruled that a transition of an Israeli company from a principal and owner of intellectual property position to a service provider role on a cost-plus basis does not necessarily trigger a capital gain tax event by means of sale of an asset.
By way of background, Broadcom Semiconductors, Ltd. is an Israeli company, was established in 2001 as ‘Dune Semiconductors, Ltd. (“Dune”). Dune engaged in the development, production, and supply of fast switches and router components. Dune had rights to certain intellectual property, both those licensed in from related affiliates as well as internally developed. The Dune companies were acquired by the U.S.-based Broadcom Corporation in November 2009. In 2011, Dune corporation changed its name to Broadcom Networking Israel, Ltd. (“Broadcom Israel”).
In this respect, Dune applied to the Office of Chief Scientist (known as the Israel Innovation Authority since 2016), a division of Israel’s Ministry of Economy and Industry, in order to seek a pre-approval for a transfer of its developed intellectual property. The application was in accordance with the Knesset’s 1984 (5744) law, the Law for the Encouragement of Industrial Research and Development,[8] and was approved by the Office of Chief Scientist, subject to a payment of approximately 60 million Israeli shekel (“ILS”) (approximately USD $17 million) due to Dune’s status as a beneficiary of grants received from the Chief Scientist Office.
Following the acquisition, Broadcom Israel entered into agreements to provide marketing and support services to a related Broadcom affiliate under a cost+ 10% structure, to provide contract development services to a related Broadcom affiliate, under a cost+ 8% structure, and a license agreement with another Broadcom affiliate to employ Broadcom Israel’s intellectual property in consideration for royalties in the range of approximately 14% of the latter affiliate’s turnover.
The ITA argued that, as a result of the new agreements, the functions, assets, and risks (FAR) that had been undertaken in Israel were transferred outside the jurisdiction, thereby constituting a business restructuring, leaving the Israeli entity as an ‘empty shell’. As a result, the ITA demanded about 100 million ILS (approximately USD $29 million) in additional taxes, claiming that the value of functions, assets, and risks transferred should be based on the purchase price and that the change in the business model should be reclassified as a sale of an asset.
According to Broadcom Israel, however, the applicability of business restructuring and transfer of functions, assets, and risks would only have been appropriate had Broadcom Israel been emptied of its activity after the acquisition. Since Broadcom Israel continued as an operational company both as a licensor and as a service provider and its financial situation actually improved following the acquisition and new business arrangement, it claims that no sale of an asset occurred. Moreover, several years following the license transaction, Broadcom Israel eventually sold its intellectual property and was taxed for the realized capital gain. Therefore, Broadcom Israel argued that it should not be subject to tax on the transfer of functions, assets, and risks prior to that sale as well.
Judge Bornstein and the Central District court sided with the taxpayer and rejected the ITA’s claim that the change in business model should be classified as sale of an asset or trigger a tax event.
In the ruling it was determined that as long as there is no concrete evidence that the business restructuring reflects a different transaction (i.e. a sale of an asset), the ITA may not intervene in reclassifying the transaction. While the court recognized that, in principle, it is correct that a business model change may, in some cases, constitute a sale of the functions, assets, and risks, it cannot be assumed and applied automatically by the tax authorities. In the words of the court ruling, the term “business restructuring” does not ‘magically’ change the classification of the transaction between the parties. Further, to determine that a business restructuring constitutes the sale of functions, assets, and risks for tax purposes, it must be demonstrated that not only that the change occurred, but also that the change would not meet the arm’s length principle, assuming unrelated parties engaged in similar circumstances. Accordingly, Broadcom Israel’s business activities are regarded to have evolved naturally. It should be noted that the arm’s length principle should still be applied in a thorough analysis of the functions, assets, and risks to determine the appropriate remuneration mechanism, but such should be done in a deliberate and measured analysis and not an automatic conclusion.
In contrast to Broadcom Israel’s position, however, the court did confirm that the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, as well as its approach to business restructuring, found in Chapter IX thereof, may be used as a reference for Israeli tax purposes.
The Broadcom Ruling also addressed other important issues including Burden of Proof, assessment of transferred functions, assets and risks, and a distinction between “Legacy IP” and “New IP”, in light of changes in functions, assets and risks and Broadcom Israel’s licensing transaction.
- Broadcom Ruling vs. Gteko Ruling
The divergence in conclusions in the Gteko Ruling vis-à-vis the Broadcom Ruling are of importance. Whereas in the Gteko Ruling, the transfers were ruled as a sale of an entire business and the IP value therefore aligned with the initial acquisition price, in the Broadcom Ruling, it was determined that there was no sale of Functions, Assets and Risks, and therefore not subject to capital gains tax.
As Judge Bornstein presided over both cases, he explains that the facts and circumstances surrounding Broadcom Israel varied greatly from those found in the Gteko Ruling and he therefore arrived at different conclusions for each case.
For Gteko, most of the economic value, including the workforce, was extracted by Microsoft while the court concluded that the Israeli entity became an ‘empty corporate shell’, seeing a dramatic collapse in Gteko business after its acquisition. The only explanation, according to Judge Bornstein, was that the any remaining economic value was shifted to the parent company.
Broadcom Israel, on the other hand, has witnessed increased activity within Israel due to the aforementioned agreements, renting more office space, and hiring more workforce. Though it may have changed certain risks associated with its activities, the fact that it is continuing to operate on a cost plus basis as well as receiving royalties in relation to its Legacy IP, leads to the conclusion that this would not be the transfer of an asset that would be subject to capital gains tax. Another argument that assets were not transferred, as of the acquisition, is the fact that Broadcom Israel sold certain intellectual property at a later date. Moreover, the court emphasized that the ITA did not take into consideration realistically available alternatives at the time of the suggested restructuring, which is one of the primary elements found in Chapter IX of the OECD Guidelines and the ITA’s Circular No. 15/2018.
- Conclusion
Taking into account the aforementioned authorities such as Chapter IX of the OECD Guidelines, Circular No. 15/2018, and the differences between the Broadcom and Gteko rulings, it is important for local taxpayers and/or their acquiring entities to be prepared to prove business reasons behind such changes taking into account realistically available alternatives.
[1] “Israel Tech Funding Report Q2 2020” by IVC Data and Insights and Zag-S&W; available at:
[2] Available (in Hebrew) at: https://www.gov.il/he/departments/policies/income-tax-professional-inst-1-2020 (accessed Sept. 2020)
[3] Available (in Hebrew) at: https://www.gov.il/BlobFolder/service/itc-1385/he/Service_Pages_Income_tax_hoz3-2008.pdf (accessed Sept. 2020)
[4] OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD 2017), International Organizations’ Documentation IBFD [hereinafter, the OECD Guidelines].
[5] DEMPE functions constitute the development, enhancement, maintenance, protection and exploitation of intangibles, as outlined in the OECD Guidelines.
[6] IL: Israeli Central District Court, 6 June 2017, 49444-01-13, Gteko Ltd. v. Kfar Saba Assessing Officer, available (in Hebrew) at https://www.gov.il/he/Departments/news/sa-070617-2 (accessed September 2020).
[7] IL: Israeli Central District Court, 9 December 2019, 26342-01-16, Broadcom Semiconductors, Ltd. v. Kfar Saba Assessing Officer, available (in Hebrew) at https://www.gov.il/he/departments/legalInfo/law26342-01-16 (accessed September 2020).
[8] IL: Law for the Encouragement of Industrial Research and Development 5744-1984, available (in Hebrew) at the Knesset Legislation Database – Updates of Law for the Encouragement of Industrial Research & Development, at https://main.knesset.gov.il/Activity/Legislation/Laws/Pages/LawPrimary.aspx?t=lawlaws&st=lawlaws&lawitemid=2000783 (accessed September 2020).