Many companies, foreign funds acquiring Israeli companies in particular, choose to fund the acquisition through a shareholder loan rather than equity, for a range of entirely legitimate commercial reasons that have nothing to do with tax. A recent judgment addressed exactly this question: when such funding is legitimate, and when it amounts to an artificial arrangement designed to avoid the tax due on profits distributed to a foreign company.

01Summary

A foreign investment fund acquired a successful Israeli cybersecurity company. It did not acquire the company directly, but through an Israeli shelf company set up for the purpose, which was funded by loans from the foreign parent totalling roughly $70 million. Over the following years the shelf company repaid those loans out of funds it received from the acquired company, partly as dividends and partly as further loans, so that in total around $86 million left Israel for the foreign parent, all of it framed as loan repayment rather than as a distribution of profits.

The question at the heart of the case was, in substance, a question of characterisation: was this a genuine loan repayment, which would not be taxable, or did the payments, whatever their legal wrapping, carry the economic substance of a dividend, which is taxable when transferred to a foreign company. The tax authority argued for the latter, invoking Section 86 of the Ordinance, an anti-avoidance provision that authorises it to disregard an artificial transaction and tax it according to its true substance.

The court accepted the tax authority's position, holding that the sequence of steps amounted to an artificial transaction and that the payments should be taxed as a dividend. The appeal was dismissed, though the penalty for failing to withhold tax at source was cancelled.

It is worth noting at the outset that no one disputed the legal validity of the loan agreements themselves: they were signed, interest was paid on them, and tax was even withheld at source on that interest. The question was not whether the loan was real, but whether there was a genuine commercial reason for setting up the structure through which it was given.

02Background: two-tier taxation

Israel's tax system separates the taxation of a company from the taxation of its shareholders. At the first tier, corporate tax is levied on the company's taxable income. At the second tier, when profits are distributed as a dividend, a further tax is levied on the shareholders.

Section 126(b) of the Ordinance provides that a dividend distributed between two Israeli-resident bodies of persons is not included in the recipient's taxable income, on the rationale that the profits have already borne corporate tax, and the second tier will arrive in due course, once the funds reach an individual.

But where the recipient is a foreign company, the Israeli chain of taxation reaches its end. There is no longer a future distribution to wait for, so the inter-company exemption does not apply. Section 125b(5) imposes tax of 25%, or 30% for a substantial shareholder, subject to relief under double-tax treaties.

03The facts

A foreign investment fund decided to invest in cybersecurity and negotiated the acquisition of an Israeli company, in a transaction carried out through a Luxembourg-resident company it controlled. In parallel, an Israeli shelf company was acquired, established as an empty shell: at the time of acquisition it had no activity, no employees, and did not even have a bank account.

On completion, the Luxembourg company paid approximately $70 million directly from its own accounts to the shareholders of the acquired company, without the funds passing through the shelf company. On that same day, loan agreements were signed and loans from the parent company in a matching amount were recorded in the shelf company's books. The shares were transferred to it the following day.

04Extracting the profits

In the years that followed, the shelf company repaid the loans to the parent using dividends and further loans it received from the acquired company, until the total transferred exceeded $86 million. Here too the funds were transferred in practice directly from the acquired company to the parent, without passing through the shelf company's bank account, but were recorded in its books as required: received from the acquired company, and paid on to the parent as loan repayment.

Under the double-tax treaty with Luxembourg, had the payments been characterised as a dividend, tax of 10% would have applied. The scale of the saving was therefore around $8.6 million.

05The legal framework

The court began by recognising a taxpayer's right to arrange his economic affairs so as to minimise his tax liability, a right treated as part of his constitutional right to property. A taxpayer is not obliged to choose the path that leads to the maximum tax.

Alongside this, Section 86 of the Ordinance sets out a general anti-avoidance norm, authorising the assessing officer to disregard a transaction that reduces tax if it is artificial, or if one of its principal purposes is an improper reduction of tax.

Two clarifications made by the court in this context are worth noting. First, the term "transaction" is construed broadly and encompasses the entire sequence of steps, so that a fragmented examination does not defeat the exposure of artificiality. Second, the fact that a step was taken lawfully and was not prohibited by the legislature does not preclude a finding that it is artificial.

The two-stage test

The first stage classifies the tax planning. Positive planning exploits an incentive or exemption the legislature deliberately granted. Neutral planning makes a considered choice between alternatives the legislature left open to the taxpayer. Negative planning exploits a gap in the legislation contrary to its purpose. Only if the planning is found to be negative does the analysis proceed to the second stage.

The second stage tests whether the commercial purpose is fundamental. A commercial purpose that is incidental or marginal will not do. The commercial purpose must be a fundamental reason for structuring the transaction as it was structured, meaning that but for the expectation of its being realised, the taxpayer would not have entered into the transaction in that way.

Supporting tests

• Credibility of the commercial purpose: presenting real evidence that the purpose claimed genuinely underlay the transaction
• Economic proportionality: a quantitative comparison between the scale of the commercial purpose and the scale of the tax saving
• Economic substance: whether, at the time of the transaction, there was a reasonable expectation of economic profit
• The risk test: the level of risk the taxpayer bore, against the certainty inherent in the tax saving

06The central finding

The court made clear that there is nothing wrong with leverage as such, and that this question was not in dispute at all. It noted, moreover, that the legislature had deliberately refrained from enacting thin-capitalisation rules, and that proposals on the subject had been raised and rejected.

The court further held, and this is the crux of the matter, that the very same structure might well be legitimate:

The reduction in tax, the court found, was plain and evident: had the shares been held directly by a foreign-resident company, it would not have been possible to transfer the profits of the acquired company to it without tax. Once an Israeli-resident company was established, the profits could be distributed to it exempt, and from there returned to the parent as repayment of a loan.

To understand why the very same structure can be treated as sound in one case and artificial in another, it is worth pausing on the simple economic distinction at the heart of the matter. Suppose the foreign company wanted to acquire the Israeli company itself, directly: it pays $70 million out of its own pocket and receives the shares in return, and on its own books that $70 million becomes equity, a share investment. Equity, by its nature, returns only through a dividend; there is no other way to take it back out, and when it goes to a foreign company the dividend is taxable. Now suppose the very same acquisition, for the same amount, except that the foreign company does not buy directly but instead lends the sum to another Israeli company, which is the one that buys and holds the shares. At the foreign company, that same $70 million is now recorded not as a share investment but as a loan advanced, and debt, unlike equity, returns as repayment, and repayment of principal is not a dividend. The foreign company paid out the same sum in both cases, and in both cases the money reached the same original shareholders; the only difference is how it was recorded on its books, and that in turn determines through which door the money can be brought back out.

It follows that inserting an Israeli intermediate company, funded by a shareholder loan, is itself what makes it possible to convert equity into debt, without the foreign company ceasing to be the beneficial owner and without it having to acquire directly. And from this follows the test the court applied: the use of leverage as such is entirely legitimate, and no one disputed that, but the question is why the intermediate company was needed at all. If the only answer is to enable this conversion from equity to debt, that is negative tax planning; if the intermediate company has an independent and substantial commercial purpose, such as risk isolation, consolidation of activity, or use as a platform for further acquisitions, that would have existed regardless of the tax consideration, the structure may stand. This is why the question, in the court's words, is essentially an evidentiary one: not what the legal structure was, but what actually lay behind it, and how that can be proven.

07Why the appeal was dismissed

The court found that the assessing officer had discharged the initial burden, and that the appellant had not discharged the burden that shifted to it. The reasoning turned almost entirely on evidentiary points.

Two further matters deserve mention. First, no one from the foreign fund was called to testify as to the considerations at the time, and the failure to call such a witness was held against the appellant. Second, the expert opinion submitted addressed the general prevalence of leverage rather than this specific transaction.

On economic proportionality, the court set the figures side by side: the tax paid in Israel on the marketing and distribution activity came to under $1.25 million, against a tax saving of more than $8.6 million.

08The outcome

The appeal was dismissed. The payments transferred to the parent company were taxed as a dividend, at the rate set under the treaty.

At the same time, the court cancelled the penalty for failing to withhold tax at source under Section 191A, holding that although this was tax planning that could not be accepted, the dispute did not reflect fraudulent or false conduct warranting a penalty.

It was further held that tax withheld at source on the interest payments would offset the tax liability, and that the amount treated as a dividend would not exceed the sum that could lawfully have been distributed under company law. The appellant was ordered to pay costs of NIS 40,000.

09Conclusion

The judgment does not hold that a structure in which an Israeli company is funded by a shareholder loan from a foreign parent is inherently improper. Quite the opposite: the court said explicitly that it may well be legitimate.

What was decided is that the outcome turns on the purpose behind the acts and how that purpose was in fact realised, and that this is essentially an evidentiary question. In the case at hand, the Israeli company was an empty shell at the time of acquisition, the funds never passed through it, and the economic substance later attributed to it developed some two years afterwards, while none of the arguments raised were supported by contemporaneous evidence.