Israeli court favors Tax Authority's position on deemed sale of IP

• An Israeli district court ruled in favor of the Israeli Tax Authority (ITA), which claimed that Medtronic Ventor Technologies Ltd. (Medtronic Israel) sold its intellectual property (IP) to Medtronic Inc. and other group companies (the Group) shortly after its acquisition.
  
  
• The court's ruling was based in part on the (i) retroactive effect of research and development services and license agreements signed between Medtronic Israel and Group companies, (ii) transfer of legal rights to some of Medtronic Israel's patents to the Group, and (iii) location of Medtronic Israel's strategic management after acquisition.
  
  
• Israeli companies and multinational enterprises that acquire Israeli companies should be mindful to adequately and sufficiently document implementation of post-merger integration (PMI) and global IP structure rationalization.

Executive summary

On 1 June 2023, the Lod District Court ruled in favor of the Israeli Tax Authority (ITA) in the appeal of Medtronic Ventor Technologies Ltd. (Medtronic Israel or the Company) against Kfar Saba's Tax Assessing Office. The ITA claimed that the real transaction between the Company and its related parties was an intellectual property (IP) sale rather than a transaction involving licensing and services (as depicted in the Company's agreements, which had retroactive effect).

The court ruled that after Medtronic Inc. acquired Medtronic Israel in 2009, the Company transferred its business functions and its risks, along with the potential benefits thereof, to Medtronic Inc. due to IP "leakage," leaving the Company as an "empty corporate shell" that shut down during 2012.

The court rejected Medtronic Israel's claim that its relationship with the Group was in fact favorable to the Company. Rather, the court concluded that the Company that started off as an independent IP owner and had essentially become a mere subcontractor in the Group with no ability to control its assets, despite that after the acquisition the Company initially increased its headcount and revenues. Although the market in which the Company was active ultimately failed to develop (due to the success of competing technologies and unfavorable clinical trial results), the court determined that the Company's shutdown was not caused by the failure of its products, but rather due to budget cuts throughout the Group.

The court also addressed the comparison the Company drew between the case at hand and previous cases that overruled sale of IP claims raised by the ITA. The court distinguished the prior cases, ruling in part that there was a clear separation between the old IP and the newly developed IP to avoid any IP leakage, as opposed to the circumstances in this case where the Group adjusted the early-stage IP to meet its needs.

Israeli companies that perform post-acquisition changes, implement post-merger integration and perform global IP structure rationalization involving Israeli IP and assets, must be mindful of the sufficiency of real-time documentation supporting such changes and of the distribution of IP management functions throughout the Group.

Detailed discussion

On 1 June, the Lod District Court ruled on an appeal filed by Medtronic Israel against Kfar Saba's Tax Assessing Office pursuant to a tax assessment claiming that IP which was originally developed by Medtronic Israel was in fact transferred to the Group rather than merely licensed to it.

The Company, which was founded in Israel in 2004 under the name Ventor Technologies Ltd., was acquired (the Acquisition) by Medtronic, Inc. (a large multinational enterprise that, together with its subsidiaries, is referred to here as the "Group") during 2009. At the time of Acquisition, the Company was at relatively early stages of developing an aortic valve intended for transplant using the "transapical method" (a different technology than the more popular "transfemoral method"). Prior to the Acquisition, Medtronic, Inc. owned 8% of the Company's shares.

After the Acquisition, in July 2010 and April 2011, the Company signed agreements with related Group companies to provide research and development (R&D) services and, in November 2011, executed a license agreement for the use of its IP. These agreements were set to be effective as of April 2009 (time of the Acquisition), according to the Company, based on the understanding that the relations between the companies were implemented from the time of the Acquisition. The Company also legally transferred the title to eight of its patents (out of a total of 185) to Group companies.

The Company began recording R&D services income during 2010 and royalties income during 2013 (per the Company's claims — following its product's regulatory approval by the EU), although, during 2012, the Company's activity was shut down and all of its employees were laid off. The ITA learned, through financial reports filed in August 2012 as part of the tax return for the year 2010, of the intercompany agreements described above and of the decision to cease the Company's operations. As part of an audit for the years 2010—2014, the ITA concluded that behind the legal arrangements between the Company and the Group a different type of transaction is obscured, in which the Company effectively transferred all of its IP, along with other functions, assets and risks (FAR) to the Group, which drained the Company of its activity and resulted in its shutdown.

The Company argued that immediately after the Acquisition its activity grew and it recruited additional personnel, set up new sophisticated facilities to continue its development activity and moved to new premises (based on such, the Company claimed that its case resembles previous court cases in which claims of sale of IP were overruled). The Company further argued that its operating margin has become positive and that its revenues grew. According to the Company, the execution of its intercompany agreements was delayed due to increased workload and that, in reality, it operated in conformity with the agreements from day one.

The Company also argued that a clerical error caused the legal transfer of the title to some of its patents to companies within the Group, and that it had 185 patents and therefore the transferred patents' value may be insignificant.

The Company asserted that the subsequent shut down of operations in 2012 was caused due to the failure of its product in the market and the success of competing technologies.

The ITA based its arguments mainly on the actions of the Group, which implied that it was the owner of the IP for all intents and purposes — including its ability to manage the R&D activity and to take financial and professional decisions over the IP, essentially turning the Company to a subcontractor for the Group. Per the ITA's approach, the increase in the Company's headcount and the capital expenditure were meant to serve the Group's goals, and an absence of a physical shift of employees did not mean that the functions did not shift to executives based overseas. Further, the ITA asserted that certain facts indicated that the IP had been sold; specifically, the intercompany agreements reflected that the weight of the future IP owned by the Group is to increase while the weight of the past IP that allegedly was left in the hands of the Company is to decrease. Lastly, the ITA argued that the failure of the Company's product in the market stemmed from events that occurred during 2014—2015, events that were not foreseen when the Company ceased its operations.

The court overruled all of the Company's claims and sustained all the arguments raised by the ITA. Specifically, the court agreed that the Company gave its parent a full and complete right to use its IP for the entire useful life of the IP. Due to the absence of sufficient evidence, the court rejected the claim that certain patents were legally transferred to the ownership of companies within the Group due to a "clerical error" and expressed doubt as to the possibility for such an error to take place in such a large multinational group.

The court further ruled that, after the Acquisition, the Company stripped itself of any ability to make decisions as to its activity and future, having transferred this control to the Group. Prior to the Acquisition, the Company had the strategic and day-to-day capacity to manage the R&D, but soon afterwards these functions were moved out of the Company, turning it into a mere subcontractor dealing with the development of different types of IP that belong to the Group.

The court determined that the timing of the agreements — signed soon before the Company's shutdown — supports the conclusion that they were used to cover the actual underlying transaction. The court found it difficult to accept that a multinational group would operate without written agreements.

When comparing this case to a former court case in which the claimed sale of IP was sustained on the one hand and cases in which the claimed sale of IP was overruled on the other, the court found that this case more closely resembles the former.

According to the court, the decision to shut down the Company's activity was based on business and other considerations that serve only the Group. The court did not accept the claim that the shutdown had something to do with the commercial problems encountered by the product based upon the Company's IP, for such developments occurred approximately three years later.

Lastly, the court accepted the ITA's position that the value of the IP should be carved out of the acquisition price. The court rejected the Company's view that the acquisition price should be adjusted to include a control premium on the grounds that the Company did not present evidence to support this position.

Implications

Multinationals involved in acquisitions of Israeli companies and Israeli taxpayers should closely review this decision and its impact on post-acquisition business restructurings. Sufficient and real-time documentation should be prepared and maintained on an ongoing basis in order to support the intercompany relations within a multinational group.

For additional information with respect to this Alert, please contact the following:

EY Israel, Tel Aviv

• Ziv Manor 
  
  
• Yaron Kafri
  
  
• Eyal Gonen
  
  
• Tsippy Herbst
  
  
• Dana Erell

Ernst & Young LLP, Israeli Tax Desk, New York

• Mark Alon

Published by NTD's Tax Technical Knowledge Services group; Carolyn Wright, legal editor

For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.