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 for the structure to formally comply with legal requirements. Rather, the underlying business purpose and the ability to substantiate that purpose in real time must also be considered. In our view, the ruling may have practical implications for how transactions involving special purpose vehicles, intercompany financing, and transfers of profits to foreign companies are structured and documented.

Facts and Key Elements of the Dispute

Q Cyber Technologies Ltd. appealed the Kfar Saba tax assessor’s withholding tax assessments for 2014-2015 and 2017-2018. The assessments alleged that the foreign parent company had devised an artificial structure to finance the acquisition of NSO shares in order to receive profits from NSO through tax-exempt loan repayments and avoid the tax that would have applied had the profits been distributed as dividends.

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 completing the acquisition, OSY established Q Cyber Technologies Ltd. (Q Cyber) as an Israeli shelf company.

Under 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 subsequently acquired the remaining shares. OSY paid the consideration directly to the sellers from its own accounts, rather than through Q Cyber’s bank account.

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

In practice, however, more than USD 86 million were transferred directly from NSO to OSY, rather than through Q Cyber’s bank account, even though Q Cyber recorded the transfers as if it had received the funds and subsequently transferred them as loan repayments.

Key Elements of the Dispute

The central issue before the court was whether the sequence of actions taken to acquire NSO, including financing the acquisition through loans from OSY and transferring NSO’s profits back to OSY as loan repayments, constituted a legitimate transaction or an “artificial transaction” under Section 86 of the Israeli Income Tax Ordinance.

The classification of the transfers to OSY is the crux of the dispute: If the payments were loan repayments to OSY, they were tax exempt. However, if they were, in substance, profits distributed as dividends to a foreign company, they were taxable.

The tax assessor claimed that the acquisition structure was artificial and devised to enable transfers of NSO’s profits to OSY while circumventing the payment of approximately USD 8.6 million in taxes. Accordingly, the tax assessor argued that the structure should be disregarded and the transferred profits taxed according to 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. However, tax planning must be documented and defensible, and will be scrutinized in light of the public interest in collecting taxes that are properly due and 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 it with a loan to acquire NSO shares for a defensible, substantive business purpose, rather than merely to extract profits from NSO without paying tax on dividends, it would have regarded the arrangement as legitimate and the payments as loan repayments, rather than an artificial transaction.

What Tipped the Scales in the Q Cyber Case?

The court rejected Q Cyber’s appeal and ruled this 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.

To refute this conclusion, Q Cyber had to prove that it was established for a genuine and substantial business purpose, rather than merely for tax avoidance. Q Cyber failed to meet this evidentiary burden because, among other things, it presented no evidence substantiating Francisco Partners’ rationale for holding NSO’s shares through it.

The court held that the tax advantage arising from the transaction structure was clear and obvious, while the fundamental commercial reasons for establishing and operating Q Cyber remained ambiguous and undocumented.

Nevertheless, the court stressed that foreign-resident parent companies may establish companies in Israel for leveraged buyouts of Israeli companies. However, they must demonstrate a substantive business rationale for the transaction structure beyond tax advantages, supported by real-time documentation of the original decision-making and consistent implementation.

Implications for Acquisition Transactions and Holding Structures

The ruling emphasizes that tax examinations of transactions and holding structures are not limited to whether each individual step is permitted by law. Rather, they focus on the sequence of actions, the structure’s economic outcome, and the correlation between holding structure, acquisition financing, and how profits are transferred.

Accordingly, in transactions involving acquisitions through a special purpose vehicle (SPV), parent-company or foreign-owner financing, intercompany loans or intergroup profit transfers, it is important to consider in advance not only the structure’s tax efficiency but also the business purpose it is intended to serve.

Equally important, the ruling underscores the value of real-time documentation. Board resolutions, transaction documents, business analyses, and commercial considerations supporting the chosen structure may carry significant evidentiary weight if the transaction is later scrutinized by the Israel Tax Authority or a court.

The bottom line: the ruling does not render a transaction structure illegitimate merely because it provides a tax advantage. However, the risk that the Israel Tax Authority will classify a transaction as artificial increases considerably where the structure presents a clear tax advantage but its business purpose is unconvincing or undocumented.

Therefore, when designing acquisition and financing structures, companies should assess not only the structure’s tax efficiency at the planning stage, but also its underlying business logic, and 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 corporate restructuring. We are at your service to provide comprehensive legal services.

Adv. Hanna Daher (CPA) is a partner and Adv. Alon Davidovich is an associate in the firm’s Tax Department.