An Israeli court has ruled that if a foreign group buys the shares of an Israeli tech start-up, strips out the IP (intellectual property) and terminates the Israeli company, the company must pay tax on the IP stripped out (Medtronic Vs. Kfar Saba Assessing Officer, District Court Civil Appeal 31671-09-18, June 1, 2023). This is the fourth in a series of similar cases, so the Israeli Tax Authority (ITA) means business. Potential foreign purchasers should sit up and take note.

The problem arises because buying the shares of an Israeli company in an M&A/exit is taxable for Israeli resident sellers and there is no step-up (revaluation) of the underlying IP for Israeli tax purposes – unlike Section 338 of the US Internal Revenue Code.

The main facts:

In 2009, Medtronics Inc., an American multinational group, acquired all the shares of Ventor Technologies Ltd, an Israeli developer of transcatheter heart-valve technology, for $325 million; and California’s CoreValve Inc, a competing maker of transcatheters, for $700 million.

In 2010 and 2011, after the deal, the Israeli company signed an intercompany R&D services agreement on a cost plus basis and an intercompany royalty agreement allowing the group to use the Israeli company’s IP.

In August 2012 the Israeli company belatedly notified the ITA of these intercompany agreements together with the fact that it had been decided in March-April 2012 to close down the company. The Israeli company then ceased operations and laid off its employees.

The ITA said the closure amounted to a taxable sale of the company’s functions, assets and risks (FAR) and issued an assessment to tax on the same amount Medtronic paid to acquire Ventor’s shares (presumably the Shekel equivalent of $325 million).

The verdict:

The Court upheld the ITA’s assessment of the sale of FAR. Medtronic had argued the IP was worthless due to a recall of products and it was necessary to use CoreValve’s technique which was different. The Court disagreed, noting that in 2012 Ventor’s products held a 41% market share and that recall was much later in 2016 by which time surgeons did generally prefer CoreValve’s technique.

The Court ruled that Israeli tax law defines a sale as including any act by which an asset leaves the possession of a taxpayer. An asset includes FAR according to OECD transfer pricing guidelines. The Court also ruled Medtronic did not provide sufficient reason (it claimed clerical error) for registering patents in its own name regarding the Israeli company’s IP.

COMMENTS:

What can be gleaned?

The same judge, the honorable Shmuel Bornstein previously ruled in favor of the ITA in the Gteko case. This involved an acquisition by Microsoft, after which the acquired Israeli company was closed down and its IP was stripped out at an undervalue compared with the price paid for its shares. But the honorable judge Bornstein ruled against the ITA in another seemingly similar case, the Broadcom case. And a different judge ruled against the ITA in the Medingo case.

So the ITA won two, lost two. What is the big difference? The Court clarified that the Gteko and Medtronic cases involved the acquisition of start-ups that stopped, while the Broadcom and Medingo cases involved the acquisition of mature Israeli companies that made various changes to increase their activity and royalty income, thereby raising profit and reducing risk.

Also, in the Medtronic case, the belated signing of intercompany agreements and clerical errors regarding patent registration are “difficult to accept”.

Possible grounds for appeal:

The OECD says when a tax administration may disregard a taxpayer’s approach to FAR and transfer pricing:

(1) if a transaction differs from what independent companies would have done,

(2) if the pre-profit becomes worse. In this case the taxpayer aimed to do what others do, namely improve profit by cornering the market (but could have done it differently).

It remains to be seen if an appeal will be filed.

Possible lessons to consider:

These may include:

(a) buy assets not shares in an exit (although this may increase the Israeli sellers’ tax bill),

(b) Leave the IP and the acquired Israeli company in place, adopt a common business model,

(c) invoke the OECD’s disregarding rules,

(d) clean up the intercompany agreement paperwork in good time,

(e ) expect further developments, this is an evolving topic.

Next Steps:

Please contact us to discuss any of the above matters further, or any other matter.

As always, consult experienced legal and tax advisors in each country at an early stage in specific cases.

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(c) Leon Harris 2023