Buying a Company at a Loss

Purchasing of a loss-making company for tax offsetting

Recently the Naawi case ruling brought back into discussion the longstanding issue of offsetting acquired losses or, more specifically, accumulated losses in a company that was purchased. In our view, this case highlights the continuing need for a permanent solution through primary legislation on the purchasing of a loss-making company for the purpose of tax offsetting. A solution would provide clarity for both sellers and buyers, preventing distortions and discrimination.

The issue at hand:

Despite the absence of any explicit prohibition, the Israeli Tax Authority generally doesn’t permit the offseting of accumulated losses in a company whose ownership has changed. They argue that in the overwhelming majority of cases, these losses should be annulled upon the sale of the company.

The Tax Authority’s stance, backed by court rulings, has led to an arms race between the Tax Authority and tax advisors/representatives.  Tax advisors have devised at least three tax planning methods which allow the transfer of control over a company while offsetting its losses. However, in response, the Tax Authority has established guidelines requiring companies to disclose when they are engaging in such tax plans and report them.

Do note, there is no absolute prohibition on utilizing these losses. Instead, it must be proven that the transaction had fundamental and economic rationale, and consideration of other similar alternatives that do not include (for whatever reason) a fiscal purpose. This requirement leads to market uncertainty regarding the issue, detrimental to both business and the Tax Authority.

In the words of Honorable Judge Yardenah Saroussi in the Naawi ruling itself:

” The principle prohibiting the acquisition of losses incurred (indirectly) by other shareholders, applies only when there is no fundamental or commercial purpose for acquiring control in the company and transferring the new profitable activities into it.

Therefore, the fact that the new controlling shareholders did not economically absorb the accumulated losses of the company, and the fact that there is not necessarily a connection between previous activities and new activities introduced to the company, by themselves does not necessarily avoid offsetting of the losses.

In almost every case in dispute concerning the acquisition of a loss-making company, the losses were inquired prior to the new acquisition and stemmed from activities different from the new ones.”     

Case Law Developments

The Rubenstein Case

This landmark ruling was handed down by the Supreme Court on July 31, 2003, by the then-President of the Court, Ahron Barak. In 1989, Yoav Rubinstein purchased Aquarium Fish, a company that raised ornamental fish, with accumulating losses exceeding four million shekels. Around six months later, the company’s name was changed to Yoav Rubenstein & Co. Ltd. and it exclusively engaged in real estate. When Rubenstein sought to offset his real estate profits with the accumulated losses from Aquarium Fish’s ornamental fish business, as permitted under Section 28(b) of the Income Tax Ordinance, the offset was rejected.

Upon first glance, Rubinstein’s offset was legal, as it aligned precisely with the language of Section 28(b) of the Ordinance. However, the Tax Assessor argued that it was an artificial transaction under Section 86 of the Ordinance. The section states that, “the Tax Assessor is authorized to disregard a transaction if they believe the transaction to be artificial or to have one of its primary purposes being tax avoidance or improper tax reduction.” Despite this, Section 86 proved to be a limited tool in Rubinstein’s case, and the district court reluctantly allowed the offset. It was only upon the Tax Authority’s appeal to the Supreme Court that the decision was reversed.

The Supreme Court ruled that Rubinstein has acquired Aquarium Fish with no economic, business, or commercial purpose, solely intending to reduce the tax burden for his real estate company.  This verdict established the precedent that behind any acquisition, there must be a legitimate purpose (i.e. rescuing a failing company, eliminating a competitor, acquiring a shell company, etc.). And only if this condition is met, can losses be offset.

The Ben Ari Case

In the 2008 Ben Ari case, the Supreme Court examined whether an individual who initially held a minority stake in a company with accumulated losses, and later acquired full ownership, could use those losses to offset their profits. In 1994, Shaul Ben Ari acquired 32% of Garage Hirschman Ltd. In 1997, after the company had accumulated losses and ceased operating, Ben Ari purchased the remaining shares at a reduced price, becoming the sole owner. Following this, he renamed the company “Ben Ari S. Insurance Agency.” In 1999, when Ben Ari attempted to offset his insurance agency profits against the company’s prior losses as a garage, the Tax Assessor stated that the transaction was artificial due to the sole goal being improper tax avoidance, as per Section 86 of The Ordinance.

The court ruled that there was no economic rationale for acquiring the company and transferring the profitable activity out of it, other than the purpose of offsetting the losses. However, the court allowed Ben Ari to offset 32% of the losses (the portion he held during the period the company accumulated its losses) against the profits transferred into the company.

Limiting the Rubenstein precedent in Ben Ari

The court distinguished between the two cases:

1. If there is no change in control (where the original shareholder holds over 51%, and the minority shareholders change) – the losses will be allowed for offsetting.
2. In the situation of loss of control, there are two cases:
   1. New majority shareholder acquires control: ‘A’ holds 51%, ‘B’ holds 49%, and ‘A’ sells to ‘C’- losses will not be allowed to be offset at all. (This ruling negatively impacts minority shareholders, even though they did not initiate any change!)
   2. The controlling shareholder sells control to the minority shareholders: In a situation similar to the first case, but where the controlling shareholder sells control to the minority shareholders, losses attributed to the former controlling shareholder will be cancelled, while losses specific to the minority shares will be recognized.

The Naawi Group Case

On January 20, 2020, the court ruled on Naawi Group’s appeal regarding its right to offset its profits against the losses of a publicly listed shell company it had purchased.

The story began with the acquisition of a publicly listed shell company with no business activity or assets and accumulated losses totaling 153 million NIS. In the years 2011-2013, Naawi Group offset its taxable income against these losses, saving 34 million NIS in taxes. The Tax Assessor denied the offset.

On appeal, Naawi Group argued that the Assessor had failed to meet the burden of proof that the transaction was artificial, and that there was business rationale for the purchase. The Tax Authority rejected these claims, stating that the very act of offsetting was proof of the tax-avoidant motive behind the acquisition.

The court dismissed the Naawi brother’s appeal, ruling that the acquisition was artificial and fiscally motivated, stating that, without the fiscal advantage the acquisition would not have occurred. The court’s decision in favor of the Tax Authority was based on the evidence showing that the Naawi brothers made no efforts to seek alternative shell companies for their business needs.

Mandatory Reporting on the Purchase of a Loss-Making Company

The 2006 income tax regulations on “Reportable Tax Planning”- require reporting to the Tax Authority when a loss-making company is acquired (Reportable Position 9/2016). The purpose is to enable the Tax Authority to examine whether the purchase was intended for loss offsetting. It’s important to remember that these regulations only apply when a tax benefit exceeds 5 million NIS in a single year or 10 million NIS over four years.

Critical and Philosophical Perspectives on the Acquistion of Loss-Making Companies for Tax Purposes:

Economically, there is logic in prohibiting the use of acquired losses, as it creates distortion- allowing the “duplication” of losses. For example;

Consider a company with accumulated losses of 1 million NIS and no other assets. Let’s assume, for simplicity, that the accounting losses are identical to the tax losses and that the controlling shareholder sells the company’s losses for tax shield value. (These assumptions aren’t very realistic, as there are always differences between accounting and tax losses and the seller will always sell the losses at a lower amount then the tax shield value in order to incentivize the buyer to proceed with the purchase).

The result is absurd- a “duplication of loss” is the amount of the difference between the original loss and the tax asset retained by the selling shareholder, in addition to the loss sold with the company.

Nonetheless, there are also substantial arguments that lead to the opposite conclusion

• Economic Rationale: Companies with accumulated losses are those with owners who paid (usually from their own pocket) for the expenses that caused those losses. Meaning, they paid for their share of the tax burden. There is no reason why these owners should not be able to reduce their losses upon sale in the amount of the tax asset resulting from the accumulated losses of the company. Especially in a situation where the shareholder is retiring. After all, if there has been a profit-the profit would have been taxable!
• Public Policy: A macroeconomic interest, in which shareholders know they will have a tax shield on losses can also reduce actual losses. In the Naawi ruling, the acquisition itself of the public shell company helped pay off all its outstanding debts when operations ceased and even returned some value to the public shareholders (which, in turn, can be translated into capital gains on which tax is paid!)

Preventing Discrimination

• In the situation that a minority shareholder sells their shares without transferring control, as established in the Ben Ari Case, there is no problem in ” selling the losses” and factoring them into the sale price. In a case like this, there is discrimination between minority shareholders and controlling shareholders, discrimination without any reasonable economic, logical basis.
• Minority shareholders are discriminated again once again- they have no actual ability to prevent majority shareholders from selling their holdings in the company, a situation that automatically reduces their equity by an amount equal to the product of the corporate tax rate and their share of the accumulated losses. Sometimes, this can be a significant amount, and there is no reason to harm their equity due to actions not done by them.
• There are at least three (legal) tax planning methods which allow a bypass of this restriction.
• Tax rulings set by the ‘Mergers and Splits Department’ at the Tax Authority have, in many cases, allowed offsetting losses in cases of transfer control during a merger (under certain conditions and limitations). This indicates that even the Tax Authority recognizes the logic of approving transfer losses from one entity to another in certain cases.

Encouraging Economic Growth:

Allowing shareholders of loss-making companies to sell their accumulated losses could help facilitate various transactions in the market. Especially, in the post-COVID era, where many companies didn’t survive and ceased to operate. Such companies, can utilize their accumulated losses as an additional asset. This allows shareholders to minimize their personal losses, move forward with a new venture or business, and ultimately stimulates economic activity.

Proposal for Balance and Legislative Amendment for the Acquisition of a Loss-Making Company for Tax Purposes:

In our view, the optimal way to address this issue is through establishing, in primary legislation, a fixed mechanism for utilizing losses in cases of transfer control in a loss-making company.

This mechanism will protect the economic rationale of utilizing appropriate losses while preserving the principle of symmetry so that the transaction is reflected uniformly between the seller and the buyer. Our proposal is to establish that the seller and buyer may agree on one or two tax treatment mechanisms for the acquired company’s losses.

1. The purchase of a loss-making company grants the buyer to offset the losses against the company’s future profits, while the seller reduces their capital losses created in the transaction (or adds to the capital gains) by multiplying the company’s accumulated losses by one minus the corporate tax rate applicable in the year following the sale.
2. The seller retains their capital losses, but the company’s tax losses are reset.

It must be established that if there is no specific reference in the company sale agreement- the second method will apply automatically.

In Conclusion

Based on the language of the law and previous cases presented, we conclude that the courts do not necessarily claim all transactions involving the acquisition of companies with accumulated losses as artificial ones. However, the buyer must demonstrate a clear business or economic purpose for the acquisition that outweighs the fiscal motivation. There are tax planning strategies that can reduce exposure in such cases, and we there is room for a fresh examination and structured legislation on the matter.