Hexadite Ltd. v. Tel Aviv 3 Assessing Officer
Background
This week, the Tel Aviv District Court (Hon. Judge Yardenna Seroussi) published another ruling addressing the valuation of a sale transaction involving the transfer of Functions, Assets, and Risks (FAR) between related parties. The precedential ruling discusses two adjustments with respect to the value of the sale: the addition of a tax gross-up and the reduction of holdback payments.
In the background of the decision – Microsoft Israel acquired all the shares of Hexadite Ltd., an Israeli cybersecurity company, in a standard share transaction between unrelated parties for USD 75 million. Shortly thereafter, Hexadite transferred all of its Functions, Assets, and Risks (FAR) to Microsoft Corporation, for USD 65.4 million.
The ruling addresses the second transaction – between related parties – and the question of how to determine the value of the FAR sold for the purpose of taxing the sale.
The Dispute
The company and the Israeli Tax Authority agreed that the correct method for determining the value of the FAR is the Comparable Uncontrolled Price (CUP) method, and specifically, that the comparable price in this case would be the price determined in the share transaction. However, they differed regarding two adjustments to be made to the share transaction price:
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Tax Gross-Up : The Tax Authority argued that when valuing the FAR sold, the tax imposed on their sale should be grossed up; therefore, the value of the FAR sold should be USD 96 million.
2. Holdback Component: The company argued that when valuing the FAR sold, approximately USD 9.3 million should be deducted from the share value, as this amount constituted part of the consideration paid to the company’s founders for their shares, but was conditional upon their continued employment for three years following the sale.
In addition, the Tax Authority argued that a “secondary adjustment” should be imposed on the Israeli company, meaning that since Microsoft Corporation did not pay the full consideration claimed by the Tax Authority, the unpaid amounts should be treated as a loan, subject to tax on deemed interest in the hands of the Israeli company.
The Court’s Decision
1. Tax Gross-Up – Appeal Accepted
The Court held that expected future tax should not be grossed up as part of determining the sale value under the Comparable Uncontrolled Price method.
The parties agreed that the consideration for the acquisition of the shares was a transaction between unrelated parties and therefore reflected the company’s market value, and that the value of the FAR sold should be determined according to the CUP (Comparable Uncontrolled Price) method. The Court ruled that the Acquisition Price Method (APM) applied by the appellant is a specific application of the CUP method, as both start from the value determined in the comparable transaction.
The Court held that when determining value based on a comparable uncontrolled transaction, there is no justification for adding potential future variables. The underlying assumption is that the price agreed upon between two independent parties already embodies their negotiated understanding and incorporates all relevant economic factors — including tax considerations.
The Tax Authority’s position that the OECD Guidelines require a tax gross-up was rejected, as the Court held that the OECD Guidelines address tax implications within the framework of the Discounted Cash Flow (DCF) method, which was not the method applied in this case.
In this context, the Court criticized the Tax Authority’s change of position and emphasized that no organized, comprehensive, and coherent policy has been published, nor has there been an update to the Income Tax Circular 15/2018, which discusses the taxation of Multinational business model restructuring.
2. Holdback Component – Appeal Rejected
The Court determined that the holdback component in the transaction at issue constitutes part of the share consideration and therefore must be included in the value of the FAR in this case. The Court held that this component represents a proportional part of the consideration received by the founders for their shares, and does not constitute an additional payment beyond what other shareholders received . The payment was solely for the shares and not for services, but rather a payment conditional upon continued employment.
Excluding the holdback component would have created a discrepancy between the value of the shares and the value of the FAR, whereas the OECD Guidelines provide that, as a rule, value does not disappear in the course of a business restructuring
3. Secondary Adjustment and Interest
The Court approved the making of a secondary adjustment in accordance with the Supreme Court’s Kontira ruling, but determined that the interest rate would be calculated according to Microsoft Group’s internal interest rate (0.175%) and not according to the rate determined by the Tax Authority. However, Judge Seroussi reiterated her remarks in the CA case, stating that the question of the source of authority to impose a secondary adjustment under Section 85A of the Income Tax Ordinance warrants further examination.
The ruling joins a series of court decisions shaping the taxation of transactions conducted by multinational corporations acquiring Israeli companies.
