Dear Clients and Friends, 

In a recent conference attended by high ranking officials of the Israel Tax Authority (ITA), the ITA indicated that it would soon publish a circular addressing its views regarding the proper transfer pricing methodology with respect to research and development (R&D) centers in Israel providing R&D services to related parties abroad. R&D centers in Israel have traditionally used the cost-plus method under the transactional net margin method or comparable profits method (in the United States). This comes as no surprise to many practitioners and market participants as the ITA has expressed its views in several audits of R&D centers conducted in recent years that under certain conditions, namely when there are indications of “economic ownership” of intangible assets or strategic roles fulfilled by the R&D center, the cost-plus methodology is not the appropriate transfer pricing methodology but rather, a profit split method should be applied.

This is also based upon the ITA’s assumption that for R&D centers, all or almost all of the operations of which take place in Israel, the cost-plus method is irrelevant where the foreign parent company does not exercise substantial functions or assets.

In a presentation to the conference attendees, the ITA laid out various factors which strengthen, in its view, economic ownership of intangible assets or strategic importance in Israel, as well as factors indicative of non-economic ownership, as follows:

Factors Indicating Economic Ownership of Intangible Assets in Israel:

• The intangible asset is sourced in Israel and its activity commenced in Israel;
• The Israeli company conducts additional activities besides the R&D activities;
• The  headquarters of the foreign multinational group of which the R&D center is part of, is located in Israel;
• The R&D center in Israel bears some of the significant risks relating to the R&D activity; and
• The activities of the R&D center provide a unique and valuable contribution to the foreign multinational group.

Factors Indicating Non-Economic Ownership of Intangible Assets in Israel:

• The Israeli R&D center was established following an initiative by a foreign multinational company;
• Decisions relating to intangible assets are concluded by employees of the foreign multinational company’s headquarters from outside of Israel;
• The Israeli R&D center does not bear any business risks relating to the R&D activity;
• The Israeli R&D center does not have the financial capability to finance the R&D activity that would establish economic ownership over the intangible assets;
• The Israeli R&D center does not have accumulated losses for tax purposes resulting from the R&D activity; and
• The Israeli R&D center does not provide a unique and valuable contribution to the foreign multinational company.

Even prior to the publication of said circular, criticism relating to the intended ITA positions therein has already surfaced. Arguments against the ITA’s position are being sounded such as (i)  the ITA’s position is a novel policy that is not based on international norms and deviates from the 2017 OECD guidelines; (ii) the new ITA’s policy creates uncertainty and potential for double taxation; (iii) the integration of Israeli residents in senior managerial positions abroad brings significant benefits to the Israeli economy and determining that the intangible assets are located in Israel based on the location of senior Israeli employees would jeopardize their positions or cause them to relocate; (iv) there is usually no “tax planning” motive in applying the cost-plus method when the multinational enterprise is resident in a treaty country; (v) the new ITA policy would result in endless competent authority procedures; and (vi) many multinational groups already paid tax with respect to intangibles’ transfer by the Israeli company post-acquisition and the intangibles’ value was determined based on the acquisition cost with a carve out related to the workforce’s value, calculated based on cost-plus.

The ITA defends its position by claiming that R&D centers should receive their “fair-share”, commensurate to their contribution to the development of the intangible asset.  ITA officials have also expressed a more conservative view that even in cases where the profit split model may not be justified due to lack of economic ownership over the intangible assets, the profit to be shared with the Israeli R&D centers should be higher than what ends up being the case under the cost plus methodology as it is currently implemented.

Despite the downsides in the ITA’s position as described above, some upsides may nevertheless exist. The ITA’s position may create new opportunities for foreign multinationals developing intellectual property given the various preferential tax regimes offered in Israel to technology companies, including reduced corporate income tax rates of as low as 6% (as opposed to the standard 23%) and a 4% dividend withholding rate, conditioned, of course, on the intellectual property being situated in Israel. The new position may also be used for rebutting FAR (Functions, Assets and Risks) transfer arguments that are often raised by the ITA in tax audits of Israeli R&D centers of foreign multinational groups.

We will keep you updated on all developments in this regard, including once the said circular is indeed published. Nevertheless, we strongly recommend that foreign multinational groups who have, or are planning to establish, R&D centers in Israel, carefully consider their tax planning and available options to ensure the highest level of certainty with respect to their intercompany arrangements in this regard.

We would be more than happy to provide you with any guidance and assistance on this issue as needed.

Sincerely,

The Tax Department

Herzog Fox & Neeman