The Israeli Supreme Court has just ruled that borderline tax planning done by a taxpayer when selling his home only 2 days after finishing it was not artificial or fictitious. But even the judges were split 2-1.
The case may be notable not only in Israel but perhaps also in other countries that have a “general antiavoidance rule” against artificial or fictitious or sham transactions (e.g. Australia, Canada, South Africa UK, USA)
The main facts:
In 2010, a taxpayer bought an unfinished home in Rothschild Boulevard, Tel-Aviv. The events in question occurred at the end of 2013. On December 3, the taxpayer phoned and asked a decorator (“shiputznik”) to quickly carry out some finishing work. These included installing toilets, baths, faucets, basins, doors, flooring, kitchen etc. The decorator finished on December 23. Two days later, the taxpayer (seller) sold the home for NIS 45 million as a finished home. The purchaser knew this finishing was done so that the seller could claim a home sale tax exemption and straight away stripped out these finishings. Had the home been sold the following month in January 2014, the seller would have been taxed on most or all his gain and the purchaser would have paid higher purchase tax, due to amendments to the Real Estate Tax Law. So the Tax Authority claimed the last-minute finishing work was “artificial”, and demanded full taxation applicable to an unfinished home.
Section 84 of the Real Estate Tax Law in Israel says the Director of the Tax Authority may ignore a transaction and assess tax accordingly if the Director believes a transaction reduces or may reduce the tax payable by a person, or avoid payment of tax, is artificial OR fictitious OR one of its principal purposes is to avoid or improperly reduce tax, even if this is not illegal. Similar rules apply to Israeli income tax and VAT.
The minority judgment:
The minority judgment basically said that given the facts and circumstances, the finishing work amounted to an artificial transaction or a pre-ordained series of transactions that should be ignored. But the majority judgement disagreed – see on.
The majority judgment:
The majority judgment which prevailed in the Supreme Court said that tax planning is a taxpayer’s right when used in certain circumstances, namely, to advance the positive objectives which the legislature (the Knesset) wishes to encourage. A two-stage test is used when characterizing a transaction: (1) is the type of tax planning positive, negative or neutral? (2) If negative, is it artificial having regard to its fundamental commercial purpose? The burden of proof of artificiality is on the Tax Authority.
But before checking fundamentality, the Court said the commercial purpose is checked. If any commercial purpose exists, the transaction cannot be artificial. Commercial purposes can be subjective or objective.
The Supreme Court ruled that the Tax Authority failed to prove objectively that the transaction was artificial. Preparing an apartment to live in before selling it is not a “suspect” transaction. The opposite is true, selling a new apartment in a residential building in a state fit for living in straight away is a completely natural act. It may increase its value and make a sale easier. It is very reasonable and even necessary, according to the Court.
In this case the Court said there was a pure economic-social objective other than tax planning for the finishing work before the change in the law – selling the apartment for NIS 45 million!
As for whether one of the principal purposes of the finishing work was “to avoid or improperly reduce tax”, the Court ruled that there is nothing wrong with an act done to qualify for an exemption or tax break in the law. In this case the only permissible use for the apartment was residential use and the law intended to grant a tax exemption upon sale of a residential apartment. Therefore, the taxpayer should enjoy the resulting tax break regardless of whether the residential apartment was an average urban place or a luxury apartment in the Rothschild Boulevard in Tel-Aviv.
The ruling reflected a 2-1 majority verdict in favor of the taxpayer. Unusually, the main judgement spanning 30 pages was written by the minority judge, as two fellow judges overruled his conclusions. This demonstrates just how slippery the concept of an ”artificial transaction” can be. Typically, a tax authority might contend tax planning was artificial if they don’t like the tax planning but can’t find a section in the law supporting them….
As always, consult experienced tax advisors in each country at an early stage in specific cases.
© Leon Harris 30.9.22