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Israeli court uses flawed logic in key transfer pricing decision

The Israeli District Court on June 6 rendered an important decision which strives to develop transfer pricing principles and guidelines in the Israeli tax law context.

Unfortunately, the conclusions in the case, Getko Ltd vs. Kfar Saba Assessing Officer, appear incorrect and lead to double taxation. The Court seems to miss the economic and tax essence of the transactions. My view is that this decision would be reversed, if appealed.

The case involves the November 2006 purchase by Microsoft Corporation of 100% of the shares of Getko Ltd., for USD 90 million.

Getko is an Israeli corporation that developed e-support technology. Microsoft made the purchase to integrate Getko’s technology into Microsoft’s OneCare product.

Following this share purchase agreement, the employees of Getko were transferred to Microsoft Israel, a subsidiary of Microsoft Corporation. Few months later, on July 1, 2007, a second agreement was signed in which Getko transferred its intellectual property (IP) to Microsoft for USD 26.6 million based on a purchase price allocation study prepared by Duff and Phelps, a leading valuation and corporate finance advisor. Based on this price, Getko filed a tax return and reported the capital gains of Getko from the IP transaction which were offset against its carried forward losses.

The assessing officer did not accept the price used in the IP transaction, arguing that it is not an arm’s length price that reflects the economic substance of the deal.

According to his assessment, the IP transaction is not really an IP deal but rather a deal in which Getko transferred all its assets as a going concern to its parent company Microsoft. Hence, the arm’s length price is not USD 26.6 million but rather almost USD 90 million based on the agreed price in the shares purchase deal.

Accordingly, tax authority issued an assessment reflecting that Getko must pay capital gains on 90 million USD instead of USD 26.6 million. The District Court rejected Getko’s appeal and confirmed the assessment of the officer with minor changes.

With all the respect, this is totally wrong.

Getko’s business, as a going concern, could be transferred through a shares purchase deal that transfers the shares of the selling company, Getko, to the purchasing company, Microsoft, and keeps both entities as full and active separate entities, but one is parent and one is subsidiary.

Alternatively, the transfer could occur through an asset deal that transfers all the assets into the purchasing company, Microsoft, which would hold all assets and the selling entity, Getko, would then become an empty entity.

There is no economic logic at all to do both transactions since no purchaser pays twice for the same economic value. But the parties to the deal could split the value into two parts — one to be transferred in the shares transaction and one in the asset transaction — for economic and tax reasons, as the parties did in this transaction, to the best of my understanding.

The total value of the deal is 90+26.6, namely, USD 116.5 million. The parties split this value, USD 90 million in the shares agreement and USD 26.6 million in the IP agreement.

This split could be motivated and explained by economic reasons, such as keeping the two entities separate but holding the IP in the top entity to benefit the whole group.

The split might also be explained by tax reasons, because Getko tried to offset the capital gains against its losses to reduce the tax burden on its shareholders.

Therefore, the assessing officer could have argued against the split and its motives as a tax avoidance scheme. If he succeeded in his arguments he wouldn’t allow any offsetting of losses and would impose capital gains tax on the amount of USD 116.6 million rather than USD 90 million on the shareholders of Getko who sold their shares to Microsoft.

But, it is contrary to tax law and the economic substance of the deal to impose double taxation on almost USD 180 million, namely, once through the shares transfer (90 million – November 2006) and then again through the assets transfer (almost 90 million – July 2007). This is unlawful and unjust taxation.

The Court started by interpreting section 85A of the Israeli Income Tax ordinance, which grants the assessing officer an anti-tax avoidance authority to intervene and imposes tax on international transactions between related parties based on the arm’s length principle.

The Court ruled that this section applies even if no tax cut and avoidance is proved. According to the Court’s interpretation, this section sets the arm’s length price as the price for tax purposes as a foundational norm or principle rather than as anti-avoidance norm.

However, I think that Section 85A is obviously an anti-avoidance norm and the Court’s interpretation contradicts the history and words of section 85A. But, in this case, section 85A applies as well as section 86 of the tax ordinance (The Israeli General Anti Avoidance Rule – GAAR), and other anti-avoidance doctrines, because the tax was reduced through splitting the deal and offsetting the losses.

Tax avoidance and anti-avoidance norms are actually the essence of this case and these issues must be analyzed. The burden of proof in these issues is complex and it is not easy to say, as the Court did, that the burden is on the taxpayer to prove the appropriate substance and classification of the deal, despite the fact that the taxpayer explained the substance of the deal and submitted all the relevant documents.

The Court must address the burdens while taking into account that the tax authorities are intervening, either through anti-avoidance doctrines (substance over form), section 85A, section 86, or through other sources.

As to pricing, the Court ruled that above market pricing based on synergy benefits is part of the price and should be taxed. Microsoft paid a high price to gain time to market and synergy benefits and this price is an arm’s length price and falls within the boundaries of the tax base.

That is totally true and the OECD transfer pricing guidelines supports this pricing, as the court mentioned. In addition, the court accurately ruled that the value of the employees and their knowledge and expertise is part of the price and the tax base. I agree with that as well and both components, synergy and employees, are included within the USD 90-116.6 million price of the deal. However, the total price can’t exceed USD 116.6 million in the facts of the case as I explained above.

In sum, Getko is expected and should submit an appeal to the Supreme Court against this important decision, but should change its approach and arguments towards the issues of tax avoidance and double taxation rather than transfer pricing. In my view, Getko should focus on arguments that reach fair taxation according to the words and purposes of section 85A and the Israeli anti avoidance norms and the Israeli Tax law.

In my opinion, the tax law, the tax interpretation jurisprudence and Israeli constitutional law and principles should lead the Supreme Court to a different result in Getko.

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