In a recently published ruling on the matter of Rosebud, the question of classification of income from sale of shares and real estate was discussed with regard to defining a CFC – Controlled Foreign Corporation.
Summary of the main facts of the case:
Rosebud Assets (Europe) Ltd. (“the Company”), a subsidiary of Rosebud Real Estate Ltd., an Israeli public company, holds full control of a subsidiary located in Holland (“Rose”), which has subsidiaries incorporated in Luxembourg. At the end of 2006, those Luxembourgian companies sold real estate for 134 million Euro without being charged tax abroad for the profit earned from the sale (“Asset Sale Transaction”). Furthermore, in August 2006, Rose purchased shares of Rosepark (a foreign company) which held an office building in Zurich, and two years later sold its shares (“Share Sale Transaction”).
The dispute revolved mainly around whether the Asset Sale and Share Sale Transactions constituted passive income for the purpose of applying CFC rules, as claimed by the income tax assessor who charged the company as if it received a dividend from Rose and the Luxembourgian companies; or, alternately, it was income from business, such that CFC rules do not apply, hence the company is exempt from being taxed in Israel? One of the fundamental conditions for classifying a foreign resident company as a CFC is either that “most of its income in the tax year is passive income or most of its earnings are derived from passive income”.
Tax Authority’s position:
Both the Asset Transaction and the Share Sale Transaction are classified as passive income: First of all, sale of an asset is considered passive since it terminates activity; secondly, the separate personality principle, i.e., each transaction is measured in the reflection of the company performing the sale; in other words, the return is from sale of an asset not used by the company in its business or occupation. Finally, the income tax assessor explained that the company was not taxed for the transactions made abroad; hence, it would be unacceptable for it not to be taxed in Israel either.
Position of the tax-paying company:
The income is active (from business): The holding of assets abroad through an international structure (i.e., through separate “Special Purpose Company”) does not make the holding company a CFC; rather, an integral part of the group’s activity including locating, purchasing, foreign financing, holding the asset, betterment and sale. All of these indicate characteristics of income from business.
Since this is a single business enterprise dealing in locating, managing, betterment and sale of real estate, and since the funds from the sale were used by the group’s sister companies through a dividend and loans, the court examined the income classification as business or passive and, in a precedential ruling, decided that with regard to application of CFC, with an overall view of the cluster of companies in the group, rather than the isolated activity of each individual company, the stated income shall not be seen as “passive income”. Thus, the appeal by the taxpayer on this issue was accepted.
We note that, by the nature of things, the court did not address the amendment of legislation on the matter of defining “passive income” in CFC rules (carried out only in 2014). In the amendment it was decided that returns from sale of a security, even when constituting income from a business shall be considered passive income, unless the security was held for less than a year and it was proven to the income tax assessor’s satisfaction that it served the company in business or occupation. In other words, with regard to the Share Sale Transaction, the new rules reinforce the position of the income tax assessor since the Rosepark shares sold, as stated above, had been held for over a year.
In addition, it is worth noting that all CFC rules apply, as stated, to a foreign resident company. A foreign company controlled and managed in Israel becomes a resident of Israel, and owes regular Israeli companies tax. On the matter of examining the overall activity in the entire cluster starting from the apex – from mother companies in Israel to target companies abroad, the issue of “control and management” is liable to arise in the foreign companies. The Tax Authority has not raised an alternative claim on the matter of control and management from Israel; hence, the court has not discussed this matter despite having taken the trouble to illuminate it.