Can a Loan provided by a Parent Company be Retrospectively Classified as a “Capital Note”? 

22 January, 2024

In various instances, we encounter scenarios where companies overseeing subsidiaries fund these subsidiaries without initially classifying the nature of the cash flow, whether as an investment or debt.

Even when it is evident that the cash transfer constitutes debt, parties often neglect to create a written contract. Consequently, there is typically no clear documentation referencing loan terms, including interest rates, loan default dates, and so forth.

The Israeli Income Tax Ordinance[1] specifies that, concerning loans issued by an Israeli company to its subsidiary, if the loan is not subject to interest, or has an interest rate lower than the FMV interest rate set by the Minister of Finance (2.9% per annum for the tax year 2023; the next update is due in March 2024), the disparity between the determined rate and the market rate is deemed notional income for the lending party.

In cases of international group loans, such as when a foreign parent company extends a loan to an Israeli subsidiary, the interest rate must adhere to the arm’s length principle, according to transfer price rules. However, in both instances, no notional interest will be considered income (and no FMV interest rate determined in international transactions) if the loan is provided under a capital note by the lender, subject to several conditions, the primary one being that the loan remains interest-free and may not be repaid before a five-year period from the loan date.

In cases where funds have been transferred and recorded as loans without a written agreement, the question arises: can the parties retroactively claim that the original loan is, in fact, a capital note, if it retrospectively meets the conditions regarding capital notes? 

An answer was provided by the Central District Court on December 5, 2023, in the case of eBay Israel Holdings Ltd[2]. The main issue revolved around classifying a loan from the American parent company to its Israeli subsidiary. After five years, only 20% of the principal amount had been repaid, and the remaining amount was outstanding.

The company argued that the loan was intended to be a non-interest-bearing capital note, citing the absence of interest, the majority of the principal amount remaining unpaid after five years, and the loan’s long-term nature.

Despite the lack of a specific definition for “capital note”, the Court ruled that the nature of the loan should be examined as at the date it was granted, and the original terms of the agreement should determine its tax classification.

Without a written agreement stating a five-year non-repayment condition, it is implied that the lending party retains the right to demand repayment at any time, even before the end of five years from the grant date.

In this specific case, partial repayment of the loan before the end of the five-year term did not benefit the company’s case. When repayment conditions rely on the parties’ discretion, the loan cannot be deemed a capital note. Consequently, it was held, such a loan cannot be classified as a capital note.

Although this judgment is from the District Court and subject to dispute or appeal to the Supreme Court, it is strongly advised that companies take necessary precautions to ensure that any fund flow between related parties, especially when categorized as a loan, involves a written agreement explicitly setting out the loan terms.

[1] Income Tax Ordinance [New Version] 5721-1961
[2] Civil Appeal 51066-03-20 eBay Israel Holdings Ltd Vs. Netanya Assessing Officer  

The information presented here is of a general nature and is not intended to answer the unique circumstances of any individual or entity. Although we strive to provide accurate and available information, we cannot guarantee the accuracy of the information on the day it is received, nor that the information will continue to be accurate in the future. Do not act on the information presented without appropriate professional advice after a comprehensive and thorough examination of the specific situation.

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