Implications of the CA Software vs. the Tax Authority ruling regarding the sale of intellectual property and activities when special relationships exist between the parties
Nowadays, many companies are executing cost reduction and reorganization plans. As part of these
processes
multinational corporations often transferring the Intellectual Property and/or other activities out of Israel.
A ruling recently published by the Tel Aviv District Court, addresses the issue of selling intellectual property
(hereinafter: “IP”) from an Israeli subsidiary to the multinational parent company. This ruling is a direct
continuation of the Gitco 1 , Broadcom 2 and Madingo 3 rulings, in which the Israeli courts define the rules and
boundaries of transactions involving the sale of activities and IP, between related parties.
The Israeli software company CA Software (formerly Memco Software Ltd. hereinafter: “Memco” or “the
company”) reported the sale of its IP for NIS 111 million, while the Israeli Tax Authority (hereinafter: “ITA”)
determined the value of the transaction at NIS 667 million. the company appealed against the ITA to the
court. The court’s educating ruling emphasizes new points relevant to cases involving transfer of activities
and/or IP between related parties.
In a detailed ruling, Judge Yardena Sarusi from the Tel Aviv District Court rejected the appeal and obliged the
company to pay an estimated supplemental tax of approximately NIS 140 million for the sale of IP, after
receiving the valuation of the ITA’s expert and subsequently ITA’s position on the value of the transferred IP.
Memco was acquired in the late 1990s by CA, a multinational group, with over 200 software companies and
development sites worldwide (Hereafter: “CA” or “the global company”). At the time of the acquisition,
Memco had 4 information security software products, developed among others, with the support of Office of
the Chief Scientist in the Israeli Ministry of Trade (OCS 4 ). Shortly after the acquisition, the company activities
concentrated in several domains: Marketing and distribution of the global company products, R&D Services
for the global company, R&D and maintenance of the Memco software products, Royalty income for the IP
owned by the company.
In 2010, the company sold its IP to the global company for a declared sum of NIS 111,300,000, in accordance
with its valuation.
The ITA, relying on section 85a. of the Income Tax Ordinance, stated that, since the transaction occurred
between related parties and since special relationships exist between the parties, it does not accept the
reported valuation. The ITA also argued that the value of the FAR (Functions, Assets and Risks) transferred as
part of the transaction, exceeds by ten folds the reported value. Subsequently, the ITA determined the value
at NIS 667,000,000.
Most of the dispute between the parties originated from the difference in valuations of the transferred
property, due to a significant variance in the basic assumptions of the parties regarding the expected lifespan
of the IP as of the date of sale, and its future expected growth rate: whether positive, as the opinion of the
ITA, or negative, as the opinion of the company.
While the company treated the IP with its future economic benefits as a kind of dead business – IP whose time
is up and whose value is declining, the ITA treated the IP, as a living business – a yielding asset with a lasting
profit potential.
In addition, since the company did not receive the full amount for the transaction, the ITA argued that the
amounts that were not transferred should be considered as a loan given to the global company, and therefore
the company should be charged for conceptual interest income.
The judge, relying on the requests for tax benefits and reports submitted in real time by the company to the
ITA and the OCS, which indicated that the revenue potential from the products is high (in contradiction to
retroactive statements presented in evidence), as well as on other data that appeared in the company
reports, ruled that the company did not meet the burden of proof required, and that the lifespan of the IP and
1 Gitco Ltd. vs. Kfar Saba Assessment Office
2 Broadcom Semiconductor Ltd vs. Kfar Saba Assessment Office
3 Madingo Ltd vs. Afula Assessment Office
4 Since 2016 called IIA- Israel Innovation Authority
the growth rates in its valuations do not correspond to the factual situation at the time of the transaction. The
court therefore received the ITA expert’s valuation in full, In accordance with the directive of the Honorable
Justice Danziger in the case of Kital. Regarding the conceptual interest charge, the judge ruled in favor of the
ITA based on the Contira precedent but mentioned that the Supreme Court should examine the issue in the
future.
Further to this ruling, we recommend that companies considering a transaction between two or more related
parties, take various actions, which may reduce future transaction associated risks:
a) Document the activities and conduct of the company in real time including: the justification for the
transaction, its advantages and disadvantages and the alternatives considered.
b) Documentation of examples of comparable third-party transactions and their prices.
c) Verify that the reports and other documents that the company submits to authorities, including the
IIA, ITA, the Israel Securities Authority, the Stock Exchange, etc., are consistent with the data that will
be used to evaluate the transferred assets, and if there are discrepancies with the reports, the
changes must be documented, and their origin justified and explained.
d) Conduct a real-time valuation of the assets being sold (as opposed to a retroactive valuation) by a
reliable external valuator in accordance with methods and principles, which are accepted by the ITA
and the courts, including analysis of the value of the FAR (Functions, Assets and Risks) transferred as
part of the transaction.
e) Take steps to verify that the key individuals involved in the execution of the transaction will be
available, if so required, to support future proceedings.
Ben Shmuel’s Economic Department has extensive experience in valuations and transfer pricing. We will be
happy to assist in relevant matters.
(*) Author: Ygal Dikovsky, CPA (MBA) is Managing Partner of Ben Shmuel’s Economic Department. He is an
expert in valuations as well as M&A transactions and is highly experienced in arbitrations and court
appearances.
