If you buy the shares of an Israeli hitech company and think you are buying the technology too, think again. The Israeli merger and acquisition (M&A) scene just took a turn for the worse.
An Israeli Court has ruled that double Israeli tax applies if a purchaser buys all the shares of an Israeli hitech company and then transfers the intellectual property (IP) and work force out the company. (GTEKO Ltd v. Kfar Saba Tax Office, Ramleh District Court, June 6, 2017 Civil Appeal 49444-01-13).
Facts Of The Case:
In November 2006 Microsoft Corporation of the US bought all the shares of GTEKO, an Israeli tech company, for around $90 million. A month later, in January 2007, the GTEKO work force was moved over to Microsoft Israel. Their services were then billed back on a cost plus basis to enable GTEKO to service its existing clients on annual support contracts until they expired. But no clients renewed their contracts after that.
Six months later, on July 1, 2007, GTEKO entered into an agreement with Microsoft to “sell and transfer… all of GTEKO’s rights, title and interest in and to any and all intellectual property that GTEKO currently owns…” at a valuation of only $27 million.
The $27 million valuation was based on a purchase price allocation (PPA) by an external US appraisal firm and an Opinion by an Israeli CPA firm.
The Israeli Tax Authority (ITA) issued a capital gains tax assessment valuing the intellectual property (IP) assets transferred at $90 million, arguing that the IP value had to be similar to the share price paid a mere seven months earlier.
The taxpayer argued that the IP value was less, because marketing tangibles were left in GTEKO and Microsoft already owned “synergy”. Synergy was said to be IP needed by Microsoft to speed up the “time to market” of a firewall and customization product it was developing at the time called “OneCare”.
The learned judge, Dr Shmuel Bornstein used to be a tax practitioner and his judgment is lengthy (63 pages) and critical of both the taxpayer and the ITA.
The Court found there were two key issues – which assets were transferred and what was their fair market value.
In brief, the Court found that GTEKO became a dormant shell company with no activity once the annual support contracts expired. Therefore FETKO retained no marketing intangibles and wasn’t intended to according to the abovementioned IP transfer agreement of July 2007. The Court also found that the synergy asset existed but it was inside GTEKO and represented part of the $90 million purchase price paid for the shares of GTEKO. Therefore, synergy was inherently part of the subsequent IP transfer of July 2007.
The Court cites numerous Israeli court cases as well as OECD pronouncements. The Court concluded by ruling that IP could not simply “evaporate”. Therefore, the fair market value of the IP transferred remained at around $90 million less a bonus paid to the old CEO of GETKO personally.
This was a District Court case and it remains to be seen if an appeal will be lodged. The judge added a significant side comment (obiter dicta) -the ITA could have claimed the IP transfer was done in an artificial or fictitious manner – a serious matter in Israel and other countries. The USA has a similar sham doctrine.
This case is important to anyone involved in an Israeli hitech acquisition.
Typically in M&A deals the purchaser typically wants to acquire specific assets, while the seller’s shareholders want to sell shares (stock) in the company itself in order to minimize the tax hit. The side with the stronger bargaining position gets their way.
After the deal, the buyer usually wants the IP in one entity in the group outside Israel.
If there is a share purchase followed by an asset transfer to the IP entity, Israel has no asset “step up” (revaluation) rules to avoid tax on the subsequent asset transfer.
This is totally unlike the US which has detailed “step up” rules. And shifting the IP at an under-value won’t work according to this judgment. Unfortunately, this is a common problem in our experience, especially when a US publicly traded buyer wants a quick deal to announce to the public. Solutions exist, but they should be considered before, not after, the deal.
To sum up:
If you are on the buying side, it may be better to go for assets. And if you are on the exit side, it just got harder to sell shares and save tax. That’s not all, every deal has many important facets from structuring the business to integrating the two sides rapidly and efficiently….
As always, consult experienced tax advisors in each country at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd