Dear Clients, Colleagues and Friends,

This is an important update for any company that is a party to an inter-group services transaction and is applying a cost-plus transfer pricing arrangement.

The Tel Aviv District Court has ruled that accounting expenses for employee equity based compensation should be included in the cost base for purposes of determining the income of an Israeli R&D subsidiary implementing a cost-plus arrangement. The Court also denied the corresponding tax deduction to the Israeli subsidiary in accordance with the specific provisions of section 102 of the Israeli Income Tax Ordinance. 

This decision results in a dramatic increase in the taxable income of the Israeli subsidiary.  The increase in the taxable income is not only the applicable margin, which in the Court case was 7%, but rather the taxable income is increased by 107% of the accounting expenses for employee equity based compensation.

Background

Section 102 of the Israeli Income Tax Ordinance determines the taxation of equity based compensation granted to employees of Israeli resident companies. The section also applies where the equity is of a parent company of an Israeli resident subsidiary. Section 102 includes three tax routes from which a company can choose: (i) a trustee capital gains route (ii) a trustee ordinary income route, and (iii) a non-trustee route. The relevant tax route in this case is the trustee capital gains route. Under the capital gains tax route, the employees are generally entitled to a tax rate of 25% and in exchange the employing company is not able to deduct the accounting expense for tax purposes. For public companies the rules are a bit different and a portion of the employee's income is classified as ordinary income and therefore allowed as a deduction (provided there is a charge back arrangement with the parent entity).

The Court Case

The Court decision concerns the taxable income of the Israeli R&D subsidiary of Kontera Technologies Inc. ("Kontera Inc") for tax years 2009 and 2010. The employees of the Israeli subsidiary received options to purchase shares of Kontera Inc., which was at the time a privately-held company that was later acquired by Amobee in 2014. The Israeli subsidiary's income was determined according to a cost plus 7% margin. The Israeli subsidiary did not include the expenses for employee equity based compensation within the cost base and the Israel Tax Authority ("ITA") objected to this position and issued a notice of deficiency under which the taxable income was increased.

The Court determined that the Israeli subsidiary should have included the accounting expenses associated with the employee based compensation within the cost base and denied the corresponding deduction.

One important comment made by the Judge is that the Black & Scholes formula may result in over- statement of the expense of employee equity based compensation given the various restrictions such as vesting, transferability restrictions etc.

Another important factor in the underlying circumstances of the case was that the inter-company agreement was retroactively amended to specifically exclude the cost of employee equity based compensation from the cost base.

Implications

This Court case comes after many years of discussions between advisors, the ITA and the companies operating in Israel that included settlements reached by certain companies with the ITA. Over the last few years, the ITA has been auditing a significant number of Israeli companies which are parties to intergroup services transactions (cost-plus arrangements).  In fact, this issue was one of the top items in the ITA audit issue list of high-tech companies.

We believe that this is a significant Court ruling which will have considerable implications not only to companies that are currently undergoing a tax audit, but also to any company implementing an inter-group services arrangement applying a cost-plus arrangement. The implications will be different for public companies and private companies due to the provisions of Section 102 of the Israeli Income Tax Ordinance and the ability of public companies to deduct certain expenses relating to employee equity based compensation provided there is a charge back arrangement in place.

We expect this Court ruling to be appealed to the Supreme Court. However, until the case is ruled by the Supreme Court, the current Court ruling will be used by the ITA to reinforce this position in its audits and will significantly influence any negotiations or discussions with the ITA.

We advise all companies operating under a cost plus arrangement to seek further advice in order to assess the exposures as a result of this Court ruling. Specifically, we recommend examining the appropriate transfer pricing methodology from both a legal and economic perspective and to further consider the economic model used to evaluate the expense of the employee equity based compensation.

Our transfer-pricing, tax and employee benefits experts are at your disposal to provide comprehensive advice targeted to the specific circumstances of your company.