Published on Lexology by: Eyal Bar-Zvi
Taxpayers engaged in cross-border controlled transactions are required to include a separate form (Form No. 1385) in their annual tax return, specifying their intra-group dealings (such as the volume of the transactions, transaction types, terms and conditions and the parties thereto) and declaring that their international transactions between related parties are conducted at arm’s length and in accordance with the Regulations. In practice, this means that taxpayers in Israel are expected, and in fact required, to hold up-to-date transfer pricing documentation, which includes (at a minimum) a transfer pricing study and an inter-company agreement relevant for the fiscal year end. Form No. 1385 is signed personally by an officer of the company (usually the company’s chief financial officer), and although no personal liability has yet been claimed by the ITA in cases where the form was inaccurate, the ITA is reviewing its position on this matter. An updated Form No. 1385 is expected, as well as Form No. 1485 (for capital notes).
In addition, the ITA is entitled to demand full transfer pricing documentation within 60 days of a request of this type. The ITA often asks to receive the documentation within a shorter period, usually 30 days or less; however, this can usually be extended to the 60-day period prescribed under the Regulations.
As noted above, by signing Form No. 1385 the taxpayer’s officer declares that the company is compliant with the arm’s-length principle and that it maintains up-to-date transfer pricing documentation (i.e., a transfer pricing study, inter-company agreement and also, where applicable, a transfer pricing policy), and it is therefore advisable to have an updated transfer pricing study in place annually. Penalties may be imposed on a taxpayer for not preparing and submitting transfer pricing documentation on time or at all. In addition to preventing penalties and fines, holding a transfer pricing study and other related transfer pricing documentation shifts the burden of proof to the AO and enables the taxpayer to maintain an arguable position regarding any determination made by the AO concerning transfer pricing adjustments. The deadline to prepare transfer pricing documentation is 31 May of the year after the tax year.
Full documentation includes the following:
- a transfer pricing study that includes:
- a description of the parties involved in inter-company transactions, including a description of the management structure of the parties and functional organisational charts;
- a description of the inter-company transactions;
- a description of the business environment and the economic circumstances in which the parties operate;
- a functional analysis of the parties involved in the inter-company transactions (including functions performed, risks assumed and resources employed);
- selection of the pricing method or methods and the reasons behind the selection;
- an economic analysis (determination of arm’s-length prices); and
- the conclusions that may be derived from the comparison to uncontrolled comparable companies; and
- additional documents that corroborate the data described above, such as:
- inter-company contracts;
- any disclosure made regarding the controlled transactions to any foreign tax authority, including any request for an advance pricing agreement (APA);
- a transfer pricing policy, if applicable;
- any differences between the prices reported to the foreign tax authority and the prices reported in the Israeli tax returns; and
- any opinion from an accountant or lawyer, if one was given.
It is recommended to update the transfer pricing study on an annual basis. Where the facts of the transactions under review have not changed materially (or at all), the entire transfer pricing study can remain the same except for the benchmark results, which should be updated every year. It is best practice to perform a new search every two years and update the results of the original search on an annual basis. From time to time, because of a lack of local comparables, the search may be broadened to a more global search, as long as it abides by the Regulations and the instructions of the ITA.
On 4 January 2017, draft legislation was proposed to amend the Ordinance to include new transfer pricing provisions with respect to Action 13 of the OECD BEPS Action Plan. The proposed legislation updates the provisions of Section 85A of the Ordinance and adds Sections 85B and 85C to the Ordinance.
In light of this proposed legislation, the burden of transfer pricing documentation will grow as taxpayers will be required to submit further documentation, reports and data to comply with the new documentation requirements.
Accordingly, in addition to the regular local file (i.e., the transfer pricing study), Israeli taxpayers that are members of a multinational group will also be required to submit data at the corporate level, namely a master file accompanied by related data of the multinational group. In addition, an Israeli taxpayer that serves as the ultimate parent of a multinational group whose consolidated turnover exceeds 3.4 billion new Israeli shekels will be required to submit a country-by-country report as well.
The draft legislation passed the first reading (of three) in the Israeli parliament; however, the applicable effective date of the proposed legislation has not yet been determined. Currently, the ITA expects that this legislation will pass during Q4, 2019.
Presenting the case
i Pricing methods
The Regulations incorporate both the OECD Guidelines and Section 482’s approach towards the determination of the correct analysis methods for examining an international transaction between related parties. As such, the 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, where there is a preference for transactional transfer pricing methods over profit-based transfer pricing methods.
According to Section 85A, the preferred method is the comparable uncontrolled price or transaction (CUP/CUT) methodology, because this method can produce the most accurate and reliable arm’s-length results. When the CUP/CUT cannot be used, then one of the following methods should be employed:
- resale price method (RPL);
- cost plus;
- profit split methods (comparable or residual); or
- transactional net margin method (TNMM, similar to the comparable profits method (CPM) in Section 482).
If none of the above methods can be applied, other methods should be used that are most suitable under the circumstances. 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.
According to the Regulations, a cross-border controlled transaction is considered to be at arm’s length if, following the comparison to similar transactions, the result obtained does not deviate from the results of either the full range of values derived from comparable uncontrolled transactions when the CUP method is applied (under the assumption that no comparability adjustments were performed), or in the interquartile range when applying other methods.
The adoption of post-BEPS measures has not yet been formalised in Israel but has been considered by the ITA. The ITA places great emphasis on business or economic substance when analysing value chains and transactions involving the transfer or use of intangible properties. This means that functions contributing to the creation of value, as well as where people are located, constitute important criteria when determining the appropriate attribution of profits among group members in multinationals. Consequently, the ITA may deem a transfer pricing analysis to be inappropriate to the application, preferring, for example, a profit split method rather than the TNMM. In other cases, the ITA has retroactively applied different methods from those used by the taxpayer, shifting between CUP and TNMM, in cases where profit split was not applicable.
As mentioned above, where a transaction between related parties lacks any commercial rationality, the ITA may not recognise the transaction in its original form, and may treat it as an entirely different type of transaction that, in its view, would reflect the business reality of the transaction in a more adequate manner. Non-recognition can be contentious and a source of double taxation.
The Israeli transfer pricing regulations do not provide specific guidelines for evaluating the arm’s-length nature of inter-company financing transactions and thus follow a broader transfer pricing approach provided under the OECD Guidelines and Section 482.
Specifically for inter-company loans, the evaluation of the arm’s-length nature is carried out by establishing an arm’s-length interest rate based on those applied in comparable third-party transactions. According to the OECD Guidelines and Section 482, the transfer pricing methodology usually used when setting arm’s-length interest rates is the CUP method, applying internal or external CUP analysis. The approach preferred by the ITA is the external CUP method, which is, in fact, a market-valuation method, as it relies on market yields of publicly traded corporate bonds that are comparable to the assessed inter-company loan in terms credit-rating and loan terms when establishing the arm’s-length interest rate.
Since the ITA has expressed its endorsement of the OECD BEPS Action Plan, it is likely that inter-company loan transactions will be the focus of increased scrutiny by the ITA. Therefore, Israeli taxpayers are advised to apply a new approach when establishing arm’s-length interest rates for their inter-company loan transactions in accordance with the BEPS Actions 8–10 guidelines. This will combine the synthetic rating approach backed by audit trails and empirical evidence, such as a description of people functions involved, and evidence demonstrating the management and control of risks by relevant parties to the inter-company loan.
In addition to the above, the fact that there are no thin-capitalisation rules in Israel will also contribute to the trend of increased tax audits relating to inter-company loan transactions. Consequently, this enables Israeli borrowers in controlled loan transactions to be highly leveraged and assume high interest payments deductible for tax purposes in Israel. This issue will be resolved when Israel implements the recommendation prescribed under BEPS Action 4 and limits the interest payment amount deductible for income tax by applying a ‘fixed ratio’ (which equals a borrower’s net deduction for interest or earnings before interest, tax, depreciation and amortisation (EBITDA) to 10 per cent to 30 per cent) or a ‘group ratio’ (which equals a group’s net deduction for interest or EBITDA).
Application of profit split
The Regulations incorporate the OECD Guidelines’ approach towards the application of the profit split method. In general, the employment of the profit split method in documentation is quite limited. However, the profit split can be a method of choice for dispute resolution.
The Regulations stipulate two profit split methods:
- Comparable profit split method: transfer prices are based on the division of combined operating profit between uncontrolled taxpayers whose transactions and activities are similar to those of the controlled taxpayers in the relevant business activity. Under this method, the uncontrolled parties’ percentage shares of the combined operating profit or loss are used to allocate the combined operating profit or loss of the relevant business activity between the related parties.
- Residual profit split method: this method involves two stages. First, operating income is allocated to each party in the controlled transactions to provide a market return for their routine contributions to the relevant business activity. Second, any residual profit is divided among the controlled taxpayers based on the relative value of their contributions of any valuable intangible property to the relevant business activity. This method is best suited for analysing the transfer of highly profitable intangibles.
The Regulations do not contain specific guidance for the application of the profit split method. Nevertheless, this method is generally acceptable to tax administrators when it is used in cases where both entities contribute or own significant intangibles, and it has recently been advocated by certain officials of the ITA. The profit split method is most often applied in the context of global value chains, where the global operations of a multinational corporation are significantly integrated.
In Israel, following the OECD BEPS Action Plan, tax practitioners are currently assessing the applicability of the profit split method in service transactions, which include the provision of significant services that contribute to the creation of profits and value (e.g., R&D, marketing, management) as a result of increasing challenges by the ITA to the cost-plus models, and recharacterisation as profit splits. The ITA is implementing a people-orientated analysis when conducting tax audits and, therefore, can, in certain cases, determine management services as being a non-routine activity for purposes of profit splits.
Concerning R&D services, in cases where R&D activity is considered non-routine by the ITA, this activity will be recharacterised as a profit split. The ITA’s determination concerning the non-routine nature of the R&D is based on several factors:
- whether the R&D relates to the development of a whole new product or the continuing development of an existing product;
- how many employees are involved in the development; and
- whether the Israeli R&D contractor is free to determine its own R&D budget or whether it is bound by the authorisation of the entity financing the R&D activity.
With respect to marketing services, the ITA challenges cost-plus models for marketing activity and recharacterises these as distribution models. This means that an Israeli company that acts as a marketing services provider could be characterised as a distributor by the ITA, and thus be subject to an appropriate profit derived from revenue concerning the sales of the products in Israel.
The characterisation of a marketing service provider as a distributor is dependent on the involvement of the marketing activity in the creation of revenue for the group in terms of, but not limited to:
- which entity oversees the engagement with customers, and where contracts are signed;
- which entity oversees the negotiations with customers;
- which entity is seen by the customers as the one responsible for sales;
- the entity that approves discounts or unusual credit terms for customers; and
- whether the employees of the marketing service provider are compensated by a certain percentage from sales of promoted products.
As regards management services, the ITA’s determination of management services as an intangible is based on the nature of the services, meaning that a management service incorporating strategic decision-making functions may be considered intellectual property for profit split purposes. As noted, this matter is currently being debated with the ITA.
Further, because of the new value-added services safe-harbour setting (a cost-plus five per cent exemption), a five per cent markup for value-adding services such as R&D services would be difficult to justify.
Application of the cost-plus method
The cost-plus method compares gross margins of controlled and uncontrolled transactions. The cost-plus method is most often used to assess the markup earned by a service-providing entity that engages with related parties.
The arm’s-length price is measured by adding an appropriate gross profit (i.e., markup) to the controlled taxpayer’s cost of producing the services involved in the controlled transaction.
The cost-plus method applies where internal data is available, in which a service renderer provides the same or similar services to both controlled and uncontrolled parties and where it provides detailed information concerning comparable transactional costs.
In practice, this method is usually not applicable for evaluating the arm’s-length nature of intra-group services, mainly because external data (i.e., transactions between two third parties) found on public databases cannot be reliably used when applying this method. This is due to inconsistencies between companies’ financial data, arising from the fact that companies allocate their costs using different accounting methods.
The degree of consistency in accounting practices between the controlled transaction and the uncontrolled comparables materially affects the gross profit markup and the reliability of the result.
When performing comparability analysis, the goal is to reach the most accurate pool of potential comparable companies. In doing so, the search process usually includes a quantitative screening followed by a qualitative screening.
It is first essential to apply Standard Industrial Classification (SIC) codes, NACE (Nomenclature des Activités économiques dans la Communauté Européenne) codes, or both, as well as specific industry classifications employed by certain databases, which classify companies by the type of economic activity in which they are engaged and the types of products or services they sell.
Following the application of the aforementioned industry codes, additional screening criteria are also applied, including geographic location, company status (i.e., active companies), company type, exclusion of operating subsidiaries from the search, years of available accounts, and limitations regarding operating losses.
Depending on the nature of the tested transaction under review, in certain cases, additional quantitative screening criteria are also applied to yield a more accurate set of comparables. This mainly includes the application of different financial ratios such as R&D expenditure sales, intangible-asset sales, inventory sales, or property, plant and equipment sales.
The next step is a qualitative screening, which focuses on examining the business descriptions of all remaining companies and then establishing a set of comparable companies.
The Regulations do not provide a reference to a specific number of comparables required for the establishment of interquartile range results. In our opinion, between 10 and 20 comparables should suffice, with the minimum being around five. There is no quantitative limit; however, the credibility of a range composed of a large number of comparables may be brought into question.
Regarding the locations of selected comparables, local (Israeli) comparables are preferred but are not often available. Practice has shown that the use of European or US comparables is also accepted by the ITA, as well as global benchmarks, as long as applicable adjustments were made (when required). However, this is examined on a case-by-case basis.
ii Authority scrutiny and evidence gatheringTax scrutiny
There is a dedicated Transfer Pricing Department (TPD) within the ITA, which is responsible for performing audits and economic analyses to determine the arm’s-length price for a taxpayer’s transactions. Further, the TPD has been given full authority to review (and tax) previously approved assessments and to reopen final assessments that were approved up to three years before their inspection. The TPD also gives guidance and instructions to local tax AOs to screen and initiate audits on a wider level. In the event of an audit by a local tax AO, certain disagreements may be handed over to the TPD.
In Israel, the tax authorities’ transfer pricing unit audits both Israeli subsidiaries of multinational enterprises (MNEs) and local corporations in all matters related to transfer pricing. However, when it comes to the pricing and taxation of employee benefits such as ESOPs, the focus is naturally on the Israeli subsidiaries of MNEs. Taxpayers can dispute the proposed transfer pricing adjustments of the tax authorities by means of appeals, courts and through the use of treaties (where relevant).
The matter of ESOPs has gained specific attention in audits performed by the TPD, has involved other departments of the ITA, and has generated three recent district court decisions, two of which are currently under appeal to the Israeli Supreme Court. Those Israeli district court decisions have ruled that an Israeli subsidiary working on a ‘cost-plus basis’ (i.e., utilising the TNMM/CPM methods) should include within the cost-plus model expenses associated with employees’ social security payments, as well as options granted by the foreign parent corporation. Those rulings affected the activities of certain R&D subsidiaries in Israel significantly.
The ITA does not usually interview persons outside the company undergoing an audit, although this is not prevented by legislation. It is common, however, to allow the professionals who act as consultants to the company to be interviewed by the ITA with regard to their work, and to present them to the ITA as part of a ‘hearing’ held for the company. These meetings occur both prior to and following the issuance of a transfer pricing tax assessment.
With regard to intra-group information requirements, the ITA may request intra-group information even if it is held outside Israel. If the company fails to present the requested information, it is likely to be viewed negatively throughout the process, including (potentially) in court, thereby preventing the company from providing the information at a later stage.
In January 2017, a proposed amendment to the Ordinance that includes transfer pricing provisions, adopting anti-BEPS measures, passed the first reading (of three) in the Israeli parliament. The proposed legislation aligns with Action 13 of the OECD BEPS Action Plan and follows a formal resolution by the Israeli government to adopt the BEPS principles.
In addition, on 12 May 2016, Israel signed the Multilateral Competent Authority Agreement for Country-by-Country Reporting (MCAA CbCR) for the automatic exchange of country-by-country reports (CbCRs), which allows all participating countries to bilaterally and automatically exchange CbCRs with each other. These steps indicate that Israel can be expected to amend its documentation requirements to also include the creation and filing of CbCRs, and to implement legislation regarding surrogate filing.
Adoption of the MCAA CbCR may indicate the ITA’s intention to implement a global tax position when assessing profit attribution among companies in a multinational corporation. It is important to note that a CbCR in itself could not be used alone by the ITA for determining transfer pricing adjustments.