Last week, the Jerusalem District Court released its ruling in the Barazani case, which dealt with the distinction (and different tax treatment) between a “capital note” and a business-to-business loan, which was granted by a Israeli parent company to its foreign subsidiary. . The district court ruled in favor of the Israel Tax Authority (ITA), accepting its approach that in this case, the intercompany finance agreement was not considered a capital note, resulting in income from deemed interest for the Israeli parent company and, in addition, a fine for deficit. The District Court further ruled that the taxpayer’s method of determining the interest rate did not comply with applicable transfer pricing rules, accepting the ITA’s position regarding deemed interest that should be charged as part of the intercompany loan.
To set the context, it is possible, subject to certain conditions being met, for a parent company to provide interest-free financing to its subsidiary via a “capital note”, which is a hybrid debt-equity instrument. Among other qualifying conditions, the financing must not be linked to an index and bear no interest or return, it has a minimum maturity period of 5 years and its repayment is subordinated to all the other obligations of the beneficiary company of the funding.
Often, companies do not pay enough attention to business-to-business financing arrangements, despite being subject to the arm’s length principle stipulated by Section 85A of the Israel Income Tax Ordinance. That is, any intercompany transaction (including financing) must be documented in accordance with the applicable transfer pricing rules, and the terms of the transaction (interest rate, loan terms, etc.) must be supported by transfer pricing documentation (study).
In many cases, the financing from the parent company to the subsidiary is done without documenting the nature of the transaction, leaving room for various classifications, such as loans, capital contributions or capital notes. The Barazani judgment underlines the importance of determining and documenting, in advance, the nature of such financing and its terms, in particular being able to demonstrate that the applicable interest rates are in accordance with market conditions.
Capital note or loan?
In the Barzani case, the ITA claimed that despite the taxpayer’s position, the parent company did not transfer funds through a capital note to its affiliates in Romania, but rather a inter-company loan interest bearing, thus forcing the Israeli parent company to granted the loan to recognize and pay taxes on the interest income accrued in its favor. To be qualified as a “capital note”, the terms and conditions of the note must be decided and documented in advance in order to show that the note meets said requirements (duration of at least 5 years, does not bear interest , is subordinated to other debts, etc.). The district court ruled in favor of the ITA, noting that the mere use of the title of “capital note” is not sufficient if the document does not meet the essential conditions to define the financing itself as genuine. “Capital note”, and most of the alleged capital notes did not meet the arm’s length principles required under Section 85A of the Israel Income Tax Ordinance.
In the financial statements of the Romanian affiliates, the financings were described as short-term loans. The taxpayer’s allegations that the loan contracts were executed in error and that the intention was to use capital notes in advance were rejected for several factual reasons, in addition to the fact that local Romanian law does not does not recognize such a business-to-business financing instrument.
Alternative Valuation Under Section 85A – Higher Interest Rate
The District Court adopted the ITA’s position, not only with respect to the amounts involved being a loan and not a principal note, but also with respect to the interest rate that should apply to the ready. The district court ruled that the market research conducted for loans granted in 2008 was not sufficient and could not be applied to interest rates on loans granted at a later stage. The District Court further found that the amount of interest chosen by the taxpayer in the transfer pricing study provided did not correspond to the jurisdiction in which the affiliates were located and that the transactions selected for comparison did not correspond to the jurisdiction in which the affiliates were located. were not appropriate. As such, the district court upheld the ITA’s position to set a higher interest rate, noting that even a higher interest rate was favorable to the taxpayer because, in the opinion of the court of district, a higher interest rate than that claimed by the ITA could have been imposed.
As part of the assessment issued to the taxpayer, the ITA imposed a deficit fine on the taxpayer, alleging that the taxpayer was negligent in filing the tax returns in the manner filed. The taxpayer, on the other hand, argued that a deficit fine should only be imposed in cases where a taxpayer knowingly submits tax returns with a low chance of being accurate. The district court rejected the taxpayer’s claims that the taxpayer’s conduct amounted to negligence. This is indeed the first case in which a fine for deficit is maintained in the context of a court decision on transfer pricing.
Key points to remember
The interest rate on related party financing should be supported by a transfer pricing study in accordance with the OECD guidelines for business-to-business financing, and interest rates should be set accordingly. The interest rate must reflect, among other things, the dates of grant and maturity of the loan, the risk inherent in the loan, the applicable thin capitalization rules and whether an unrelated third party would grant, in the circumstances , a loan to the subsidiary. The provision of a guarantee by the parent company is also subject to arm’s length rules and should be duly taken into account. The possibility of issuing a capital note must be considered in advance, before granting the loan, and the conditions of Article 85A of the Israel Income Tax Ordinance must be fulfilled.
We note that the decision was issued by the District Court and is subject to change by the Supreme Court to the extent that an appeal is actually filed.