Underlying Legal and Regulatory Framework of Office of the Chief Scientist of the Israeli Ministry of the Economy

By Raz Tepper | Jan 2014 | Publication

1. General

 The Office of the Chief Scientist (“OCS”) of the Israeli Ministry of the Economy oversees all Israeli Government sponsored support of research and development (“R&D”) in the Israeli industry.[1] Pursuant to the Encouragement of Industrial Research and Development Law, 1984 and the regulations promulgated thereunder (the “R&D Law”),[2] the OCS provides Israeli companies (each, a “Recipient”) with grants to fund their R&D activities. This governmental support is conditioned upon the Recipient’s ability to comply with certain requirements specified in the R&D Law, in the OCS’s rules and in the specific grant approvals. The R&D Law and the OCS rules can have significant implications for transactions between Recipients and non – Israeli companies, as further detailed below.

2. Royalties

Under the R&D Law, R&D programs that meet specified criteria and are approved by the OCS’s research committee (the “Approved Program” and the “Research Committee”, respectively) are eligible for grants of up to 50% of the approved expenditures incurred in connection with such Approved Programs. In exchange, the Recipient is required to pay the OCS royalties at rates ranging from 3% to 6%[3] (or at the Increased Rate, as defined below) of the revenues arising from products incorporating know-how developed within or derived from the Approved Program (the “Know-How”)  or from ancillary services provided in connection therewith (collectively, the “Products”), up to an aggregate of 100% of the dollar-linked value of the total grants received in respect of the Approved Program (or up to the Enlarged Royalty Ceiling, as defined below), plus interest.

The Recipient must submit to the OCS periodic reports regarding the royalties that are payable. The OCS has a right to inspect the Recipient’s books, usually for a period of seven years from the commencement of the Approved Program, or six years from submission of the final report, whichever is later. The restrictions regarding Transfer of Manufacturing and Transfer of Know-How detailed below continue to apply even after payment of the royalties in their entirety.

3. Changes to the Approved Program  

Under the R&D Law, any changes made to the Approved Program, including with respect to the identity of the party carrying out of the Approved Program, the budget, the definition of the Products, and similar matters, are subject to the prior approval of the OCS.

4. Transfer of Means of Control

Recipients must notify the OCS if their “Means of Control” are transferred to foreign companies, with the result that the foreign residents become “Interested Parties” (as defined in the Israeli Securities Law-1968)[4] in the company. “Means of Control” means the right to vote at a general meeting of a company or a corresponding body of another company, and (ii) the right to appoint directors of the company or its general manager. The transfer of the Means of Control requires the foreign company to execute an undertaking to adhere to the R&D Law (the “Undertaking”).

5. Creation a Pledge Over the Know-How

A transaction between the Recipient and a third party resulting in the creation of a pledge over the Know-How is subject to the OCS’ prior approval. If the third party is a foreign company, the creation of the pledge requires the foreign company to execute the Undertaking.

6. Liquidation and Bankruptcy Proceedings

If a liquidation proceeding, or a request for bankruptcy proceeding or any other arrangement with creditors is undertaken or filed against the Recipient or if the Recipient undergoes a voluntary liquidation, the OCS must be notified within the time periods set forth in the R&D Law. If the court appoints a liquidator or similar officer for the Recipient (the “Officer”), the Officer is required to notify the OCS.

7. Territorial Limitations on Manufacturing and Transfer of Manufacturing

The R&D Law requires the Recipient to declare in its grant application the scope of manufacturing and the percentage of the added value[5] in Israel with respect to the Products (the “Declared Manufacture and Added Value Percentage”). In the event that the Recipient declares that the manufacturing is conducted outside Israel, the royalty rate is (A) increased by 1%, if the manufacture outside Israel is effected by the Recipient (or by a “Related Corporation” [6]), or (B) set at a rate equal to the total grants received by the Recipient divided by the total grants plus the Recipient’s investments in the Approved Program (as determined by the OCS), if the manufacture outside Israel is effected by a third party (the “Increased Rate”).

The Recipient must obtain OCS approval to transfer the manufacture of the Products or to transfer of manufacturing rights[7] outside Israel (collectively, the “Transfer of Manufacturing”), if such Transfer of Manufacturing results in the decrease of the percentage of manufacturing in Israel relative to the Declared Manufacture and Added Value Percentage. The OCS’ approval of a Transfer of Manufacturing is conditioned upon (A) payment of the Increased Rate, and (B) (i) payment of an aggregate amount of up to 300% of the grant (the “Enlarged Royalty Ceiling”)[8],or (b) the reciprocal import to Israel of manufacturing and/or manufacturing rights of a product having at least the same degree of technological complexity as the product transferred outside of Israel; provided that the scope of employment and creation of new jobs in Israel, the rate of added value in Israel and the overall scope of marketing to the international market that are expected to be achieved by such transfer of manufacturing and/or manufacturing rights into Israel will not be less than those similar rights that are expected to be achieved by the manufacturing and/or the manufacturing rights to be transferred outside Israel (the “Alternative Manufacturing”). In such cases, the Recipient must provide the OCS with a guarantee issued by a bank (in an amount to be determined by the Research Committee) to secure the Alternative Manufacturing.

However, where the Transfer of Manufacturing, together with previous Transfers of Manufacturing, results in a decrease of manufacturing in Israel of no more than 10% of the Declared Manufacture and Added Value Percentage, only notification to the OCS is required, but the OCS may object to the transfer and/or require the Enlarged Royalty Ceiling. If the OCS does not object to the transfer within 30 days, then the transfer is deemed approved.

8. Transfer of Know-How Outside Israel

The R&D Law provides that the Know-How may not be transferred to third parties outside Israel, except in certain circumstances and subject to the OCS’ prior approval and the payment of additional consideration by the Recipient to the OCS (the “Transfer Fee”), as further detailed below:

8.1          Sale of the Know-How. In a transaction for the sale of the Know-How only, the consideration required to be paid by the Recipient to the OCS is equal to: (A) the ratio of: (i) the aggregate grants received by the Recipient under the R&D Law, to (ii) the aggregate financial investments made by the Recipient in executing the Approved Program, multiplied by (B) the actual sale price of the Know-How; provided that the amount so paid shall not be less than the aggregate grants plus interest (the “Basic Amount for Sale of Know-How”).

8.2          Sale of Recipient. The consideration required to be paid by the Recipient to the OCS, in a transaction in which the Recipient ceases to be a company organized in Israel (a “Sale of the Recipient“) , is equal to: (A) the ratio of: (i) the aggregate grants received by the Recipient under the R&D Law, to (ii) the aggregate investments made by the Recipient in R&D (less the amounts invested in financial assets), multiplied by (B) the actual sale price for the Recipient; provided that the amount so paid shall not be less than the aggregate grants, plus interest (the “Basic Amount for Sale of the Recipient” and, together with the Basic Amount for the sale of Know-How, the “Basic Amount”).

To the extent that the consideration for the Sale of the Recipient is comprised (in whole or in part) of shares of the acquirer (“Consideration in Shares”) and the difference between the sale price for the Recipient and the Consideration in Shares (the “Cash Consideration”) is lower than the Transfer Fee, then, subject to the prior approval of the Research Committee, the Recipient will pay the OCS the Cash Consideration and the payment of the remaining amount (i.e., the difference between the Transfer Fee and the Cash Consideration) will be postponed, subject to the pledge of the shares received as consideration for the sale of the Recipient, for the benefit of the State.

Certain deductions are made to the outcome obtained from the foregoing formulas. First, the R&D Law provides that the outcome obtained by subtracting the grants plus interest from the applicable Basic Amount is amortized, on a linear basis, over a period of seven years commencing three years following the completion of the R&D activities under the Approved Program. Second, the royalties actually paid by the Recipient to the OCS are also subtracted (“Reduction in Payment”).

Under the R&D Law the maximum payment to the OCS, when utilizing the foregoing formulas, is capped at six times the aggregate total of the grants received by the Recipient in connection with the transferred Know-How, plus interest, in the case of a sale of the Know-How (as provided under Section 8.1 above), and at six times the aggregate total grants received by the Recipient (as provided under Section 8.2 above), in the case of a Sale of the Recipient.[9]

If, however, subject to the determination of the Research Committee, the acquirer of the Know-How undertakes to maintain the Recipient’s R&D activity in Israel after the transfer of the Know-How, the maximum OCS payment described above is set at three times the aggregate total of the grants received by the Recipient (in connection with the Know-How being transferred or any and all grants, as the case may be) plus interest. Specifically, the undertaking requires, even after the transfer of the Know-How, the employment in Israel of 75% of the Recipient’s R&D employees (calculated based on the average number of such employees in the six months prior to the submission of the request to transfer the Know-How out of Israel) during the three-year period following this payment to the OCS. In such a case, the Research Committee may also condition its approval of the transfer of the Know-How on the deposit of a security interest to guarantee the difference between the assessed payments, i.e., the difference between three times and six times the aggregate grants received by the Recipient (in connection with the Know-How being transferred or any and all grants, as the case may be).

8.3          Exchange of Know-How. A transfer of the Know-How in exchange for alternative know-how, where the Research Committee finds that the benefit for Israel from such alternative know-how is greater than its benefit from the Know-How transferred outside Israel, does not require the payment of any consideration. In such cases, the alternative know-how is deemed to have been developed under the original Approved Program and, therefore, is not subject to the provisions of the R&D Law.[10]

8.4          Liquidation. If the transfer of Know-How outside Israel is incidental to a liquidation and the sale price (of the Know-How or of the Recipient, as the case may be) is lower than the aggregate financial investments made by the Recipient in executing the Approved Program or invested in the Recipient, as the case may be, the OCS may prescribe that the provision requiring the applicable Basic Amount to be not less than the aggregate of the grants plus interest will not apply. However, in such a case no Reduction in Payments will be made.

In certain circumstances the Research Committee has the authority to determine the sale price (of the Know-How or of the Recipient, as the case may be). Such circumstances include a sale (i) without consideration; (ii) between related companies; (iii) through merger, or (iv) that the Research Committee believes was consummated for unrealistic consideration.

The transfer of Know-How outside Israel that is not effected in compliance with the R&D Law is a criminal offense, punishable by up to three years in prison.

9. License Agreements

The grants by the Recipient of a license to an Israeli resident and to a foreign resident are treated differently. The grant by the Recipient of a license to an Israeli company is regulated by the OCS rules and is subject to the prior approval of the OCS. In certain cases, the licensee may be required to repay the grants received by the Recipient with respect to the subject Know-How, in whole or in part. This issue should be addressed in the license agreement between the Recipient and the licensee.

To date, the grant by the Recipient of a license to a foreign resident to use the Know-How has not yet been regulated under the R&D Law.[11] As long as the license is limited to “license to use/sell of Products”, the OCS views such a license as a sale of Products by the Recipient, and the Recipient is required to pay royalties. However, if the license is not limited to use, but provides the licensee with broader rights, such as rights to research and develop the Products, the license will be considered as a transfer of Know-How, which is subject to the approval of the OCS and the payment of the applicable Transfer Fee.

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[2]A “free translation” of the Encouragement of Industrial Research and Development Law, 1984 is available on the OCS website; see http://www.moital.gov.il/NR/exeres/9F263279-B1F7-4E42-828A-4B84160F7684.htm

[3] While the regulations under the R&D Law state that the royalty rate may, under certain circumstances, be raised up to 6%, in practice, and in accordance with the OCS rules, the rate typically is increased only up to 3.5%, beginning with the fourth year of repayment of the grants (unless otherwise increased as a result of manufacturing or transferring the manufacture outside Israel, as described in Section 7 below).

[4] Anyone holding 5% or more of the issued share capital of the company or of the voting power therein, anyone who is entitled to appoint one or more of the directors of the company or its general manager, anyone holding an office as a director of the company or as its general manager, or a company in which a person as aforesaid holds 25% of the issued share capital or of the voting rights, or is entitled to appoint 25% or more of its directors.

[5] The Declared Manufacturing and Added Value Percentage is defined in the R&D Law, with regard to a Product, as the amount of the manufacturing costs carried out in a particular country, less “imported” costs for the purpose of manufacturing in such country, compared with the price of the Product ex works.

[6] “Related Corporation” means any of the following: (i) a company that is Controlled, directly or indirectly, by the Recipient; (ii) a party that Controls, directly or indirectly, the Recipient; (iii) a company that is Controlled, either directly or indirectly, by a party to which the provisions of sub-sections (i) or (ii) apply, or by the party that received an approval in the manner set out in sub-section (iv), or (iv) a party that received approval to manufacture the Product from the Recipient or from a party to whom sub-sections (i) to (iii) apply. Control has the meaning assigned to this term in the Israeli Securities Law-1968, i.e., “the ability to direct the activity of a company, excluding an ability deriving merely from holding an office of director or another office in the corporation, and a person shall be presumed to control a company if he or she holds half or more of a certain type of Means of Control of the company”.

[7]A “transfer of manufacturing rights” is defined under the R&D Law as “an authorization to a third party to use Know-How developed in the scope of or resulting from an Approved Plan, for the purpose of manufacturing a particular Product only, while all the remaining rights to use and exploit the Know-How remain vested in the transferor in Israel”.

[8] The extent of the Enlarged Royalty Ceiling depends on the portion of the manufacturing volume carried on outside Israel.

[9] The regulations provide that if the Recipient receives an approval to sell the Know-How and thereafter applies to effect a Sale of the Recipient, the Research Committee may, at its discretion, deduct from the Transfer Fee required to be paid in connection with the Sale of the Recipient, any Transfer Fee paid in connection with the sale of the Know-How.

[10] Similar provisions apply with respect to sharing the Know-How of the Recipient with a third party outside Israel, in exchange for sharing know-how of such third party with the Recipient, provided that such sharing is made for the purpose of new and joint research and development.

[11]Although the R&D Law provides the Ministers of the Economy with the authority to enact regulations with respect to the grant of a license to use the Know How to a foreign residents no such regulations have been enacted to date.

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