Precedent: Forfeiture of bank guarantees due to contractor collapse entitles to VAT refunds of millions of shekels

The forfeiture of bank guarantees due to the collapse of a contracting company entitles the collapsing company to a VAT refund of millions of shekels — this was ruled by Tel Aviv District Court Judge Yardena Sarusi. She accepted the argument of the construction companies "Ortam Sahar" and "Malibu," which are in liquidation, that the forfeiture of guarantees they provided as part of incomplete construction projects reduced the consideration for these transactions, and therefore also the VAT they were required to pay.

The ruling rejected the argument of the Gush Dan VAT manager that VAT should not be refunded because it is a retroactive compensation and not a change in the original transaction price. The court noted that "accepting the VAT manager's position could lead to double taxation." The Tax Authority was also ordered to pay 75,000 shekels in legal costs to the companies in liquidation.

The ruling, which is expected to affect the real estate industry and insolvent companies, confirmed that the forfeiture of guarantees constitutes a "reduction of transaction price" that entitles the companies to a tax refund. Judge Sarusi determined that changes in the price of transactions require the Tax Authority to refund the VAT paid in excess.

Facts of the case: the companies collapsed and guarantees were forfeited

The decision was given in the case of the company Ortam Sahar Engineering, which was a public contracting company whose shares were traded on the Tel Aviv Stock Exchange, and which fell into insolvency proceedings about a decade ago. The company had two subsidiaries — "Malibu" and "Ortam Sahar Infrastructure" — which were also included in the stay of proceedings.

The companies entered into lump-sum agreements with clients, where consideration is fixed and paid against the execution of work. To secure their obligations, they provided autonomous bank guarantees for performance and warranty service. Between 2016 and 2019, due to financial difficulties, the companies could not fulfill their obligations, and clients requested the forfeiture of these guarantees. Agreements were reached whereby only a portion of the guarantee was forfeited, corresponding to the damages actually incurred by the clients.

The dispute: reduction of consideration and tax

The companies issued credit notes to the clients, reducing the original transaction price, and on this basis, reduced the sales tax paid to the VAT manager by approximately 12 million shekels. The VAT manager argued that the forfeiture of guarantees was compensation for damages, not a change in the transaction price, and that the companies had failed to comply with bookkeeping rules.

In the appeal filed by Adv. Shay Berger and Adv. Raquel Sheinwald, it was argued that VAT liability is derived from the consideration agreed upon between the parties, and any reduction of this consideration due to non-compliance with contract terms should lead to a tax adjustment. The Tax Authority argued that the guarantees belong to the bank and their forfeiture is a separate system of relationships that does not affect the underlying transaction.

Decision and implications

Judge Sarusi stated:

"The appellants undertook to perform certain work within a certain period of time. In exchange for fulfilling these obligations, the clients agreed to pay a certain price. However, the appellants did not fulfill their obligations. The forfeiture of the guarantees adjusted the original transaction price to the value of the work actually performed."

Adv. Raquel Sheinwald noted that this ruling has broad implications for contractors who are often forced to pay compensation to clients for delays or defects. The decision recognizes the entitlement of a business that pays compensation to a buyer due to non-compliance with contractual obligations to adjust the transaction price and refund sales tax paid in excess, in accordance with the scope of the service actually provided.

The Tax Authority responded that it is studying the ruling and will make a decision accordingly.