In a recent discussion, a senior Israel Tax Authority officer expressed the Israel Tax Authority's position that in certain circumstances, Israeli R&D centers of multinational enterprises should be compensated based on the profit split method, rather than the cost plus method that is most commonly used today. Such compensation may result in significant tax consequences, both from administrative perspective and from tax liability perspective.


In the last three decades, a vast number of multinational enterprises operated R&D centers in Israel. This phenomenon derives from several reasons, including Israel's unique human capital and the tax benefits offered to such R&D centers.

As of today, the absolute majority of such R&D centers are compensated on a cost-plus basis. Namely, a non-Israeli company within the multinational enterprise, that is the owner of the multinational enterprise's IP, compensates the Israeli company for its costs, with certain profit margin that is determined based on the common margin in the relevant industry. The implementation of the cost-plus compensation method was mostly accepted by the Israel Tax Authority and disputes mainly revolved on the profit margin rate (the markup) that suits the R&D centers.

Recently, however, practitioners encountered a growing number of cases in which the Israel Tax Authority argues that the R&D centers should not be compensated on a cost-plus basis, but rather that a profit-split method should be implemented for allocating the worldwide profits of the multinational enterprise between the Israeli R&D center and the rest of the multinational group. This position represents a potential dramatic change in the taxation of the activity of multinational enterprises in Israel. However, until recently no formal indication was published by the Israel Tax Authority regarding this significant change.

The Newly Published Indication:

In a recent conference, attended by many practitioners, tax authority personnel and academic staff, Mr. Roland Am-Shalem, the senior deputy director general of the ITA, indicated that the Israel Tax Authority is indeed considering a change in its position with respect to the taxation of R&D centers located in Israel. According to Mr. Am-Shalem, the question of whether the Israeli R&D center should be compensated on a cost-plus basis or based on the profit split method should be determined based on the facts and circumstances of each and every case. Specifically, Mr. Am-Shalem noted that the profit split method should be implemented where the R&D center is the beneficial owner of the IP it develops.

The Israel Tax Authority's officer noted that the tax authority's position is based on a recent publication of the OECD ("Revised Guidance on the Application of the Transactional Profit Split Method"). He also indicated that the profit split method is more suitable where the R&D center meets some or all of the following characteristics:

  1. The R&D center develops mainly IP that was initially developed by it, rather than by a non-Israeli entity in the multinational enterprise.
  2. The Israeli R&D center engages in additional activities, rather than exclusively in R&D.
  3. The multinational enterprise's headquarters are located in Israel.
  4. The R&D center bears a substantial portion of the R&D risks.
  5. The R&D center's activity contributes significate and unique value to the multinational enterprises.

While breaking down the factors that may indicate that the profit-split method is more appropriate, Mr. Am-Shalem also listed some factors that may indicate that the R&D center should be compensated on a cost-plus basis:

  1. The R&D center was initially established by a foreign multinational enterprise (namely, the multinational enterprise did not acquire an existing company that transitioned from self-development to the provision of R&D services). 
  2. The R&D center does not bear business risks.
  3. Decision making regarding the IP is executed by headquarters employees outside of Israel.
  4. The Israeli R&D center's activity is funded mainly by non-Israeli entities of the multinational enterprise, rather than based on it own sources.
  5. The R&D center has no NOLs that derive from the development of the IP.
  6. The R&D center's activity does not create any significate and unique value to the multinational enterprise.

We note that both of these lists are merely indicative, and do not constitute exhaustive lists of the characteristics that may be analyzed by the Israel Tax Authority. In addition, it should be noted that the Israel Tax Authority's position is not binding on the taxpayer or the Court (even more so in the case in hand, as the publication was not included in a formal publication but rather published incidentally).

The Implications of the New Position:

The implications of the potential change in the Israel Tax Authority's position may be significant for R&D centers and the multinational enterprises that they are part of, on several levels.

First, it may undermine the relative certainty that has existed so far regarding the Israeli taxation of R&D centers. This, since it there is no bright-line test that can be used for determining whether the R&D center should be compensated on a cost-plus basis or rather the profit split method should be implemented. 

Second, the amount of tax that the Israeli R&D centers will be required to pay in Israel may increase, in light of the allocation of additional profits to Israel.

Third, tax audits of R&D centers may become more complexed, in light of the need to determine whether the profit split method should be implemented and if so, how. In order to decide on these questions, the Israel Tax Authority might require to be provided with documents regarding non-Israeli affiliates of the R&D center (it is yet to be determined whether the Israeli R&D center is required to provide such documents).

In addition, the new approach may lead to more cases of double taxation. Such double taxation may arise where other states argue that the profit split method should not be implemented at all, as well as where other states argue for a different allocation under the profit split method. The resolution for such double taxation cases will generally be in complicated Mutual Agreement Procedures.

Lastly, to the extent that the implementation of the profit split method results in the allocation of excessive profits to Israel (in comparison with the cost plus compensation), the repatriation of such profits will result in increased withholding tax liabilities.

Notwithstanding the above, the change in the Israel Tax Authority's approach may also create certain new possibilities and opportunities for multinational enterprises.

First, in the relevant cases, the implementation of the profit split method may result in the allocation of loss to Israel, whereas an R&D center that is compensated on a cost-plus basis would be subject to tax even if the multinational enterprise's activity, as a whole, is not profitable.

Second, Israel offers attractive tax regimes to hi-tech companies that are part of multinational enterprises (the various "preferred enterprise" tax regimes). Under such regimes, the Israeli tax liability may be reduced to as low as 6%. Accordingly, the attribution of profits to Israel may even result, in some cases, in the reduction of the multinational enterprise's total tax liability.

Third, the Israel Tax Authority often argues that Israeli companies that were acquired by multinational enterprises transferred their FAR (functions, assets and risks) shortly after the acquisition, often resulting in a very substantial capital gain tax liability. Although it has not yet been formally addressed by the Israel Tax Authority, it seems that the FAR transfer argument is not consistent with the implementation of profit split method. In appropriate cases, especially given the preferred enterprise tax regimes, it may even be more tax-efficient to argue that the profit split method should be implemented, since the Israeli company's IP remains in Israel (namely, no FAR transfer), than arguing that the Israeli R&D center should be compensated on a cost plus basis (bearing the FAR transfer exposure).

In addition, in a 2018 ruling, the Israeli Supreme Court determined that an expense derived from Share-Based Compensation (SBC) issued to the employees of an Israeli R&D center by a foreign affiliate, should be included in the cost base of the Israeli subsidiary. This ruling significantly increased the tax liability of R&D centers in Israel. The manner in which such expenses should be treated under the profit split method has not been addressed yet, but it seems reasonable to argue that they should reduce the taxable income of the R&D center.

In light of the above, we recommend that multinational enterprises that operate R&D centers in Israel, as well as multinational enterprises that are currently considering establishing such centers, obtain further advice regarding the various tax and transfer pricing consequences of the new position of the Israel Tax Authority.