In this case, an Israeli subsidiary provided certain research and development services to its U.S.-based parent under a transfer pricing agreement that established the subsidiary’s income as an amount equal to its costs plus a 7 percent margin. Employees of the subsidiary received various stock awards under the “capital gains course” of Section 102 of the Israeli Tax Ordinance (“Section 102”). Section 102 generally applies to Israeli resident companies and non-Israeli companies that have a permanent research and development center in Israel. The subsidiary did not include accounting expenses for employee stock awards in its cost base and retroactively amended the transfer pricing agreement with its parent to reflect this treatment. The Israeli Tax Authority (“ITA”) disagreed with the exclusion of these expenses. The Tel Aviv District Court agreed with the ITA, ruling that (i) the accounting expenses for employee equity-based compensation should be included in the subsidiary’s cost base under this type of cost-plus arrangement and (ii) because the equity awards were subject to capital gains treatment under Section 102, the subsidiary was not entitled to a corresponding tax deduction. Although this ruling is expected to be appealed, companies that grant equity awards to employees of their Israeli subsidiaries operating under a cost-plus arrangement should consult with their benefits and tax counsel regarding the impact of this ruling on their employee equity awards.

Kontera Ltd. v. Assessing Officer Tel-Aviv 3 (Tax Appeal 40433-11-12).