Dear Clients, Colleagues and Friends,

The Tel Aviv District Court issued a new ruling in the tax appeal filed by C A Software Israel Ltd. (“C A Software”). The C A Software ruling is the most recent case in which the Israel Tax Authority (the “ITA”) challenges the characterization and value of transactions that involve intellectual property (“IP”) entered into by Israel taxpayers.

In previous court decisions, the ITA argued that a transfer or license of IP by an Israeli company shortly after its acquisition by a multinational entity, together with, or as part of, a change in the business model of the Israeli company, should be viewed as a business reorganization that de facto, is as a taxable sale of functions, assets and risks (“FAR”) of such company, in light of the circumstances, which include the growth in revenue and profits of the Israeli company and the market in which it operates.

Thus far, the ITA has experienced limited success with the FAR transfer arguments. The Broadcom court decision, and more recently the Medingo court decision (client updates here and here), rejected the ITA’s position that a business reorganization following an acquisition whereby an Israeli company licenses its IP to a foreign related party and becomes an R&D center (remunerated under a cost plus method) should be viewed as a FAR sale, in light of the circumstances, which include the growth in revenue and profits of the Israeli company and the market in which it operates.

In the C A Software case, the appellant was an Israeli subsidiary of CA Technologies (formerly CA Inc.) since the late 1990s. In addition to providing R&D and marketing services to the group, the appellant also developed software, which was sold by the group worldwide. The appellant was entitled to receive 35% of the revenue from the sales of the self-developed software.

In 2010, the appellant sold the IP to CA Technologies in consideration for NIS 111m. The ITA assessed the appellant for additional capital gains tax based on an argument that the value of the FAR that was transferred as part of this transaction was actually NIS 667m. In addition, the ITA made a secondary adjustment, claiming that the difference between the assessed consideration (NIS 667m) and the actual consideration paid (NIS 111m) should be viewed as an interest-bearing loan extended by the appellant to CA Technologies.

At the outset of the discussion, the District Court determined that the classification of the transaction as a FAR sale or IP sale is immaterial to the dispute. Both parties agreed that the value of the sold asset – whether IP or FAR – should be determined based on the present value of the expected revenue stream from the asset on the date of the sale. Therefore, and based on the agreement of both parties to the litigation, the District Court noted that there is no significance in characterizing the sale as a FAR sale or IP sale, and that the question that needs to be answered is the expected revenue stream.

The main question, therefore, that was at the heart of the dispute was the valuation issue. The appellant argued that the useful life of the legacy IP is very limited and the revenue generated by the IP was expected to decline; the ITA, on the other hand, argued that the useful life of the legacy IP is significant and the revenue generated by the IP was expected to grow.

The burden of proof in Israeli tax appeals is usually on the taxpayer. The District Court determined that the valuation offered by the appellant was insufficient to support its claims and therefore ruled in favor of the ITA, despite the fact that the court acknowledged that the market growth rates used in the ITA’s valuation were “optimistic.”

The most detrimental fact that led the District Court to reject the appellant’s position was the appellant’s own submission to the Israeli Innovation Authority (the “IIA”) in 2009, one year before the IP sale transaction took place. The appellant submitted an application to the IIA to receive certain tax benefits regarding accelerated amortization of R&D expenses. In its application, the appellant described its IP as having significant commercial potential, in a manner that inconsistent with its arguments before the court, and could not provide any explanations to these inconsistencies.

The appellant could not produce any documents from real time supporting its position regarding the expected useful life of the IP or witnesses that were involved in the transaction in real time. The appellant’s witnesses were mainly former employees who provided hindsight explanations regarding the transaction, but could not provide any insights on the facts from real time knowledge. These witnesses were not able to testify about the use of the IP in the post-acquisition period, which was a necessary fact, according to the court, to determine the value of the IP. In this respect, the court noted that the fact that the IP was not commercialized as a stand-alone product does not necessarily mean it does not have a significant value as a complementary product.

Finally, the District Court also affirmed the ITA’s position with respect to the secondary adjustment, following a previous ruling by the Israeli Supreme Court on this matter. However, we note that the court expressed significant discomfort on this point, noting that it believes that a secondary adjustment is not necessarily required under Israeli law and calling for the Supreme Court to reexamine its position on this matter.

We are available to further discuss with you the potential impacts of the C A Software ruling and provide you with relevant tax advice in connection with the matters discussed herein.

Sincerely,
Herzog Fox & Neeman