Two judgments, which were handed down in recent months in the matters of Finisar and Quneitra Technologies, are not good news for Israeli companies used as development centers, and which bind the parent companies with respect to the cost + basis.

The discussion focused on Section 85A of the Income Tax Ordinance [New Version], 5721-1961 (the "Ordinance") which addresses transfer pricing.  The question which the Court was required to address was at to the manner of calculation the basic cost of the services provided by the Israeli company which is used as a development center and from which the amount paid to the development center is derived.  It should be mentioned that until now, the majority of companies refrained from bringing into the calculation of this cost the expenditure inherent in the grant of options to their employees.

His Honour, Judge Magen Altuvia, of the District Court of Tel-Aviv, agreed with the approach contended for by the taxing officer.   According to this approach, it is necessary to bring into account the expenses involved in the grant of options to employees when calculating the cost and also on this element the plus, to which the development center is entitled to receive from the foreign parent, will be calculated. In essence this brings about a substantial increase of the basic cost in the inter-company accounting, and where large development centers are concerned which employ 100's of employees (and even thousands) in Israel, this gives rise to an enormous increase in the amounts of tax to be paid.

The result of these cases are particularly severe for companies which elected to grant options to their employees under the capital gains route provided by Section 102 of the Ordinance.

With respect to companies which chose this route, not only is the expense not recognized for the purpose of calculating taxable income, but according to these new cases now it will be necessary for these companies to put these costs into the basic cost of the services provided to the foreign parent company, which in and of itself increases their taxable income and thereby the tax payments which will apply to them.

One possible outcome of these judgments is that the companies will elect to grant their options under the income route under which – by contrast with the capital gains route – a refundable expense can be taken into account for the purposes of calculating taxable income.

These judgments are not clear as which year the income should be recorded or as to what amount should be written in for it.  So it seems, therefore, that this is not the last word on the subject.

Reference:  CM (Tel-Aviv District) 1300/09 Finisar Israel Ltd v The Taxing Officer of Rehovot, District Laws 2016 (20) 1499 (14/01/2016); CM (Tel-Aviv District) 40433/11/12 Quneitra Technologies Ltd v The Taxing Officer Tel-Aviv 3, District Law 2015 (235) 1099 (24/12/2015)