Q Cyber ruling: limits on using shelf companies in Israeli acquisitions

The Q Cyber ruling sharpens the boundary between legitimate tax planning and a transaction that may be regarded as artificial for tax purposes. The judgment underscores that, when examining acquisition, financing and holding structures, it is not sufficient that the structure formally complies with the requirements of the law; the underlying business purpose and the ability to substantiate it in real time must also be considered. In our view, the ruling may have practical implications for the manner in which transactions involving special purpose vehicles, intercompany financing and transfers of profits to foreign companies are structured and documented.

The facts and key elements of the dispute

Q Cyber Technologies Ltd. filed an appeal of the Kfar Saba tax assessor’s withholding tax assessments issued in respect of 2014-2015 and 2017-2018, whereby the foreign parent company devised an artificial structure for financing and acquiring NSO’s shares in order to receive profits from NSO through tax-exempt loan repayments and avoid paying the tax that would have applied had the profits been distributed to it as a dividend.

The facts in a nutshell:

in 2014, the foreign private equity fund, Francisco Partners, decided to acquire shares of an Israeli cybersecurity company, NSO, through its Luxembourg-based subsidiary, OSY. Shortly before executing the acquisition transaction, the foreign company established an Israeli company, Q Cyber Technologies Ltd. (Q Cyber), as a shelf company held by OSY.

According to the chosen transaction structure, OSY and Q Cyber entered into a trust agreement, pursuant to which OSY acquired the NSO shares in trust for Q Cyber.

OSY initially acquired 70% of NSO’s shares and later, the remaining shares. OSY paid the consideration of the shares to the sellers directly from its own accounts and not through Q Cyber’s bank account.

At the same time, Q Cyber recorded the NSO acquisition transaction in its books as being financed by loans from OSY. In subsequent years, Q Cyber recorded repayments of those loans in its books using funds deriving from NSO’s profits, whether by way of intercompany loans or by way of dividends distributed to Q Cyber.

In practice, however, more than USD 86 million were transferred directly from NSO to OSY and not through Q Cyber’s bank account, even though Q Cyber recorded these transfers in its books as if Q Cyber had received those funds and later transferred them as loan repayments.

Key elements of the dispute

The salient issue deliberated by the court was whether the sequence of actions taken for the purposes of acquiring NSO, including financing the acquisition through loans from OSY and transferring NSO’s profits back to OSY by way of loan repayments, constituted a legitimate transaction or an “artificial transaction” pursuant to section 86 of the Israeli Income Tax Ordinance.

The classification of the money transfers to OSY is the crux of the matter: if at issue are loan repayments to OSY, the transfers are tax exempt; however, if at issue are essentially profits distributed as a dividend to a foreign company, they are taxable.

The tax assessor claimed that at issue was an artificial acquisition transaction with a structure devised to enable transfers of NSO’s profits to OSY while circumventing the payment of taxes totalling about USD 8.6 million, and that therefore, the transaction structure should be disregarded and the transferred profits should be taxed according their economic nature.

When is tax planning deemed an artificial transaction?

The court emphasized that tax planning and the use of tax benefits prescribed by law are legitimate and sometimes even appropriate courses of action. However, tax planning must be documented and defensible and will be scrutinized against the public interest in collecting taxes that are actually due and in maintaining an equitable tax burden.

For this purpose, section 86 of the Income Tax Ordinance empowers the tax assessor to disregard any transaction that is artificial or that essentially serves to illegitimately reduce tax liabilities and to tax the transaction according to its true economic nature.

The court clarified that, had OSY established Q Cyber and provided the loan to Q Cyber to acquire NSO shares for a defensible substantive business purpose – and not merely for the purpose of extracting profits from NSO without paying tax on dividends – then it would have viewed its conduct as legitimate and the payments as loan repayments, and not deemed it an artificial transaction.

What tipped the scales in the Q Cyber case?

In this case, the court rejected the appeal and ruled that at issue was an artificial transaction devised to reduce the tax liability and enable OSY to extract profits from NSO without paying the tax that applies to cross-border transfers of profits from an Israeli company.

In order to refute this conclusion, the appellant, Q Cyber, had to prove that it was established for a real and substantial business purpose and not merely for tax avoidance, but the appellant failed to meet this evidentiary burden since, inter alia, it presented no evidence to substantiate Francisco Partners’ rationale in real time for holding NSO’s shares through the appellant.

The court ruled that the tax advantage deriving from the devised transaction structure was clear and obvious, while the fundamental commercial reasons for establishing and operating the appellant were left ambiguous and undocumented.

Nevertheless, the court stressed that foreign-resident parent companies are indeed allowed to establish companies in Israel for the purposes of leveraged buyouts of Israeli companies, but they must provide evidence of substantive business rationale behind the transaction structure besides exploiting tax advantages, and orderly real-time documentation of the original decision-making and consistent implementation.

What are the implications for acquisition transactions and holding structures?

The ruling emphasizes that examinations for tax purposes of transactions and holding structures are not limited to whether each separate action is permitted by law, but rather, focus on the sequence of actions, the economic outcome of the structure, and the correlation between the holding structure, the financing of the acquisition and how profits are transferred.

Therefore, in transactions involving acquisitions through a special purpose vehicle (SPV), financing from a parent company or foreign owners, intercompany loans or intergroup transfers of profits, it is important to examine in advance not only the structure’s tax efficiency but also the business purpose it is designed to fulfill.

No less important, the ruling underscores the importance of real-time documentation: board resolutions, transaction documents, business analyses and commercial considerations that support the chosen structure carry significant evidentiary weight if the transaction is retrospectively scrutinized by the Israel Tax Authority or the court.

The bottom line: the ruling in no way illegitimizes a transaction structure merely because it provides a tax advantage. However, the risk that the Israel Tax Authority will seek to classify the transaction as an artificial transaction is elevated considerably if that structure demonstrates a clear tax advantage while its business purpose is unconvincing or undocumented.

Therefore, when formulating acquisition and financing structures, companies should analyze not only the tax efficiency of the structure during the planning stage, but also the business logic underpinning it and they must ensure that it is defensible in real time.

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Barnea Jaffa Lande’s Tax Department has extensive experience advising on company acquisition and sale transactions and on corporate restructuring and is at your service to provide comprehensive legal services.

Adv. Hanna Daher (CPA) is a partner and Adv. Alon Davidovich is an associate in our Tax Department.