Tax Update | November 2020

Capital Notes, Transfer Pricing and Taxation of Financing Income between Related Companies

It is common among international companies with operations in different countries to transfer funds via the provision of loans, capital investments or capital notes, in the context of financing activities or the acquisition of companies.

There was a recent ruling decided in the District Court in Barzani Brothers (1974) Ltd.. Tax Appeal54727-02-17  and Tax Appeal 54659-02-17 (the “Ruling”), which dealt with the classification of the financing provided by Barzani Brothers (1974) Ltd. (“Barzani”), an Israeli parent company, to its foreign subsidiaries.

In the Ruling proceedings, Barzani claimed that the financings that were provided to several subsidiaries in Romania (the “Foreign Companies”) were within the category of capital notes and accordingly not subject to interest and linkage differential payments, and therefore, Barzani did not report interest income in its tax returns.

However, the Tax Assessment Officer and the court rejected this claim, since in the context of the loan agreements with the foreign companies it was explicitly stated that the loans bear interest, and in their subsidiaries’ tax returns, interest expenses were recorded.

Barzani claimed that the original loan agreements contained an error and subsequent to the discovery of this error the agreements were amended, reflecting that the transaction was a capital note investment. However, this claim was rejected by the court due to several factual reasons and that in addition, Romanian law does not recognize a “capital note” instrument and therefore it is unclear how the foreign companies could issue capital notes.

The court also ruled that the fact that the contractual interest was not paid to Barzani does not negate the tax liability by Barzani.

In general, international transactions within a group of companies are examined in accordance with the provisions of Section 85A of the Income Tax Ordinance (“ITO”). Notwithstanding the above, it is established that financings that comply with the conditions of such section, such as by meeting the definition of a capital note, are excluded from the applicability of this section, provided that the following conditions are satisfied:

  1. The recipient of the loan is a body of persons under the control of the lender;
  2. The loan is not linked to any index and does not carry any interest or yield (for these purposes, the exchange rate of the currency will not be considered as an index if the currency of the loan is the currency of the borrower’s country);
  3. The loan is not repayable before the end of a period of 5 years from the date of its grant;
  4. The repayment of the loan is subordinate to other liabilities and precedes only the distribution of assets to the shareholders in liquidation.

In the Ruling, since Barzani’s claim was rejected, the court ruled that the intercompany loan was interest bearing and therefore, Section 85A of the ITO applies. As a result, the court ruled that the tax calculation of the intercompany loan should be determined by the interest rate in accordance with market conditions, and not based on the agreements between the parties.

The Ruling once again clarified that a financing transaction that claims to be a “capital note” and does not meet the requirements for an exception set forth in Section 85 of the Income Tax Ordinance, will be classified by the Israel Tax Authority as a loan. In such a case, conceptual interest income will be attributed to the Israeli company; the interest rate will be determined by market value conditions; tax will be owed on the conceptual interest income; and there is an exposure to double taxation and

excess tax while the interest is not recorded as an expense to the subsidiary.

There is no doubt that the result of a reclassification of a capital note as a loan has significant tax consequences for a company. Therefore, we recommend examining the intercompany financing arrangements, especially in those circumstances in which an Israeli company provides financing to a foreign subsidiary, and we specifically emphasize the importance of:

  • Compliance with the criteria set for the exclusion of a “capital note” from the application of Section 85A of the ITO.
  • The existence of intercompany agreements that reflect and document the intercompany financing.
  • The classification and presentation of the financing in the financial statements of each of the companies in the group.
  • The analysis of VAT aspects which relate to the intercompany financing.


For further information regarding this update, please contact Adv. Oren Biran, Partner, Head of Tax Practice – 

Gross, Kleinhendler, Hodak, Halevy, Greenberg, Shenhav & Co. (GKH), is one of the leading law firms in Israel, with over 170 attorneys. GKH specializes, both in Israel and abroad, in various fields of law including Mergers and Acquisitions, Capital Markets, Technology, Healthcare and Life Science, Banking, Real Estate, Project Finance, Litigation, Antitrust, Energy and Infrastructure, Environmental Law, Intellectual Property, Labor Law and Tax.
This alert is prepared as an informational service to clients and colleagues of Gross, Kleinhendler, Hodak, Halevy, Greenberg, Shenhav & Co. (GKH) and the information presented is not intended to provide legal opinions or advice. Readers should seek professional legal advice regarding the matters about which they are particularly concerned.

Oren Biran

Phone +972-3-6074547

Download vCard