In a ruling handed down in late April 2018, the Israeli Supreme Court sided with the Israel Tax Authority (ITA) and upheld two decisions of the lower District Court in the Kontera Technologies Ltd. and Finisar Israel Ltd. cases, resulting in a potentially increased tax burden for Israeli subsidiaries of multinational companies offering share-based awards to Israeli employees. We strongly recommend that you share this alert with your Tax colleagues and discuss the availability of a tax deduction.
The Supreme Court ruled Israeli subsidiaries operating on a cost-plus model, where the parent reimburses the subsidiary for all expenses and pays a mark-up, must include the accounting expense related to stock-based compensation in the cost base. The Supreme Court also ruled such expenses could not be deducted for tax purposes (but a tax deduction for the portion of the award income that is taxable as ordinary income in the hand of the employee may be available, as further discussed below). Requiring the stock-based compensation expense to be included in the cost base, without allowing for a tax deduction in the full amount of that expense, will result in additional taxable income for the subsidiary equal to the excess of the inclusion over any allowed deduction, plus the amount of the mark-up on the whole included expense.
Finally, the court ruled that the mark-up which was to be paid by the parent to the Israeli subsidiaries should have been 9.1% instead of the 7% used by the companies.
Companies that did not conform their transfer pricing policies with the District Court decisions will likely owe taxes and be subject to penalties if audited by the ITA. The Supreme Court also ruled the ITA could carry out a “secondary adjustment” to increase the corporate income of the Israeli subsidiary and impute interest on an amount equal to the accounting expense that should have been paid by the parent company.
Companies with cost-plus arrangements with their Israeli subsidiaries should review and ensure their cost-plus arrangements conform with the Supreme Court’s ruling, by including the accounting expense of the stock-based compensation in the cost base. In this case, to reduce the tax burden, publicly-traded companies will want to consider granting RSUs under the “capital gains tax” route of a trustee plan, which will enable them to take a tax deduction for the value of the shares subject to the RSUs at the time of grant (i.e., the part of the income that is taxed as ordinary income in the hands of the employee). It may also be possible to take a tax deduction for the discount at purchase under an ESPP. By contrast, any tax deduction for stock options will be very limited to non-existent, making options a less desirable award vehicle for Israeli employees.
Alternatively, companies may want to revisit their transfer pricing arrangements with Israeli subsidiaries and consider a different methodology. For example, a comparable uncontrolled price (CUP) transfer pricing method might avoid this issue.