On 12 January 2012, the Israeli District Court of Appeals (case n^o 1029/00), published a ruling which highlights the guiding principles on when a company established abroad will be considered to be Israeli resident for tax purpose, as far as the management and control of its business are conducted in Israel. In this case, shareholders of an Israeli company (the “Israeli Company“), engaged in export of textile products, established in 1990 a foreign company in the Bahamas (the “Foreign Company“) and transferred to the latter the Israeli company’s activity regarding non-Israeli customers. It should be mentioned that three years later, the Foreign Company sold back the activity to the Israeli Company, resulting in a substantive tax benefit for the Israeli shareholders according to the Israeli Tax Ordinance (“ITO“), as formulated before the implementation of a worldwide tax system in Israel.

According to appellants (the Israeli Company and its shareholders), the Foreign Company’s business was conducted by managers and employees living outsideIsrael: the foreign board included three non-Israeli members; board meetings were held outside ofIsrael and the decisions of the board were made by the directors independently without involvement of the Israeli Company or its shareholders; the foreign directors had thorough knowledge of the relevant activities; the Foreign Company’s head office and two other offices were located outside Israel; the orders from around the world, the financial management and the issuance of receipts and letters of credit were all made from the Foreign Company’s offices abroad. The Israeli Tax Authority (“ITA“) argued that the management and control of the Foreign Company were carried-out in Israel. Further alternatives claims were argued, including artificiality of the acts according to the general anti-avoidance rule set up in Article 86 of the ITO.  The court examined the evidences and facts and ruled that the Foreign Company should be seen as a company whose business is managed and controlled in Israel and accordingly, as an Israeli-resident company for tax purpose. The main principles arising from the contemplated case are discussed henceforth:

Foreign Company’sactivity – prior to the establishment of the Foreign Company, the activity with foreign buyers and Israeli manufacturers was performed ​through an independent agency in the U.S. (run by an American individual); therefore, there was no substantial need of the Foreign Company’s existence. The ruling emphasized that under the circumstances, the facts indicate that: “a corporate mechanism that includes board, offices, bank accounts and so forth, is not enough to indicate that there is an independent corporate entity separated from the Israeli Company and/or the appellants. Such  echanism may constitute an artificial platform…“

As was following discussed, the Foreign Company has not provided the professional tools required for the contemplated marketing activities. Moreover, the Foreign Company’s business was partially conducted in Hebrew, which is not spoken by its managers nor by its employees, and actually were lying on business communication and documentation transferred between the Israeli Company and the independent agent.

Independent agent’s activity – in this case, there was no difference, whatsoever, between the agent’s activities prior to the establishment of the Foreign Company and afterwards. He continued to work with the Israeli Company, without any involvement of the Foreign Company’s managers and employees, including the determination of fees received by each of the factors involved in the said business. Apparently, this fact reinforced the Court’s statement that the Foreign Company’s establishment was of an artificial nature.

Conduct of managers and employees – the evidences presented to the court showed that the Foreign Company’s directors were not engaged in daily activities for and on behalf of the company and had no real knowledge about its business activity. During his investigation, one of the directors couldn’t mention not even one of the manufacturers’ names with whom the company was associated. Later, the ruling stated that: “even if one of the directors was engaged in daily administrative activity, after all, it doesn’t suffice for demonstrating a real management support of the company.“

Shareholders’behavior – ITA Circular n^o 4/02, dealing with guidelines for management and control’s determination, provides that one should examine who is the factor managing and controlling the business’s activity: in the case that strategic decisions are not determined at the company board level, the shareholders are presumed to be the decision makers. In this case, one of the shareholders (an Israeli resident), confirmed that him and the other shareholders decided whether to engage with a customer suggested by the independent agency – a fact that contradicts the appellants claim. The facts further indicate that decisions regarding policy management and contractual agreements were made by them rather than by the Foreign Company’s managers (we would mention merely that management and control is conducted where the directors carry out their powers, regardless their residency).

Protocols and documents – the ruling emphasizes the importance of what is written in various documents. In this case, the facts showed that no significant decisions were made by the Foreign Company or by its managers. Documented decisions were short and laconic, without any relevant discussions or comments regarding the issues that were allegedly on the agenda. Judge Altoviah noted that “in matters relating to the Foreign Company’s business existence, the protocol should reflect how the decisions were made and if the participants relied on any expert reports, this fact should have been reflected in the protocols.” With this regards, previously mentioned ITA Circular 4/02, emphasizes that in order to locate the place where strategic decisions are made, it is important to examine the decision making process as a whole. That is, one should examine where decisions were essentially made and not only the place were technical formalities were performed, when generally; the process of significant decisions is not shaped at a specific time.

In our opinion, the discussed ruling was given in response to the “full picture” which involves a quite radical tax planning and behavior, in addition and regardless of the management and control issue: the judge explicitly states that “The sale back of the company’s business to the Israeli Company and the transfer of the dividend to the appellants was made with a main purpose of avoiding tax or reducing it inappropriately.” After all, it appears that the ruling‘s was aimed  to “repair” the distortion that was (artificially) created. It should be mentioned that the ruling deals with a daily and acute international tax issue in which an Israeli court decision hasn’t been given for more than twenty years, since the “Solel Boneh” supreme-court decision in 1994. However, the contemplated last ruling is a District Court ruling, and therefore, is not considered a binding precedent.