In the third week of October, the District Court in Jerusalem released its decision in connection with the – very tax relevant – difference between a "loan" and a "capital note", a hot topic also in the eyes of the Israeli tax authorities in the arena of 'transfer pricing' as also clearly stated in recent proposals for amendment and expansion of transfer pricing legislation and regulations.

Loan or capital instrument; inclusion interest income or not

A parent company in Israel – B Ltd – had provided interest-free financing to foreign subsidiaries shaping the commitments in what it believed to be "capital notes". Financing provided by an Israeli company to a (domestic or foreign) subsidiary which qualifies as a "capital note" releases the creditor from having to report interest income in its annual tax return in relation to the financing involved. Certain high risk long term loans may qualify as a "capital notes" when the principal is not linked to any index, does not carry an interest or any other 'yield', is not repayable within 5-years and the standing of the creditor subordinate to other obligations of the recipient of the loan. For a debt to qualify as a "capital note" the mentioned terms and conditions must be cemented in to the terms of the "debt note" (the 'I owe you') which the debtor will generally issue.

In the case at hand, the Israel tax authorities positioned that the parent company had not financed the affiliated Romanian group companies against issuance of "capital notes", but that it had provided plain "loans".

When the tax assessor argued that the parent company should have recognized interest income in relation with the loans and issued his tax assessments in accordance, the District Court supported the view of the tax authorities and confirmed that the mere use of the wording "capital note" on documents do not turn a 'loan' – which does not meet all of the defining terms of a "capital note" as in Income Tax Ordinance – into a 'capital instrument'. In the case at hand most of the 'notes' did not meet the terms and therefor fell within reach of the transfer pricing chapters of the Income Tax Ordinance and required that an arms' length percentage of interest should have been reported by the Israeli parent-lender. An unfortunate circumstance for the taxpayer had been that the financial statements of the Romanian subsidiaries had described the loans as 'short term' (rather than 'long term').

The court rejected the explanations of the taxpayer that the agreements of loan had been executed by mistake, and that the intention -all long- had been to provide 'long term capital against issuance of capital notes'. Not only because legal rules in Romania do not recognize intercompany financing instruments – such as capital notes- but also because of factual considerations the Court supported the views of the tax assessor. The Court rejected also the secondary argument of the tax payer, that the calculation by the tax assessor of an arms' length rate for the interest income did not comply with transfer pricing rules, and again accepted the tax assessor's calculation of the interest income that should have been reported.

The District Court ruled that the transfer pricing study provided by the taxpayer had been composed for loans granted in 2008 and was not sufficient, and could not be applied, regarding loans granted much later than 2008. The District Court further held that the amount of interest chosen by the taxpayer in the transfer pricing study did not correspond to the economic surroundings in the jurisdiction of the affiliated companies debtors, and that the comparable transactions selected were not appropriate.

An quite concerning detail of the proceedings was that the original assessment issued contained a sturdy fine for misreporting by the taxpayer – on top of a 4% interest charge on the additional corporate income tax demanded. When the taxpayer pleaded that imposing also these punitive fines was really quite excessive, the District Court actually pointed out that taxpayer's behavior had been way beyond 'just negligent'.

Something to think about

Currently an amendment of Israel's transfer pricing legislation is under consideration (see link). The proposal explicitly places the burden of proof on the tax-payer and only when the taxpayer will have – satisfactorily – met the 'documentational requirements' can the burden of proof move over to the tax assessor. This is not a small matter especially when meeting the burden of proof will often be subject to the benevolent view of the tax assessor. Intergroup cross-border financing should be supported by detailed written agreements, proper qualification of nature of the relevant transactions, and supported by a transfer pricing study in accordance with the domestic (and OECD) guidelines. The determination of the financial terms and interest on "debt" – which cannot be labelled 'quasi-equity' (as can a 'capital note') are also subject to fierce and increasing transfer pricing scrutiny; when was the loan granted, which are the repayment dates of the loan, what is the inherent risk tied to the loan, and whether an unrelated third party would have granted a (similar) loan. In light of the growing transfer pricing ambitions of the Israeli tax authorities, and the proposed heavy burden of proof on the taxpayer in Israel, finance management of international groups which are managed – or active – in Israel should carefully carve out their 2020 intercompany financing models and transfer pricing strategy. An optimal use of the right financial instruments, whether loans or quasi capital', or a mixture thereof, should support sensible long-term cross-border financing planning.

The development of a transfer pricing strategy in relation to cross-border financing should best be developed whilst weighing cash-flow capabilities and forecasts of the group; and all should be diligently supported by well drafted legal and supporting economic documentation, allowing finance management and the corporate taxpayer to claim good faith, deal with the obligation to prove its positions and escape administrative penalties of a distinctly serious kind, as they resulted in the case at hand.

Originally Published By Pearl Cohen, November 2020

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