November 16, 2022
Israeli court rules IP value is six times higher
On 25 October 2022, the Tel Aviv District Court (the Court) ruled in favor of the ITA in the appeal of CA Software Israel Ltd. (CA Israel or the Company) against Tel Aviv's Tax Assessing Office #3. The tax authorities claimed that the IP CA Israel valued at ILS111m should in fact be as high as ILS667m.
The Court ruled that CA Israel was not successful in shifting the burden of proof to the ITA, since it did not bring before the Court all of the relevant documentation necessary to support its claim. In fact, the Court came to the conclusion that the Company did not bring any documentation or proof from the time of the deal (which took place back in 2010), which supported the Company's position that the IP was close to the end of its economic life and that its value was decreasing.
The ITA, on the other hand, presented the court an old application from 2009, that the Company filed with the Israeli Innovation Authority (IIA formerly known as the Israeli Office of the Chief Scientist), in which the Company described a market size of at least US$1b for the IP-based products, their big potential and the considerable effort and expense incurred in the further development of such IP (all of which undermined the Company's position).
Israeli companies which sell IP or other assets should ensure that they have sufficient documentation to support any value they claim before the ITA, and also that any documentation from the time of sale does not contradict their position. Multinational enterprises (MNEs) that acquire Israeli companies should be mindful of the sufficiency of documentation they have at or around the time of acquisition in support of any PMI and global IP structure rationalization involving Israeli IP and assets.
On 25 October 2022, the District Court in Tel Aviv ruled on an appeal filed by CA Israel against Tel Aviv's Tax Assessing Office #3 pursuant to a tax assessment claiming that IP which CA Israel sold to a related party should have been valued at ILS667m rather than ILS111m. The Court also ruled that a secondary adjustment should deem the difference between the values as an amount which was lent to the purchaser and interest income should be assessed at the level of the Company on such deemed receivable.
The Company, which was founded in Israel in 1990 under the name MemCo, was acquired towards the end of the 1990s by CA Inc. (a large multinational enterprise which together with its subsidiaries shall be referred to as the "Group"). At the time of acquisition, the Company had four main products which were developed with the support of grants from the IIA.
Of the four products, a security software named SeOS (which was later renamed to CA Access Control) was the Company's most important product.
Soon after the acquisition, the Company's activities were comprised of: (i) marketing and distribution of global CA products in Israel; (ii) research and development (R&D) services rendered to an affiliated company in exchange for a cost-plus 12.5% remuneration (R&D for External IP); (iii) internal R&D and maintenance of Company IP (the R&D for Internal IP); and (iv) royalty income for the use of the Company's IP.
During 2010, CA Israel sold its entire IP to CA Inc. in exchange for ILS111,300,000 based on a third-party valuation.
The main dispute between the parties was the value of the sold IP, where the ITA took the position that the transfer of Functions, Assets and Risks (FAR) was far more valuable and assessed it at ILS667,000,000. The ITA further claimed that since the Company did not receive the entire consideration for its IP, funds which were not remitted to it should be referred to as an outstanding loan bearing an annual interest rate of 2.2585% (which is akin to the interest rate set on another loan between the Company and CA Inc.).
The main arguments raised by the ITA revolved around the irrelevance of the documentation supporting the value which the Company presented, since the valuation was prepared at a later time — although there were two other valuations which were prepared around the time of the sale and which showed significantly different values. The ITA further contended that the expert opinions which the company brought were irrelevant due to the limited information that was furnished to them. Lastly, the ITA contended that in a request filed with the IIA during 2009 (the IIA Application) the Company claimed that it invested ILS 20m in the development of the sold IP and described the IP as very lucrative with a potential market of over US$1b (it also added a description of an additional module which was claimed by the Company to be part of the Group's IP, rather than the Company's IP (the Additional Module)).
The Company mainly argued that the IP that was sold was outdated and had many competitors in the market with good-enough products built in in the operating systems. The Company also argued that the ITA used unreasonable assumptions for its valuation, such as an indefinite IP lifetime and over-optimistic growth rate. The Company also argued that the ITA should be prevented from raising a new argument based on the application it filed with the IIA in 2009, as this evidence was not discussed during the assessment process.
Burden of proof
The Court started with the discussion on the burden of proof and stated that the burden of proof lies first and foremost with the Company, both since the Company is the appellant and since the Israeli transfer pricing provision in the Israeli Tax Ordinance stipulates that the burden of proof shall be met by the taxpayer only if it submits all the documents and information held by it in connection with the deal and with how it was priced. In this regard, the Court ruled that the Company did not furnish the ITA with all the documents and information because the Company did not provide any real-time documentation prepared around the time of the transaction, such as: End of Support, End of Sale, End of Life and other documentation, or any other document which could shed light on the intentions of the Company with respect to its products.
Fair Market Value
The Court outlined the fact that both parties brought economic and technology experts who supported the positions of each of the parties. The Court also noted that the Discounted Cashflow (DCF) valuation method normally relies on assumptions and speculations, which inherently may result in manipulation. To determine which valuation was the most acceptable, the Court had to either appoint a court expert or choose based on the evidence of one of the expert opinions. Since it was apparent to the Court that the main difference between the valuations was the assumed lifetime and growth rate of the IP, which are questions of fact, it decided not to appoint a court expert but to rule on the assumptions based on the evidence brought before it.
Based on the above, the Court stated that the only evidence which it found useful to reach a decision was the IIA Application filed to receive various tax benefits. The Court described it as the only real-time official document in which the appellant described the technology it possessed and its market potential(over US$1b).
In the IIA Application, the Company stated that the R&D was for Internal IP which was comprised almost entirely from the CA Access Control software. Also, the Company included in the same application the Additional Module, which implied that it was indeed part of the Company's IP which did not belong to another Group entity. Although the Company had all the information available to it, the Company was not able to rebut what was mentioned in the IIA Application. In addition, the witnesses who were summoned to argue on the Company's behalf were not high-ranking officers able to discuss first-hand the intentions regarding the sold IP.
Furthermore, the Court stated that even though it seemed that the growth rate which the ITA used was a bit optimistic, the Company showed consistent growth in revenue from the IP in another document that was filed with the IIA in 2008, reaching to an expectation of US$35m in 2013. The Court also noted that in the last year before the valuation, the Company had an operating margin of ILS70m. It therefore did not seem reasonable that IP with the above indicators would be valued at slightly above ILS100m. In addition, taking into account that the Company was acquired by the Group for around US$400m, it made sense that the valuation would be higher than what the Company claimed.
Disallowance of the IIA Application evidence
The Court noted that the Company had an opportunity to address the arguments arising from the IIA Application, including filing complementary affidavits. Therefore, no procedural injury was caused to the Company. Furthermore, the ITA could not be blamed for not providing this document in the assessment stage, due to the simple fact that it did not possess the document. The Company had the document and was the one that should have revealed it in the first place.
The Court expressed doubt as to whether there was indeed room for a secondary adjustment, when no actual payment was made or required to be made, which is not necessarily supported by the language of the law. However, due to the precedent set in the Kontera case, the claims raised in this respect were overruled by the Court. The Court did suggest that the Supreme Court would address this issue.
Multinationals involved in acquisitions of Israeli companies and Israeli taxpayers should closely review this decision and its impact on post-acquisition business restructurings. Companies should take notice of the lessons learned from the case, especially as to the importance of sufficient real-time documentation which is aligned with other internal or external representations given to governmental authorities in Israel (such as the IIA), in order to be well prepared for potential controversy. As such, companies with pending cases should review their documentation and prepare their cases accordingly, especially as those cases tend to reach the Court.
Companies should also be mindful of efforts they should take and evidence they should bring in order to be able to shift the burden of proof to the ITA.
Lastly, companies should also give attention to the information provided to experts, based on which valuations and other analyses are performed, and make sure that the information is sufficient and does not contradict other positions.
For additional information with respect to this Alert, please contact the following:
EY Israel, Tel Aviv
Ernst & Young LLP, Israeli Tax Desk, New York