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Israel's transfer pricing regime is regulated under Section 85A (Section 85A) of the Israeli Tax Ordinance (the Ordinance), which came into effect on 29 November 2006 and applies to corporate tax. Guidance regarding transfer pricing is provided in several tax circulars issued by the Israel Tax Authority (ITA). At the time of writing, several material changes are expected, including regarding adopting the country by country reporting (CbCR) and master file concepts, as well as requirements for further information to be included in the study (local file).

The regulations promulgated under Section 85A (the Regulations) adhere to the arm's-length principle and incorporate the approach taken in the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines), issued in 2017, and the approach taken in Section 482 of the US Internal Revenue Code (Section 482) towards determination of the correct analysis methods for examining an international transaction between related parties. It should be noted, however, that certain tax circulars offer a 'safe-harbour' mechanism with specific margins.

The scope of transfer pricing regulations in Israel is limited to cross-border transactions in which a 'special relationship' (as defined below) exists between the parties to the transaction. However, the ITA unofficially implements the principles of Section 85A with respect to related-party transactions within Israel, mainly when involving entities that receive tax benefits (e.g., preferred technological enterprise) or that carry losses.

The term 'special relationship' includes the association between an individual (including an entity) and that individual's relatives, the control of one party to the transaction over the other, or the control of one individual over the other parties to the transaction, whether directly or indirectly, individually or jointly with other individuals.2

A relative is a spouse, sibling, parent, grandparent, child, spouse's child and the spouse of each of these. Nonetheless, the ITA can often perform a qualitative test for the above threshold, and look at a transaction even if the threshold itself is not met.

The Regulations cover various types of transactions, including: services (e.g., R&D, manufacturing and marketing); the use or transfer of tangible and intangible goods (i.e., distribution); the use or transfer of intangible assets (e.g., know-how, patents, trade name or trademark); and financing transactions3 (e.g., capital notes, guarantees, captive insurance and loans), which are required to be carried out at arm's length. Upon the approval granted by the tax-assessing officer (AO) to a taxpayer, certain one-time transactions may be excluded from the scope of the Regulations.

Application of the arm's-length principle is generally based on a comparison of a cross-border controlled transaction with similar uncontrolled transactions entered into between independent companies under similar conditions and circumstances (comparable companies). To determine if a cross-border controlled transaction is at arm's length, the following steps must be taken:

  1. identify the cross-border controlled transactions within the group;
  2. identify the tested party for each relevant transaction;
  3. perform a functional analysis with special emphasis on comparability factors such as business activity, the characteristic of the property or service, the contractual conditions of the cross-border transaction and the economic circumstances in which the taxpayer operates;
  4. select the appropriate transfer pricing method or methods;
  5. select the comparable companies and establish an arm's-length range, determined by the comparable companies; and
  6. examine whether the tested party's results fall within the arm's-length range.

According to the Regulations, the initial burden of proof lies with the taxpayer and shifts to the ITA once a transfer pricing study has been submitted for assessment, assuming the study describes the factual background agreeable to the ITA. As such, companies that do not transact at arm's length, or that do not hold the required transfer pricing documentation may be exposed to penalties and to a change of pricing as determined by the ITA at its discretion. In these cases, companies would be required to adjust their net income to incorporate the appropriate transfer prices for their intra-group transaction. This unilateral adjustment could lead to double taxation regarding income taxed in other jurisdictions.

On the basis of Tax Circular 1/2020, the rules for shifting the burden of proof have been aggravated because the filing of a transfer pricing study alone does not necessarily shift the burden of proof to the ITA where there is a disagreement on the factual background, the method chosen or when the submitted transfer pricing study is incomplete.

In rare cases where a transaction between related parties lacks any commercial rationale (namely the same transaction under similar economic circumstances would not have been agreed between non-related parties), the ITA may choose not to recognise the transaction in its original form, and may treat it as an entirely different type of transaction; a type of transaction that, in its view, would reflect the business reality of the transaction in a more adequate manner. This type of reclassification of a transaction can relate, inter alia, to the treatment of inter-company loans or cash pooling or non-repayment of inter-company debts, as dividends, as well as to the ownership of intangibles. Non-recognition can be contentious and a source of double taxation and, while derived from Section 85A, it is also based on Section 86 of the Ordinance.

As regards the accounting treatment of transfer pricing positions, one of the main issues currently under discussion in Israel relates to the inclusion of expenses related to employee stock option plan (ESOP) matters in the cost base of an Israeli R&D subsidiary implementing a cost plus arrangement, where the matters of vesting, exercise and cancellation of options granted to the employees of an Israeli subsidiary by the (foreign) parent corporation are considered.

Recent developments – Israeli transfer pricing regulationsTax Circular 1/2021

Tax circular 1/2021 addresses the ITA's views on the tax treatment applicable to recharge payments relating to grants of stock-based compensation in multinational groups. Recharge payments are costs assumed by a foreign issuing company in connection to vested equity compensation that are granted to employees of an Israeli affiliated company (i.e., employing company). These recharge payments are charged by the issuing company to the employing company.

The ITA sets forth in the Circular its views as to when recharge payments should be treated as a dividend (or capital reduction), which is generally subject to tax withholding, and when such payments can be treated as reimbursement of expenses to the issuing company, which are not subject to withholding tax.

Tax Circular 1/2020

In accordance with Tax Circular 1/2020, the filing of a transfer pricing study, in and of itself, does not shift the burden of proof from the taxpayer to the ITA in cases where there is a disagreement on the factual background or on the method chosen, or when the submitted transfer pricing study is incomplete.

It is important to state that the position of Tax Circular 1/2020 is that where the ITA rejects the transfer pricing study filed by the taxpayer based on the foregoing, or where the taxpayer has not filed a transfer pricing study at all, the results will be the same, and the ITA can, inter alia, set the tax assessment without the need to provide a complete study on its behalf. While the ITA inspectors cannot set this arbitrarily, they can base such assessment upon their general experience and past assessments, as well as upon estimations. Additionally, the ITA inspectors may impose fines on the taxpayer.

Tax Circular 15/2018

On the basis of the Gteko court ruling (6 June 2017) and the OECD Guidelines, on 1 November 2018, the ITA published Tax Circular 15/2018 dealing with business model restructuring by a multinational enterprise (MNE), and involving the functions, assets and risks (FAR) associated with the Israeli subsidiary of a MNE. The Circular presents the ITA's position with respect to business restructuring, defines ways for identifying and characterising business restructurings, and offers methodologies that are accepted by the ITA for valuation of transferred, ceased or eliminated FAR commonly involved in the course of a business restructuring (e.g., intangibles, skilled work force). With regard to each FAR transferred in a business restructuring, the Circular sets guidelines for the characterisation of a FAR transfer as a sale transaction or a 'grant of temporary-usage permit' transaction, for classifying it as a capital or ordinary income transaction.

Tax Circulars 11/2018 and 12/2018

On 5 September 2018, the ITA published two circulars, Tax Circulars 11/2018 and 12/2018, setting out its approach towards classification and transfer pricing methods appropriate for use in connection with certain inter-company transactions between an Israeli entity and related overseas parties that are part of a multinational group. The Circulars focus on inter-company transactions involving marketing services or sales and, in particular, on the approach to be used to classify a given entity as either a marketing services entity or a sales (distributor) entity. In addition, the ITA opined on how to choose the most appropriate transfer pricing method, as well as which ranges of profitability (safe harbours) it sees as appropriate for these types of Israeli entities.

Taxpayers submitting reports in accordance with the approach outlined in Circular 11/2018, and whose results fall within the safe harbours provided under Circular 12/2018, would be exempt from the requirement to provide benchmarking support for the assertion that the transfer prices used are in accordance with market pricing. Nonetheless, the Circular does not otherwise provide an exemption from the existing requirement to prepare transfer pricing documentation.

Circular 12/2018 safe harboursDistribution activity

For taxpayers where the analysis of the FAR aligns with sales activities for low-risk distributors (LRDs), the exemption would be provided in the event that the entity reports an operating margin of three to four per cent in the domestic market.

Marketing activity

For taxpayers where the analysis of the FAR aligns with an entity performing marketing activities, and not sales activities, the circulars indicate that an appropriate transfer proving method would be based on the costs of this activities, with an appropriate markup added. The exemption for supporting the markup over the costs incurred based on benchmarking analysis would be provided for entities reporting a markup of 10 per cent to 12 per cent.

Low-value-added services

The Circulars provide that for taxpayers with transactions involving low-value-added services (generally consistent with the OECD Guidelines), an exemption from some documentation requirements would be provided where the entity reported a markup of 5 per cent associated with these activities.

Tax Circular 4/2016

In 2016, in Tax Circular 4/2016, the ITA issued an update regarding the operations of foreign multinationals in Israel through the internet. This Circular, inspired by Action 1 of the OECD's Action Plan on Base Erosion and Profit Shifting (the OECD BEPS Action Plan) concerning the digital economy, provided new guidelines and rules under which foreign companies' income derived from selling products or providing services through the internet to Israeli residents (digital activity) will be deemed the income of a permanent establishment (PE) in Israel for tax purposes. The Circular distinguishes between foreign enterprises that are residents of a treaty state (treaty resident companies) and foreign enterprises that are residents of a non-treaty state (non-treaty resident companies), and provides different rules for determining the income attributed to the Israeli PE for each of the aforementioned company types.

Expected circulars

Currently, the ITA is holding round-table talks4 on other draft circulars, including in the fields of implementation of development, enhancement, maintenance, protection and exploitation of intangibles (DEMPE) analysis; profit split over cost plus for R&D centres; profits associated with management functions and the incorporation of the master file and CbCR.

Broader taxation issues

i Diverted profits tax digital sales taxes and other supplementary measures

As noted above, the ITA may use either Section 85A and the Regulations, or other means such as Section 86; however, no specific measures relating to transfer pricing matters have been enacted, since, among other reasons, the current measures (i.e., Section 86) are general enough to be implemented (also with regard to transfer pricing). However, certain reportable tax positions, the list of which is amended from time to time by the ITA, require the taxpayer to state the transaction and report it to the ITA.

ii Tax challenges arising from digitalisation

Currently, there is no update on whether Israel will adopt the OECD's Pillar One and Pillar Two blueprints and apply a minimum standard. Nevertheless, Israel monitors any updates concerning this issue.

iii Transfer pricing implications of covid-19

Israel has not issued any guidelines concerning the implication of the covid-19 pandemic on transfer pricing. In general, Israel follows the OECD Guidelines and may also adopt recommendations promulgated under the OECD Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic.

iv Double taxation

Double taxation would seem to be unavoidable in cases where another jurisdiction has taxed the company on account of transfer pricing issues. For example, in the event that a related party in a foreign jurisdiction is characterised as a permanent establishment, or accused of having inadequate transfer pricing documentation or failing to implement it, the foreign jurisdiction will tax it accordingly and the ITA will not take this into consideration, which will result in double taxation. Nevertheless, a MAP process is available where applicable.

v Consequential impact for other taxes

VAT and inter-company transactions have been the focus of several recent ITA audits, and of a recent court ruling, which imposed VAT on sales performed from Israel. Although this matter is tied heavily to transfer pricing, the issue of transfer pricing itself was not argued by the parties in this case and was not decided by the court.

Customs are also of relevance when the sale of tangible goods takes place between related parties. However, as transfer pricing cases rarely reach the courts, any use of transfer pricing rules is usually part of the discussion with customs.

Outlook and conclusions

Eyal Bar-Zvi (the author of this chapter) has recently participated in discussions, on behalf of the Israeli Bar, with the Finance Committee of the Knesset (the Israeli Parliament) with respect to the amendment of the Ordinance, as well as to the Israeli transfer pricing regulations. The discussions specifically focused on the implementation of the master file and CbCR concepts and reporting obligations in Israel, in addition to further amendments to the existing regulations.

The key takeaways from these discussions include shortening the period of time required to submit TP documentation to the ITA, upon request, to 30 days, as well as establishing required sections in the classic TP documentation, either similar to or adapted from the requirements in the OECD.

Furthermore, the Finance Committee is looking to incorporate master file and CbCR requirements, effective as of FY 2022 onwards. The master file thresholds will be 150 million shekels, while the CbCR threshold will be 3.4 billion shekels.