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Revolutionary District Court Decision | Change of Business Model and FAR Transfers

11 December 2019

The New Revolutionary District Court Decision on Change of Business Model and FAR Transfers

Dear Clients, Colleagues and Friends,

On December 9, 2019, a District Court judgment was rendered which could have dramatic implications on M&A transactions involving Israeli target companies. The judgment concludes that matters pertaining to “business model changes” in Israeli target companies acquired by foreign entities are transfer pricing matters and no presumption should be drawn whereby in every “business model change” case, there is a sale of functions, assets or risks (FARs).

The judgment is in direct contrast to the practice of the Israel Tax Authority (ITA), including as reflected in circulars the ITA published on this issue, and its position in audits of Israeli target companies acquired by non-Israeli entities as well as in court hearings.

In this client update, we briefly present the facts behind the judgment, the important rulings of the court, and the potential implications the judgment may have.

Facts of the Judgment

Dune Networks Inc. (the “Parent Company”) held all of the shares of an Israeli company called Dune Semiconductor Ltd. (the “Target Company”). Broadcom Corporation acquired the Parent Company in November 2009 for roughly US $200 million. Following the acquisition, the Target Company granted a license with respect to its legacy IP (the IP that existed until the date of acquisition) to a non-Israeli affiliate company in the Broadcom Group. The fee for the license was determined based on royalties at a rate of approximately 14% of the non-Israeli company’s sales. In parallel, the Target Company began to provide R&D services to Broadcom Corporation on a cost plus 8% basis, as well technical support services on a cost plus 10% basis to another non-Israeli entity in the Broadcom Group.  In November 2016, the Target Company sold its IP to Avago Technologies (which acquired the Broadcom Group) for US $73 million.

The ITA argued that a “business model change” or “business structure change” occurred, which should be classified as a sale. The ITA based its arguments on the OECD guidelines and published ITA circulars, the last of which is ITA Circular 15/2018, as well as on the Gteko judgment (rendered by the same judge presiding over the case in question). The ITA argued that the Target Company transferred

its FAR and that the consideration in the transaction should be determined based on the acquisition price of the Parent Company’s shares (acquisition price method) with certain adjustments. The Target Company, on the other hand, argued that full validity should be given to the agreements between the parties pursuant to which it did not sell anything, but rather granted a license in exchange for royalties and switched to a model of providing services on a cost plus basis.

The Court’s Judgment

The District Court accepted the Target Company’s argument that no transfer of FAR occurred. The judgment is lengthy and contains significant determinations. We summarize below some of these determinations, which may have across-the-board implications on FAR-transfer cases.

  1. Not every case in which a change in business model occurs or a target company reduces risks or changes its functions, should be viewed as a transfer of FAR.


  1. The question to be addressed in change of business model cases is a transfer pricing question and an a-priori assumption cannot be drawn that a FAR transfer exists. Namely, it should be analyzed whether the transaction would have occurred to begin with among unrelated parties, or did the company involved in the change in business model receive adequate compensation comparable to that of an unrelated transaction. The Court ruled that the Target Company was able to prove that there was an increase in the number of employees it employed, as well as in its income and profit and that it received appropriate consideration within the intercompany agreements with its affiliates (the ITA did not raise any arguments with respect to the appropriate compensation but only argued that there was a FAR transfer).


  1. However, the Court notes that where the circumstances clearly indicate that the change of the business model includes a transaction which is more extensive than the intercompany agreements imply, a reclassification of the transaction may be made (see section 4 below).


  1. A change that empties the Israeli company and essentially turns it into an “empty shell”, as was done in the circumstances of the Gteko case, or even significantly diminishes its activity, is a change that implies that a FAR transaction took place. However, in other cases, where the change of the business model did not result in significant changes, and particularly where the change resulted in the Target Company’s growth and an increase in its activity, manpower, income and profit, it will be harder to reclassify the inter-company transactions as a FAR transfer.


  1. Separation of old and new IP – the Court accepts the argument that new IP can be separated from legacy IP even in situations where the new IP is based on the old IP. The separation must be supported by objective evidence.


  1. Control premium – the Court ruled that when extracting the value of the transferred FAR from the acquisition price paid for shares in an acquisition transaction, the value of the control premium should be reduced. However, target companies are required to present real-time documentation (namely, before the acquisition) that supports the argument that the control premium was taken into consideration for the purpose of determining the consideration in the shares transaction. This ruling is in contract to the ITA’s position, as was expressed within ITA Circular 15/2018.


Implications of the Judgment

As stated above, the judgment was rendered by a District Court such that it does not create a binding precedent. In addition, several FAR transfer cases are currently pending in other District Courts, which may express positions that are different from those expressed in the judgment at hand. In addition, the ITA will likely appeal the judgement to the Supreme Court. Nevertheless, the judgment certainly has immediate implications on structuring of acquisitions of Israeli target companies, on the documents that should be prepared in real time during such acquisitions, on audit discussions with the ITA, on Court cases that are currently pending and on tax provisions in financial statements. The judgment significantly strengthens the positions we take in various audits and opinions, and essentially accepts a significant portion of our arguments. Accordingly, we recommend that in every case that the ITA argues for FAR transfer, to analyze the totality of the circumstances and the ability to refute the ITA’s arguments. Moreover, with respect to M&A transactions involving Israeli target companies, we recommend to make relevant arrangements and consider ahead of time, in advance of executing the transaction, how to structure and implement a change of the business to mitigate to the extent possible the exposure of a FAR transfer audit. Lastly, it should be noted that the judgment also emphasizes yet again the importance of preparing transfer pricing studies with respect to international transactions.

Our firm has extensive experience in dealing with FAR transfer issues, both during the acquisition structuring stage and later stages of tax audits and court proceedings, as well as with respect to the transfer pricing aspects involved. Our firm is the only law firm that has an integral autonomous transfer pricing department, that, among other things, can provide transfer pricing studies. We recommend contacting us for purposes of analyzing the implications of the judgment, including for considering the possibility of cancelling tax provisions.


Tax Department

Herzog Fox & Neeman



Meir Linzen | Chairman
Chairman of the firm and Head of Tax Department
Guy Katz | Partner
Tax Department
Dr. Yuval Navot | Partner 
Tax Department

Eyal Bar-Zvi | Partner
Head of Transfer Pricing
Tax Department
Dr. Ehab Farah | Partner
Tax Department
Ofer Granot | Partner
Tax Department

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