Author : Eyal Bar-Zvi

As local R&D and marketing services subsidiaries of multinational enterprises (“MNE”) are heavily audited – is the cost plus model still relevant to Israeli subsidiaries?

In September last year, the Israeli Tax Authority (“ITA”) issued two circulars (both published in Hebrew): Circular 11/18, which details the expected transfer pricing methods to be used for certain distributorship and marketing services transactions performed by MNE in Israel through a related party, and Circular 12/18, which sets various safe harbors for those transfer pricing methods (collectively: the “Circulars”). Since the publication of the Circulars, there is a growing trend of regulatory enforcement activity against Israeli subsidiaries of MNE, including audits carried out by the ITA's transfer pricing department in connection with the nature of the reporting of such transactions, and the associated profits restatement (i.e., using a cost plus profit level indicator (“PLI”) or an operating profit margin). Some of these audits have developed into currently trialed cases.

Additionally, R&D services, which are carried out frequently by Israeli subsidiaries of MNE, are also the focus of ITA audits, attacking the cost plus method (the transactional net margin method (“TNMM”)) and trying to impose a profit-split method on the earnings derived by the MNE from the products developed by the R&D services conducted in Israel.

Currently, most of the Israeli companies in multinational groups that provide marketing or R&D services submit their tax reports to the ITA in accordance with the cost plus method. However, the ITA tends to reject this reporting method, and tries to tax those companies based upon the operating margin PLI (for marketing services deemed as distributions), or profit-split methods (for R&D services). By this, the ITA is trying to associate the local subsidiary's revenues with the MNE's proceeds, potentially increasing the group's taxed income and tax rate. Due to the double taxation risk, the audits performed by the ITA have already led to MNE filing for a mutual agreement procedure (“MAP”), which is a costly and lengthy process.

Recently, the author and head of HFN's transfer pricing practice has been involved in discussions with the ITA's transfer pricing department regarding the development of appropriate policies to address these issues. The results of those discussions are two new ITA circulars that are expected to be published at the beginning of 2020, if not earlier.

The two currently considered circulars are novel in their nature, and deal with (a) the burden of proof in transfer pricing audits, which has been the matter of discussion in certain recent court cases; and, (b) criteria that will provide greater certainty concerning the cases in which an Israeli subsidiary should be taxed (in the ITA's view) in accordance with the profit-split method rather than the cost plus method.

As DEMPE analysis is mostly inconclusive, and since the profit-split method may lead to more uncertainty and added discussions with the ITA, our transfer pricing group has developed an innovative method to discuss DEMPE analysis and results with the ITA, titled “SDDE” (Suggest, Discuss, Decide, and Execute), which effectively measures and describes value creation in the provision of R&D and other services. Based on this method, our team has provided the ITA with several examples, in which the application of a higher cost plus model is more appropriate than the implementation of a profit-split method.

If an MNE has an Israeli subsidiary with marketing or R&D activities in Israel, we recommend reviewing the value creation process and taking the necessary steps in advance, in order to ensure a greater certainty with regard to the transfer pricing method that may apply to such activities.