The Israeli Supreme Court recently ruled a judgment on the matter of high-tech companies Kontera Technologies Ltd. and Finisar Israel Ltd. The court deliberated the question of whether the cost of employee’s stock option allotments should be included in the calculation of the Cost Plus method. De facto, the Supreme Court accepted the position of the Israeli Tax Authority.

The facts underlying this judgment are relevant to many technology and startup companies in Israel engaged in R&D services (or other services) with their foreign parent companies, and which their revenue is being calculated using a Cost-Plus method.

Also, in the cases of Kontera and Finisar, the US parent granted options to its employees in accordance with Section 102 of the Israeli Income Tax Ordinance (capital gains track). The legal dispute concerned whether the costs of allotting the options to the employees should be included in the cost base calculation of the profit in a Cost-Plus transaction, as well as what should be the customary rate of the profit under arm’s length principle (the Plus).

The Supreme Court concurred with the judgment of the district court and ruled that, since the companies have chosen to allot the options to their employees through a capital gains track, they are not allowed to deduct this expense for Israeli tax purposes in accordance with section 102 of the Ordinance. Consequently, while on the one hand, the companies must include the allotment cost of the options in the cost base, on the other hand, these expenses cannot be deducted. This has created an absurd situation of the companies paying higher tax in Israel.

Although the district court accepted the plea that the transaction can be reported according to a profit rate of 7% (Cost + 7%), the Supreme Court did not accept this determination and ruled that the transaction should be taxed for a profit rate of 9.1%.

We point out the Supreme Court’s statement that the inclusion of the cost of the option allotments in the cost base does not mean the tax assessor is automatically allowed to intervene in the parties’ agreements when reporting the price of the transaction. Such intervention is only possible if the taxpayer does not meet the burden of persuasion that the transaction price, which includes the value of the options, is in accordance with the arm’s length principle. The court ruled that, in this case, the taxpayer had neither met the burden of providing evidence nor the burden of persuasion needed in relation to the transfer pricing method in accordance with Section 85A of the Ordinance.