Dear Client, Colleagues and Friends,

This is to update that the Israel Tax Authority (the “ITA”) published yesterday a draft circular (the “Draft Circular”) for comments from the public to be provided until March 23, 2025.[1] The Draft Circular is the result of collaborative efforts by the ITA, the Budget Division at the Ministry of Finance, and the Israel Innovation Authority, following a government decision on this issue, and is intended to provide certainty for multinational companies on the implementation of transfer pricing methodologies. This issue is very significant for multinational companies with business activities in Israel (commonly through Israeli subsidiaries that serve as R&D centers providing R&D services to the multinational groups), due to the threat of profits-split transfer pricing-based adjustments. While a final version of the Draft Circular is yet to be published, the publication of the draft is an extremely important step and is particularly relevant to multinational groups.

The Draft Circular notes that it aims to provide certainty by adopting a route for obtaining a tax ruling from the ITA in cases where an Israeli technology company is acquired and its intellectual property (“IP”) is then transferred outside Israel, following the acquisition, and it becomes an R&D center. In addition, the Draft Circular proposes the adoption by the ITA of internal audit mechanisms, as further discussed below.

Internal Audit Mechanisms

The ITA has introduced an internal audit mechanism in this part of the Draft Circular, which requires various permissions from high-level ITA officials, prior to issuing a tax assessment, based on a claim that the transfer pricing methodology should be changed (namely, a profit-split as opposed to a cost-plus (TNMM/CPM) methodology).

More specifically, pursuant the Draft Circular:

• For multinational companies with less than NIS 10 billion (~US $ 2.8 billion) in revenues:

• • A referent from the Professional Division is required to be involved and accompany the assessment process, even before raising a profit-split claim against the taxpayer.

• • A Division Manager (or a higher-ranking officer) at the Professional Division needs to approve in advance the assessment issuing a so-called Stage A assessment (which is the notice of deficiency issued by the local tax office at the end of a tax audit. The taxpayer can submit an administrative appeal, an “objection,” to the local office with respect to such an assessment).
  • The Head of at the Professional Division needs to approve in advance issuing a so-called Stage B assessment (which is the notice of deficiency issued by the local tax office at the end of the administrative appeal process and can be appealed by the taxpayer to a District Court).

• For multinational companies with more than NIS 10 billion (~US $ 2.8 billion) in revenues:

• • In addition to the accompanying referent from the Professional Division, the Head of the Professional Division is required to approve in advance a claim against the taxpayer regarding profit-split.

• • For a Stage A assessment, the Head of the Professional Division is required to approve in advance issuing an assessment, in consultation with a senior ITA officer (the Deputy for Economy and Professional Advisor to the Director of the ITA).

• • The Director of the ITA is required to approve in advance an issuance of Stage B assessment.

These limitations apply with respect to companies that meet the following conditions:

• • The ultimate parent company of the multinational group is a foreign company, resident in a jurisdiction with which Israel has signed a tax treaty, and holds all rights, directly or indirectly, in both the Israeli company and the company receiving the R&D services.
  • Israeli residents (including former residents, during the 10-year period preceding the tax year for which the audit is conducted), taking into account various attribution rules and certain reliefs for publicly traded companies, do not hold more than 10% of the so-called “means of control” of the ultimate parent company from the date of establishment of the Israeli company until the tax year for which the audit is conducted.
  • The Israeli company’s income is generated from providing R&D services, and it doesn’t have any activities or assets that are not related to the provision of the R&D services. The Draft Circular clarifies that this condition is not tainted, if the ultimate parent company holds, directly or indirectly, another Israeli company with other activities, in addition to the Israeli company serving as an R&D center.
  • Based on the intercompany agreement between the Israeli company providing the R&D services and the company receiving them, the Israeli company is renumerated on a cost-plus (TNMM/CPM) basis.
  • The Israeli company’s income qualifies as “preferred income” under the Law for the Encouragement of Capital Investments of 1959 (the “Encouragement Law”), and the Israeli company meets the conditions required under said law for benefiting from reduced tax rates.
  • The Israeli company needs to attach a schedule to its annual tax return (ITA Form 1385) confirming, that it is in compliance with domestic transfer pricing rules as well as OECD transfer pricing guidelines, the attribution of profits with respect to the R&D services should are based on a TNMM/CPM methodology, and attach the inter-company R&D services agreement and a transfer pricing study, with a supporting DEMPE analysis and a comparables matrix.

Importantly, the Draft Circular notes that the above provisions apply to assessments (whether Stage A or Stage B) that the ITA has already began to conduct, provided that from the date of publication of a final circular until the date of the statute of limitations, more than 6 months remain.

Safe Harbor when Purchasing and Extracting IP

The Draft Circular introduces a new safe harbor, aimed at providing further certainty to multinational companies that purchase Israeli technology companies and subsequently transfer their IP outside of Israel, and turn them into R&D centers. Under this safe harbor, if tax was paid in connection with the sale or transfer of the Israeli company’s IP, the company (now the R&D center) will benefit from this safe harbor ‘protection’ for a period of 8 tax years (the “Validity Period”). Put differently, the Draft Circular indicates that when applicable, the ITA would issue a tax ruling (see further below), which will be valid throughout the Validity Period, confirming that (1) the TNMM/CPM transfer pricing methodology is applicable in connection with the R&D services; (2) the margin over the cost; and (3) the consideration attributable to the sale of the IP, are all at arm’s length, essentially preventing the ITA from raising a profit-split claim in connection with the sold IP, even where such IP continues to be developed in Israel. The conditions for the safe harbor are as follows:

• The acquired Israeli company was a so-called “preferred technological enterprise”, its income qualifies as “technological income” (or entitled to be qualify as such, if the company did not have taxable income) and the IP Is a “preferred IP”, all as defined under the Encouragement Law.
• The Israeli company meets the conditions noted above throughout the Validity Period.
• While the acquiring company can be a foreign or Israeli resident company, the acquisition funding used for acquiring the Israeli company, is sourced outside Israel or from profits that were taxed in Israel, and the acquisition of the IP must be from the acquiring company’s own capital.
• The ultimate parent company of the multinational group and/or its significant shareholders (very generally, 10% or more holders) must not have been significant shareholders in the acquired Israeli company prior to the acquisition, and vice versa.
• The Israeli company transfers all of its rights in the IP within 30 days from the closing date of its acquisition.
• The consideration for the transferred IP (“TPIP”) must be at least 85% of the aggregate consideration paid in the acquisition transaction in which the company’s rights were acquired, plus excess balance sheet liabilities, off-balance sheet liabilities to the Israel Innovation Authority or bonuses for employees, minus cash and cash equivalents. The value should be calculated on a grossed-up basis, taking into account the tax liability for the transfer of the IP. This will typically result in a TPIP that exceeds the stock purchase price, deviating from the ITA’s published guidance on FAR transfer valuations and previous settlement agreements. As a result, it is expected to attract significant public commentary, and it remains to be seen whether it will be incorporated into the final guidance.
• During the Validity Period, the Israeli company continues to provide R&D services for development of the IP it sold to the company receiving such services.
• Following the acquisition of the Israeli company, and throughout the Validity period, the number and employment cost of its employees providing R&D services does not decrease by more than 20% compared to the two fiscal years prior to the acquisition, unless such higher-than-20% decrease is yet lower than an overall decrease in the number and cost of employees across the multinational group.

A taxpayer that meets these conditions will be able to apply for, and obtain, a specific tax ruling from the ITA. The Draft Circular indicates that the procedures thereunder are applicable for the 2025-2028 tax years, with a review planned for 2028 to consider any necessary extensions or changes.

The Draft Circular is silent on the features of application of the TNMM. It is silent on the margin to be applied on the costs. We expect that the ITA will request at least 12%. It is also silent on the costs to be included in the cost base. In the past there have been major disputes over characterization of various expenses as pass-through costs, and it remains to be seen how the ITA will approach this issue in its ruling.

Finally, the Draft Circular provides two additional routes for receiving clarity regarding the applicable TP methodology. First, the Draft Circular notes that companies that provide R&D services to their non-Israeli affiliates can approach the ITA for a preliminary tax ruling confirming the applicability of the cost-plus (TNMM/CPM) method and the applicable margin. The Draft Circular determines that the ITA shall not issue a disputed tax ruling unless the Head of at the Professional Division approved such tax ruling. In addition, the Draft Circular notes that another alternative is to apply for a Bilateral (or Multilateral) Advance Pricing Agreement which the ITA encourages.

We are reviewing the provisions of the Draft Circular carefully, and expect to submit, together with other professionals and professional organizations and associations, concentrated comments to the Draft Circular, prior to the end of the public comment period. To the extent the provisions of the Draft Circular are relevant to you or may otherwise have an impact on your international tax planning strategies, we encourage you to reach out to us to discuss and share any comments or concerns you may have in relation to the Draft Circular, during the public comment period. We will, of course, keep you posted on the developments in this regard and upon the publication of a final version of the Draft Circular.

Our tax department has extensive experience in these issues. We regularly advise and assist large multinational companies in M&A transactions and represent Israeli companies that are part of multinational groups in tax audits and tax litigation on these matters. We are available to discuss the potential impacts of the Draft Circular or to provide any tax advice related to the matters discussed herein.

[1] A link to the draft circular in Hebrew can be found here.