Income Attribution for R&D Centers and Post‑Acquisition IP Sales

On November 2, 2025, the Israel Tax Authority (“ITA”) published a circular regarding the transfer pricing framework for Israeli R&D centers (the “Circular”) (see the formal Hebrew publication here). This final publication follows the initial draft released earlier this year (see our clients update here), and it reflects extensive industry feedback and the outcome of the public consultation process, in which we actively participated by submitting detailed comments on behalf of our clients and the industry and engaging in multiple discussions with the ITA. The purpose of the Circular is to provide certainty to multinational enterprises with respect to the tax consequences of having Israeli activities, specifically in the context of having an Israeli R&D center or in the acquisition of IP developed by Israeli companies. As further detailed below, the ITA introduces some mechanisms that will provide certainty, but unfortunately it did not include a safe harbor with respect to the extraction of intellectual property from Israeli companies to the non-Israeli affiliates, although such safe harbor was included in the drafts of the circular.  

Internal Audit Mechanisms

The Circular introduces a formalized and restrictive internal audit framework governing the change of a taxpayer’s transfer pricing method within a tax audit from a cost‑plus methodology (TNMM/CPM) to a profit‑split methodology. This framework is designed to increase internal oversight, limit discretionary challenges, and enhance certainty for multinational groups. Under the Circular, the ITA must follow a tiered approval process before issuing any assessment that relies on a change in the TP method:

• For taxpayers that are members of a group with less than NIS 10 billion (~ USD 3 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 Senior 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 taxpayers that are members of a group with more than NIS 10 billion (~ USD 3 billion) in revenues:

1. • 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.

The Circular clarifies that these approvals relate only to the change of transfer pricing method itself and not to other elements of the assessment such as the calculation of the cost basis for the cost-plus calculation or other issues. In addition, the Circular clarifies that this mechanism shall apply to ongoing audits (both Stage A and Stage B audits) and with respect to all tax returns that will be submitted until the end of tax year 2029. These limitations apply with respect to companies that meet the following conditions:

1. Ultimate Parent and Group Structure. 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.
2. Israeli Ownership Limitation. Israeli residents (including former residents who would not qualify as “veteran returning residents” for Israeli tax purposes, had they returned to Israel in 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, directly or indirectly, 10% or more 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.
3. Transfer Pricing Method and Profitability Metric. the Israeli company is renumerated on a cost-plus (TNMM/CPM) basis.
4. Annual Tax Return Disclosure. 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, that the attribution of profits with respect to the R&D services should be based on a TNMM/CPM methodology and are so reflected in its financial statements. The Israeli company will also attach the inter-company R&D services agreement and a transfer pricing study, with a supporting DEMPE analysis and a comparables matrix.
5. Notice to the ITA. the Israeli Company is required to add a note to its Israeli tax return stating that it wishes to be subject to the Circular and that it meets the requirements stipulated thereunder, or alternatively, give a notice to this effect to the tax assessment officer at the outset of a tax audit.

  Importantly, the Circular clarifies that that it does not determine that cost-plus is not the appropriate TP model for Israeli R&D centers not meeting the above conditions.  

Increasing the Cost‑Plus Margin Above 14%

The Circular introduces a specific oversight requirement for cases where the ITA seeks to increase the cost‑plus margin implemented by the Israeli company to more than 14%. Where an Israeli R&D company meets all the conditions outlined above, and the assessing officer intends to determine, whether in a Stage A assessment or a Stage B assessment that the cost‑plus margin should exceed 14%, a Stage A assessment must be pre-approved by a referent from the Professional Division and a Stage B assessment must be pre-approved by the Head of the Professional Division.  

Tax Rulings with respect to Acquisition and Extraction of IP

In the initial drafts of the circular, the ITA contemplated introducing a safe harbor aimed at providing greater certainty to multinational companies that acquire Israeli technology companies, transfer their IP outside of Israel, and subsequently convert the Israeli entities into R&D centers. Under the first draft, the sale of IP for consideration equal to 85% of the acquisition price of the Israeli company’s shares (subject to certain adjustments), with the amount grossed-up at the Israeli corporate income tax rate, would be deemed at arm’s length. In the second draft, as well as the final Circular, the ITA removed the gross-up mechanism (see here our clients update regarding a landmark case in which the Court ruled in favor of our client and rejected the implementation of the gross-up mechanism). In addition, the second draft limited the safe harbor to cases where the acquirer was part of a multinational group with revenues exceeding NIS 10 billion, while also introducing additional adjustments to the acquisition price. The final version of the circular, however, eliminates the safe harbor entirely. Instead, it allows Israeli taxpayers to apply for a tax ruling to confirm that:

1. The consideration attributable to the IP sale is at arm’s length; and
2. The TNMM/CPM transfer pricing methodology applies to the ongoing R&D services for a period of seven years from the transaction date, effectively preventing the ITA from asserting a profit-split claim with respect to the sold IP, even if development activities continue in Israel. Notably, such a ruling would not determine the appropriate margin for the cost-plus compensation.

The ITA is required to issue its decision on such ruling applications within specified timelines. The circular sets out various conditions for obtaining a tax ruling. Among other things, a ruling will be issued only where the capital gain is subject to a 6% tax rate under the Law for the Encouragement of Capital Investments (and subject to obtaining the required approval from the Israeli Innovation Authority for applying this reduced rate), and provided that extensive documentation is submitted for the ITA’s review. The Circular clarifies that where the terms of the circular are met, capital gains from the IP sale will be treated as business capital gains, which generally may be offset against carried-forward business losses. The Circular further clarifies that the sale of the Israeli company’s R&D activity will be analyzed separately from the sale of its IP. Another significant change in the final version of the Circular relates to the withdrawal of tax ruling applications. While the drafts explicitly allowed taxpayers to withdraw an application if no agreement was reached with the ITA, the final circular does not provide such a right. Although, in practice, the ITA may still permit withdrawals, the absence of a guaranteed right could make the tax ruling route somewhat less compelling.  

Additional Certainty Ensuring Routes

In addition to the above mechanisms, the Circular outlines two additional routes for obtaining clarity regarding the applicable TP methodology. First, it provides that companies rendering R&D services to their non-Israeli affiliates may apply to the ITA for a preliminary tax ruling confirming the applicability of the cost-plus (TNMM/CPM) method and the relevant margin, even if they do not meet the conditions for getting a tax ruling under the IP transfer route described above. The ITA is required to issue its decision on such applications within specified timelines. . However, in contrast to the approach in the IP transfer context, the Circular explicitly provides that an Israeli company may withdraw its application if no agreement is reached with the ITA regarding the content of the tax ruling. In addition, the Circular notes that another alternative for securing certainty is to apply for a Bilateral (or Multilateral) Advance Pricing Agreement which the ITA encourages. The key advantage of an APA is that it is binding not only on the Israeli taxpayer but also on the tax authorities of all participating jurisdictions, providing cross border certainty and minimizing the risk of double taxation. The Circular states that the ITA is not subject to statutory timelines in the framework of an APA. We are carefully reviewing the provisions of the Circular and their potential implications. Our tax department has extensive experience with these matters. 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, tax litigation concerning transfer pricing, tax rulings applications and related issues. If any of the issues introduced in the Circular are relevant to you or may affect your international tax planning strategies, we encourage you to reach out to us to discuss possible paths and opportunities.     Respectively, Herzog, Fox, Neeman Tax Department This client update does not constitute legal advice, and should not be relied upon without obtaining proper legal counsel.