The Israel Tax Authority (ITA) has quietly issued some pronouncements that may have a profoundly positive effect on the Israeli economy, regardless of which government is in power. The pronouncements are relevant to “carve-outs” after an exit deal.
We have already seen many massive exit deals, such as Google-Wiz ($32 billion), Palo Alto Networks-CyberArk ($25b.), and Intel-Classiq ($2.2b. reportedly).
Why IP carve-outs can trigger triple taxation
There are two main ways of structuring an M&A (merger & acquisition) deal: asset acquisition or share acquisition. Large multinational buyers typically prefer to buy assets (especially intellectual property, IP) and park them abroad.
More than 60% of Fortune 500 companies apparently hold their IP in Delaware due to its friendly legal situation and protection for patents, trademarks, copyrights, and trade secrets.
But if the sellers have something the buyer needs badly, they may insist on a share sale to reduce the tax on their exit.
If the buyer buys the shares of the Israeli target company, then makes the company transfer the IP to a foreign country (a carve-out), the ITA taxes both the share sale and the IP carve-out, and possibly a deemed in-kind dividend, i.e., double or triple tax that could approximate over 80%.
There have been numerous Israeli court cases about this massive tax hit. In many cases, the ITA won, but not when the IP transfer was part of a legitimate business-model change.
A telltale sign that a taxable carve-out has occurred is when most or all of the target company’s personnel are laid off after the M&A deal.
Israel Tax Authority’s three cures for carve-outs
The ITA pronouncements offer three potential cures to triple taxation: 1) R&D centers; 2) a joint venture, using a cost-sharing arrangement; 3) just develop new IP.
They shouldn’t impact the sellers’ capital-gains tax liability, but they may bypass the carve-out taxes. In our experience, they may be combined with forward or reverse triangular mergers, which may confer yet more advantages (beyond the scope of this article).
Under this scenario, an Israeli special preferred technological enterprise (as defined) may change its business model after an exit transaction. There are two main components.
First, a low capital gains tax on the IP carve-out of only 6%. The carve-out taxable value should be at least 85% of the M&A value, with adjustments for cash, employee bonuses, etc.
Second, low-risk R&D in Israel for the US acquirer, for a fee of cost plus 14%, for a period starting on the M&A date and ending seven to eight years later on December 31. This way, the acquirer gets to own the IP where it wants, but the Israeli R&D personnel stay employed.
This treatment is reserved for acquiring groups with global revenues over NIS 10b. in which the parent company resides in a country that has a tax treaty or an information-exchange agreement with Israel.
Israeli residents and people who left Israel over the past 10 years should hold less than 10% of the acquirer. Other conditions also apply.
Joint venture using a cost-sharing agreement (CSA): This scenario is based on OECD pronouncements and refers to cases in which an Israeli target company is acquired by a US-based group.
Participating companies decide which countries each company will sell to. They then allocate new intangible property development costs pro rata to reasonably anticipated benefits. Each participant bears its own marketing costs in its territory.
Developing new IP for a foreign acquirer
Royalties based on sales are paid for any old, historic IP used. Other conditions also apply. Adopting a CSA should not trigger a taxable carve-out. No withholding tax should apply to development-cost payments.
Under this scenario, the Israeli company conducts R&D for a foreign multinational. Traditionally, this was done on a cost-plus-10% basis, applying the TNMM (transaction net margin) method approach to transfer pricing.
But a recent Israeli tax ruling specifies cost plus 13% when the R&D is done for a foreign publicly traded company with consolidated annual revenues over $10b. resident in a country that has a tax treaty with Israel. Other conditions also apply.
This is a general ruling. In the M&A context, the ruling addresses the development of new IP for a foreign acquirer, apparently letting the old IP wither, i.e., become obsolete. But until then, consider paying royalties.
Any IP carve-out should be carefully evaluated when planning the main M&A deal.
As always, consult experienced professional advisers in each country concerned at an early stage in specific cases. See also the author’s book The Essence of M&A on Amazon.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.