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September 24, 2021
2021-5990

Israeli Court rules on reclassification of trademark transaction between a shareholder and its company and the armís-length return on R&D services

Executive summary

The Israeli Jerusalem District Court (the Court) ruled, on 16 August 2021, in the case of Sephira & Offek Ltd and Israel Daniel Amram vs. Jerusalem 3 Assessing Officer on the reclassification of a transaction in which a New Immigrant1 sold, in a tax exempt transaction, its French-registered trademark (SEPHIRA) to its wholly-owned Israeli company (the Company), following which the Company amortized that trademark that was deducted against the royalty income received from a French-related company, for the use of the said trademark.

In addition, while the Company recorded its income from research and development (R&D) services as Preferred Income entitled to tax incentives under the Encouragement Law,2 the Court accepted the Israeli Tax Authority’s (ITA) position that excess income beyond the amount regarded as arm’s length should be considered as ordinary income, and therefore not be entitled to the said tax incentives. However, the Court accepted the taxpayer’s position as to the way such excess income and arm’s length should be determined. While the profit level recorded by the Company for the said R&D services was higher than the interquartile range of the operating profit in R&D service provider companies as presented in the Company’s Transfer Pricing (TP) study, the Court did not accept the ITA’s position that the Company’s preferred income should be determined at the median level as set in the TP study. Rather, the Court accepted the taxpayer’s position and ruled that Section 85A of the Income Tax Ordinance (ITO) only applies when the Israeli reported income is lower than the arm’s-length income as determined by the company’s TP study, and therefore an appropriate objective indication can be the maximal profit identified in the study for transactions between unrelated parties.

Multinationals should carefully review this Court ruling for its reclassification analysis under Israeli General Anti-Avoidance Rule (GAAR), as well as its use and reference to the Company’s TP study to determine that excess income recorded beyond arm’s length should be regarded as ordinary income.

Detailed discussion

Israel Daniel Amram (Amram) is an engineer who was employed by the French Government where he was involved in a national medical project, following which he developed his own idea for a digital financial interface between insurance companies and medical service providers. In 1999, Amram registered the trademark SEPHIRA and formed a French company under the name Sephira SAS. In 2003, Amram moved to Israel and formed Sephira & Offek Ltd (Sephira Israel) which provided R&D services to related companies abroad and acted as a call center.

As of 2011, Sephira Israel reported its income from R&D services as Preferred Income under the Encouragement Law.

In July 2011, Amram signed an agreement with Sephira Israel for the sale of his rights in the SEPHIRA trademark in return for €8.4m in semi-annual payments not to be lower than €150,000. In practice, Sephira Israel paid for the consideration within four years. As a New Immigrant, this sale was tax exempt to Amram.

Following the trademark sale-purchase agreement, Sephira Israel engaged with Sephira SAS for the license of the trademark in return for royalty payments.

In parallel, Amram had a payable to Sephira Israel in an amount of NIS5m that was offset against the Company’s payable to Amram following the trademark sale-purchase agreement.

The trademark was classified as goodwill in the Company’s books and was amortized in different amortization rates throughout the years (5% to 7%), even though the amortization rate for goodwill is 10% under Israeli tax regulations.

The ITA contended that: (i) the sale of the trademark is an artificial transaction that should be ignored for all purposes; and (ii) the profit level recorded by the Company for its R&D activity exceeds the industry’s profit level, and therefore the taxable income that exceeds the acceptable profit level for R&D services should be classified as ordinary income that is subject to the standard corporate income tax (CIT) rate.

Based on the various arguments made by the ITA, the Court ruled that the trademark sale transaction was artificial under Section 86 of the ITO and should therefore be ignored, together with its resulting implications (the amortization and the royalty income at the level of the Company). The Court also agreed with the ITA that Amram took advantage, in a so-called “negative tax planning,” of tax benefits that he was entitled to as a New Immigrant, by selling, in an artificial manner, its trademark to his own company, and that the Appellants did not prove the commercial reasons for the transaction.

The Court also agreed with the ITA that the royalty income was earned by Amram, and therefore should be subject to marginal tax rate in his hands.

In parallel, the ITA audited the operating profit level of Sephira Israel for the income from its R&D activity, and asserted it is in excess to the interquartile range in the Company’s TP study. The ITA claimed that the Company had a preference to shift profit from the high tax rate that was applicable to Sephira SAS in France, to the lower tax rate that applied in Israel on the Company’s Preferred Income from R&D services. Based on the said differences between the Company’s profit level and the arm’s length under the Company’s TP study, the ITA’s position, which was accepted by the Court, was that the excess income should be regarded as ordinary income that is subject to the standard CIT rate as management income, rather than Preferred Income that is entitled to tax incentives.

While the ITA asserted that the excess amount should be determined as the profit level above the median rate in the Company’s TP study, the Court accepted the Appellants’ position according to which Section 85A of the ITO (Transfer Pricing in a Cross-Border Transaction) is only applicable to cases where the taxpayer records lower income than required, and therefore, since the ITA is using other GAAR doctrines, a proper objective indication for the excess profit level can be the maximal profit level identified in transactions between unrelated parties. Accordingly, it was determined that the operating profit that is above 40% will be regarded as management income that is taxable at the standard CIT rate.

Implications

Multinationals should carefully review this Court ruling for its reclassification analysis under Israeli GAAR and the arguments made by both parties and discussed by the Court, as well as its use and reference to the Company’s TP study to determine that excess income recorded beyond arm’s length should be regarded as ordinary income. Following this decision, companies should consider the alignment of income and profit recognition for preferred activities with their TP studies, to avoid a reclassification of an income that is entitled to tax incentives into an ordinary income, that is subject to the standard CIT rate.

_________________________________________

For additional information with respect to this Alert, please contact the following:

EY Israel, Tel Aviv

Ernst & Young LLP (United States), Israel Tax Desk, New York


Endnotes

  1. A New Immigrant under Israeli domestic law is a person who immigrated to Israel and became an Israeli tax resident for the first time, where this status provides a 10-year holiday period during which the New Immigrant is entitled to wide exemptions on his non-Israeli source income.
  2. The Encouragement of Capital Investments Law. 1959.
 
 

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