Israel's transfer pricing regime is regulated under Section 85A (Section 85A) of the Israeli Tax Ordinance (the Ordinance), which came into effect on 29 November 2006 and applies to corporate tax. Guidance regarding transfer pricing is provided in several tax circulars issued by the Israel Tax Authority (ITA), the most recent at the time of writing being Tax Circular 1/2020 (initially titled Tax Circular 8/2020) with regard to the burden of proof in transfer pricing audits.
The regulations promulgated under Section 85A (the Regulations) adhere to the arm's-length principle and incorporate the approach taken in the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines2) and the approach taken in Section 482 of the US Internal Revenue Code (Section 482) towards determination of the correct analysis methods for examining an international transaction between related parties. It should be noted, however, that certain tax circulars offer a 'safe-harbour' mechanism with specific margins.
The scope of transfer pricing regulations in Israel is limited to cross-border transactions in which a special relationship (as defined below) exists between the parties to the transaction. Transfer pricing issues normally arise in relation to transactions carried out by companies that are part of a multinational group; however, the ITA has recently started to implement the principles of Section 85A unofficially with respect to related-party transactions within Israel. According to Section 85A and the Regulations, the tax assessment officer (AO) may issue an approval that certain one-time transactions are excluded from the scope of the Regulations; however, such approvals are rare.
The term 'special relationship' includes the association between an individual (including an entity) and that individual's relatives, the control of one party to the transaction over the other, or the control of one individual over the other parties to the transaction, whether directly or indirectly, individually or jointly with other individuals.
'Control' means holding, directly or indirectly, 50 per cent or more of one of the indicators of control. An indicator of control is defined as:
- the right to profits;
- the right to appoint directors or the general manager or other similar positions;
- the right to vote in the general shareholders' meeting;
- upon liquidation of the company, the right to a share in the equity after all debts are paid; or
- the right to determine which party has one of the aforementioned rights.
A relative is a spouse, sibling, parent, grandparent, child, spouse's child and the spouse of each of these. Nonetheless, the ITA can often perform a qualitative test for the above threshold, and look at a transaction even if the threshold itself is not met.
The Regulations cover various types of transactions, including: services (such as research and development (R&D), manufacturing and marketing); the use or transfer of tangible and intangible goods (i.e., distribution); the use or transfer of intangible assets (e.g., know-how, patents, trade name or trademark); and financing3 (e.g., capital notes, guarantees, captive insurance, loans) transactions, which are required to be carried out at arm's length.
Because of the nature of the Israeli market, the ITA gives special attention to R&D services provided by Israeli subsidiaries and matters relating to intangibles, which may also involve governmental support. The ITA also focuses its audits on the restructuring of functions, assets or risks (FAR) and on the distinction between marketing services and distributorship activities carried out in Israel by MNEs.
Application of the arm's-length principle is generally based (when the comparable uncontrolled price (CUP) method is not applicable) on a comparison of the conditions in a cross-border controlled transaction with conditions in similar transactions entered into between independent companies (comparable companies). To determine if a cross-border controlled transaction has been carried out in accordance with the arm's-length principle, the following steps must be taken:
- identify the cross-border controlled transactions within the group;
- identify the tested party for each relevant transaction;
- perform a functional analysis with special emphasis on comparability factors such as business activity, the characteristic of the property or service, the contractual conditions of the cross-border transaction and the economic circumstances in which the taxpayer operates;
- select the appropriate transfer pricing method or methods;
- select the comparable companies and establish an arm's-length range, determined by the comparable companies; and
- examine whether the tested party's results fall within the arm's-length range.
According to the Israeli transfer pricing rules, the initial burden of proof lies with the taxpayer. As such, companies that do not transact at arm's length, or that do not hold the required transfer pricing documentation (proving their compliance with the arm's-length principle), may be exposed to penalties and to a change of pricing as determined by the ITA at its discretion. These companies would be required to adjust their net income to incorporate the appropriate transfer prices for their intra-group transaction. This unilateral adjustment could lead to double taxation regarding income taxed in other jurisdictions.
Based on recent court rulings, and as recently stated by Tax Circular 1/2020, the burden of proof is normally on the taxpayer, and it does not necessarily shift to the tax assessment officer once a transfer pricing study has been submitted for assessment and where there is a disagreement on the factual background or on the method chosen. Moreover, the tax assessment officer may use Section 85A and transfer pricing rules to de facto reclassify a transaction (and the method used).
In rare cases where a transaction between related parties lacks any commercial rationale (namely the same transaction under similar economic circumstances would not have been agreed between non-related parties), the ITA may choose not to recognise the transaction in its original form, and may treat it as an entirely different type of transaction; a type of transaction that, in its view, would reflect the business reality of the transaction in a more adequate manner. This type of reclassification of a transaction can relate, inter alia, to the treatment of inter-company loans or cash pooling or non-repayment of inter-company debts, as dividends, as well as to the ownership of intangibles. Non-recognition can be contentious and a source of double taxation and, while derived from Section 85A, it is based also on Section 86 of the Ordinance.
With regard to the accounting treatment of transfer pricing positions, one of the main issues currently under discussion in Israel relates to the recognition of expenses with regard to employee stock option plan (ESOP) matters (see also Section VII.i), where the matters of vesting, exercise and cancellation of options granted to the employees of an Israeli subsidiary by the (foreign) parent corporation are considered.
Recent developments – Israeli transfer pricing regulations
Tax Circular 1/2020
In accordance with Tax Circular 1/2020, the filing of a transfer pricing study, in and of itself, does not shift the burden of proof from the taxpayer to the ITA. The transfer pricing study will first be reviewed by the ITA to verify it complies with the requirements of the Ordinance. For example, where the facts underlying the transaction are in dispute, or the tax inspector disagrees with the type of transactions conducted between the parties, the taxpayer is still required to prove those facts, and the submission of the transfer pricing study is not sufficient to shift the burden of proof to the ITA. The ITA may also request to see how the transaction was recorded by the other (non-Israeli) party to the transaction.
Tax Circular 1/2020 states, as an example which complements the ITA's stand for some time now, that a transfer pricing study implementing the TNMM (in the US, CPM) method (i.e., a cost-plus arrangement), albeit the existence of valuable intangibles with both parties to the transaction, without sufficiently explaining why the profit split method was rejected, may lead the ITA to state that the taxpayer has not met the required standard in order to shift the burden of proof to the ITA.
An additional case in which the burden of proof will not shift from the taxpayer to the ITA, in accordance with Tax Circular 1/2020, albeit the filing of a transfer pricing study, is where there is an incomplete transfer pricing study, namely a study missing, for example, one or more of the following: a complete search process; the reasoning for choosing the applicable transfer pricing method; the reasoning for choosing the comparables; and financial data of comparables.
It is important to state that the position of Tax Circular 1/2020 is that where the ITA rejects the transfer pricing study filed by the taxpayer based on the foregoing, or where the taxpayer has not filed a transfer pricing study at all, the results will be the same, and the ITA can, inter alia, set the tax assessment without the need to provide a complete study on its behalf. While the ITA inspectors cannot set this arbitrarily, they can base such assessment upon their general experience and past assessments, as well as upon estimations. Additionally, the ITA inspectors may impose fines on the taxpayer.
Tax Circular 15/2018
Based on the recent Gteko court ruling (6 June 2017) and the OECD Guidelines, the ITA published on 1 November 2018 Tax Circular 15/2018 dealing with business model restructuring inside a multinational enterprise (MNE), and involving the FAR associated with the Israeli subsidiary of a MNE. The Circular presents the ITA's position with respect to business restructuring and defines ways for identifying and characterising business restructurings, and offers methodologies that are accepted by the ITA for valuation of transferred, ceased or eliminated FAR commonly involved in the course of a business restructuring (e.g., intangibles, skilled work force). With regard to each FAR transferred in a business restructuring, the Circular sets guidelines for the characterisation of a FAR transfer as a sale transaction or a 'grant of temporary-usage permit' transaction, for classifying it as a capital or ordinary income transaction.
Tax Circulars 11/2018 and 12/2018
On 5 September 2018, the ITA published two circulars, Tax Circulars 11/2018 and 12/2018, setting out its approach towards classification and transfer pricing methods appropriate for use in connection with certain inter-company transactions between an Israeli entity and related overseas parties that are part of a multinational group. The Circulars focus on inter-company transactions involving marketing services or sales and, in particular, on the approach to be used to classify a given entity as either a marketing services entity or a sales (distributor) entity. In addition, the ITA opined on how to choose the most appropriate transfer pricing method, as well as which ranges of profitability (safe harbours) it sees as appropriate for these types of Israeli entities.
Taxpayers submitting reports in accordance with the approach outlined in Circular 11/2018, and whose results fall within the safe harbours provided under Circular 12/2018, would be exempt from the requirement to provide benchmarking support for the assertion that the transfer prices used are in accordance with market pricing. Nonetheless, the Circular does not otherwise provide an exemption from the existing requirement to prepare transfer pricing documentation. A benchmarking analysis is not required in the event of an exemption, but other parts of the study are still required, together with a rationale for the method and safe harbour applied by the circulars.
Circular 12/2018 safe harbours
For taxpayers where the analysis of the functions, risks and assets aligns with sales activities for low-risk distributors (LRDs), the exemption would be provided in the event that the entity reports an operating margin of three to four per cent in the domestic market (i.e., an operating margin profit level indicator (PLI) shall be implemented at rates ranging from 3 per cent to 4 per cent).
For taxpayers where the analysis of the functions, risks and assets aligns with an entity performing marketing activities, and not sales activities, the circulars indicate that an appropriate transfer proving method would be based on the costs of this activities, with an appropriate markup added. The exemption for supporting the markup over the costs incurred based on benchmarking analysis would be provided for entities reporting a markup of 10 per cent to 12 per cent. (i.e., a net cost-plus PLI shall be implemented at rates ranging from 10 per cent to 12 per cent).
The Circulars provide that for taxpayers with transactions involving low-value-added services (generally consistent with the OECD Guidelines), an exemption from some documentation requirements would be provided where the entity reported a markup of five per cent associated with these activities (i.e., a net cost-plus PLI (i.e., a markup) shall be implemented at the rate of 5 per cent).
Tax Circular 4/2016
In 2016, in Tax Circular 4/2016, the ITA issued an update regarding the operations of foreign multinationals in Israel through the internet. This Circular, inspired by Action 1 of the OECD's Action Plan on Base Erosion and Profit Shifting (the OECD BEPS Action Plan) concerning the digital economy, provided new guidelines and rules under which foreign companies' income derived from selling products or providing services through the internet to Israeli residents (digital activity) will be deemed the income of a permanent establishment (PE) in Israel for tax purposes. The Circular distinguishes between foreign enterprises that are residents of a treaty state (treaty resident companies) and foreign enterprises that are residents of a non-treaty state (non-treaty resident companies) and provides different rules for determining the income attributed to the Israeli PE for each of the aforementioned company types.
Currently, the ITA is holding round-table talks4 on other draft circulars, including in the fields of implementation of development, enhancement, maintenance, protection and exploitation of intangibles (DEMPE) analysis; pricing of options; and profits associated with management functions.
II FILING REQUIREMENTS
Taxpayers engaged in cross-border controlled transactions are required to include a separate form (Form No. 1385) in their annual tax return, specifying their intra-group dealings (such as the volume of the transactions, transaction types, terms and conditions and the parties thereto) and declaring that their international transactions between related parties are conducted at arm's length and in accordance with the Regulations. The ITA issued a new version of Form No. 1385, applicable to fiscal year 2019 onwards, that requires additional details regarding the implemented TP method, the profitability rate used for transactions and whether the transactions are reported based on the new safe harbours set forth in Tax Circular 12/2018.
In practice, this means that taxpayers in Israel are expected, and in fact required, to hold up-to-date transfer pricing documentation, which includes (at a minimum) a transfer pricing study and an inter-company agreement relevant for the fiscal year end. Form No. 1385 is signed personally by an officer of the company (usually the company's chief financial officer), and although no personal liability has yet been claimed by the ITA in cases where the form was inaccurate, the ITA is reviewing its position on this matter. An updated Form No. 1385 is expected, as well as Form No. 1485 (for capital notes).
In addition, the ITA is entitled to demand full transfer pricing documentation within 60 days of a request of this type. The ITA often asks to receive the documentation within a shorter period, usually 30 days or less; however, this can usually be extended to the 60-day period prescribed under the Regulations.
As noted above, by signing Form No. 1385 the taxpayer's officer declares that the company is compliant with the arm's-length principle and that it maintains up-to-date transfer pricing documentation (i.e., a transfer pricing study, inter-company agreement and also, where applicable, a transfer pricing policy), and it is therefore advisable to have an updated transfer pricing study in place annually. Penalties may be imposed on a taxpayer for not preparing and submitting transfer pricing documentation on time or at all. In addition to preventing penalties and fines, holding a transfer pricing study and other related transfer pricing documentation shifts the burden of proof to the AO and enables the taxpayer to maintain an arguable position regarding any determination made by the AO concerning transfer pricing adjustments. The deadline to prepare transfer pricing documentation is 31 May of the year after the tax year.
Full documentation includes the following:
- a transfer pricing study that includes:
- a description of the parties involved in inter-company transactions, including a description of the management structure of the parties and functional organisational charts;
- a description of the inter-company transactions;
- a description of the business environment and the economic circumstances in which the parties operate;
- a functional analysis of the parties involved in the inter-company transactions (including functions performed, risks assumed and resources employed);
- selection of the pricing method or methods and the reasons behind the selection;
- an economic analysis (determination of arm's-length prices); and
- the conclusions that may be derived from the comparison to uncontrolled comparable companies; and
- additional documents that corroborate the data described above, such as:
- inter-company contracts;
- any disclosure made regarding the controlled transactions to any foreign tax authority, including any request for an advance pricing agreement (APA);
- a transfer pricing policy, if applicable;
- any differences between the prices reported to the foreign tax authority and the prices reported in the Israeli tax returns; and
- any opinion from an accountant or lawyer, if one was given.
It is recommended to update the transfer pricing study on an annual basis. Where the facts of the transactions under review have not changed materially (or at all), the entire transfer pricing study can remain the same except for the benchmark results, which should be updated every year. It is best practice to perform a new search every two years and update the results of the original search on an annual basis. From time to time, because of a lack of local comparables, the search may be broadened to a more global search, as long as it abides by the Regulations and the instructions of the ITA.
On 4 January 2017, draft legislation was proposed to amend the Ordinance to include new transfer pricing provisions with respect to Action 13 of the OECD BEPS Action Plan. The proposed legislation updates the provisions of Section 85A of the Ordinance and adds Sections 85B and 85C to the Ordinance.
In light of this proposed legislation, the burden of transfer pricing documentation will grow as taxpayers will be required to submit further documentation, reports and data to comply with the new documentation requirements.
Accordingly, in addition to the regular local file (i.e., the transfer pricing study), Israeli taxpayers that are members of a multinational group will also be required to submit data at the corporate level, namely a master file accompanied by related data of the multinational group. In addition, an Israeli taxpayer that serves as the ultimate parent of a multinational group whose consolidated turnover exceeds 3.4 billion new Israeli shekels will be required to submit a country-by-country report as well.
The draft legislation passed the first reading (of three) in the Israeli parliament; however, the applicable effective date of the proposed legislation has not yet been determined. Currently, the ITA expects that this legislation will pass during 2020.
III PRESENTING THE CASE
i Pricing methods
The Regulations incorporate both the OECD Guidelines and Section 482's approach towards the determination of the correct analysis methods for examining an international transaction between related parties. As such, the Regulations require that the arm's-length result of a controlled transaction be determined under the method that, given the facts and circumstances, provides the most reliable measure of an arm's-length result, where there is a preference for transactional transfer pricing methods over profit-based transfer pricing methods.
According to Section 85A, the preferred method is the comparable uncontrolled price or transaction (CUP/CUT) methodology, because this method can produce the most accurate and reliable arm's-length results. When the CUP/CUT cannot be used, then one of the following methods should be employed:
- resale price method (RPL);
- cost plus;
- profit split methods (comparable or residual); or
- transactional net margin method (TNMM, similar to the comparable profits method (CPM) in Section 482).
If none of the above methods can be applied, other methods should be used that are most suitable under the circumstances. However, this should be justified both economically and legally, and the application of a different method cannot normally be justified when one of the above-prescribed methods is applicable.
When applying a certain transfer pricing method, an adjustment is sometimes required to eliminate the effect of the difference derived from various comparison characteristics between the controlled and comparable uncontrolled transactions.
According to the Regulations, a cross-border controlled transaction is considered to be at arm's length if, following the comparison to similar transactions, the result obtained does not deviate from the results of either the full range5 of values derived from comparable uncontrolled transactions when the CUP method is applied (under the assumption that no comparability adjustments were performed), or in the interquartile range when applying other methods.
The adoption of post-BEPS measures has been formalised in part in Israel, including guidance concerning restructuring and low-value-adding services, and measures related to the digital economy; other post-BEPS measures are under consideration by the ITA. The ITA places great emphasis on business or economic substance when analysing value chains and transactions involving the transfer or use of intangible properties. This means that functions contributing to the creation of value, as well as where people are located, constitute important criteria when determining the appropriate attribution of profits among group members in multinationals. Consequently, the ITA may deem a transfer pricing analysis to be inappropriate to the application, preferring, for example, a profit split method rather than the TNMM. In other cases, the ITA has retroactively applied different methods from those used by the taxpayer, shifting between CUP and TNMM, in cases where profit split was not applicable.
As mentioned above, where a transaction between related parties lacks any commercial rationality, the ITA may not recognise the transaction in its original form, and may treat it as an entirely different type of transaction that, in its view, would reflect the business reality of the transaction in a more adequate manner. Non-recognition can be contentious and a source of double taxation.
The Israeli transfer pricing regulations do not provide specific guidelines for evaluating the arm's-length nature of inter-company financing transactions and thus follow a broader transfer pricing approach provided under the OECD Guidelines and Section 482.
Specifically, for inter-company loans, the evaluation of the arm's-length nature is carried out by establishing an arm's-length interest rate based on those applied in comparable third-party transactions. According to the OECD Guidelines and Section 482, the transfer pricing methodology usually used when setting arm's-length interest rates is the CUP method, applying internal or external CUP analysis. The approach preferred by the ITA is the external CUP method, which is, in fact, a market-valuation method, as it relies on market yields of publicly traded corporate bonds that are comparable to the assessed inter-company loan in terms credit-rating and loan terms when establishing the arm's-length interest rate.
Following the issuance of the OECD's final guidance on financial transactions on 11 February 2020, it is likely that inter-company loan transactions will be the focus of increased scrutiny by the ITA. Therefore, Israeli taxpayers are advised to apply a new approach when establishing arm's-length interest rates for their inter-company loan transactions in accordance with the OECD's final guidance. This will combine the synthetic rating approach backed by audit trails and empirical evidence,6 such as a description of people functions involved, and evidence demonstrating the management and control of risks by relevant parties to the inter-company loan.
In addition to the above, the fact that there are no thin-capitalisation rules in Israel will also contribute to the trend of increased tax audits relating to inter-company loan transactions. Consequently, this enables Israeli borrowers in controlled loan transactions to be highly leveraged and assume high interest payments deductible for tax purposes in Israel. This issue will be resolved when Israel implements the recommendation prescribed under BEPS Action 4 and limits the interest payment amount deductible for income tax by applying a 'fixed ratio' (which equals a borrower's net deduction for interest or earnings before interest, tax, depreciation and amortisation (EBITDA) to 10 per cent to 30 per cent) or a 'group ratio' (which equals a group's net deduction for interest or EBITDA).
Application of profit split
The Regulations incorporate the OECD Guidelines' approach towards the application of the profit split method. In general, the employment of the profit split method in documentation is quite limited. However, the profit split can be a method of choice for dispute resolution.
The Regulations stipulate two profit split methods:
- Comparable profit split method: transfer prices are based on the division of combined operating profit between uncontrolled taxpayers whose transactions and activities are similar to those of the controlled taxpayers in the relevant business activity. Under this method, the uncontrolled parties' percentage shares of the combined operating profit or loss are used to allocate the combined operating profit or loss of the relevant business activity between the related parties.
- Residual profit split method: this method involves two stages. First, operating income is allocated to each party in the controlled transactions to provide a market return for their routine contributions to the relevant business activity. Second, any residual profit is divided among the controlled taxpayers based on the relative value of their contributions of any valuable intangible property to the relevant business activity. This method is best suited for analysing the transfer of highly profitable intangibles.
The Regulations do not contain specific guidance for the application of the profit split method. Nevertheless, this method is generally acceptable to tax administrators when it is used in cases where both entities contribute or own significant intangibles, and it has recently been advocated by certain officials of the ITA. The profit split method is most often applied in the context of global value chains, where the global operations of a multinational corporation are significantly integrated.
In Israel, following the OECD BEPS Action Plan, tax practitioners are currently assessing the applicability of the profit split method in service transactions, which include the provision of significant services that contribute to the creation of profits and value (e.g., R&D, marketing, management) as a result of increasing challenges by the ITA to the cost-plus models, and recharacterisation as profit splits. The ITA is implementing a people-orientated analysis when conducting tax audits and, therefore, can, in certain cases, determine management services as being a non-routine activity for purposes of profit splits.
Concerning R&D services, in cases where R&D activity is considered non-routine by the ITA, this activity may be re-characterised as a profit split. The ITA's determination concerning the non-routine nature of the R&D is based on several factors:
- whether the R&D relates to the development of a whole new product or the continuing development of an existing product;
- how many employees are involved in the development; and
- whether the Israeli R&D contractor is free to determine its own R&D budget or whether it is bound by the authorisation of the entity financing the R&D activity.
With respect to marketing services and in accordance with Circular 11/2018, the ITA challenges cost-plus models for marketing activity and re-characterises these as distribution models. This means that an Israeli company that acts as a marketing services provider could be characterised as a distributor by the ITA, and thus be subject to an appropriate profit derived from revenue concerning the sales of the products in Israel.
The characterisation of a marketing service provider as a distributor is dependent on the involvement of the marketing activity in the creation of revenue for the group in terms of, but not limited to:
- which entity oversees the engagement with customers, and where contracts are signed;
- which entity oversees the negotiations with customers;
- which entity is seen by the customers as the one responsible for sales;
- the entity that approves discounts or unusual credit terms for customers; and
- whether the employees of the marketing service provider are compensated by a certain percentage from sales of promoted products.
As regards management services, the ITA's determination of management services as an intangible is based on the nature of the services, meaning that a management service incorporating strategic decision-making functions may be considered intellectual property for profit split purposes. As noted, this matter is currently being debated with the ITA.
Further, because of the new value-added services safe-harbour setting (a cost-plus five per cent exemption), a five per cent markup for value-adding services such as R&D services would be difficult to justify.
Application of the cost-plus method
The cost-plus method compares gross margins of controlled and uncontrolled transactions. The cost-plus method is most often used to assess the markup earned by a service-providing entity that engages with related parties.
The arm's-length price is measured by adding an appropriate gross profit (i.e., markup) to the controlled taxpayer's cost of producing the services involved in the controlled transaction.
The cost-plus method applies where internal data is available, in which a service renderer provides the same or similar services to both controlled and uncontrolled parties and where it provides detailed information concerning comparable transactional costs.
In practice, this method is usually not applicable for evaluating the arm's-length nature of intra-group services, mainly because external data (i.e., transactions between two third parties) found on public databases cannot be reliably used when applying this method. This is due to inconsistencies between companies' financial data, arising from the fact that companies allocate their costs using different accounting methods.
The degree of consistency in accounting practices between the controlled transaction and the uncontrolled comparables materially affects the gross profit markup and the reliability of the result.
When performing comparability analysis, the goal is to reach the most accurate pool of potential comparable companies. In doing so, the search process usually includes a quantitative screening followed by a qualitative screening.
It is first essential to apply Standard Industrial Classification (SIC) codes, NACE (Nomenclature des Activités économiques dans la Communauté Européenne) codes, or both, as well as specific industry classifications employed by certain databases, which classify companies by the type of economic activity in which they are engaged and the types of products or services they sell.
Following the application of the aforementioned industry codes, additional screening criteria are also applied, including geographic location, company status (i.e., active companies), company type, exclusion of operating subsidiaries from the search, years of available accounts, and limitations regarding operating losses.
Depending on the nature of the tested transaction under review, in certain cases, additional quantitative screening criteria are also applied to yield a more accurate set of comparables. This mainly includes the application of different financial ratios such as R&D expenditure sales, intangible-asset sales, inventory sales, or property, plant and equipment sales.
The next step is a qualitative screening, which focuses on examining the business descriptions of all remaining companies and then establishing a set of comparable companies.
The Regulations do not provide a reference to a specific number of comparables required for the establishment of interquartile range results. In our opinion, between 10 and 20 comparables should suffice, with the minimum being around five. There is no quantitative limit; however, the credibility of a range composed of a large number of comparables may be brought into question.
Regarding the locations of selected comparables, local (Israeli) comparables are preferred but are not often available. Practice has shown that the use of European or US comparables is also accepted by the ITA, as well as global benchmarks, as long as applicable adjustments were made (when required). However, this is examined on a case-by-case basis.
ii Authority scrutiny and evidence gathering
There is a dedicated Transfer Pricing Department (TPD) within the ITA, which is responsible for performing audits and economic analyses to determine the arm's-length price for a taxpayer's transactions. Further, the TPD has been given full authority to review (and tax) previously approved assessments and to reopen final assessments that were approved up to three years before their inspection. The TPD also gives guidance and instructions to local tax AOs to screen and initiate audits on a wider level. In the event of an audit by a local tax AO, certain disagreements may be handed over to the TPD.
In Israel, the tax authorities' transfer pricing unit audits both Israeli subsidiaries of multinational enterprises (MNEs) and local corporations in all matters related to transfer pricing. However, when it comes to the pricing and taxation of employee benefits such as ESOPs, the focus is naturally on the Israeli subsidiaries of MNEs. Taxpayers can dispute the proposed transfer pricing adjustments of the tax authorities by means of appeals, courts and through the use of treaties (where relevant).
The matter of ESOPs has gained specific attention in audits performed by the TPD, has involved other departments of the ITA, and has generated a recent ruling issued by the Supreme Court on 22 April 2018 recognising that an Israeli subsidiary operating as a contract R&D services provider and working on a 'cost-plus basis' (i.e., utilising the TNMM/CPM methods) should include within the cost-plus model expenses associated with employees' social security payments, as well as options granted by the foreign parent corporation (this may also apply to other types of services). Currently, the ITA is considering a circular on the recharge agreements typical of those arrangements.
The ITA does not usually interview persons outside the company undergoing an audit, although this is not prevented by legislation. It is common, however, to allow the professionals who act as consultants to the company to be interviewed by the ITA with regard to their work, and to present them to the ITA as part of a 'hearing' held for the company. These meetings occur both prior to and following the issuance of a transfer pricing tax assessment.
With regard to intra-group information requirements, the ITA may request intra-group information even if it is held outside Israel. If the company fails to present the requested information, it is likely to be viewed negatively throughout the process, including (potentially) in court, thereby preventing the company from providing the information at a later stage.
In January 2017, a proposed amendment to the Ordinance that includes transfer pricing provisions, adopting anti-BEPS measures, passed the first reading (of three) in the Israeli parliament. The proposed legislation aligns with Action 13 of the OECD BEPS Action Plan and follows a formal resolution by the Israeli government to adopt the BEPS principles.
In addition, on 12 May 2016, Israel signed the Multilateral Competent Authority Agreement for Country-by-Country Reporting (MCAA CbCR) for the automatic exchange of country-by-country reports (CbCRs), which allows all participating countries to bilaterally and automatically exchange CbCRs with each other. These steps indicate that Israel can be expected to amend its documentation requirements to also include the creation and filing of CbCRs, and to implement legislation regarding surrogate filing.
Adoption of the MCAA CbCR may indicate the ITA's intention to implement a global tax position when assessing profit attribution among companies in a multinational corporation. It is important to note that a CbCR in itself could not be used alone by the ITA for determining transfer pricing adjustments.
IV INTANGIBLE ASSETS
When pricing a transaction involving the right to exploit or the transfer of intangible assets, the Regulations adopt the OECD Guidelines' approach.
In general, the most common transfer pricing methodology implemented in cases of exploitation of intangible assets (such as know-how, proprietary technology, patents, trade name or trademark and unique business model) is the CUP/CUT method. This method uses external data concerning comparable agreements entered into between independent parties (or, when available, internal data provided by the taxpayer regarding its comparable uncontrolled transactions with third parties) for comparing the compensation terms stipulated in such agreements and, accordingly, establishing a royalty benchmark.
The process of evaluating arm's-length pricing for the transfer or exploitation of intangibles is more complex and requires the valuation of the expected return derived from intangible assets at their present value. This ex ante pricing is based on the assessment of the taxpayer regarding the expected return. As such, it will most certainly deviate from the actual return of ex post outcomes. Recently, the ITA has demonstrated an implementation of the hard-to-value-intangibles (HTVI) principles published by the OECD, in which it concurred with ex ante assumptions, as the ex post result could not have been anticipated by the (related) parties to the transaction under review.
However, it is important to note that, in certain cases, the ITA will impose a tax adjustment based on ex post outcomes as it sees fit, although there is no specific regulation concerning such adjustments and each case is individually examined.
On several occasions, the ITA has noted that it intends to adopt the recommendation promulgated under the BEPS Actions 8–10, with respect to intangibles. Therefore, it is expected that Israeli tax practitioners will conduct their inspections of transactions involving intangibles in accordance with the new HTVI rules, with greater emphasis regarding the attribution of profits based on value creation.
Therefore, when conducting a transfer pricing study for transactions involving intangible assets, the recommendation is to delineate the transaction in a manner reflecting the business reality of the transaction, providing a detailed functional analysis with emphasis on important functions that contribute to the creation and value of the intangible assets under review, as well as related risks.
The ITA's audits into the commercialisation of intangibles originating in Israel are growing; however, holding supportive documentation has proven to be an effective way to rebut and mitigate any assumed ITA adjustments.
The matter of DEMPE7 functions has been 'on the table' for the ITA in recent years, mainly with regard to the exploitation of R&D originating in Israel and R&D subsidiaries established in Israel by foreign entities.
According to ITA officials, DEMPE is one of the matters considered by the ITA when auditing a transfer pricing case, but not necessarily the only one. Moreover, these aspects were relevant to ITA audits even before BEPS. Because of the extensive R&D functions carried out by Israeli companies, DEMPE is a tool used by the ITA and thus should be considered by any transfer pricing practitioner. Currently, the ITA is engaged in discussions8 regarding defining the applications of the DEMPE analysis, and a circular in this respect is expected in the coming quarters.
Transfer pricing cases are rarely adjudicated in court in Israel. Since the adoption of the Regulations 10 years ago, very few transfer pricing cases have been submitted to the courts, with most cases being settled with the ITA out of court.
APAs are not common in Israel, although they exist, and settlement can sometimes also be carried forward as part of an APA. However, settling a past audit cannot guarantee the same treatment in the future, unless an APA is reached.
Investigations usually stem from either a local tax AO's review or specific audits by the TPD. Normally, the process is initiated by a request for the applicable transfer pricing study or studies, and the inter-company agreements.
The current legal time limit for the presentation of a study is within 60 days; however, often the ITA requests receipt of the study within a shorter period. If this is the case, the taxpayer can request to make the submission within 60 days and not within a shorter period. However, this indicates to the ITA that the study may have not been prepared in time, and may indicate that an audit is required. This time frame normally cannot be extended beyond 60 days.
Following the presentation of the study and review by the ITA, it is likely that if the ITA has any remarks or questions, it will summon the company for a meeting, usually prior to the formalisation of an assessment by the ITA.
Assessments are usually followed by meetings between the ITA, the company and its transfer pricing consultants, to rebut the assessment (and if successful then the assessment is adjusted). It is important to note that the scope of audits is often wider than simply transfer pricing and also involves a review of permanent establishments and controlled foreign companies; however, transfer pricing methods and tools are usually acceptable in such audits.
Very few transfer pricing cases make their way to the courts in Israel. Several adjudicated cases (including by the Israeli Supreme Court) dealt with the inclusion of expenses related to ESOPs in the cost-plus basis of Israeli companies providing R&D services to their foreign parent corporations.
In these cases, the district courts and the Supreme Court in Israel have reaffirmed that options granted to employees are related to their employment benefits and thus should be included as part of the 'cost' of their employment. The courts rejected the analogy with the Xilinx case in the United States, as it was irrelevant to the provision of R&D services on a cost-plus (TNMM) basis, and the claim that this grant of options dilutes the shareholders (and thus its cost is already acknowledged) has also been rejected by the courts, as this type of grant is supposed to increase the value of the company and in turn the shareholders' holdings.
Important takeaways from those court rulings are the facts that the court was somewhat reluctant to take a retroactive transfer pricing study into consideration long after the date on which it was supposed to be in place and thus may not have correctly reflected the Regulations. The court was also reluctant to accept results that were not segmented properly.
Additionally, the court rejected the inter-company agreement between the parties since it did not abide by the requirements of the Regulations and the OECD.
A court ruling in the Gteko case concerned the tax implications of changing a business model and the transfer of activity and assets from Israel abroad between related parties. The main dispute in the Gteko case concerned the scope of the transfer transaction that legally referred to the transfer of IP only and to the market value of the assets sold under the transfer.
The court ruled in favour of the ITA and its decision relied on the following:
- the difference between the 2006 share purchase of Gteko's share capital by Microsoft (United States) of US$90 million (the Share Transaction) in comparison to the IP transfer transaction of US$26.6 million (the IP Transaction);
- the fact that the parties were unrelated when the Share Transaction was completed; and
- the fact that following the Share Transaction, Gteko's entire staff was immediately transferred to Microsoft Israel.
On the basis of these facts, the court agreed with the ITA that as a result of the IP transfer, Gteko's interests are subordinated to Microsoft, as the latter dictates Gteko's policy. In light of the specific circumstances of the case, and in accordance with transfer pricing regulations incorporated in Section 85A, the court ruled in favour of the ITA and determined that the IP Transaction is greater in its scope and equals the sale of the entire activity of Gteko to Microsoft (United States) (subject to certain adjustments). Therefore, the transaction should be taxed accordingly, with the starting point for determining the market value for the IP Transaction being the consideration paid in the Share Transaction.
Another case of business restructuring ruled by the district court was the Broadcom case, which dealt with the classification of a business restructuring concerning a post-acquisition set of agreements that included the license of intellectual property (IP) in return for royalty and the provision of R&D, marketing and technical support services on a cost-plus basis, provided by the acquired Israeli company to its US parent and other group entities.
The court ruled in favour of the taxpayer and decided that the change of business model does not necessarily lead to the conclusion that the company essentially sold its assets. The general claim of the ITA according to which any business restructuring and change in the composition of FAR results in a capital gain requires a careful analysis and comparison of pre- and post-FAR, and is not automatic.
The implications of this ruling can be very significant for multinationals acquiring Israeli technology companies and performing a business restructuring thereafter. In the Broadcom case, the court also referred to the burden of proof issue, which later led to Tax Circular 1/2020 described above. The court ruled that in cases where there is a disagreement concerning the factual background of the intercompany transaction under assessment, the burden of proof remains with the taxpayer and not the tax assessment officer, as the taxpayer has the full knowledge to justify the facts relating to the assessed transaction. This is relevant in cases where the tax assessment officer reclassifies the form of the transaction or otherwise questions the nature of the transaction or the method applied.
VIII SECONDARY ADJUSTMENT AND PENALTIES
The ITA is entitled to impose secondary adjustments and, in fact, does so in practice. For example, if the taxpayer made an adjustment (the first adjustment) according to its transfer pricing policy and determined its profit to be a certain percentage (based on its transfer pricing study or transfer pricing range), and the ITA disagreed with its policy or benchmark analysis, the ITA could, in that case, carry out a secondary adjustment.
Penalties are uncommon in Israel and, although discussed as a possibility, have not yet been enacted. Adjustments, linkage, interest and statutory fines on assessments, which already appear in the Ordinance, currently apply to transfer pricing as well.
In this respect, it is also important to note that, in the past, ITA officials have indicated that submitting a Form No. 1385 that includes a personal affidavit by a company's officer subsequently found to be erroneous can lead to criminal liability, although such liability has not been imposed to date.
IX BROADER TAXATION ISSUES
i Diverted profits tax and other supplementary measures
As noted above, the ITA may use either Section 85A and the Regulations, or other means such as Section 86; however, no specific measures relating to transfer pricing matters have been enacted, since, among other reasons, the current measures (i.e., Section 86) are general enough to be implemented (also with regard to transfer pricing). However, certain reportable tax positions, which list is amended from time to time by the ITA, require the taxpayer to state the transaction and report it to the ITA.
ii Double taxation
Double taxation would seem to be unavoidable in cases where another jurisdiction has taxed the company on account of transfer pricing issues. For example, in the event a related party in a foreign jurisdiction is characterised as a permanent establishment, or accused of having inadequate transfer pricing documentation or failing to implement it, the foreign jurisdiction will tax it accordingly and the ITA will not take this into consideration, which will result in double taxation. Still, a MAP process is available where applicable.
iii Consequential impact for other taxes
VAT and inter-company transactions have been the focus of several recent ITA audits, and of a recent court ruling, which imposed VAT on sales performed from Israel. Although this matter is tied heavily to transfer pricing, the issue of transfer pricing itself was not argued by the parties in this case and was not decided by the court.
Customs are also of relevance when the sale of tangible goods takes place between related parties. However, as transfer pricing cases rarely reach the courts, any use of transfer pricing rules is usually part of the discussion with customs.
X OUTLOOK AND CONCLUSIONS
As is appropriate in this post-BEPS era, the ITA announced that it would adopt the BEPS principles as an amendment to the Ordinance with respect to transfer pricing matters. At this stage, the amendment has already passed the first of three readings in the Israeli parliament and is expected to be adopted by 2020. The applicable effective date of the proposed legislation has not yet been determined. Additionally, the ITA regularly publishes circulars announcing its position on various matters, such as safe harbours and applicable methods for pricing inter-company transactions, business restructuring and digital economy measures.
Measures have been carried out concerning several subjects, including the following:
- The signing of the MCAA CbCR, as well as the steps being taken regarding proposed legislation, implementing Action 13 of the OECD BEPS Action Plan, indicating the adoption of the three-tier documentation approach of CbCRs, master files and local files supplemented with additional relevant material. Although we do not expect many Israeli MNEs to be subject to CbCRs given the size of the Israeli market, we do anticipate that subsidiaries of foreign MNEs may be required to file in the event that the parent MNE is obligated to file in its jurisdiction. Furthermore, the ITA's increased focus on business or economic substance when analysing value chains and transactions involving the transfer or use of intangible properties, indicates that functions contributing to the creation of value, as well as geographic locations, constitute important criteria when determining the appropriate attribution of profits among group members in MNEs. This is also affecting the government subsidies granted to R&D centres in Israel.
- The ITA's intention regarding the adoption of the recommendation promulgated under Actions 8–10 of the OECD BEPS Action Plan, with respect to intangibles, should be taken into consideration by Israeli tax practitioners when conducting their inspections of transactions in accordance with the new rules for HTVI. Greater emphasis should be placed on the attribution of profits based on value creation, and consideration should also be given to the DEMPE principles. Taxpayers are therefore recommended to conduct transfer pricing studies in accordance with the OECD's recommendation. Particular emphasis should be given to appropriate delineation of the tested transaction to reflect the business reality of the transaction, providing a detailed functional analysis with emphasis on important functions that contribute to the creation and value of the intangible assets under review, as well as related risks.
- The ITA's intention regarding the adoption of the recommendations promulgated under Actions 8–10 of the OECD BEPS Action Plan with respect to inter-company financing transactions should be taken into consideration by taxpayers when constructing their intra-group financing. It is therefore recommended that financing transactions be properly constructed and documented in accordance with the BEPS Actions 8–10 guidelines, focusing on a detailed description of people functions involved and empirical evidence demonstrating the management and control of risks by relevant parties involved in a controlled financing transaction.
- The ITA has reviewed its assessment concerning the applicability of the profit split method in service transactions that include the provision of significant services contributing to the creation of profits (e.g., R&D, marketing and management). Nonetheless, this is more of an evolution than a revolution as, because of the significant level of R&D activity in Israel, the ITA has already been focusing on, inter alia, lines similar to those presented by the BEPS principles, and thus we do not expect the nature of the audits to change, but rather their intensity and scope.
- The ITA has recently carried out audits on marketing services providers that do not, in the ITA's view, adhere to the circular issued by the ITA in this respect.
- The ITA has recently carried out audits on MNEs whose management (or parts thereof) is located in Israel.
- With respect to Pillar One of the OECD's Unified Approach, the Unified Approach covers mainly (but not only) highly digital companies, with a broad focus on consumer-facing businesses (sales of goods or provision of digital services that are consumer facing). Under the Unified Approach, economic nexus is no longer dependent on physical presence in order to acquire taxation rights over a non-resident taxpayer's revenues from digital activities. Rather, economic nexus can be established based on a certain sales threshold (adjustable based on the size of a particular market to ensure smaller markets get their fair share), while taking into account additional factors such as online advertising targeted at a specific market.
- While Israel has not yet enacted laws addressing digital economy taxation rights, the ITA published Tax Circular 4/2016 which takes somewhat aggressive positions that, practically speaking, may subject almost every non-Israeli company active in the Israeli market to Israeli corporate income and value added taxes and registration obligations. For treaty-partner countries, the circular expands the interpretation of a PE through a 'fixed place of business' or a 'dependent agent' in such tax treaties in the context of the digital economy.
- For companies resident in non-treaty jurisdictions, the circular notes that the ITA will acquire taxing rights over a non-Israeli taxpayer based on domestic law principles (namely, business activity conducted in Israel, which generally requires a lower threshold than the PE treaty standard). One of the examples that the circular cites as meeting this standard is the existence of 'significant digital presence' even without a physical presence in Israel.
- Given that the circular interprets existing law and PE definitions, it applies retroactively. On this basis, many multinational companies with digital activities in Israel are undergoing audits for all open tax years, which are supervised by a special tax force at the ITA national office.
1 Eyal Bar-Zvi is a partner and the head of the transfer pricing department at Herzog Fox & Neeman Law Offices. The author wishes to thank Annette Cohen for her contribution to this chapter.
2 In our advisory work we adhere to the new OECD Guidelines issued in 2017, as well as any new complementary guidance of the OECD. The Israeli courts and ITA's issued tax circulars also normally apply the OECD Guidelines.
3 Concerning financing transactions, the provisions of Section 85A explicitly address inter-company credit transactions (loans) and capital notes. However, in practice all types of financial arrangements between related parties must be transacted at arm's length.
4 The author's firm, Herzog Fox & Neeman Law Offices, is the only law firm participating in these talks.
5 The full range is spread between the minimum and maximum prices or percentile.
6 Audit trails or empirical evidence may include the number of FTEs on the payroll of the lender; a creditworthiness analysis of the borrower conducted by the lender; evidence of negotiation of the clauses to the inter-company loan agreement, etc.
7 Development, enhancement, maintenance, protection and exploitation of intangibles.
8 The author's firm, Herzog Fox & Neeman Law Offices, among other parties, is engaged in these discussions with the ITA.