Transfer Pricing 2022 Comparisons

In Israel, the transfer pricing rules are governed by Section 85A of the Income Tax Ordinance [New Version], 5721-1961 (the “Ordinance”), and the Income Tax Regulations (Determination of Market Conditions), 5767-2006 promulgated thereunder (the “Regulations”).

Section 85A provides that intercompany transaction shall be taxed according to arm’s-length conditions. The broad language of Section 85A makes it applicable to various types of intercompany transactions, including sale or transfer of assets or other rights, provision of services of different sorts and credit transactions (excluding capital notes that fulfil certain conditions).

The Regulations provide instructions for selection and application of the methods for determination of arm’s-length conditions (“market conditions”).

The Israeli Tax Authority (“ITA”) has issued several tax Circulars and public tax rulings which provide additional guidance regarding transfer pricing. These rules generally adhere to the arm’s-length principle of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the “OECD Guidelines”) as well as the approach provided by US transfer pricing rules. These publications reflect the ITA’s position but are not legally binding on taxpayers or the courts.

Pending Changes: Updating Israeli Tax Law to Reflect BEPS Action 13

Section 85A was added to the Ordinance on 1 January 2003 (as part of a tax reform) and the Regulations were enacted and approved effective 29 November 2006. Since then, there have been no major changes to the regime. 

However, certain legislative changes are pending. In January 2017, a legislative bill was introduced to amend the Ordinance to implement certain transfer pricing provisions under Action 13 of the OECD Base Erosion and Profit Shifting (BEPS) Action Plan. On 18 October 2021, the Knesset (the Israeli Parliament) gave its approval to the first reading this bill, which would amend Section 85A and add Sections 85B and 85C to the Ordinance. The bill will now be discussed by the Knesset Finance Committee, before being returned to the Knesset for its second and third readings. It is anticipated that this amendment will be enacted by the current Knesset.

The amendment will increase the reporting and documentation requirements of Israeli companies that are part of multinational groups, or are parties to an international transaction with related parties. It includes requirements for providing data and documentation regarding the related party transactions, the parties to the transactions and the entire group. Accordingly, in addition to the regular local file (ie, 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. The amendment will also require an Israeli company that is the ultimate parent of a multinational group with revenue in excess of ILS3.4 billion to submit a report on the group and its activity on a country-by-country basis.

Recent Developments

The following paragraphs summarise the recent development in the ITA’s position with respect to various issues, as published in its transfer pricing Circulars in the past few years.

Burden of evidence

Section 85A(c)(2) shifts the burden of evidence to the ITA if the taxpayer provided all the data and documentation that was requested by the ITA. Tax Circular 1/2020 presents heightened standards that must be met, according to the ITA’s position, in order to shift such burden of evidence from the taxpayer to the ITA, based on the Israeli Supreme Court ruling in the Kontera case (see 14.2 Significant Court Rulings).

According to the ITA’s position, the mere filing of a transfer pricing study is not sufficient to meet the requirements of Section 85A(c)(2) and shift the burden of evidence to the ITA, and lack of adequate documentation may disqualify the taxpayer from meeting the requirements of this provision. The ITA provides an open list for data that, if not provided, may lead to this result, including:

• the reasoning for choosing the applicable transfer pricing method;
• documentation of the search for comparables;
• the reasoning for choosing or rejecting comparables; and
• financial data of comparables.

In such cases, the ITA can set the tax assessment without the need to provide a complete study on its behalf. This Circular, which is not legally binding on taxpayers or courts, allows the ITA significant discretion in transfer pricing audits and as a practical matter may result in the burden of evidence not shifting to the ITA even in cases where the taxpayer has provided all relevant information.

Business restructurings

Tax Circular 15/2018 deals with the identification and characterisation of business restructurings within multinational enterprises (MNE’s) that involve an Israeli company.

The ITA discusses particular use cases such as the transfer of functions, assets and risks (FAR) without transfer of legal ownership, which shall be examined based on economic ownership; and means to differentiate a sale from a grant of a right of use. It also discusses means for determination of arm’s-length prices and valuations for a business restructuring based on similar transactions (including guidelines for comparison to a previous acquisition of shares using the acquisition price method, following the discussion in the Gteko case – since business restructuring following an acquisition of a company by an MNE is a typical case in the Israeli landscape) or in the absence of such transactions. While the ITA’s position purports to rely on the OECD Guidelines, it has expressed a position that no value disappears or diminishes within a business restructuring on the basis of a misinterpretation of the examples in Chapter 6 of the OECD Guidelines.   

Methods and pricing for certain transactions

Tax Circulars 11/2018 (“Determination of the appropriate transfer pricing method for distribution, marketing and sales activities of a multinational group in the domestic market”) and 12/2018 (“Transfer pricing – profitability rates and ranges in certain transactions”) set out the ITA’s approach towards FAR analysis and transfer pricing methods appropriate in connection with sales, marketing and distribution services provided by an Israeli entity to a non-Israeli entity within the same MNE. The Circulars focus on the factors that should be accounted for in the performance of a FAR analysis with respect to such activities, the approach to be used to classify the service-providing entity as a marketing services entity or a sales (distributor) entity, the appropriate transfer pricing method to apply to such entities and the ranges of profitability (safe harbours) it sees as appropriate for these types of Israeli entities.

Operations of foreign multinationals in Israel through the internet

Tax Circular 4/2016, which predates the BEPS 2.0 and Pillar 1, provides guidelines under which foreign companies may be taxable in Israel with respect to income from e-commerce and digital services provided to Israeli residents. According to the Circular, which reflects the views of the ITA, such activity may give rise to a permanent establishment (PE) of the foreign company in Israel for tax purposes. The Circular discusses the criteria for an Israeli PE determination in the context of the digital economy and provides the rules for attribution of income to the Israeli PE, taking into account whether the company operates from a country with which Israel has a double tax treaty.

The Israeli transfer pricing rules apply to cross-border transactions in which a special relationship exists between the parties to the transaction. The term “special relationship” is defined as the relationship between a person (including an entity) and that person’s related parties (the term used in the Ordinance is “relatives”), as well as the control of one party to the transaction over the other, or the control of one individual over the other parties to the transaction, directly or indirectly, alone or together with another.

“Control” means holding, directly or indirectly, 50% or more of one or more means of control, for at least one day during the tax year. A means of control is defined as any one of:

• the right to profits;
• the right to appoint a director or a general manager of a company, or other similar positions;
• the right to vote in the shareholders’ meeting;
• the right to the remaining assets of the company upon its liquidation after all debts have been paid; or
• the right to instruct the holder of one of these rights on how to exercise that right.

“Together with another” means together with a relative, or a person who is not a relative, if they regularly – directly or indirectly – co-operate by agreement on matters important to the body of persons.

In addition to the 50% threshold for determining “control”, the ITA may determine that a special relationship exists based on a qualitative test even if the quantitative threshold for control is not satisfied.

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. The Regulations provide the following list of specific transfer pricing methods:

• the comparable uncontrolled price or transaction (“CUP/CUT”) methodology;
• the resale price method;
• the cost-plus method;
• the comparable profits method (“CPM”, referred to as the transactional net margin method (“TNMM”) in the OECD Guidelines); and
• the profit split methods (comparable or residual).

Under the Regulation there is a hierarchy under which the CUP/CUT method will be deemed the most appropriate one if it can be applied.

The Regulations provide that if it is not possible to apply the CUP/CUT method or any other of the specified methods, a taxpayer may use “another method that is the most suitable in the circumstances, which compares the international transaction with a similar transaction”. An unspecified method ranks lower in the ITA’s hierarchy of methods (see 3.3 Hierarchy of Methods) than the others, so that the burden of reasoning and proof is borne by the party who determined the price for the transaction based on methods not specified in the Regulations. The ITA has also recognised the availability of other methods in connection with the valuation applied in the case of a business restructuring.

There is a hierarchy under the Regulations. The first method which should be used to determine the arm’s-length conditions of a transaction is the CUP/CUT methodology, according to the Regulations (if applicable). The primary use of the CUP/CUT method may also be inferred from Section 85A, which provides that where a special relationship exists between the parties to a transaction, the transaction should be reported and taxed as if it were at arm’s length – ie, under the price and conditions that would have been determined between unrelated parties in the same circumstances. This provision indicates that the most preferred method is the CUP/CUT one, which compares the price charged for goods or services transferred in a controlled transaction with the price charged for goods or services in an uncontrolled transaction between comparable independent parties in similar circumstances, using 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).

In situations where the CUP/CUT method cannot be used, the next method that should be employed is one of the “profit” methods – ie, methods that compare the level of profitability of the parties from a controlled transaction with the level of profitability of parties to uncontrolled transactions. The comparison could be based on different possible indexes of profitability. The guidelines for selecting the proper profitability comparison methodology are detailed in the Regulations. The selection depends on the circumstances and varies between fields of operation. The primary methods included under the gross profits method are the cost-plus method and the resale price method. If those are not applicable, then the comparable profits method should be used. The profit split method is at the same level of hierarchy as the three aforementioned methods, and can be selected alternatively to those methods if it is the more appropriate method under the specific circumstances.

Only if it is not possible to apply the CUP/CUT method or one of the profit methods, may a taxpayer use “another method that is the most suitable in the circumstances, which compares the international transaction with a similar transaction”.

The taxpayer may be required to submit a transfer pricing study (under the current legislation, the study has to be submitted within 60 days from an ITA request) which contains the range of values and the inter-quartile range of comparables. The basis for comparison is the value range obtained from comparables. An international transaction will be deemed a transaction at arm’s length if the result obtained from its comparison to comparables, using the methods prescribed by the Regulations, is within the inter-quartile range between the 25th and the 75th centiles. If the pricing of the international transaction is outside this range, the transaction price will be adjusted to the 50th centile in the range.

The Regulations provide that a transaction can only be considered a “similar transaction” if adjustments were made to the extent there are differences between the related party transaction and the comparables. Adjustments can be made for the field of operation (ie, manufacturing, sales, distribution, R&D, and provision of services), the contractual terms, risks (including geographic, financial and credit risks), economic environment and the effect of goodwill or other intangible assets.

There are no specific rules relating to the transfer pricing of intangibles in Israel. However, the ITA has been considering a tax Circular that would make public its position on the use of the profit split method in connection with R&D centres that have traditionally been charging on a cost plus basis using the comparable price method. The ITA basically suggests that entities providing R&D services may have economic ownership of the MNE’s intangibles purporting to rely on a development, enhancement, maintenance, protection and exploitation (DEMPE) analysis. The ITA’s view on what would constitute indications for “economic ownership” of intangibles by an Israeli entity operating an R&D centre are as follows:

the origin of the intangible asset and “its activity” began in Israel;

• the Israeli entity conducts activities in addition to the R&D;
• the headquarters of the MNE is located in Israel;
• the R&D centre in Israel bears some of the significant risks relating to the R&D; and
• the R&D centre conducts activities creating a unique and valuable contribution to the MNE.

In contrast, the following criteria may indicate the entity providing R&D services does not have “economic ownership” of intangible assets:

• the Israeli R&D centre was established at the initiative of the foreign MNE;
• decisions relating to the intangibles are made by employees of the MNE headquarters located outside of Israel;
• the Israeli R&D centre does not bear any business risks;
• the Israeli R&D centre cannot fund any activity that would establish economic ownership of the intangibles;
• the Israeli R&D centre does not have accumulated losses as a result of R&D; and
• the R&D centre does not conduct any activity creating a unique and valuable contribution to the MNE.

Consistent with the recommendations promulgated under BEPS Action 8 relating to hard-to-value intangibles, the ITA’s position is that it is entitled to use ex post evidence about financial outcomes in evaluating ex ante pricing arrangements. However, the ITA’s discretion is limited and the ex-post evidence may not be used without considering whether the information on which the ex post results are based could or should reasonably have been considered by the associated enterprises at the time the transaction was entered into.

There are no special rules in the Ordinance or the Regulations regarding cost sharing/cost contribution agreements. In Circular 9/2017 regarding the Encouragement of Investments Law (“Encouragement Law”) the ITA acknowledged that if an Israeli company is a party to a cost-sharing agreement which governs a development activity that is carried out from outside Israel, such activity shall be considered to have been performed directly by the Israeli company (for the purposes of calculating the company’s R&D expenses under the Encouragement Law and the nexus formula). This is indicative of the ITA’s recognition of cost-sharing agreements in general. In the absence of particular rules or further guidelines that apply to such arrangements, the OECD Guidelines serve as an interpretive source for the tax treatment applicable to such agreements. The US Treasury Regulations are also a source of guidance when dealing with cost-sharing agreements that involve parties in the USA.

There are no specific rules regulating a taxpayer making affirmative transfer pricing adjustments after filing tax returns and an affirmative adjustment would be considered like any amendment of the tax return after having been filed. This would be possible as long as the statute of limitations had not expired but as a matter of practice the ITA would be resistant.

Israel has an extensive tax treaty network with customary exchange of information clauses under which Israel shares information with and solicits information from other countries. Also, effective 1 January 2019, Israel became a signatory to the Multilateral Instrument (MLI). 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). This agreement allows all participating countries to bilaterally and automatically exchange CbCRs with each other. It is expected that Israel will amend its documentation requirements to also include the creation and filing of CbCRs, and to enact legislation regarding surrogate filing.

Israel has an advance pricing agreement (APA) programme under Sections 85A(d) and 158 of the Ordinance.

Applications are filed in accordance with the general mechanism included in the Ordinance, allowing taxpayers to approach the ITA for a private letter ruling regarding the tax outcomes of a certain action, income, profit, expense or loss (including in transfer pricing issues). The ruling could be granted unilaterally or in agreement with the taxpayer.

The Transfer Pricing Department of the ITA administers the APA programme.

As opposed to APA provisions, mutual agreement procedure (MAP) provisions have not been incorporated into domestic Israeli law. However, Section 196 of the Ordinance provides that once a tax treaty becomes effective, its provisions supersede any domestic Israeli law provisions. The Israeli Tax Authority issued instructions on MAPs in Implementation Order 23/2001, explaining the purposes of MAPs and setting forth the guidelines for filing a request with the ITA, and has recently stated its intention to update this Implementation Order in light of the minimum standard on dispute resolution under BEPS Action 14, which Israel is obliged to implement. In case of a bilateral APA with another treaty country, which have thus far been very rare in Israel, both the APA provisions as well as the MAP would be used to conclude the agreement.

There are no limitations. An application may be made by any taxpayer seeking an APA to cover an international transaction or a series of international transactions between related parties. Unilateral and bilateral APAs are available.

There is no particular timeframe for the filing of an APA application. Taxpayers are subject to the general timeframe for applying for a private letter ruling, according to which the application must be filed prior to the filing of the tax return that accounted for the action, income, profit, expense or loss which is the subject of the ruling.

There is no filing fee for an APA application.

There is no specific guidance for APA term limits. In practice, the APA term will range between three to five years. In a sole published summary of an APA ruling that was published by the ITA (Tax Ruling 3006/19), the approval was granted for a period of three years.

Section 85A(d) refers to the right of the taxpayer to seek a “preliminary ruling”, indicating that the APA is viewed as prospective. As a practical matter it may be agreed that the APA would cover a prior open year.       

There are currently no specific penalties that relate to transfer pricing; although they have been proposed. The ITA may impose standard penalties under the Ordinance, including linkage, interest, and statutory fines on transfer pricing assessments. Criminal liability may be imposed under certain circumstances, although such liability has not been imposed (only threatened by the ITA) to date by the courts in the context of transfer pricing. The general penalties would be 15% or 30% of the additional tax liability depending on the magnitude of the additional tax liability and whether the taxpayer was deemed negligent or intentional in the tax return.

The ITA also takes the position that it is entitled to impose secondary adjustments. If the ITA made a primary adjustment in its assessment and determined the taxpayer’s profits to be higher than the profits reported by the taxpayer, the ITA may also classify the difference as an intercompany balance. If, for example, the balance is due between the Israeli subsidiary and a non-Israeli parent, the ITA could classify such balance as a deemed dividend or a deemed loan, imposing a secondary adjustment in the form of additional tax liability on dividend withholding tax or tax on the deemed interest charges (respectively). Despite the absence of an explicit source that allows for secondary adjustments in the Ordinance, secondary adjustments were implicitly approved by the Supreme Court in the Kontera case without much deliberation (see 14.2 Significant Court Rulings). 

Draft legislation has been proposed, but not yet enacted, to amend the Ordinance to include transfer pricing provisions to implement the documentation requirements contemplated by the OECD Transfer Pricing Guidelines (see 1.2 Current Regime and Recent Changes).

Israel’s domestic transfer pricing rules, however, require taxpayers engaged in cross-border controlled transactions to include a separate form (Form 1385, and Form 1485 specifically for intercompany financing transactions) in their annual tax returns. This form requires the taxpayer (i) to disclose the details of these intercompany transactions (including the volume of the transactions, transaction types, terms and conditions, and identifying the parties thereto) and (ii) to declare that their international transactions between related parties are conducted at arm’s length and are in compliance with the Regulations. The current version of the form also requires the taxpayer to provide additional details regarding the transfer pricing method used by the taxpayer, the profitability rate applied to transactions, and whether the transactions are reported based on certain safe harbours outlined in Tax Circular 12/2018.

The ITA and the courts consider the OECD Guidelines as guiding principles, particularly in the absence of detailed rules in domestic legislation. Amendments to the Ordinance have been proposed to implement and adopt the principles of the OECD Guidelines. While these are anticipated, there is no certainty regarding when they will be enacted and effective.

While the ITA has adopted many of the principles of the OECD Guidelines, it has also expressed positions that deviate from them on certain issues, as in the context of the profit split method detailed in 4.1 Notable Rules or as further detailed in 11.3 Unique Transfer Pricing Rules or Practices.

The arm’s-length principle is the foundation of the Israeli transfer pricing rules, and there are no prescribed circumstances under which a departure from such principle is provided. The future adoption of Pillar 1 may change that.

Even without formal amendment to the Ordinance and Regulations, the ITA, has sometimes selectively adopted many of the principles of BEPS Actions 8–10, including guidance concerning restructuring and low-value-adding services, and measures related to the digital economy. 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, preferring, for example, a profit split method rather than the CPM. In other cases, the ITA has retroactively applied different methods from those used by the taxpayer, shifting between the CUP/CUT method and the CPM, in cases where profit split was not applicable.

In a public announcement made on 22 June 2021, the Israeli Ministry of Finance confirmed Israel would support and join the framework for Pillar One and Pillar Two and it was one of the countries supporting the announcement. The Ministry of Finance acknowledged that Israel would likely see some positive windfall as a result of an implementation of the Pillar One new taxing rights to market jurisdiction with respect to very large MNEs. However, the Ministry of Finance did not make any statement as to whether there would be an alignment of corporate tax rates with the agreed upon global minimum rate. A 15% corporate tax rate could threaten the Israeli preferred statutory corporate tax rates under the Encouragement Law, which makes available different beneficial corporate tax rates such as 6% for special preferred technological enterprises or 12% for preferred technological enterprises, as compared to the standard corporate tax rate of 23%. These rates are important for Israeli subsidiaries of foreign‐based MNEs but are also significant for Israeli‐based MNEs.

Israel has not yet made policy decisions on important issues, such as:

• whether it will implement Pillar Two only with respect to companies with revenue of at least EUR750 million (which would exclude most Israeli‐based MNEs) or apply it to all companies;
• whether such implementation will be consistent with the statutory commitment to the “stability” of the tax benefits provided under the Encouragement Law;
• how differences between tax rules and accounting rules will be addressed (such differences generally being a potential source for arbitrage and new controversies between MNEs and tax administrations); and
• the steps to be taken to maintain a competitive environment for foreign‐based MNEs, such as repealing withholding tax on outbound dividends (at least as an election for Israeli subsidiaries that may be subject to a 15% corporate tax rate).

There are no specific rules regarding allocation of risks between entities. An intercompany transaction that transfers risks from one party of the agreement to another is examined based on the same rules and principles as other transactions between related parties.

Israel refers to the OECD Guidelines with respect to transfer pricing matters and the UN Manual has no impact.

In Circular 12/2018, the ITA provided the following safe harbours for certain inbound intercompany transactions.

Distribution Activity

An Israeli low-risk distributor (LRD) that meets the criteria provided by the ITA in Circulars 11/2018 and 12/2018 may report an operating margin of 3–4% of sales performed by the entity.

Marketing Activity

An Israeli marketing services entity that meets the criteria provided by the ITA in Circulars 11/2018 and 12/2018 may use a transfer pricing method based on the costs of providing such services, and a markup over such costs within a range of 10–12% would be respected.

Low Value-Added Services

The ITA generally adopts the OECD Guideline’s definition of and approach to low-value-added services – ie, services that have a supportive nature and are not within the core activity of the MNE (in addition to other criteria). For taxpayers with transactions involving low-value-added services, the ITA provided that a transfer pricing method based on the costs of providing such services with a markup over such costs within a range of 5% would be respected.

Taxpayers submitting reports accordingly would be exempt from the requirement to provide benchmarking support for the prices determined. Transfer pricing documentation is still required, including the rationale for the selection of the method and safe harbour applied by the Circulars.

There are no specific rules governing savings that arise from operating in Israel.

The ITA has expressed in audits and public appearances positions on certain issues that are considered extreme. The following are some prominent examples.

Broad Interpretation of Business Restructuring Events

The ITA has a broad view of the events that shall give rise to a business restructuring that is regarded as a taxable sale, giving rise to a capital gains event for the restructured company. The ITA has raised claims that a business restructuring has occurred even when the business in Israel was shut down (and not continued in another country). See further details on this issue in the description of the Gteko and Broadcom cases in 14.2 Significant Court Rulings.

Application of the Profit Split Method to R&D Centres

As described in 4.1 Notable Rules, in many cases, the ITA argues that the appropriate transfer pricing method to be applied to Israeli R&D centres of a foreign-based MNE is the profit split method, rather than cost-plus. For example, in Circular 1/2020, the ITA expressed its opinion that when both parties to the transaction have valuable intangibles that significantly contribute to the creation of profit or loss, the profit split method should be the default method. If the cost-plus method was applied, the lack of a sufficient explanation for not selecting the profit split method might lead to a conclusion that the taxpayer has not met the required standard in order to shift the burden of proof to the ITA.

Limitation on Chargeback Payments for Equity-Based Compensation

The ITA has taken a restrictive (and questionable) approach with respect to outbound reimbursement for stock-based compensation of foreign companies granted to employees of Israeli companies within the same MNE (recharge or chargeback payments), inconsistent with the position of the OECD. In January 2021, the ITA issued Circular 1/2021 titled “Payment to a Parent Company for Grants of Stock-Based Compensation to the Employees of its Subsidiary (Recharge Agreements), as part of an International Transaction” setting forth its position on the classification of recharge payments to the parent company. Generally, the ITA’s view is that a recharge payment should be classified as a dividend (or a capital reduction, if such payment does not meet the conditions specified in the Circular.

The Circular first provides that the reimbursement payment to the parent for the stock-based compensation would be deductible only to the extent allowed under the provisions of the Ordinance, which generally provides in Section 102(d) that the deductible amount in respect of stock-based compensation is the lower of the employee’s ordinary income and the recharge amount paid to the parent company. The Circular then focuses on the classification of the recharge payment to the parent and examines whether it should be deemed a dividend. The Circular provides that a recharge payment will not be classified as a dividend (or a capital reduction), if all of the following conditions are met:

• the payment to the parent company is only with respect to stock-based compensation that has vested – the ITA’s view is that the recharge payment cannot occur prior to the vesting of the stock-based compensation but does not restrict the actual payment from being made later than that (so the recharge payment may also occur upon the exercise of a stock option or the sale of shares even if vesting was earlier);
• the payment is based on the value recorded as an expense in the financial statements according to acceptable accounting principles (typically the fair value of on the date of grant);
• a recharge agreement was executed prior to the grant of the stock-based compensation; and
• the cost of the stock-based compensation to the employer-subsidiary is included in the cost basis, or as an expense for the purpose of determining the arm’s-length pricing for transactions of such subsidiary.

There is no formal cross-referencing or co-ordination between the transfer pricing rules and valuation for customs.

The controversy process in Israel is the same with respect to transfer pricing as with other tax assessments.

Following the issuance of the assessment officer’s “best judgement assessment” (known as stage A), if discussions between the taxpayer and the assessment officer do not result in an agreement, the taxpayer may file a written administrative objection with the ITA detailing its arguments. The objection serves as a basis for de novo review of the case handled by a different officer from the same tax office (known as stage B). If within the later of one year from commencement of stage B or the lapse of four years from the end of the year in which the tax return under audit was filed, the audit and discussions in stage B do not result in an agreement, the assessing officer issues an assessment order, with respect to which the taxpayer may file an appeal with the District Court in the jurisdiction of the tax office. Both the taxpayer and the assessing officer have a right to appeal the decision of the District Court to the Supreme Court. The taxpayer does not have to pay the disputed tax for as long as the assessment is under dispute and under review of the tax office or with the District Court. If there is an appeal to the Supreme Court, the tax liability generally has to be settled in advance.

While there have been a few significant court rulings, particularly in the area of business restructuring discussed in 14.2 Significant Court Rulings, the judicial precedent is very limited. Transfer pricing cases are rarely adjudicated in courts in Israel, although their number has been increasing, with most controversies still settled with the ITA out of court.

Kontera Technologies Ltd. and Finisar Israel Ltd. v Tel Aviv 3 Tax Assessor

The Kontera case is the sole transfer pricing case adjudicated by the Supreme Court of Israel to date, whose ruling is therefore legally binding. Kontera and Finisar were two (unrelated) Israeli companies that provided R&D services to each of their US parent corporations under an intercompany cost-plus agreement, with the markup percent based on a transfer pricing study that has been performed. In both cases, the US parent granted stock options to employees of the Israeli company, and the cost of the stock options was excluded from the determination of the remuneration to be paid by the US parent to the Israeli company. The ITA claimed that the stock-based compensation expenses should be included in the operating costs when applying the cost plus charges.

The Supreme Court dismissed the appeal of the Israeli companies and held that the stock options component should be included in the determination of the cost for the purposes of the compensation under the R&D agreement with the US parent. Since Kontera’s adjusted profit rate after accounting for the costs of the stock based compensation fell below the value range (as provided by the Regulations), the Supreme Court determined that the correct level of profitability is at the 50th centile of the relevant range.

The court decision also discussed an administrative issue, the burden of persuasion and burden of evidence. The Supreme Court held that the burden lies with the assessing officer solely if the taxpayer sufficiently established its position based on an appropriate transfer pricing study and related documentation, comparing the transaction to similar ones. Finally, the ruling approved the secondary adjustment that was performed in this case (though the concept itself was not substantially discussed).

Gteko v Tax Assessor of Kfar Sava

The Gteko case concerned the tax implications of a transfer of IP assets to a related party outside of Israel following the acquisition of Gteko, and the consequences of the transfer of its employees to another related party within the acquiring MNE to this issue. The main dispute in the Gteko case concerned the substance of the asset transaction and the magnitude and value of the assets that should be treated as transferred.

The taxpayer argued that the transferred assets comprised only certain IP assets. The court, however, held in favour of the ITA and determined that the value of the transferred assets should reflect the entire value of the selling company (as determined in its acquisition) subject to minor adjustments. Since a vast majority of Gteko’s employees transitioned to become employees of another entity soon after its acquisition, the main functions of Gteko – R&D and marketing – were effectively transferred to a subsidiary of the acquirer.

Broadcom Semiconductor Ltd. v Tax Assessor of Kfar Saba

The Broadcom case dealt with a business restructuring of an Israeli company following its acquisition, including entering cost-plus agreements for providing services and a licence agreement for royalty payments. The key claim of the ITA against the company was that the company had undergone a “business restructuring” that had taken place after the acquisition of the company by Broadcom and that, in the framework of this business restructuring, the company had transferred its functions, assets and risks, constituting a taxable event.

The court (interestingly the judge was the same as in the Gteko case) held in favour of the taxpayer and determined that changes in business activity and even a business restructuring do not necessary indicate a sale of assets. In contrast to the Gteko case, in which the Israeli company was left as an “empty corporate shell,” with the parent company having removed from it of all of its economic value, Broadcom’s activity expanded and its revenue and profits increased.

There are no restrictions on outbound payments relating to uncontrolled transactions in Israel.

There are no restrictions on outbound payments relating to controlled transactions in Israel.

There are no specific rules regarding the effects of other countries’ legal restrictions in Israel.

Audit outcomes are not published. The ITA occasionally publishes summaries of tax rulings that were granted to particular taxpayers. In a sole published summary of an APA ruling (Tax Ruling 3006/19), it was determined that the cost-plus method should be applied in a services transaction in which an Israeli subsidiary provided services to a non-Israeli parent, which included advertising; monitoring of implementation of plans; and organisation of meetings, conferences, and occasional visits of the parent’s personnel. The operating profit margin was determined to be 10% of all direct and indirect costs incurred by the Israeli subsidiary. In addition, it was determined that the Israeli subsidiary could not incur financial expenses that exceed 10% of the total operating profits generated over the term of the approval. The approval was granted for a period of three years.

It is unclear whether, under Israeli law, the ITA may use comparable data from taxpayers’ tax filings or audits when those taxpayers are unrelated to the taxpayer under assessment. This is currently not a common practice of the ITA.

The ITA does, however, have a broad general authority to demand information from persons who have business relations with the taxpayer under assessment for the purposes of performing its assessments. In this framework, the ITA may investigate any person who has a business contact with the taxpayer (other than its relatives or employees) who, in the ITA’s view, may be able to testify regarding the taxpayer’s income, and demand such person to provide documents related to that income. In addition, the ITA may demand business owners provide to the ITA documents and information about their suppliers and customers or any person with whom they have a business relationship, even if those are not required for the purposes of assessing the business owner’s own income. These authorities are not specific, nor prohibited for use in transfer pricing assessments.

While the ITA has not published any guidance on the impact of the pandemic on transfer pricing issues, the economic impact clearly affects determination of fair market value and arm’s-length pricing methods and indices. It is unclear whether the ITA will take these into consideration in applying transfer pricing rules.

Other than a certain extension for handling APA applications, the government did not officially and comprehensively grant any relief or change in standards with respect to transfer pricing assessments.

The progress of tax audits in Israel has not been materially affected by COVID-19.