Israel's R&D Law - the impact of change

The 2003 and 2005 changes to the Encouragement for R&D in Industry Law 1984 will have a major liberalizing effect on the way Israeli high-tech companies operate in the global market. Part one of a two-part series.

1. Introduction

Recent changes to Israel’s Encouragement for Industrial R&D Law 1984 (the “R&D Law”) create long-awaited mechanisms for allowing Israeli high-tech companies that are funded by the Office of the Chief Scientist (OCS) to export both the production and the know-how of products developed in funded industrial R&D programs.

This represents a radical change to the OCS legal regime, and should have a considerable impact on the way such companies do business in the future, in particular on their commercial contacts with foreign companies and other entities. Understanding the scope of these changes will be crucial to Israeli high-tech companies already receiving OCS grants or considering whether to apply for such grants.

Non-Israeli companies and investors engaged with such companies in joint ventures, or executing license agreements, or contemplating mergers or acquisitions, or merely doing business with such companies, should also take careful note.

At the heart of the changes is a mechanism for authorizing the transfer of know-how abroad. Instead of a situation in which no transfers abroad of any kind are allowed, the OCS can now approve a transfer abroad, and the funding recipient can pay accordingly. The 'Price' to be paid by the funding recipient is intended to reflect the added value of the know-how to the national economy. ‘Added value’ here is calculated as the indirect value of the know-how to the economy as a whole, rather than just the value to the individual company.

The formula for calculating the Price assesses the extent of OCS investment relative to other investment in the particular program/company, and multiplies the resulting percentage by the purchase price of the know-how. The depreciation of know-how over time is also taken into account in the final sum owed to the OCS.

The amended R&D Law adapts the above formula for seven different scenarios. These include: the sale of know-how to a foreign entity, the sale of the company (with the know-how), a know-how swap, joint ventures under an international R&D agreement, and so on. We look at all seven scenarios in detail, and the price entailed for each in the second part of this article.

The overall impact of the changes to the R&D Law is likely to be very great indeed. The obstacles which the R&D Law placed in the way of Israeli high-tech companies in the area of know-how transfer and the transfer of the production of products abroad made it extremely difficult for such companies to operate in a global technology market. The restrictions made those companies already in receipt of OCS funding unattractive to potential foreign investors, and consequently deterred other companies from seeking OCS funding in the first place. The removal of the restrictions should have the opposite effect.

This article is directed at investors, CEOs, CFOs, directors, company counsel, company auditors, as well as legal and financial consultants, informing them of the changes in the area of the transfer of production rights and the transfer, or sale, of know-how. We leave out reference to many of the other changes to the 50-odd sections of the Law created by these amendments, in particular the amendments of 2003. Anyone needing further information on these is advised to seek legal counsel. For the sake of good order it should also be noted that the information provided in this article is purely for information purposes, and should not be taken as a definitive legal opinion.

2. Background: The Encouragement for Industrial R&D Law 1984

The 1984 Law institutionalized a regime for government assistance to R&D in industry that had begun in the 1970’s, as Israel sought to capitalize on a highly skilled scientific workforce and an emerging reputation for technological innovation, to fuel the rise of a distinctive Israeli high-tech industry. The Law, as passed in 1984, established four basic principles. These reflected the government’s desire to provide incentives for Israel’s burgeoning high-tech industrial sector, while zealously maintaining a competitive edge over other countries in this field. The four basic principles were:

  1. Funding would be provided for up to 50% of an R&D program, geared towards a product, by an Israeli company with a manufacturing base.
  2. Funding would only be given where the recipient undertook to develop and manufacture the product in Israel and sell it abroad.
  3. The transfer of know-how resulting from the R&D program was prohibited.
  4. The recipient would repay the funding in the form of royalties from sales of the product.

The Law was first amended in 1995. The prohibition against the transfer of know-how (principle number 3 above) was clarified and actually strengthened: while the Research Committee (the body, headed by the Chief Scientist, which was responsible for implementing the Law) could now authorize the transfer of such know-how within Israel and under certain conditions, including the duty on the recipient of such know-how to pay royalties to the OCS from the sales of resulting products, the transfer abroad of know-how resulting from a funded R&D program was criminalized, and the Research Committee had no discretion to authorize it.

Applicants for funding also had to give an undertaking that production would take place solely in Israel. However the Research Committee could allow the transfer abroad, at a later stage, of a portion of production rights in exceptional circumstances, under terms and conditions which it could determine.

3. Background to the 2003 and 2005 amendments

An important principle established by the Law in 1984 was that recipients of funding were obliged to repay all amounts received from the OCS for a particular program, in the form of royalties from sales of the resulting product. However, even with the completion of such payments, the recipient of funding was still be bound by the other provisions of the Law, including the requirement for production to take place within Israel and the prohibition against the transfer of know-how abroad.

With respect to the transfer abroad of production rights, an amendment to the Royalties Regulations in the late 1990s created a simple mechanism for charging the recipient of funding an increase in their overall debt to the OCS, proportionate to the percentage of production being transferred. Thus, if up to 50% of production were transferred, the overall royalties debt would be increased by 20%, and if up to 90% were transferred, the debt would be increased by 50%.

No such mechanism could be introduced for the transfer, or sale, of know-how abroad, which remained a criminal offence. The belief was that in order to maintain and nurture a competitive high-tech sector in Israel, it was essential to prevent Israeli produced know-how draining out of the country. The problem was that the restriction had almost the opposite effect: limiting high-tech companies’ room for maneuver, and stifling their freedom of operation in what had become a distinctly global market. For many reasons, some of which we highlight below, the regime created by the Law, even after its amendment in 1995, appeared unsuited to the changing needs of the market:

  1. Faced with a complete lock-up of their know-how if they received OCS funding, many companies were deterred from applying to the OCS at all, and sought funding elsewhere, with varying degrees of success.
  2. Companies already in receipt of funding found it difficult to attract foreign investment. Investors were deterred by the prohibition on the transfer of know-how. Likewise, the prohibition made it very difficult for such companies to engage in joint ventures in R&D with foreign companies.
  3. The cases of companies already in receipt of funding, and wishing to transfer production (and its accompanying know-how) abroad was not be consistently handled by the Research Committee. General conditions for the authorizing of the transfer of production were not set down; the Research Committee determined conditions on a case-by-case basis. This created an atmosphere of great uncertainty.
  4. Standard license agreements for a company’s know-how werebarred by the Law. In addition, the rules governing the transfer abroad of intellectual property rights arising from know-how (as opposed to the transfer of know-how itself) remained uncertain.
  5. Standard commercial and legal scenarios, such as escrow agreements or arrangements for disposing of the assets of a company in liquidation, were not adequately dealt with by the law. The OCS handling of such scenarios was therefore severely limited. In the event of liquidation, for example, even if a potential buyer of the company’s know-how assets could be found, if that buyer were a foreign entity, the sale of such assets could not be authorized. (It should be noted that the Israeli court in the case of the liquidation of Pro-Lazer Ltd. (2003), upheld the primacy of OCS rulings in liquidation cases).

In the light of these and other considerations, the Law underwent significant changes, initially in 2003, and latterly, and most significantly, in 2005.

4. The 2003 Amendment: The transfer abroad of production and production rights

Firstly, production of the OCS aided products may now take place both in Israel and abroad. Instead of having to declare (and prove to the satisfaction of the OCS) that all production will take place in Israel, the applicant for funding is now required to declare, at the application stage, what percentage of production will take place in Israel, what percentage abroad, and what will be the degree of local ‘added-value’ in Israel.

The change reflects a move to a sounder, more economic-based, test of a proposed program. The Research Committee is now required to weigh up the potential added value to the Israeli economy of such a program. In this, the possibility of some production taking place abroad represents a significant, but no longer a disqualifying factor, in determining whether, and by how much, to fund such a program. Among other things, where 50% or more of production is to take place abroad, the applicant will not get 50% of funding for the program.

Secondly, the Research Committee may, in certain exceptional cases, and at any time after the approval of the program, authorize the further transfer of production abroad, under the following conditions:

  1. The recipient of funding is required to pay royalties from sales of the product at an increased rate, as set out in the Royalties Regulations; or
  2. The recipient of funding undertakes to transfer a different product for production to Israel one which meets the standards and requirements of the OCS (added value to Israeli economy, marketability abroad, and so on). In this latter case the recipient of funding will not be charged an increased rate of royalties.

Where the proposed transfer means that the aggregate of all such transfers amounts to a reduction of less than 10% in the percentage of production in Israel as originally declared, the recipient of funding need only give the Research Committee prior written notice of such transfer and will not need its approval, provided the Research Committee does not object within 30 days.

5. The 2005 Amendment:A mechanism for regulating the transfer abroad of know-how

The most significant change to the R&D Law was the introduction (in 2005) of a mechanism by which the Research Committee could authorize the transfer of know-how abroad. We will look at this mechanism in detail in part two of this article.

The writer, a senior associate at Aaronsohn Sher Aboulafia Amoday & Co., is a former legal advisor to the OCS at the Ministry of Industry and Trade.

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Published by Globes [online], Israel business news - www.globes.co.il - on September 3, 2006

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