The Israeli Tax Authority (ITA) on February 27, 2025, issued a draft circular on the attribution of income to Israeli R&D centres, also known as Israeli development centres (IDCs). The circular provides guidance on two aspects of the transfer pricing of intercompany transactions -- how the R&D activity is taxed in Israel, and how IP migrations should be treated for tax purposes.
Recently, we have sensed significant tension in tax assessment discussions revolving around the taxation of IDCs, which provide development services to related foreign entities. On the one hand, these discussions create a potential for substantial additional tax burden by the Israeli Tax Authority (ITA)1, while also creating the potential for tax leakage. On the other hand, the Ministry of Finance and the ITA aim to enhance the Israeli high-tech sector and maintain Israel's attractiveness in the global high-tech arena.
To balance these interests, the ITA recently published a draft circular intended to provide tax certainty for multinational technology companies operating in Israel. Under the circular, if an IDC meets certain conditions – primarily relating to the nature of the activity and providing a detailed transfer pricing analysis with the tax return -- the ITA will self-impose certain limitations during the tax assessment stage, which will grant the IDC some tax certainty.
The main dispute during tax assessment discussions revolves around transfer pricing, when the IDC provides development services to a foreign entity and charges it for its services. Because the IDC is a related party to the foreign entity, it must prove that the amount charged is determined in accordance with market conditions (that is, at arm's length) and indirectly, that the profit remaining in Israel is appropriate for the activity performed.
If the IDC provides a simple development activity, the ITA may approve a profit amount based on the cost-plus mechanism. If the IDC’s activity is more complex, the ITA may argue that an amount determined according to the profit split method should remain in Israel. In other words, a percentage of the "global" profit of the multinational high-tech group should be attributed to Israel and taxed accordingly.
It should be noted that the IDC is required to declare in its tax return, inter alia, the pricing method it chose, and to state that it prepared a transfer pricing analysis that supports the amount it charged the foreign related entity.
According to the draft circular, IDCs that meet certain conditions will be able to limit the tax assessor's ability to determine an assessment using a different transfer pricing method than the one chosen by the IDC. For example, if an IDC chose to apply the cost-plus method, then the tax assessor will be restricted in a certain manner in issuing a profit split assessment.
The main conditions for IDCs to be eligible to benefit from the draft circular's conditions are as follows:
If an IDC does not meet the conditions in the circular -- for example, because it did not prepare a transfer pricing analysis that meets the draft circular's requirements, or because the IDC provides significant nonroutine development services - then no limitation is imposed on the tax assessor in issuing an assessment according to the pricing method chosen (within the general tax law limitations).
Additionally, the draft circular offers a mechanism whereby an IDC may apply for a specific tax ruling (within a set time frame) determining that the cost-plus margin is at arm's length conditions, provided the IDC meet's the draft circular's requirements. It is also possible to request a bilateral agreement (between the tax authorities of two countries) regarding the transfer pricing methodology if the foreign country entered into a double tax treaty with Israel.
The draft circular also mentions the possibility of applying for a specific tax ruling in cases where an Israeli company is acquired by a foreign corporation and becomes a limited-risk development service provider after the acquisition. Among the conditions allowing for this decision:
Although it is a draft circular, it is recommended to be prepared accordingly.
Amit Shalit
BDO in Israel
1 Please see our previous publication regarding development centres - https://tinyurl.com/3r2frtbr
Background
Recently, we have sensed significant tension in tax assessment discussions revolving around the taxation of IDCs, which provide development services to related foreign entities. On the one hand, these discussions create a potential for substantial additional tax burden by the Israeli Tax Authority (ITA)1, while also creating the potential for tax leakage. On the other hand, the Ministry of Finance and the ITA aim to enhance the Israeli high-tech sector and maintain Israel's attractiveness in the global high-tech arena.To balance these interests, the ITA recently published a draft circular intended to provide tax certainty for multinational technology companies operating in Israel. Under the circular, if an IDC meets certain conditions – primarily relating to the nature of the activity and providing a detailed transfer pricing analysis with the tax return -- the ITA will self-impose certain limitations during the tax assessment stage, which will grant the IDC some tax certainty.
The main dispute during tax assessment discussions revolves around transfer pricing, when the IDC provides development services to a foreign entity and charges it for its services. Because the IDC is a related party to the foreign entity, it must prove that the amount charged is determined in accordance with market conditions (that is, at arm's length) and indirectly, that the profit remaining in Israel is appropriate for the activity performed.
If the IDC provides a simple development activity, the ITA may approve a profit amount based on the cost-plus mechanism. If the IDC’s activity is more complex, the ITA may argue that an amount determined according to the profit split method should remain in Israel. In other words, a percentage of the "global" profit of the multinational high-tech group should be attributed to Israel and taxed accordingly.
It should be noted that the IDC is required to declare in its tax return, inter alia, the pricing method it chose, and to state that it prepared a transfer pricing analysis that supports the amount it charged the foreign related entity.
Guidance
According to the draft circular, IDCs that meet certain conditions will be able to limit the tax assessor's ability to determine an assessment using a different transfer pricing method than the one chosen by the IDC. For example, if an IDC chose to apply the cost-plus method, then the tax assessor will be restricted in a certain manner in issuing a profit split assessment.The main conditions for IDCs to be eligible to benefit from the draft circular's conditions are as follows:
- The development services provided must be routine, the IDC must bear limited risk, it may not perform additional activities in Israel, and it may own no assets unrelated to the provision of development services. For example, the IDC may not own any intangible property (IP).
- The foreign service recipient must bear the development and financing risks and control and manage these risks (if its consolidated revenue exceeds 10 billion NIS, additional limitations will apply to the tax assessor).
- The foreign service recipient’s ultimate parent company must be a foreign entity resident in a country that has entered into a tax treaty with Israel. The ultimate parent company that owns the group, holds all/most rights, directly or indirectly, both in the IDC and in the company to which the IDC provides services (Israeli residents do not hold together more than 10% of any controlling rights in the ultimate parent company).
- The IDC's income from providing development services is preferred income under the Israeli Encouragement Law, and it meets all the conditions required for eligibility for a reduced tax rate.
- The relevant transfer pricing analysis for the tax year that the IDC must prepare (as part of its legal requirements) must include, inter alia, a functional analysis according to the DEMPE principles articulated in the OECD transfer pricing guidelines, supporting the transfer pricing method, a matrix of comparable companies accepted or rejected for determining the cost-plus mark-up, etc.
- The IDC must have declared in its annual tax return that it operates under the cost-plus method, and this must be consistent with its financial statements.
- The IDC must attach to the annual tax return a copy of the intercompany agreement and the transfer pricing analysis.
If an IDC does not meet the conditions in the circular -- for example, because it did not prepare a transfer pricing analysis that meets the draft circular's requirements, or because the IDC provides significant nonroutine development services - then no limitation is imposed on the tax assessor in issuing an assessment according to the pricing method chosen (within the general tax law limitations).
Additionally, the draft circular offers a mechanism whereby an IDC may apply for a specific tax ruling (within a set time frame) determining that the cost-plus margin is at arm's length conditions, provided the IDC meet's the draft circular's requirements. It is also possible to request a bilateral agreement (between the tax authorities of two countries) regarding the transfer pricing methodology if the foreign country entered into a double tax treaty with Israel.
The draft circular also mentions the possibility of applying for a specific tax ruling in cases where an Israeli company is acquired by a foreign corporation and becomes a limited-risk development service provider after the acquisition. Among the conditions allowing for this decision:
- The acquired company is defined as a preferred technological enterprise
- It owns the IP
- It is fully acquired by the acquiring company
- Shortly after the acquisition, the acquired company sells its IP to a related foreign company, and then the acquired company becomes a company providing only development services to a related foreign company.
Although it is a draft circular, it is recommended to be prepared accordingly.
Amit Shalit
BDO in Israel
1 Please see our previous publication regarding development centres - https://tinyurl.com/3r2frtbr