Issues surrounding government funding from the Israel Innovation Authority (the IIA) can play an important part in M&A transactions involving Israeli technology companies. Funded companies are subject to various obligations and limitations, including royalty payment obligations and limitations on using and sharing IP globally, often influencing the structure of transactions.

Below are a few specific IIA issues raised in M&A transactions in 2022 that we thought are worth sharing. Of course, these highlights do not cover all IIA issues and are not to be considered as IIA advice for M&A transactions.

(1) Engagement of R&D and other positions abroad that are exposed to IIA-funded knowhow

• During due diligence, IIA-funded companies sometimes argue that engagement of personnel outside of Israel that are exposed to IIA-related knowhow does not require approval of the IIA if those positions are contractors or consultants rather than employees, or if they are not engaged in the core R&D activity of the company.

This is not correct according to the IIA regulations.

• In a few recent cases the IIA clarified that engagement of R&D or other positions outside of Israel, even after the period of the IIA-funded project, requires a specific approval of the IIA, if those positions are exposed to IIA-funded knowhow. This applies to employees, consultants, contractors and any other forms of engagement.

Depending on the circumstances, such engagement of personnel abroad may be considered as a “transfer of knowhow outside of Israel” for IIA purposes, and may trigger payments to the IIA. In some cases, the IIA approval may be without payment, for example, if the IIA-funded knowhow is shared only for the purpose of maintenance and support activity outside of Israel, or in case of engaging R&D personnel outside of Israel that have unique qualifications that cannot be found in Israel.

• At the same time, if a company discloses in its funding request to the IIA that it will engage certain R&D or others positions outside of Israel during the period of the IIA-funded project, such engagement does not require a separate IIA approval, but this applies only during the period of the IIA-funded project. Any subsequent engagement will require specific IIA approval.

• In case of a funding request that included manufacturing abroad, no additional IIA approval will be required for continued manufacturing abroad (as was stated in the funding request) after the end of the IIA-funded project.

• The IIA is considering relief regarding the engagement of certain positions and the performance of various activities outside of Israel. However, until any new rules are published by the IIA, the above principles apply.

(2) Relocation of Israeli R&D employees outside of Israel who will continue to work on IIA-funded knowhow.

The IIA was willing to approve a relocation of an Israeli R&D employee of an IIA-funded company where the relocation was not initiated by the funded company but happened due to other reasons of the employee. There was no blanket approval given for continued exposure to IIA-funded knowhow for all relocated Israeli employees.

(3) Obtaining IIA approvals to “buyout” the IIA restrictions as part of M&A transactions

• The General rule. It is possible to “buyout” the IIA restrictions as part of M&A transactions in order to be able to freely use the IP post-closing. Repayment of the IIA funding is not sufficient. A complete buyout of the IIA restrictions requires the approval of the IIA and payments of “redemption fees” to the IIA (calculated based on statutory formulas), which could be significant. The tax exposures such approval may trigger should also be considered.

• Stricter review. The IIA is one of the most industry-oriented government-related bodies in Israel. Still, in the last year the IIA was relatively stricter than in past years with issuing buyout approvals in M&A transactions. The IIA asked more questions, and depending on the circumstances imposed various conditions as part of the approvals. Having said that, like in previous years, we have not faced any transaction in which a request for the approval of the IIA was rejected.

• Buyout approvals in acquisitions of IIA-funded companies by investment funds (VC, PE)
In acquisitions of IIA-funded companies by operating business corporations, the IIA understands the need of the IIA-funded company to be able to freely use its knowhow globally in order to strategically benefit from the acquisition. However, in acquisitions of IIA-funded companies by investment funds the IIA may require further reasoning for the necessity of the company to have flexibility in using or sharing the knowhow outside of Israel due to the acquisition.

• IIA buyout approvals are used by the Israel Tax Authority in tax audits – the Israel Tax Authority has used IIA buyout approvals to argue that the approval is an indication that the company actually transferred knowhow (assets, functions, risks) outside of Israel for tax purposes. In the only court ruling on this matter, a District Court ruled that obtaining IIA buyout (“transfer”) approval does not mean that there was a transfer for tax purposes, and the tax implications have to be examined based on the actual transactions that took place. The ruling was issued by a District Court and therefore does not constitute a legally binding precedent.

(4) Assignment of IIA-funded technology to an Israeli company

• Requires the approval of the IIA;

• The buyer will have to assume all the obligations and liabilities towards the IIA regarding the IIA-related knowhow, including royalty payments obligations (if applicable) and the restrictions on the use of IIA-related knowhow; and

• If the assignment of the knowhow is between unrelated parties, the seller will have to pay royalties to the IIA based on the value of the assignment (even if the assignment is for no consideration).

(5) The IIA is disclosing information to the Israel Tax Authority

The Israeli Tax Authority continues to ask the IIA for information regarding IIA-funded companies, including information regarding the R&D projects of the companies, notices and requests made by companies, and approvals granted to companies by the IIA.

Main areas of interest of the Israeli Tax Authority are, for example: the R&D efforts of the IIA-funded companies; the technology that companies develop or fail to develop; the ways IIA-funded companies use their technology (commercialization, licensing, manufacturing, sharing with other entities); and terms of investments and M&A transactions.