A Revolutionary Tax Case Law on “Business Restructuring”

In the revolutionary case law of Broadcom Semiconductor Ltd. vs. The Tax Assessing Officer of Kfar Saba (Tax Appeal 26342-01-16; published on December 9, 2019) the District Court ruled in favor of the taxpayer and held that if there was no material indication that the change of business model reflected a different transaction than the one presented by the parties, there should be no room for involvement of the tax assessing officer in classification of the transaction, but only in the pricing of it, based on transfer pricing rules.

This case law has a material effect on post-acquisition integration of Israeli hi-tech companies, and should be taken into account upon planning of business restructuring of such companies, following an acquisition.

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The Factual Background:

An Israeli start-up company that was acquired by Broadcom Semiconductor Inc. changed its business model after the acquisition, as follows:

  • it began to provide marketing and support to a related company for compensation that was calculated on a cost plus basis;
  • it began to provide R&D services to another related company, for compensation that was calculated in the same way; and
  • it gave another group company a license to use its IP, in return for royalties.

The Parties’ Approach:

The Israeli Tax Authority (the “ITA”) claimed that following this set of transactions the company has transformed from a company that was engaged in R&D, production (through subcontractor), marketing and sales, into a company that provides R&D services to the company that acquired it.  Hence, the ITA claimed that the company sold its IP and that it should be subject to capital gains tax on the sale.

The company, on the other hand, claimed that it has not sold anything and that it was not restricted from commercializing its IP, through granting a license to use it; while providing R&D services to another related company that led to the development of new IP, based on the “old” IP it possessed (and licensed to another).

The Court’s Decision:

The Court differentiated between this case and the precedential case of Gteko Ltd. vs. The Tax Assessing Officer of Kfar Saba (Tax Appeal 49444-01-13, published on June 7, 2017) that related to a post-acquisition, one-time sale of IP, by a start-up company; and was held by the same judge, however in favor of the ITA.

In the Gteko Case, the acquired company was stripped from all of its Functions, Assets and Risks (“FAR”) and was eventually dissolved; whereas in the case at hand the company has proven that following this set of transactions it has increased its activities; hired more employees; and generated more revenues.  Moreover, in the case at hand the company sold its IP for a material amount several years after it was acquired.  This event has been treated by the Court as an indication that the company kept the IP and did not sell it in the framework of restructuring its business, as was claimed by the ITA.

The court ruled that the ITA could not simply change the classification of a transaction by claiming “change of a business model”.  Hence, it ruled that the ITA should have taken additional measures in order to justify its approach; and implied that it should have alternatively challenged the value of the licensing and service provision transactions.

In addition, the court ruled that the question that needs to be asked in such cases is not whether there was a change in the business model (which was clearly the case here); but rather, had it not been a transaction between related parties – would this transaction have occurred in the same conditions?

The Court clarified that the issue here was whether, in the framework of the agreements that established the three transactions (licensing, provision of R&D services and provision of marketing and support services), the company actually sold its FAR and not – what the value of the company was, or what the value of its FAR was, as was claimed by the ITA.

The court stressed that if there was no material indication that the change of business model reflected a different transaction than the one presented by the parties, there should be no room for involvement of the tax assessing officer in the classification of the transaction, but only in the pricing of it, based on transfer pricing rules

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