Beware split real estate deals in Israel - the Tax Authority may notice

It’s always a good idea to avoid mistakes, especially big mistakes. The English in Elizabethan times called it “being hoist by your own petard”. Israelis call it a “work accident”. Let’s consider a recently reported case where the taxpayer was not too successful with some tax planning that the Israeli Tax Authority saw through (Sismop Technologies Ltd vs. Haifa Real Estate Tax Director, Vav Ayin 37489-06-21, Haifa District Court, July 31, 2022 and August 8, 2021).

The Main Facts:

The case is full of legal and procedural twists, so we may not have the full picture. In 2011 the taxpayer purchased land in Yokneam Elite and undertook to complete the construction of a factory building there.

On May 28, 2018, the taxpayer sold the land for NIS 2.88 million to another company. But previously, in 2014, the controlling shareholder in the purchasing company had granted a loan of NIS 3m. to finance the construction of the factory building. In the period 2015-2017, this loan was increased to NIS 13m.

On December 1, 2018 the taxpayer issued a tax invoice to the customer in the sum of NIS 14.4m. for construction services.

In 2019, the ITA issued a tax assessment to the best of its judgment deeming the sale price to be NIS 20m. rather than NIS 2.88 m. The ITA claimed this was the fair market value of the deal as the ITA saw it.

What was really going on?

It seems the core issue was splitting the sale of a factory building between the land element and the construction element. The ITA combined these elements as it considered this reflected the real deal.

Leaving the deal split up may apparently have yielded both the taxpayer and the purchaser a number of potential tax advantages which we can only surmise. Was there an attempt to avoid purchase tax (perhaps 6%?) on the construction services? Was there an attempt to defer company tax (now 23%) on the construction profit? Was there insufficient documentation supporting the construction expenditure?

We can only guess what the taxpayer planned, but the ITA taxed the overall deal their way and the District Court ruled in the ITA’s favor.

What else happened?

The latest District Court case marked the culmination of multiple appeals by the taxpayer against the ITA’s assessment.

One appeal was a request by the taxpayer to disqualify the judge after he gave a negative judgment at an earlier stage of the case. After reviewing the evidence, the judge had already expressed doubt about the taxpayer’s chances of success. The taxpayer claimed the judge was therefore biased.

The District Court said any such claim of bias should have been made by the taxpayer during the earlier stage, not afterwards. The Court then ruled that the judge’s remarks merely opened up the possibility of compromise or presenting better evidence. Therefore, the Court refused to disqualify the judge.

Another appeal by the taxpayer called for the Israel Tax Authority (ITA) to respect an alleged earlier settlement agreement to respect the loans. The Court reviewed the facts of the case and found that the agreement merely called for the ITA to review things and issue a new tax assessment. The ITA did so, but decided to allow less expense deductions than the taxpayer claimed.

Comments:

There seem to be several morals to this story.

1. First, don’t split real estate transactions into a land transaction plus a subsequent construction services transaction if they are really one combined deal. This situation is not uncommon in Israel – beware. Big amounts of money may be involved that are visible to the Tax Authority. This case tells us how risky it is for all the parties  – builder and client – splitting the land element from the construction element.
2. Second, beware of construction progress payments being called “loans” and only later recorded as construction service fees. 
3. Third, if you do get caught out, using technicalities and arguments of bias may not work too well. 
4. Fourth, if the Tax Authority does issue a best-judgement estimated assessment, it may well estimate the sale value in its favor. Would anyone else have paid NIS 20 million for the land and factory in this case?

All in all, do not get hoist by your own petard. A little caution may go a long way.

As always, consult experienced lawyers and tax advisors in each country at an early stage in specific cases.

leon@h2cat.com

The writer is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd