In the recent meeting of the Legal and Accounting committee of the Israeli Advanced Technologies Industries, Israel’s largest umbrella organization representing the high tech and life science industries, the concern of vigorous and growing number of transfer pricing audits was raised, specifically in the field of ESOP matters.

The matter of employee benefits granted to the employees of related parties, such as of the granting entity’s subsidiary, has been in the focus of the Israeli and foreign tax authorities for a coupe of years, with several cases currently being tried in Israel, due to the fact that the Israeli tax authorities and the audited companies could not reach a settlement acceptable to the parties.

In Israel, the tax authorities’ transfer pricing unit audits both Israeli subsidiaries of multinational enterprises (MNE), and local corporations, in all matters related to transfer pricing. However, when it comes to the pricing and taxation of employee benefits such as ESOP, the focus is naturally on the Israeli subsidiaries of MNEs.

In general, those Israeli subsidiaries are usually characterized as service providers (for example R&D) and are being compensated by the foreign parent corporation at what is generally referred to as “cost+”.

However, one must be aware of the following matters: (a) not always is the “cost+” the right transfer pricing method which should apply to the transaction; (b) the “plus” itself has to be closely inspected and wisely chosen – if it applies; and (c) one must consider carefully whether or not the cost associated with the ESOP and/or other employee benefits, granted to the employees of the Israeli subsidiary, are to be taken and included at the basis of the “cost” or otherwise.

The question of whether or not the cost (direct and indirect) of the options and other benefits granted to the Israeli (or foreign, for that matter, if granted by an Israeli company to one of its related parties), should be calculated as part of the “cost” underlying the “cost+” calculation is not clearly defined in the Israeli transfer pricing regulations, or in the OECD transfer pricing guidelines, although one can differentiate between the various transfer pricing methods and deduct, based upon the OECD transfer pricing guidelines (which discuss the inclusion of both direct and indirect costs associated with certain services) and foreign court resolutions (such as the US Xilinx case), in which cases such costs should be taken into consideration.

This matter, and others, will be discussed in the coming transfer pricing conference to be held at our offices on January 7, 2015.