Transfer Pricing News Issue 35 - April 2021

The Israeli tax authority tightening its standpoint regarding development centres

The Israeli tax authority recently announced its intention to tighten its standpoint with tax audits in relation to transfer pricing ("TP") policies with regard to research and development ("R&D") centres in Israel[1].

Generally, when an Israeli R&D centre considers itself a services provider (for a foreign related party), it chooses a cost base mechanism plus certain markup for determining the remuneration for its services.

According to the Israeli tax authority (stated in unofficial public discussion), it should be examined carefully, within FAR[2] analysis, whether the Israeli R&D centre indeed functions as a service provider or as a partial/full owner of an intangible asset being developed.

To the extent it can be concluded that the R&D centre economically owns an intangible asset, the costs base mechanism will not apply, due to the fact that it does not accurately reflect the contribution of the R&D centre. In such cases, a different pricing mechanism should be applied (i.e. profit split) between the R&D centre and its foreign related party. This approach is based on the OECD guidelines regarding the BEPS project.

According to the Israeli tax authority's perspective, the following are examples of characteristics which support the conclusion that the R&D centre might have an economic ownership of an intangible asset:

  1. The origin of the intangible asset was in Israel and its development started in Israel.
  2. The Israeli entity engages in other activities besides the R&D activities.
  3. The group's headquarters are located in Israel.
  4. The Israeli R&D centre is undertaking significant risks relating to the R&D activities.
  5. The activity of the Israeli R&D centre is valuable and provides a unique contribution within the multi-national group.

In contrast, the following are examples given by the Israeli tax authority for characteristics which represent the lack of economic ownership of an intangible asset:

  1. The Israeli R&D centre was established at the initiative of a foreign multi-national group.
  2. The decisions regarding the intangible assets are made by the headquarters' personnel which are based outside Israel.
  3. The Israeli R&D centre is not taking part in major business risks.
  4. The Israeli R&D centre does not have the financial capabilities to support its activities.
  5. The Israeli R&D centre does not have accumulated losses for tax purposes with respect to the development of intangible assets.
  6. The Israeli R&D centre does not provide a valuable and unique contribution within the multi-national group.

The more significant the R&D activity is (concerning the development activity of an intangible asset), the more vulnerable a cost base pricing method will be.

It is important to note that a representative of the Israeli tax authority indicated that in his opinion the majority of R&D centres in Israel are probably "caught somewhere in the middle". As such, it cannot be definitively assumed that R&D centres own or do not own an intangible asset. This position increases the tax uncertainty for Israeli R&D centres (and this can become complicated, particularly when it may lead to potential double taxation).

Furthermore, the Israeli tax authority recently upgraded the TP documentation requirements (for example in a circular[3] issued in January 2020(, which outlines the standards for documentation, upgrades the 1385 TP form required with annual tax returns, and also published a bill[4] to update the documentation requirements, including reference to Master File and Local Files.

The main points of the ITO's 01/2020 circular dealing with documentation requirements are as follows:

This details the conditions required to comply with the provisions of Section 85A of the Income Tax Ordinance and the regulations promulgated thereunder - which require preparation of a Transfer Pricing ("TP") analysis for international transactions performed between related parties in accordance with section 85A (c) (1) and TP Regulation.

 The fulfillment of the conditions means transferring the burden of proof to the ITA inspector (within the framework of a tax audit), as opposed to the rule placing the burden of proof and the burden of persuasion on the taxpayer.

The following is a non-exclusive list of the main conditions detailed in the Tax circular:

  1. Detailed and Substantiated TP analysis
  2. Method selection
  3. Documentation of Benchmark's steps
  4. Additional supporting documents
  5. The arm's length TP analysis refers to transactions with similar characteristics.
  6. Implementation

We strongly recommend that international groups with relevant R&D centres in Israel re-examine their TP policies in light of these developments. For further details and assistance please contact:

Amit Shalit