Anna Liskanich, Attorney at Law

The Facts:

The appellant and her two brothers inherited shares in a private company from their deceased father (hereinafter: “the company”). Each sibling inherited 33.3% of the company. After a while, a conflict arose between the siblings. As a result, around 2001, the appellant decided to sell her rights in the company to her brothers. In the 2002 financial statements, the appellant declared a dividend income of NIS 3,485,000 from the company and additional revenue of NIS 1,681,000 as the proceeds from the sale of her shares in the company. The respondent did not accept the aforementioned statement and issued an assessment order, which led to the appeal under debate.

The Parties’ Arguments:

The respondent claims that reference is to an artificial transaction. The dividend that the appellant received close to the sale of the shares forms a part of the proceeds of the sale of the company’s shares. The transaction must be presented according to its true essences – he believes a share sale transaction involving a sum of NIS 5,166,000.

The appellant counterclaims that, over the years, the company accrued substantial earnings that had not yet been distributed by her brothers, who had managed the company while depriving her of her rights. In the appellant’s opinion, the dividend distributed by the company was distributed according to the distribution rules prescribed in the Company Law. Consequently, the respondent cannot classify the income in any other way.

The Question of Law:

Has the respondent established competence to disregard the transaction declared by the appellant by virtue of the directives in Section 86 (a) of the Income Tax Ordinance (New Version), 5721 – 1961 (hereinafter: “the ordinance”), which deal with artificial transactions?

The District Court (through the Honorable Justice Altuvia) has adjudicated:

The Court did not relate to the appellant’s argument that the distribution is consistent with the provisions in the Company Law, but referred directly to examining the question – Does the respondent have the competence to classify the transaction as an art official transaction as defined in Section 86 (a) of the ordinance?

Firstly, the court ruled that the determining preliminary condition in Section 86 (a) of the ordinance, had been established – Id est, the declared transaction had created a tax reduction.

Secondly, the court examined whether one of the causes listed in Section 86 (a) of the ordinance existed: “An artificial transaction,” a fictitious transaction, “non-activation of a kind of transfer” and/or “an undue tax avoidance or reduction.” On considering the question as mentioned earlier, the Court related to the following evidence:

1. The appellant’s letter to the company – In which the appellant offers to sell her shares for a consideration of $1 million because of conflicts related to the management of the company.
2. A letter on behalf of the company – An acquisition offer detailing the company’s offer to acquire the appellant’s shares (inter alia, by distributing a dividend to the appellant before the sale).
3. The General Meeting’s resolution – In which it was resolved to allow 110,000 class A ordinary shares, which do not impart any voting rights, to the appellant. It was further resolved to amend the company’s Articles of Association granting the General Meeting the authority to distribute a dividend to shareholders of a particular share class only (id est, the appellant).
4. The General Meeting’s resolution (after amending the articles) – In which it was resolved to distribute a dividend of NIS 3,485,000 to the appellant only (as a holder of class A shares).
5. The sale of the appellant’s shares for NIS 1,681,000 shortly after the resolution relating to the dividend distribution.

In view of the aforementioned, the court decided that the aforementioned activities lack any economic meaning, was not essential for executing the sale of the shares and, consequently, should be perceived as an artificial transaction. Furthermore, the court reprimanded the appellant for her conduct and ruled that reference was to “a procedure, the illegitimacy of which permeates from all parties to it.”

Despite the severe result that the Court reached, it should be noted that, in our opinion, a dividend can still be distributed close to the sale of the company (and thus reduce the company’s value for the sale), provided that the dividend distribution shall be pro rata to all shareholders according to their share in the company.

The aforementioned should not be perceived as a recommendation and/or expression of opinion. In all instances, we recommend receiving professional individual advice following the concrete circumstances of every event. We would be happy to be at your disposal for any queries and or explanations regarding this or any general issue.

Yours sincerely,

Lior Pick & Co. Legal Offices