Israel’s New Approach to Transfer Pricing Controversy

Over the past several years, the OECD’s 2015 BEPS project has exerted a significant influence on how tax authorities think about and handle transfer pricing controversy, particularly in Israel. The Israel Tax Authority (ITA) has deployed innovative theories aimed at capturing the full value of the functions, assets, and risks (FAR) attributable to Israeli entities, and identifying when some of that value may have been transferred outside of Israel, and it has drawn from BEPS concepts and updated OECD guidance in this regard. This article summarizes some recent experiences that are representative of these developments and provides insight into how taxpayers can arrive at pragmatic resolutions.

Deemed Capital Gain

In 2013, a U.S. multinational enterprise (MNE) acquired an Israeli company for approximately $24 million. The two entities then entered into an intercompany license arrangement, which allowed the U.S. parent to use intangible property (IP) owned by the Israeli entity. The Israeli company (the Company) continued to provide research and development (R&D) services to the MNE as a service provider, and was compensated by the payment of a mark-up on its R&D costs. Under this arrangement, all new IP that was developed was owned by the U.S. parent.

Under the license agreement for the existing IP, the U.S. parent paid royalties determined on a high-level valuation of the Israeli IP as of the acquisition date, which were approximately $11 million. The MNE initially projected that these royalties would be paid for approximately 5-8 years; however, the Company’s actual results differed from the projections. After 3.5 years, the royalties paid totaled $14 million, which exceeded the IP valuation. The Company therefore decided to discontinue the royalty payments.

The ITA asserted that the license arrangement had effectively transformed the Company into a limited risk service provider and inferred a de facto transfer of the Company’s IP to its U.S. parent. The resulting adjustments related to 2013 through 2016 included the following components:

• The application of the full 23% tax rate on the income received by the Israeli company (as opposed to the 16% rate applicable to royalty income), resulting in about $1.25 million in tax due;
• Additional capital gain income, based on the ITA’s determination that the value of the IP was greater than the $14 million already received, which resulted in approximately $1 million in new tax;
• Additional income from the company’s R&D services, which was adjusted to include the costs of stock-based compensation that was granted to Israeli employees but had not been reflected in the local financial statements and was not deductible for Israeli purposes, resulting in approximately $1.3 million in additional tax;
• A secondary transfer pricing adjustment with respect to the additional capital gain, subject to 25% withholding tax (WHT) under the U.S.-Israel income tax treaty;
• A secondary transfer pricing adjustment with respect to the additional R&D income, which is treated as a deemed dividend subject to 15% withholding tax (WHT) under the U.S.-Israel income tax treaty; and
• Interest, which was fixed at 4% by regulation.

In total, the tax due (including interest) came to approximately $6 million.

In responding to the ITA, the Company was able to point to Broadcom Semiconductor Ltd. vs. Kfar Saba Assessment Officer, a 2019 decision in which the court rejected the ITA’s argument that a license and cost-plus R&D arrangement should inherently be regarded as a de facto transfer of IP. Although the Company was not able to convince the ITA that its position was incorrect, the decision in Broadcom and a looming assessment deadline created a window for a mutually acceptable compromise. The case settled for approximately $2.1 million in tax due, roughly split between the IP capital gain and stock-based compensation issues. The Company was able to avoid the proposed secondary adjustments by recording an intercompany account in the amount of the additional assessed income, which would bear interest until settled in cash.

Assignment of Patents vs Actual Profit Allocation

In 2013, an Israeli company that developed and manufactured medical devices merged with a U.S. MNE group. At the time of the merger, the Israeli company was valued at approximately $40 million, which included the portfolio of patents (approximately 50-60) owned by the Israeli entity. Post-merger, the Israeli company provided ongoing R&D services to the U.S. MNE (among other activities) but maintained ownership of the pre-existing IP. Because the Israeli entity owned valuable IP, the MNE group employed a residual profit-split methodology (RPSM) to price the intercompany transactions. Unfortunately, due to changing market forces and competitive pressures, the new MNE group began winding down business activities in 2017.

When the Israel Tax Authority opened its audit, the business activities of the MNE group had ceased. As a result, any remaining IP was assumed to have negligible value, in line with the cessation of the associated business. However, based on conversations with unidentified former employees, the ITA posited that the IP had in fact been effectively transferred soon after the original merger. Although under Israeli law, the ITA is barred from talking with employees without company consent, with one local court holding that the prohibition extends to former employees as well, the ITA still engages in this practice with some frequency.

The Israel company noted that the transfer pricing methodology (i.e., the RPSM) reflected the fact that the IP was both owned and continuously maintained in Israel. Moreover, the Israeli company contested the ITA’s assertion that there was a transfer of the existing intangible assets, noting that the Israeli entity continued to function in every way as the IP owner after the merger, which included receiving its share of the MNE group’s profits.

In their questioning of former employees, the ITA found an instance of a former senior R&D employee who had signed an assignment of any theoretical rights that he might have had in the company’s patents, which invited some ambiguity as to the true owner of the patents between the U.S. and Israeli entities. On this basis, coupled with purported statements by the former employee, the ITA claimed that at least some portion of the intangible assets were effectively transferred.

To arrive at the primary adjustment, the ITA used the equity value at the merger ($40 million) as a starting point for the IP valuation/deemed capital gain. In addition, the ITA asserted a secondary adjustment in the form of a deemed dividend. While the ITA indicated a willingness to deduct any excess profits earned under its profit split beyond what it might have earned as a routine cost-plus entity, the total adjustment still amounted to approximately $22 million in tax, when including a secondary adjustment of a deemed dividend.

To counter the ITA’s claims, the company made extensive efforts to track down the documentation of each registered patent, as well as their individual use and application within the MNE group’s products in the subsequent years. A comprehensive report was provided to the ITA exhaustively demonstrating the provenance and continued ownership of all of the company’s IP assets. Ultimately, the ITA and the company agreed to settle for a deemed capital gain of $10 million with no secondary adjustment, coupled with a statement that the settlement covers all of the company’s IP with no potential for any future claims. The resulting tax to the company was approximately $2.5 million.

ITA Challenging Cost-Plus Structure on DEMPE Grounds

The ITA recently audited an Israeli company functioning as an R&D center of a large U.S. global technology MNE group. Over the years, the MNE group experienced organic growth of its workforce in Israel, which was supplemented by the MNE group’s acquisition of additional Israeli companies and their employees. Importantly, following each acquisition of an Israeli company, the MNE group sold the underlying IP/intangibles of the acquired company to foreign group entities (which were, at times, the subject of separate ITA audits of the selling entities), leaving only the routine workforce of the acquired company, which was then transferred to the existing Israeli R&D center. The Israeli R&D center from its establishment was compensated using a cost-plus transfer pricing methodology (specifically, cost-plus 8%), which was supported by annual transfer pricing documentation.

The ITA challenged the use of a cost-plus transfer pricing methodology, and instead asserted that the RPSM is the most appropriate method based on the following claims:

• The Israeli R&D center engaged in high-value DEMPE functions with a specialized workforce;
• The local activity in Israel was highly integrated and interdependent with the MNE group’s broader technology development; and
• Under OECD Guidelines and BEPS Action 8-10, the Israeli R&D center managed, and thus bore economic risk with respect to, intangible development, which should result in remuneration that is commensurate with the Israeli company’s functions and activities.

The ITA employed a high-level calculation/formula to arrive at a theoretical allocation that was based on relative R&D expenses and headcounts. This resulted in additional profit allocated to the Israeli company of approximately 1 billion shekels ($316 million) over the five-year audit period.

While the company ultimately settled the audit with no conclusion on the merits, it agreed to increase the effective cost-plus mark-up by 50% (i.e., from 8% to 12%), resulting in increased profit of approximately 250 million shekels. Importantly, the 12% mark-up was within the interquartile range of the MNE group’s benchmarking studies. In addition, the ITA imposed a secondary adjustment in the form of a deemed dividend, resulting in further withholding taxes of approximately 25 million shekels.

Pharmaceutical FAR Transfer

An Israeli company provided pharmaceutical components for the U.S. market through a U.S. affiliate. Historically, the Israeli entity had engaged in marketing and business development, but it had ceased to perform these functions well before any of the relevant tax years. A U.S. MNE subsequently acquired both entities for $35 million, which was allocated evenly between the two. After the acquisition, a transfer pricing analysis was undertaken to bring the Israeli company’s compensation in line with its functional profile.

The ITA initially explored the possibility that the change in the company’s transfer pricing methodology had resulted in a de facto transfer of value out of the Israeli entity. However, the company was able to successfully demonstrate that there had been virtually no change in the Israeli company’s activity as a result of the acquisition, and that the new transfer pricing methodology was supported by a valid economic analysis.

However, in reviewing the company’s FAR, as presented in its transfer pricing study, the ITA discovered a handful of differences from the documentation that the company had provided in an ITA audit several years prior. The ITA asserted that these discrepancies reflected that a transfer of FAR out of Israel had occurred. Without identifying a specific transfer event or conducting a detailed valuation of the activity believed to have been transferred, the ITA announced its intention to issue an assessment with the following components:

• Deemed capital gain of approximately $9 million, which represented about half of the Israeli entity’s value as of the acquisition; and
• A secondary transfer pricing adjustment, which would take the form of a deemed dividend and be subject to 25 percent WHT under the U.S.-Israel treaty.

The total tax resulting from these proposed assessments would have been about $4.6 million after including interest and CPI linkage.

However, the ITA offered the company a settlement under which the capital gain would be reduced to approximately $7.7 million, no secondary adjustment would be applied, and an additional tax expense of $3.25 million would be permitted in future years. Taking timing considerations into account, this would have resulted in about $1.2 million of tax due.

The company was initially loath to accept the proposed settlement and opted to first explore the potential for a competent authority resolution under the mutual agreement procedure (MAP) article of the U.S.-Israel treaty. To that end, it engaged in preliminary discussions with the U.S. Advance Pricing and Mutual Agreement Program.

While it appeared that the MAP would likely have been successful at eliminating double taxation, and could have resulted in a reduction of the ITA’s transfer pricing adjustment, the secondary adjustment would have effectively doubled any primary adjustment, and thus MAP would have needed to achieve a nominal 70%-80% reduction in the primary adjustment in order to provide a result that would have resulted in less tax due than the ITA’s compromise offer. With that understanding, the company opted to accept the ITA’s settlement and request unilateral relief from double taxation from the U.S. competent authority.

Recharacterization of Independent Distributor

An Israeli company functions as the local distribution, sales, and marketing presence of a large global MNE. Historically, the MNE group employed an internal transfer pricing policy that combined product pricing (which was based on a gross mark-up) and an additional royalty from the selling entities to the group IP holder.

In response to some of the OECD BEPS proposals and initiatives, the MNE group revisited its internal transfer pricing policy. As part of that effort, the MNE group adjusted the transfer pricing methodology for entities that fit within the suggested profile of a limited risk distributor (LRD) to apply a guaranteed operating margin based on return on sales within a benchmarked range. Consequently, the local distributor margins declined from greater than 10% in 2014 to 2.6% in 2017, which in turn required the company to make a significant transfer pricing adjustment prior to closing the 2017 books that reflected the new 2.6% operating margin.

During the same period, the MNE group was also in early stages of implementing a new enterprise resource planning (“ERP”) system group-wide. As part of that process, in 2014, the MNE group allocated expenses associated with the ERP implementation to its subsidiaries. The local Israeli entity, however, did not claim the expense deduction for tax purposes, pending the new ERP system being operational, which had not yet occurred.

Upon audit, the Israel tax authority made three broad claims for the company’s fiscal years 2014-2017. First, the ITA rejected the characterization of the Israeli entity as an LRD, and instead asserted that the historical royalty mechanism should have continued, along with the associated withholding tax. More specifically, the ITA noted that MNE group had applied two different royalty mechanisms in prior years; the two royalties consisted of 6% and 1% of net sales for use of product IP and brand, respectively. Under the historical transfer pricing policy, the local entity paid a royalty of 1% of net sales for use of the MNE group’s branding; however, the ITA asserted that the MNE group’s transfer pricing documentation discussed an additional 6% royalty.

Second, the ITA rejected the 2017 transfer pricing adjustment on the grounds that the LRD characterization (and the accompanying lower target operating margins) was inconsistent with the functions, assets, and risks of the local Israeli entity. Finally, the ITA challenged the ERP cost allocations and claimed that these expenses did not have a valid business purpose and the transferred funds represented a deemed dividend, with the resulting withholding tax.

The company provided the ITA with internal contemporaneous documentation from the period of the original transfer pricing policy that had analyzed the local functional profile and concluded that an LRD return should be sufficient from an Israel perspective.

The audit was closed in a settlement on the basis of the following:

• While not expressly agreeing to the irrelevance of the additional 6% royalty, WHT was assessed on the 1% royalty for the years under audit. In addition, the agreement was silent to the nature of the tax so as not to prejudice future periods.
• The 2017 TP adjustment was accepted in part, setting the local operating margin at the median of the group’s interquartile range of 4.0%.
• The ERP expenses were reclassified as a deemed dividend subject to the ITA’s express agreement that, upon the local company claiming the relevant tax expense in the future, a further cash transfer may be made without incurring additional WHT.

Conclusion

MNEs operating in Israel, and particularly those that have recently acquired or are considering acquiring Israeli companies, should take heed of the ITA’s new approach. These BEPS-driven theories are important considerations, not only when undertaking tax planning projects, but also when monitoring year-over-year business. The Covid-19 pandemic has further accelerated the dispersal of a remote workforce for many companies, and companies that have personnel moving into or out of Israel should take careful stock of the tax implications of those moves and document them accordingly.

The principles that have emerged from the OECD’s BEPS project are still evolving, and not all tax authorities or taxpayers share the ITA’s views on how these principles should apply. Our experience has shown that the ITA has incorporated multiple approaches in applying an expansive view of the BEPS project conclusions. At the same time, the ITA is willing and able to arrive at pragmatic settlements, and to engage productively with its foreign counterparts in MAP with the aim of eliminating double taxation.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

David Samson is a director in KPMG Israel, Sean Foley leads the Global Transfer Pricing Dispute Resolution practice for KPMG LLP, Mark Martin co-leads the Tax Controversy and Dispute Resolution (TCDR) group in the Washington National Tax (WNT) practice of KPMG LLP, Theresa Kolish, Josh McConkey and Thomas Bettge are managing director, senior manager and manager in WNT’s TCDR group.

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