Pricing methodsAccepted methods
What transfer pricing methods are acceptable? What are the pros and cons of each method?
To determine whether an international transaction between related parties is at arm’s length, the Israeli Income Tax Regulations (Determination of Market Conditions) (TP Regulations) require the taxpayer to apply one of the following methods, in order of preference:
- comparable uncontrolled price (CUP) or comparable uncontrolled transaction (CUT) method;
- resale price method (RPM);
- cost-plus method;
- transactional net margin method (TNMM);
- profit split method (comparable or residual);
- other methods.
The CUP is the most preferred method when reliable data can be ascertained, as it provides a direct measure of the arm's length. The CUP can be applied using external data (data regarding comparable transactions entered into between third parties) or internal data (data provided by the taxpayer regarding its comparable uncontrolled transactions with third parties). However, it requires a high degree of comparability in products or services, functions and risks, contractual terms and other factors to produce reliable arm's-length results. Thus, it may be difficult to identify comparables for use with this method.
The CUP is often used to set royalty rates or service fees using comparable agreements entered into between independent parties (or, when available, internal data). It is also used to establish interest rates of controlled financing transactions using market yields of comparable publicly traded corporate bonds.
RPM and cost-plus methods
- the RPM is often used for product resale activities where the arm’s-length price is measured by subtracting an appropriate gross profit from the applicable resale price of the property involved in the controlled transaction; and
- the cost-plus method is often used for services transactions, where the arm’s-length price is measured by adding an appropriate gross profit (markup) to the controlled taxpayer’s cost of producing the property involved in the controlled transaction.
Both methods measure the gross margin profitability and thus require a high degree of comparability in products or services sold, functions and risks, embedded intangibles, cost structure and accounting consistency. As a result, a higher degree of comparability is more likely to exist between controlled and uncontrolled resales of property by the same reseller or sale of services by the same service renderer – namely, internal data.
In practice, these methods are usually not applicable for evaluating the arm’s-length nature of intragroup services or resale activities, mainly because external data found on public databases cannot be used reliably when applying these methods due to inconsistencies in accounting methods and cost structures among companies.
TNMM (similar to the comparable profits method (CPM))
The TNMM measures the operating margin profitability of comparable uncontrolled companies using different profit level indicators to establish the arm's-length price.
The TNMM is considered a less direct method for establishing arm's-length pricing in comparison with transactional transfer pricing methods (CUP/CUT, RPM and cost-plus). Nevertheless, as the TNMM measures arm's-length profitability at the operating margin level, the comparability degree required for TNMM is less sensitive to differences in functional or product or service comparability and thus reliable external data can be identified for use with this method. This is the reason the TNMM is the most common method used in transfer pricing.
The profit split method is used where the parties to the controlled transaction own or contribute (or both) valuable, non-routine intangible properties or perform valuable functions with significant economic substance in a highly integrated business. In such circumstances, it is appropriate to divide the total operating profit available to the related entities based on their relative contributions to the profit creation.
This method is complex in terms of application, and usually involves the evaluation of the non-routine or valuable contributions of each party to the controlled transaction using discounted cash flow or other economic models or the application of accounting allocation keys.Cost-sharing
Are cost-sharing arrangements permitted? Describe the acceptable cost-sharing pricing methods.
Cost-sharing arrangements are not common in Israel, and there is no specific guidance in this respect. Nevertheless, there is no prohibition on applying them to establish the relationship and obligations of joint ventures. Usually in Israel, cross-licensing agreements, along with services agreements, are used to establish the responsibilities and rights of the parties to a joint venture.Best method
What are the rules for selecting a transfer pricing method?
The TP Regulations incorporate both the OECD Transfer Pricing Guidelines and the approach of section 482 of the US Internal Revenue Code (section 482) towards the determination of the correct analysis methods for examining an international transaction between related parties.
The TP Regulations require that the arm’s-length result of a controlled transaction be determined under the method that, given the facts and circumstances, provides the most reliable measure of an arm’s-length result. The following hierarchy should be employed in implementing the best-method rule:
- The preferred method is the CUP/CUT method because it can produce the most accurate and reliable arm’s-length results.
- When the CUP/CUT method cannot be used, then one of the following methods should be employed:
- the RPM;
- the cost-plus method;
- the profit split method (comparable or residual); or
- TNMM (similar to the CPM in section 482).
- If none of the above methods can be applied, other methods that are more suitable under the circumstances should be used. However, this should be justified both economically and legally, and the application of a different method cannot normally be justified when one of the above-prescribed methods is applicable.
When applying a certain transfer pricing method, an adjustment is sometimes required to eliminate the effect of the difference derived from various comparison characteristics between the controlled and comparable uncontrolled transactions.Taxpayer-initiated adjustments
Can a taxpayer make transfer pricing adjustments?
Yes. Taxpayers must conduct their international dealings with related parties at arm’s length and make transfer pricing adjustments in cases where a cross-border controlled transaction falls outside the arm’s-length benchmark set by a transfer pricing study. The implementation of transfer pricing adjustments can be done gradually during the year with a settlement at the end of the fiscal year, or it can be done as a one-time adjustment at year-end.Safe harbours
Are special ‘safe harbour’ methods available for certain types of related-party transactions? What are these methods and what types of transactions do they apply to?
On 5 September 2018, the Israeli Tax Authority (ITA) published two tax circulars: 11/2018 and 12/2018. The first circular distinguishes between activities that would be seen as consistent with a full-risk distributor, a limited-risk distributor and a marketing entity, and specifies the transfer pricing method that would be the most appropriate according to the ITA in each case. The second provides the ITA’s indicative ranges for certain types of transactions (distribution, marketing and LVA services), as follows:
- Distribution Activity: a safe harbour of 3 to 4 per cent operating margin for entities characterised as low-risk distributors;
- Marketing Activity: a safe harbour of 10 to 12 per cent markup imposed on service costs; and
- LVA Services: a safe harbour of a 5 per cent markup, in accordance with the OECD Guidelines and Actions 8 to 10 of the OECD base erosion and profit shifting (BEPS) Action Plan.
Taxpayers that submit reports in accordance with the approach outlined in the first circular and whose results fall within the ranges provided in the second circular are exempted 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; the documentation simply does not need to include a benchmarking analysis if an exemption applies.
The ITA issued a draft circular that would have set safe harbours for R&D centres located in Israel, on when the TNMM would apply and not a profit split method; however, this circular has not been officially published yet.