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Policy, trends and developments

Government policy

Describe the general government/regulatory policy for transfer pricing in your jurisdiction. To what extent is the arm’s-length principle followed?

The current legal framework in Israel is based mainly on Section 85A of the Israeli Income Tax Ordinance. Section 85A was enacted in 2006 and introduced the arm's-length principle (previously unofficially enforced through Section 86 of the ordinance, which deals with artificial transactions), asserting that an international transaction between “parties with special relationships” (ie, related parties) should be reported to the tax assessment officer and be taxed in line with the appropriate market price. Guidance regarding transfer pricing is incorporated in line with the regulations promulgated under Section 85A and circulars issued by the Israeli Tax Authorities (ITA).

The arm's-length principle is thus enforced mainly through verifying the factual background of a transaction and comparing it with the statements and/or documentation presented by the company; such factual background is collected by the ITA from documents of the audited company and through interviews with company officials. The notion of the arm's-length principle is often audited and enforced between related parties within Israel, either because the parties are located in different tax zones or for other reasons (eg, accumulated losses and different shareholding).   

Trends and developments

Have there been any notable recent trends or developments concerning transfer pricing in your jurisdiction, including any regulatory changes or case law?

The main recent developments include:

  • the ruling by the Israeli Supreme Court on the inclusion of expenses associated with stock options in the cost basis of cost-plus (transactional net margin method) arrangements, and on the ability of the ITA to set the median as the reference point where no contemporaneous documentation exists; and
  • two circulars distributed by the ITA on the methods and margins expected for pricing intercompany transactions which involve marketing services or distributorship activities (mainly limited risk distributor) and non-value-added services, in each case provided by an Israeli company to its parent or related party outside Israel.

Legal framework

Domestic legislation and applicability

What primary and secondary legislation governs transfer pricing in your jurisdiction?

The main legislation is Section 85A of the Income Tax Ordinance and the regulations promulgated thereunder. In addition, a draft law amending the ordinance – including additional sections which adopt certain Organisation for Economic Cooperation and Development (OECD) base erosion and profit shifting recommendations – is in the legislative process. However, certain positions of the Israeli Tax Authorities (ITA), as published from time to time through circulars, should also be taken into consideration.

Are there any industry-specific transfer pricing regulations?

No.

What transactions are subject to transfer pricing rules?

All international intercompany transactions between "parties with special relationships” (ie, related parties) are subject to transfer pricing rules. A ‘special relationship’ is defined as:

  • the relationship between an entity (including an individual) and its relative;
  • the control of one party to a transaction over the other; or
  • control of one individual (or entity) over the parties to the transaction, directly or indirectly, individually or jointly with others.

In this context, ‘control’ is defined as “holding, directly or indirectly, 50% or more in one of the means of control”, where the term ‘means of control’ includes the following:

  • the right to receive profits;
  • the right to appoint directors, the general manager or other similar positions;
  • the right to vote in the general shareholders' meeting;
  • on liquidation of the company, the right to a share in the equity following payment of all outstanding debts; and/or
  • the right to determine which party receives any of the aforementioned rights.

The term ‘relative’ means “a spouse, sibling, parents, grandparent, offspring, spouses' offspring and the spouse of each of these”.

Transactions between related parties within Israel may also be scrutinised under the transfer pricing terms, despite there being no specific legislation enforcing this.

How are ‘related/associated parties’ legally defined for transfer pricing purposes?

All international intercompany transactions between "parties with special relationships” (ie, related parties) are subject to transfer pricing rules. A ‘special relationship’ is defined as:

  • the relationship between an entity (including an individual) and its relative;
  • the control of one party to a transaction over the other; or
  • control of one individual (or entity) over the parties to the transaction, directly or indirectly, individually or jointly with others.

In this context, ‘control’ is defined as “holding, directly or indirectly, 50% or more in one of the means of control”, where the term ‘means of control’ includes the following:

  • the right to receive profits;
  • the right to appoint directors, the general manager or other similar positions;
  • the right to vote in the general shareholders' meeting;
  • on liquidation of the company, the right to a share in the equity following payment of all outstanding debts; and/or
  • the right to determine which party receives any of the aforementioned rights.

The term ‘relative’ means “a spouse, sibling, parents, grandparent, offspring, spouses' offspring and the spouse of each of these”.

Are any safe harbours available?

Yes. According to two recent circulars issued by the ITA, the following safe harbours are accepted:

  • a mark-up of 10% to 12% for marketing services;
  • an operating margin of 3% to 4% for distributorship activities in the form of limited risk distributorship; and
  • a 5% mark-up for non-value-added services (as defined in the circulars).

According to the relevant circulars, a transfer pricing study is still required if a multinational enterprise chooses to apply the safe harbours, in order to demonstrate the applicability of the chosen safe harbour.

Regulators

Which government bodies regulate transfer pricing and what is the extent of their powers?

The Israeli Parliament is the legislative body, while the regulations are promulgated by the relevant ministry. The ITA (specifically the Transfer Pricing Department) conducts audits and issues circulars setting out its interpretations and expectations regarding legislation. Audits are conducted in accordance with applicable rules and legislation. However, in some cases taxpayers are requested to provide information not required under current legislation (eg, a master file, if available) and within a shorter timeframe than prescribed by law for presenting transfer pricing-related materials (mainly the study). Such requests, if submitted, may be declined.

International agreements

Which international transfer pricing agreements has your jurisdiction signed?

Israel is a signatory to bilateral tax treaties containing standard OECD-type transfer pricing and secondary adjustment articles.

To what extent does your jurisdiction follow the Organisation for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines?

The regulations promulgated under Section 85A of the Income Tax Ordinance adhere to the arm’s-length principle and incorporate guidelines from both the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and Section 482 of the US Internal Revenue Code with regard to determining the correct analysis methods for examining an international transaction between related parties.

Transfer pricing methods

Available methods

Which transfer pricing methods are used in your jurisdiction and what are the pros and cons of each method?

Customary Organisation for Economic Cooperation and Development (OECD) methods.

Preferred methods and restrictions

Is there a hierarchy of preferred methods? Are there explicit limits or restrictions on certain methods?

This is in line with customary OECD recommendations.

In general, the best-method rule set forth in the Israeli regulations requires that the arm’s-length result of a controlled transaction be determined under the method that, given the facts and circumstances, provides the most reliable measure of an arm’s-length result. The application of the best-method rule thereby establishes an arm’s-length range of prices or financial returns with which to test the controlled transactions. The following hierarchy should be employed while implementing the best-method rule.

The primary methods to be used are those based on comparison between the group's transactions with unrelated parties. These methods are similar to the comparable uncontrolled price/transaction methods. If these methods cannot be used due to lack of similar comparable transactions, then one of the following methods should be employed:

  • a comparison between the mark-ups on direct expenses in the tested and comparable transactions (similar to the cost-plus method);
  • a comparison between the gross profit margin of the seller in the tested and comparable transactions (similar to the resale price method); or
  • a comparison between profit level indicators (PLI) established in the tested and comparable transactions (similar to the transactional net margin method or the comparable profits method). The PLI selected should be in accordance with the regulations.

Where none of the above can be applied, the most suitable method can be used. However, this should be justified both economically and legally, and the application of a different method cannot normally be justified when one of the aforementioned methods is applicable.

Comparability analysis

What rules, standards and best practices should be considered when undertaking a comparability analysis?

Customary OECD recommendations should be considered. However, due to insufficient information regarding Israeli comparables, a global benchmark (focused mainly on EU and North American companies) is acceptable.

Special considerations

Are there any special considerations or issues specific to your jurisdiction that associated parties should bear in mind when selecting transfer pricing methods?

Services (mainly R&D but also marketing and others) should be carefully examined and the right transfer pricing method should be adopted. The Israeli Tax Authorities (ITA) may try to impose a profit-split method where appropriate, instead of the transactional net margin method. In addition, contemporaneous documentation is important; although no formal fines are set in the current legislation, the ITA may reject any non-contemporaneous documentation. Moreover, an Israeli company involved in an intercompany transaction subject to transfer pricing regulation should file a separate Form 1385 annually, together with its tax return, in which it states (in the form of an affidavit signed by an officer of the company) that it abides by the transfer pricing legislation.

Documentation and reporting

Rules and procedures

What rules and procedures govern the preparation and filing of transfer pricing documentation (including submission deadlines or timeframes)?

Section 85A of the Income Tax Ordinance and the regulations promulgated thereunder. The Israeli Tax Authorities (ITA) may require a relevant study prepared by the audited taxpayer within 60 days; however, normally the tax authorities request the study within a shorter timeframe (30 days). Although the company is under no obligation and may request 60 days, if the company does not present the study in a timely manner, it usually indicates to the ITA that the company is not in possession of the required study.

Content requirements

What content requirements apply to transfer pricing documentation? Are master-file/local-file and country-by-country reporting required?

A transfer pricing study (similar to a local file) is required, in a form similar to the requirements in other Organisation for Economic Cooperation and Development countries. Country-by-country and master-file requirements have passed the first reading (out of three) in the Israeli Parliament and are not currently binding, although the ITA tends to request a master file from the taxpayer if available. 

Penalties

What are the penalties for non-compliance with documentation and reporting requirements?

There are no specific fines related to transfer pricing. In addition to the reversed burden of proof and setting the required results at the median, interest and linkage are applied in the form of primary and secondary adjustments. In cases where a transaction between related parties lacks any commercial rationality (namely, the same transaction under similar economic circumstances would not have been agreed between non-related parties), the ITA may choose not to recognise the transaction in its original form and may treat it as an entirely different type of transaction in the form, which in its view would reflect the business reality of the transaction in a more satisfactory way.

Reclassifications such as these can relate to (among other things) the treatment of intercompany loans, cash pooling or non-repayment of intercompany debts as dividends, as well as to the ownership of intangibles. Non-recognition can cause double taxation and, while derived from Section 85A of the Income Tax Ordinance, is also based on Section 86 of the ordinance. A note regarding Form 1385 should be added: although no personal or criminal liability has yet been claimed by the ITA in cases where the form was deemed inaccurate (or not filed), we understand that the ITA is discussing this issue internally.

Best practices

What best practices should be considered when compiling and maintaining transfer pricing documentation (eg, in terms of risk assessment and audits)?

Best practices include:

  • correct characterisation of the transaction in terms of methods used and expected profit margins;
  • contemporaneous updates (annually); and
  • using the same definitions of the study in intercompany agreements.

Although in our experience most cases do not reach court and are settled, in recent years several cases have been adjudicated by the Israeli courts, which have generally accepted the positions taken by the ITA.

Advance pricing agreements

Availability and eligibility

Are advance pricing agreements with the tax authorities in your jurisdiction possible? If so, what form do they typically take (eg, unilateral, bilateral or multilateral) and what enterprises and transactions can they cover?

Yes, agreements are available – both unilateral (most common) and otherwise.

Rules and procedures

What rules and procedures apply to advance pricing agreements?

Pursuant to the Income Tax Ordinance, discussions and negotiations with the Transfer Pricing Department of the Israeli Tax Authorities (ITA) relate to both future and past transactions. Settling a past or current audit cannot guarantee that the same treatment will be awarded in the future, unless an advance pricing agreement is reached. 

Timeframes

How long does it typically take to conclude an advance pricing agreement?

Several months.

What is the typical duration of an advance pricing agreement?

Three to five years.

Fees

What fees apply to requests for advance pricing agreements?

None.

Special considerations

Are there any special considerations or issues specific to your jurisdiction that parties should bear in mind when seeking to conclude an advance pricing agreement (including any particular advantages and disadvantages)?

In terms of audits by the ITA, it is advantageous to have an advance pricing agreement, although one should take into account whether the results reached in a unilateral advance pricing agreement would be accepted by other relevant jurisdictions.

Review and adjustments

Review and audit

What rules, standards and procedures govern the tax authorities’ review of companies’ compliance with transfer pricing rules? Where does the burden of proof lie in terms of compliance?

Standards are similar to normal tax audits. Compliance requires contemporaneous documentation and its application to the relevant transaction.

Do any rules or procedures govern the conduct of transfer pricing audits by the tax authorities?

Procedures are similar to normal tax audits.

Penalties

What penalties may be imposed for non-compliance with transfer pricing rules?

There are no specific fines related to transfer pricing. In addition to the reversed burden of proof and setting the required results at the median, interest and linkage are applied in the form of primary and secondary adjustments. In cases where a transaction between related parties lacks any commercial rationality (namely, the same transaction under similar economic circumstances would not have been agreed between non-related parties), the Israeli Tax Authorities (ITA) may choose not to recognise the transaction in its original form and may treat it as an entirely different type of transaction in the form, which in its view would reflect the business reality of the transaction in a more satisfactory way.

Reclassifications such as these can relate to (among other things) the treatment of intercompany loans, cash pooling or non-repayment of inter-company debts as dividends, as well as to the ownership of intangibles. Non-recognition can cause double taxation and, while derived from Section 85A of the Income Tax Ordinance, is also based on Section 86 of the ordinance. A note regarding Form 1385 should be added: although no personal or criminal liability has yet been claimed by the ITA in cases where the form was deemed inaccurate (or not filed), we understand that the ITA is discussing this issue internally.

Adjustments

What rules and restrictions govern transfer pricing adjustments by the tax authorities?

Standards are similar to normal tax audits. Compliance requires contemporaneous documentation and its application to the relevant transaction.

Challenge

How can parties challenge adjustment decisions by the tax authorities?

In the tax assessment process, and then in court.

Mutual agreement procedures

What mutual agreement procedures are available to avoid double taxation arising from transfer pricing adjustments? What rules and restrictions apply?

The competent authority process.

Anti-avoidance framework

Regulation

What legislative and regulatory initiatives has the government taken to combat tax avoidance in your jurisdiction?

There are regulations listing certain transactions requiring disclosure in an annual tax return. Recently, the Israeli Tax Authorities (ITA) identified a comprehensive list of tax positions requiring disclosure in an annex to the annual tax return if certain tax-saving thresholds are reached by utilising these positions. Finally, certain tax opinions also require disclosure in an annex to the tax return. These extended reporting requirements allow the ITA to identify and scrutinise tax avoidance structures.

To what extent does your jurisdiction follow the OECD Action Plan on Base Erosion and Profit Shifting?

Audits are already taking base erosion and profit shifting recommendations into consideration, although the essence of the recommendations has long been the standard for enforcement in Israel in terms of transfer pricing audits. Country-by-country and master file are awaiting formal ratification by the Israeli parliament.

Is there a legal distinction between aggressive tax planning and tax avoidance?

As a general rule, Section 86 of the Income Tax Ordinance contains a general anti-avoidance provision which allows the tax assessment officer to disregard a transaction deemed artificial or fictitious, or one whose principal objective is improper avoidance or reduction of tax.

In addition, even in the absence of express statutory provisions, the ‘substance over form’ doctrine is a generally accepted principle of Israeli case law.

Regulations have also been promulgated under the Income Tax Ordinance which impose a disclosure requirement with respect to certain defined categories of transaction. In addition, the ITA recently published a comprehensive list of "reportable tax positions". If a taxpayer takes a position that contradicts the reportable tax position, thus creating a tax saving of more than NIS5 million (or NIS10 million over four years), it should be specifically reported on a separate form.

Penalties

What penalties are imposed for non-compliance with anti-avoidance provisions?

Certain listed transactions and reportable positions require disclosure under Israeli law and failure to disclose such transactions and positions gives rise to fines amounting to 30% of the deficit amount, in addition to standard applicable fines and financial sanctions that may be imposed in accordance with the Income Tax Ordinance.