Supreme Court of Israel Ruling Changes Classification of Dividend Distribution as part of the Value of a Shares Transaction
On February 28, 2019, the Israeli Supreme Court ruled in an appeal on the Central District Court’s decision relating to a share transfer transaction. The court ruled that tax planning is legitimate only when it has a commercial rationale and not just when it is designed to reduce the tax burden.
In the case at hand, Sochnei Delek Veshmanim Ltd. (the “Buyer”) acquired Tahanat HaArba Ltd. (the “Company”), whose main asset consisted of real estate on which a gas station was built (the “Real Estate”). Prior to the sale transaction, a third-party expert appraised the Real Estate at NIS 19.5 million. Because the book value of the Real Estate on the Company’s balance sheet was approximately NIS 5 million, the re-evaluation of the Real Estate resulting in non-cash re-evaluation profits of approximately NIS 14.5 million.
The Company and the Buyer agreed that prior to the closing of the transaction, most re-evaluation profits (approximately NIS 12.6 million) would be distributed as a dividend to the Company’s shareholders. Because the profits were non-cash and resulted from the re-evaluation of the Real Property, the Buyer loaned the Company approximately NIS 9.8 million to distribute the dividend in cash. This enabled the parties to reduce the value of the Company for tax purposes, reducing the taxes payable by the selling shareholders.
The Israeli Tax Authority (the “ITA”) determined that the distribution to the shareholders of the dividend should be considered part of the consideration paid for the Company, and the ITA imposed additional capital gains tax on the shareholders.
Following a District Court ruling in favor of the ITA, the Company’s shareholders appealed to the Supreme Court. The Supreme Court rejected the appeal, stating that under such circumstances, the dividend distribution prior to the transaction was improper tax planning which resulted in an “artificial” transaction. Therefore, the court ruled that the ITA had the authority under the Israeli Income Tax Ordinance [New Version] 5721-1961 to re-characterize the transaction and establish the valuation of the Company shares in accordance with the Real Estate valuation obtained prior to the closing of the transaction.
This case demonstrates the Supreme Court’s willingness to intervene in the agreements between parties with respect to the structuring of transactions. In addition, this decision continues the negative attitude of the Israeli courts and the ITA in recent years regarding the distribution of non-cash revaluation profits.
