New Court Decision Affirms the ITA’s Position regarding FAR Transfer

The Central Region District Court recently issued a ruling with respect to a tax appeal filed by Medtronic Venture Technologies Ltd. (the “Taxpayer“). The Medtronic ruling deals with a notice of deficiency issued by the Israel Tax Authority (the “ITA“), in which it determined that the Taxpayer transferred its functions, assets and risks (“FAR“) to its parent company – Medtronic Inc. (“Medtronic US“). The District Court rejected the appeal and affirmed the ITA’s notice of deficiency, ruling that the Taxpayer indeed transferred FAR in a taxable transaction.

The ruling was issued by Judge Bornstein, who previously ruled on the Broadcom case in which the court rejected the ITA’s claim of a FAR transfer (link to our client update here), and on the Gteko case in which the court rejected the taxpayer’s claims that no FAR was transferred (link to our client update on the ITA guidance issued following the Gteko case here). In addition, the Tel Aviv District Court also issued a ruling in the matter of Medingo, in which the court rejected the ITA’s claims of a FAR transfer (link to our client update here).

The Medtronic ruling, the most recent link in the chain of FAR court rulings, provides additional insights around the circumstances under which a transaction may be viewed as a taxable sale of FAR.

Below is a short summary of this court ruling.

The Facts – What Supported the FAR Tax Assessment of Medtronic?

The Taxpayer, an Israeli private company established in 2004, was engaged in developing an aortic valve and catheter. In 2008, Medtronic US acquired 8% of the share capital of the Taxpayer and in 2009 it acquired the remaining share capital of the Taxpayer in a transaction reflecting a USD 325 million value of the Taxpayer.

At the time of the acquisition, Medtronic US did not have technology that enabled to surgically insert aortic valves with catheters. Around the time it acquired the Taxpayer, Medtronic US acquired another company that offered competing technology to that of the Taxpayer, as it was unclear to it which technology would become a market winner.

The Taxpayer signed a License Agreement and R&D Services Agreement with Medtronic-related entities. These agreements were signed in July 2010, April 2011 (the R&D Services Agreement) and November 2011 (the License Agreement). The agreements had a retroactive effective date of April 25, 2009 (immediately after Medtronic US acquired the Taxpayer).

The Taxpayer reported income from R&D services as of tax year 2010 and licensing income as of 2013, the year in which it received regulatory approvals in Europe and began selling its products there.

During 2010, the Taxpayer transferred eight or ten patents (out of 185 patents that were registered under its name at the time) to Medtronic US. These assignments were not reported to the ITA and were not mentioned in the financial statements of the Taxpayer which were filed with its tax returns.

Eventually, the Taxpayer’s technology failed, and in 2012, the Taxpayer discontinued its business activity and did not report any income in connection with the termination of its business.

The Ruling – What can be Learned for Future FAR Transfer Cases?

The court reviewed the intercompany agreements and overall conduct of the parties and concluded that the Taxpayer transferred its FAR to Medtronic US.

The main facts that led the court to rule in favor of the ITA are as follows:

• The license agreement was for the entire duration of the remaining useful life of the IP.
• The Taxpayer was unable to substantiate its claim that the assignment of the patents was a “clerical error” or that the value or the importance of the relevant patents was insignificant.
• The legacy IP could not be separated from the new IP.
• The management and decision-making process with respect to the main functions of the Taxpayer were exercised by Medtronic US. Medtronic US also effectively controlled the workforce of the Taxpayer that provided R&D services with respect to other unrelated products as well. The relevant function, therefore, was ruled to have been transferred, even though the number of R&D employees in Israel increased following the acquisition.
• The intercompany agreements were signed with retroactive effective dates and the signing date was close in time to the termination of the business activity of the Taxpayer, which was indicative in the court’s view that this was part of a broader transaction to transfer IP and functions to Medtronic US. The CEO of the Taxpayer could not explain why these agreements were signed with a retroactive effect or how the royalty rates were determined when no IP existed at the time and could not confirm whether he considered the benefit of the Taxpayer or the entire group when signing the agreements.
• Unlike in the Broadcom and Medingo cases, the Taxpayer did not transfer any IP or know-how to Medtronic US when its business was terminated. It was clear from the evidence, as it was confirmed by the Taxpayer’s CEO, that Medtronic US already had the relevant know-how by such time, which in the court’s view proved that some IP had previously been transferred.
• Unlike in the Broadcom and Medingo cases, the Taxpayer’s IP was at its early stages of development. The connection with, and eventually the acquisition by, Medtronic US was necessary to allow the Taxpayer to continue the development and bring its IP to maturity. This fact was interpreted by the court to mean that the formal separation of the legacy IP from the new IP was unrealistic in this case. The court emphasized the fact that in the Broadcom case the taxpayer was able to prove that the legacy IP and the new IP were separable (because the taxpayer in that case licensed the legacy IP to a third-party). Medtronic US essentially used the Taxpayer’s pre-mature IP and tailored it to Medtronic US’s purposes and business interests. The focus of the deal, according to the court, was not the legacy IP but rather the new IP to be developed by the Taxpayer. The court distinguishes this transaction from an acquisition of a company with IP in “advanced stages of development”, in which case the license and services agreements should be viewed as “replacing risk with return”, i.e., replacing the option of high-reward and high-risk activity with lower-reward and lower-risk activity. The fact that the IP in the Broadcom and Medingo cases was well-established at the relevant time can be learned from the fact that at the end of the license period, the IP was sold for a significant consideration. The court noted that the totality of the agreements in this case necessarily result in the Taxpayer becoming an “empty corporate shell” and the termination of business activity in 2012 was a foregone conclusion.
• Unlike in the Broadcom case, the Taxpayer was not able to demonstrate that its transaction with its parent company was conducted at arm’s length. In fact, the Taxpayer’s CEO confirmed that the intercompany agreements would never have been signed if the Taxpayer was not a wholly-owned subsidiary of its parent company.
• Lastly, the Taxpayer was unable to explain why its activity was terminated and actually, it indicated that the employees believed its full potential had not been realized at the time of the termination.

The Medtronic ruling is another important step in the development of Israeli case law regarding FAR transfers. The ruling is very instructive of the do’s and don’ts with respect to Israeli affiliates of multinational enterprises, especially when compared with previous court rulings in which taxpayers managed to prove that FAR was not transferred.

Certain key facts that led the court to rule in favor of the ITA (such as signing intercompany agreements with retroactive effect, failure to protect the legacy IP of the Israeli company, failure to report and pay capital gains tax on the transfer of IP assets when business operations were terminated, etc.), could have been avoided with proper planning in advance. Taxpayers should be aware of the potential adverse consequences of changing the business model of an Israeli subsidiary in a manner which may amount to a taxable FAR sale.

Our tax department has extensive experience in these issues. We are at your disposal if you want to further discuss the potential impacts of the Medtronic ruling or require any tax advice in connection with the matters discussed herein.