Your Taxes: Moving onshore is tax evasion, says court

An Israeli court recently ruled that moving a subsidiary company from Dutch to Israeli ownership is tax evasion (Gottex case). Everyone loses, as discussed here.

In 2013, it was decided to change the structure and take Swimwear out of Dutch ownership. So, the Israeli resident individuals incorporated a new Israeli holding company known as Holdings.

Then the relevant Dutch holding company, known as Findings, sold its 100% holding in the Swimwear shares to Holdings for NIS 491 million.

No cash was used. Instead, group debts due to Swimwear were extinguished by having Swimwear declare a dividend to Holdings to enable Holdings to pay Findings.

But the Israel Tax Authority (ITA) didn’t like this turn of events. It decided to assess 30% dividend withholding tax on the grossed-up amount, meaning that NIS 491m. received was 70% of the gross dividend. This resulted in a 42.8% effective tax rate (30/70) on NIS 491m. In addition, a 15% fine was imposed.

The court ruled that bringing Swimwear into Israeli ownership was legitimate, but the WAY it was done was artificial, or fictitious, i.e., tax evasion (under Section 86 of the Israel Income Tax Ordinance).

No tax was paid, no cash was paid, and only accounting entries were made.

Moreover, the cost basis of the Holdings investment in Swimwear was stepped up to NIS 491m. in the event of any future sale.

There were several reasons for the court’s decision.

First, the court said the way group debts were “concentrated” in Swimwear was “incoherent,” as the transaction that triggered most of the debt involved a different company in the group.

Second, the court said the taxpayer had explained various steps, but not the rationale for the “overall process.” This is sometimes known as a preordained series of transactions.

So, the court declared the arrangement artificial and imposed a 5% dividend withholding tax on most of the grossed-up deemed dividend (NIS 208m.) under the Netherlands-Israel tax treaty.

This was because the Dutch holding company Findings was deemed to be the beneficial owner, i.e., it determined whether to pass on dividends and wasn’t shown to be a conduit company.

Nevertheless, the court imposed a 15% dividend withholding tax on part of the deemed grossed up dividend (NIS 101m.) under the treaty. This was because the taxpayer and the ITA agreed in 2013 that part of the debt balances were apparently owed to the individuals.

Also, the court said the 15% fine remained due.

A tax of 5% may sound better than 30%. In fact, everyone loses.

First, the ITA receives less tax.

Third, the court and the ITA concluded there was an artificial, preordained series of transactions, because the group debts were shifted around on the books. Does that prove artificiality?

Fourth, because of this artificiality, the court said the competent tax authorities of Israel and the Netherlands are precluded from resolving the issue together under the Israel-Netherlands treaty.

Fifth, regarding business rationale, the taxpayer said the deal was meant to separate industrial from retail activity and to segregate the Canadian parent company from the rest of the group. Why? Because it was “poisonous.” Unfortunately, no further details are given in the judgement.

In the Shalam Packaging case, for example, an Israeli court examined and accepted the taxpayer’s business rationale that there was no tax evasion.

Sixth, as for the 5% or 15% dividend withholding taxes, we would have thought only the Netherlands can collect these taxes under the Netherlands-Israel tax treaty.

We are living in changing times. Other ways of moving onshore are potentially possible.

It remains to be seen whether an appeal is lodged and/or whether the ITA starts encouraging companies to migrate activities and ownership to Israel. This might help increase future tax revenues without raising tax rates.

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