In a new ruling addressing the legal validity of simulated contracts and the agreements concealed behind them, the Israeli Supreme Court significantly weakens the standing and legal validity of these contracts, while making it clear that the courts will not continue legalizing such simulated contracts whose sole purpose is to deceive the authorities and commit tax evasion. Thus, it appears the Supreme Court is taking a step forward toward resolving the long-standing judicial debate that repeatedly arises when parties to a contract petition the court to allow the “desire of the parties” and validate such contracts.

Simulated Contracts

The Supreme Court ruling concerns an agreement signed in 2004, a matter initially adjudicated by the district court. This simulated contract for the sale of rights in real estate masked an additional, underlying unwritten sale agreement that stipulated a different sale price than the price declared to the tax authorities. The buyer also exploited the simulated contract to obtain financing for the payment stipulated in it, since the seller returned this financing to the buyer within a short time.

In a declaratory judgment, the district court nullified the simulated contract, as well as the concealed agreement, by virtue of section 13 of the Contracts Law and due to the fundamental breach of the concealed agreement. The case was appealed to the Supreme Court, and the Supreme Court also nullified both agreements, but for different reasons.

Classification of Contracts

The Supreme Court ruling made strict determinations regarding simulated contracts whose sole purpose is to defraud the tax authorities and the banking system. Inter alia, the Supreme Court addressed the long-standing judicial debate about the classification of simulated contracts. One position in the debate is that every simulated contract should be classified as illegal, a classification that usually results in the nullification of both contracts. A second position holds to leave the classification to the court adjudicating each case, while allowing the use of the simulated contract doctrine. Namely, to nullify the unlawful simulated contract and to validate and enforce the concealed agreement, i.e., the contract that was never reported to the tax authorities and remained a secret between the parties thereto.

The ruling did not resolve the debate but, de facto, the court ruled that “… the parties’ intention from the outset was to execute the engagement between them whose purpose was to fulfill the concealed agreement in an unlawful manner by way of tax evasion and fraudulently obtaining a loan. Under such circumstances, the grave illegality of the contract from the outset, by ‘concealing’ the invalid contract, cannot be legitimized by the laws governing simulated contracts … and focusing on examining the provisions of the concealed agreement.” Thus, the Supreme Court is expressing its clear position that parties who signed simulated contracts designed to defraud the tax authorities should refrain from appealing to the courts, since the courts will not validate any of the contracts.

What to Expect?

Up until this judgment, parties to simulated contracts could expect, to some extent, that if a dispute arose between them and they went to court, the simulated contracts doctrine would be used during the hearings and the concealed, real agreements would be enforced. However, in this ruling, the Supreme Court has chosen, for the first time, to clearly express the legal system’s repugnance for validating agreements whose sole purpose is to defraud the tax authorities. Moreover, it has narrowed the range of possible pleas in such cases.

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