What do you do if the Israeli Tax Authority (ITA) throws the book at you and accuses you of artificial tax evasion? One taxpayer threw the book right back and won in the Israeli District Court (Shalam Packaging(1998) Ltd vs Netanya Assessing Officer, Civil Appeal 38077-02-21 of April 25, 2024).
Israel has a general anti-avoidance rule (GAAR) in Section 86 of the Income Tax Ordinance, which allows the ITA to disregard artificial or fictitious acts and acts where one of the aims is to improperly reduce the tax liability.
Depending on the severity, this can be criminal or civil. Countries like the UK and Canada have similar GAAR rules, but the Israeli version tends to be upheld more often in court. Not this time – so what happened?
A privately owned packaging company acquired the shares of another packaging company that used different packaging techniques from Kibbutz Yakum in stages between 2008 and 2013. In that period, the subsidiary made losses of around NIS 54 million. At the beginning of 2014, the parent company moved its activity to the subsidiary company and notified the ITA that this was a tax-deferred reorganization (under ITO Section 104A).
The parent company then acted as a holding company, holding the subsidiary company concerned and other separate subsidiaries. The subsidiary company also then moved its operations from Yakum to Caesarea near where the parent company and other subsidiaries were located.
In June 2014, the subsidiary company’s factory in Caesarea was burned down in a fire. In February 2015, its insurance company paid NIS 155m., resulting in a capital gain.
The taxpayer sought to offset its past business losses against the capital gain, leaving only a small balance of tax to pay. The ITA thought differently.
The ITA’s claims
The ITA found all this too convenient and claimed two main things.
First, the ITA claimed the subsidiary company had really sold its activity to the parent company, – not the opposite – when it physically moved its operation from Yakum to Caesarea, thereby forfeiting past losses and triggering a $30m. capital gain.
Second, if the first claim didn’t succeed, the ITA’s alternative claim was that the parent company had effectively forgiven a loan of NIS 50m. to the subsidiary company as the loan wouldn’t be repaid.
Debt forgiveness is taxable in Israel for the forgiven party (the subsidiary). The loan in question took the form of a perpetual loan note which the parent company took over from the old shareholder of the subsidiary.
Either way, the ITA invoked the general anti-avoidance rule in Section 86 against alleged artificial or fictitious acts by the taxpayer. And for good measure, the ITA sought to impose an extra 15% deficiency fine. The ITA threw quite a big book against the taxpayer – the subsidiary company.
The Court judgment
The Court dug deep into the facts and ruled that the taxpayer did NOT act in an artificial or fictitious manner or in a way intended to improperly reduce its tax liability.
The consolidation of activity in Caesarea was done for fundamental commercial reasons to help turn around the subsidiary from losses to profits.
The court was impressed by the testimony of the principal shareholder/entrepreneur, Emanuel Shalam, who cited an Arab proverb: “Thread by thread, you make a hat.”
What he meant was buying more from fewer suppliers to get better terms; and selling more to the same customers to save on delivery costs, pallets, and sales personnel. By making savings on purchases, logistics, and sales “I gave an answer to my competitors”. Also, “We saved as it was by my home, I moved to be within 4 minutes from the plant. This business works 24/7”.
The shareholder/entrepreneur explained why he moved the parent company’s activity into the subsidiary company – to consolidate packaging activities, install a separate management team, and be able to sell the company in the future without affecting other subsidiaries.
As for the perpetual loan note, it was not forgiven, it was an integral agreed part of the acquisition of shares of the subsidiary. The seller, Kibbutz Yakum, insisted on leaving in place funding for employment as the subsidiary’s employees included members of that Kibbutz.
The Court did claim that subsidiary company losses may be picked up by the parent company, citing the Ben Ari case of 2008 (7387/06). Comment: That may be a stretch.
It remains to be seen whether the ITA will appeal the case.
To sum up: Businesses should always have a commercial rationale for their acts.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
leon@hcat.co
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax.