Recently, the District Court in Tel Aviv was required to address the question as to whether foreign companies with an Israeli Permanent Establishment (PE) should include on their revenue calculation unrecognized expenses for tax purposes. Such expenses would include payroll expenses for granted employee’s options and the social expenses derived from it, in companies whose revenues are calculated at the 'Cost Plus' pricing method, even though the options were granted to employees under Section 102 of the Israeli Income Tax Ordinance

The decision addressed the circumstances of a private company which provides R&D services for its foreign parent company. The two companies signed an agreement under which the parent company agreed to cover the full expenses incurred by the Israeli subsidiary, and will pay an additional amount that will constitute a marginal gain of 7% of the total expenditures. Determining the cost and the income derived from it affects the Israeli tax that would be paid by the PE. Naturally, the higher the set 'Cost', the higher the set 'Profit' that will be taxed in Israel. 

In 2009 and 2010, the Foreign Parent Company issued options to the subsidiary's employees and chose the capital gains course for the options. 

The main dispute between the tax assessor and the Israeli company was whether the company had to include the payroll expenses for granted employee's options, as part of the 'Cost'? As mentioned above, the company's revenues in Israel were taxed in Israel on a cost plus basis, with a profit margin of 7%. Therefore, including any salary expenses with respect to options and the social costs derived from it, would lead to a higher profit for tax purposes. 

In its appeal against the tax assessor's decision, the company claimed two arguments: 

  • That the inclusion of the value of the options would lead to a higher profit margin compared to similar transactions in the market; and
  • That the value of the options is not considered an expense or replacement to payroll expenses but rather constitutes an investment of the parent company in the Israeli company's equity.

This is due to the fact that the parent company carries the costs and settles the stock option arrangement by issuing its own equity instruments to the employees of the Israeli company. Moreover, the Israeli company is not allowed to deduct the expense incurred by granting the options to the employees, while taxing the employees on their income derived from these options on a capital gain tax rate (which is 25% in Israel), and not at a marginal rate (that may exceed up to 48%). 

The District Court ruled against the company's position. The court has ruled that there is an expectation that the payroll expenses from granted options will be recognized for tax purposes, since this expenditure is made as part of the integral core business of the Israeli company. However, as determined in a decision given by the Supreme Court in Israel (in the matter of Yehezkel Lapid), the capital gain tax rate structure in Section 102 of the Israeli Tax Ordinance, is a special arrangement in which its economic purpose is to provide incentives for employees by making them an active part of the ownership of the company as well as not allowing the company to deduct the expense. 

The significance of the court decision for foreign companies operating in Israel is not relevant only to issuing stock options to employees of their Israeli PE, but also to additional expenses that may not be deductible for tax purposes in accordance with the Israeli Income Tax Ordinance. For example, excess expenses, benefits paid by an employer to his employees that cannot be attributed to specific employee, etc. In these circumstances, not only will these expenses not be deductible, but they will increase the margin of profit and as a result will increase the PE's income for tax purposes. 

We recommend paying attention to these points within the framework of agreements between related parties.