Business and economic substance

tax benefits|business purpose|Israel Tax

Dr. Avi Nov, Adv.

September 2009

In examining the term “business and economic substance”, Israeli case law has referred to US legal literature and jurisprudence. Accordingly, a transfer of assets should be disregarded if it lacks a business purpose. In the case of Smith v. Commissioner, the US Supreme Court concluded that “transactions, which do not vary control or change the flow of economic benefits, are to be dismissed from consideration”.

In this regard, subsequent US court decisions have held that where there is a genuine transaction with economic substance, motivated by business realities and non-tax considerations, and is not shaped solely by tax avoidance features, it should be upheld by the authorities.

In Merryman v. Commissioner, 873 F.2d 879, 881 (5th Cir. 1989), and Holladay v. Commissioner, 649 F.2d 1176, 1179 (5th Cir. Unit B 1981), the courts ruled that the existence of a tax benefit resulting from a transaction, does not automatically make it a sham or artificial transaction as long as the said transaction is imbued with tax-independent considerations.

In the Compaq decision, in an attempt to determine the nature of a transaction, the court indicated a two-prong test:

  • Is the transaction motivated by no business purpose other than obtaining tax benefits; and
  • whether the transaction has no economic substance because no reasonable possibility of profit exists.

The court noted that in the context of determining business purpose, a taxpayer’s subjective attempt to avoid taxes would not, in itself, determine the absence of business purpose. Even if the taxpayer sought to obtain otherwise unavailable tax benefits, this would not necessarily invalidate the transaction.

If, for example, a corporate structure lacks business rationale or economic substance, then section 86 of the Israel Tax Ordinance may be applied to disregard the structure. See also: Artificial Transaction in Israel tax law.

However, even in the event that the corporate structure is deemed artificial under section 86 of the Israel Tax Ordinance, the question remains whether, in light of international tax practice, section 86 would apply to a corporate structure involving a company from a treaty country, essentially overriding provisions of the Israel specific tax treaty.
Dr. Avi Nov Law Offices, Israeli & international tax law 
*This article is intended for informative purposes only and is in no way to be construed as tax advice or a legal opinion

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