Deemed loan interest

The District Court has ruled that large interestfree loans from a US parent corporation to an Israeli subsidiary company are not OK (eBay Israel Holdings Ltd vs. Netanya Assessing Officer, civil appeal 51066-03-20, of December 5, 2023). But the judgment has many twists and turns, and some Hebrew writeups appear to have missed the point. The judge was Shmuel Bornstein, who used to be a tax practitioner himself.

Main facts

In 2005, eBay Inc. (the US parent corporation) set up an Israeli company (eBay Holdings Ltd or the taxpayer) to buy and hold all the shares in a successful Israeli hi-tech company, Shopping.com, for $685 million.

To finance the deal, the parent corporation invested $45 million in the equity share capital of eBay Holdings Ltd and lent it a further $635 million (which adds up to $680 million). This loan was repayable upon demand after no fixed period, and no interest was due. The loan was received on August 30, 2005.

After two years, eBay Holdings Ltd repaid the US parent corporation $133 million of the loan. It also made a tax-free repayment of $110 million of the share capital. (It is not clear from the judgment how $110 million of capital was repaid if the capital invested was only $45 million).

The Israeli Tax Authority (ITA) allowed these payments to be made to the US parent corporation without withholding tax and then changed its mind, saying the loan should have borne interest at the “arm’s length” market rate under Section 85A of the Israeli Income Tax Ordinance (ITO). Section 85A deals with “transfer pricing” of international intercompany transactions, where one company controls 50% or more of any means of control of the other, directly or indirectly.

In 2018, $230 million of the loan was repaid, and the rest was turned into an interestfree “capital note” for at least five years. The Israeli company (eBay Holdings) applied regulations allowing dollarbased tax reporting.

The issue

The issue in this case was whether the ITA could insist on an arm’s length interest on the intercompany loan from eBay Inc. to its Israeli subsidiary, eBay Holdings Ltd. This is an important question for multinational groups. Interestfree

loans can be repaid without tax or withholding tax. By contrast, dividends out of profits are subject to withholding tax (up to 25%), as is interest, if it exists.

The ITA didn’t want $635 million of profits to be paid to the US parent corporation under the guise of loan repayments rather than dividends and interest.

Meandering discussion

In the judgment, the Court said the dollar tax regulations changed nothing. The taxpayer initially argued that loans repayable upon demand count as capital notes and there was no need to recognize interest on them. The Court disagreed, saying repayable upon demand pre-2018 did not meet a five-year minimum term required under various Israeli tax laws and that part of the loan was repaid after only two years in 2007. The Court ruled that Section 85A was the wrong section; it only became effective in Israel in 2006, after the loan was made. This would have implied that no interest needs to be recognized. So the ITA changed its mind again, saying that interest may be deemed at an annually prescribed rate under Section 3(j) (“Shalosh Yud”) of the Income Taxed Ordinance. The Court agreed, partly because the taxpayer had no right to appeal if forced to record more expenses (the interest at issue) under ITO Section 152(b).

To sum up, the Court allowed the ITA to recognize deemed interest expense under Section 3(J) and presumably levy withholding tax on that deemed interest.

Comments

Assuming the above figures are correct, the debt-equity group financing of eBay Holdings Ltd was initially high, perhaps around 93%:7%.

Subject to any appeal, the ITA may collect up to 25% withholding tax on deemed interest over many years. Questions arising include: (1) Will fines also be imposed for lateness? (2) Will the US Internal Revenue Service grant a foreign tax credit? and (3) Will a VAT of 17% also be imposed? Methods of avoiding this exist, but time limits and conditions apply.

More generally, Israel lacks “thin capitalization” rules restricting actual interest expense deductions where a high level of leverage exists – say 93% initially, in this case. Israel has a general antiavoidance rule against artificial or fictitious transactions but it wasn’t used in this case.