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Transfer pricing in a nutshell: Israel

Article by: Eyal Bar-Zvi (Herzog Fox & Neeman)


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. Guidance regarding transfer pricing is provided in several tax circulars issued by the Israel Tax Authority (ITA).

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 Guidelines) 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:

  1. the right to profits;
  2. the right to appoint directors or the general manager or other similar positions;
  3. the right to vote in the general shareholders’ meeting;
  4. upon liquidation of the company, the right to a share in the equity after all debts are paid; or
  5. 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 financing (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.

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:

  1. identify the cross-border controlled transactions within the group;
  2. identify the tested party for each relevant transaction;
  3. 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;
  4. select the appropriate transfer pricing method or methods;
  5. select the comparable companies and establish an arm’s-length range, determined by the comparable companies; and
  6. 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.

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 regulationsTax 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 functions, assets or risks (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 harboursDistribution activity

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).Marketing activity

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).Low-value-added services

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.Draft circulars

Currently, the ITA is holding round-table talks on other draft circulars, including in the fields of burden of proof; implementation of development, enhancement, maintenance, protection and exploitation of intangibles (DEMPE) analysis; and profits associated with management functions.

Broader taxation issuesi 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).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.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.