Israel court rejects Israel’s Tax Authority business restructuring claim – and finally criticizes the ITA’s aggressive approach against foreign purchasers
On May 8th 2022, a landmark ruling was given by the Tel Aviv District Court, presided by the honorable judge Yardena Sarusi, in the case of Madingo Ltd. (“Madingo”) vs. Israel Tax Authority, in which, the court rejected the Israeli Tax Authority’s claim of a deemed sale of IP as a part of “Business Restructuring” among related parties; and accepted the taxpayer’s position that the actual transaction that has occurred is the one stated in the intercompany agreements and should be taxed as such.
This court ruling is significant as it continues the proper approach set by previous court ruling in the Broadcom matter, where a similar aggressive approach assumed by the Israeli Tax Authority was rejected by the courts. Those court rulings were given in the wake of years of an aggressive position taken by the Israeli Tax Authority, concerning any international related party transaction; more specifically, the purchase of an Israeli company by a foreign entity and the subsequent license and R&D agreements between the two entities. In such cases, the Israeli Tax Authority wrongfully (so proven) argued that license and R&D agreements constitute a deemed sale of the subsidiary’s activities, and thus are taxable as an addition transaction. Needless to say, such a position resulted in a massive tax risk for foreign companies purchasing companies in Israel.
Accordingly, the Madingo court ruling (as well as the court ruling in the Broadcom matter) has major significance to any foreign company that is doing, or considering doing, business in Israel, or acquiring Israeli companies. The facts of the court ruling are as follows.
Madingo was incorporated in 2005 in Israel and has developed a unique insulin pump for diabetic patients called “Solo”. On April 13th, 2010, Madingo was purchased by the Roche Group (“Roche”) for approximately US$160 million.
About six months after the acquisition by Roche, four intercompany agreements were signed between Madingo and Roche as follows: an R&D agreement on a cost + 5% basis; a service agreement on a cost + 5% basis; a production agreement on a cost + 5% basis; and a license agreement for Madingo’s existing IP (“Old IP”) for royalties set at a rate of 2% of the net sales of products incorporating the IP.
In January 2012, Madingo’s employees were notified that Madingo’s activity in Israel would cease no later than December 31st, 2013, as part of Roche’s plan to reduce activity sites.
On November 1, 2013, an agreement was signed between Madingo and Roche for the sale of Madingo’s Old IP for CHF 42.9 million.
The assessing officer rejected Madingo’s tax return, as the transaction was set between related parties and, according to the assessing officer, was not made at arm’s length nor did it adhere to an acceptable transfer pricing regime; and therefore claimed that Madingo had transferred most of the functions, assets, and risks (FAR) during the year 2010, as part of the intercompany agreements aforementioned. The tax assessing officer issued an audit for a taxable transaction – the sale of Madingo’s activity, valued at NIS 481,354,600 and a subsequent tax liability of NIS119,962,719.
The court rejected the assessing officer position on all counts, citing the following reasoning:
The matter boils down to two questions: (a) whether the intercompany agreements constitute a sale of the activity; and (b) if they do not constitute a sale of the activity, were the intercompany agreements affected by the relation between the parties so that in practice, the agreements should be regarded as a sale of the activity between the parties.
The court ruled that the material presented indicated that the activity was not transferred in 2010, but rather continued, and even more so, in accordance with the intercompany agreements. Namely, Madingo continued its activity, including the R&D functions, production, marketing, and management, and there was no dispute that Madingo continued to carry out the R&D activity and has received compensation in return. Therefore, the court concluded that the alleged activity was not actually a sale , but rather remained with Madingo.
Furthermore, the court noted that there is no dispute that after the conclusion of the intercompany agreements there was a change in the manner of Madingo’s activity. However, this change occurs due to any agreement that redistributes risks and opportunities, even between unrelated parties. Therefore, this does not indicate that the Madingo transferred or sold its activities to Roche. An alleged ‘loss of economic value’ may indicate, at most, that the price paid for the services under the agreements does not reflect their true value. However, this is a matter that concerns the pricing of the transaction, and not its classification.
As for the second matter the court examined whether the intercompany agreements and the business restructuring would not have come into being had it not been for the relationship between the parties.
The court noted that two different issues must be examined using the arm’s length principle: (1) the characterization of the transaction and (2) the pricing of the transaction. The characterization of the transaction must first be examined, and it must be examined whether it would also have been made between unrelated parties. if the examination reveals that even unrelated parties would have entered into a transaction in the same situation, then it must be further examined whether the price paid for the assets complies with market conditions.
Finally, after examining the characterization of the transaction, the court did not find a material flaw in the intercompany agreement at hand.
Consequently, the court rejected the assessing officer’s claims and sided with Madingo.
Due to the scope and complexity of the matter, this summary only pertains to the “highlights” of the court ruling in the Madingo case. However, it can be inferred that careful and sound business practices and conduct between related parities when such intercompany transactions are undertaken, can be used to deflect such aggressive audits by the Israeli Tax Authority. Therefore, it is wise to carry out such business and intercompany transactions while seeking the advice of an Israeli tax adviser, in case a future tax audit by the Israeli Tax Authority arises.