Transfer pricing – business restructuring
Israel, often dubbed the ‘startup nation’, sees a relatively high number of transactions in which a startup company is acquired by a multinational group. These transactions are often followed by a post-closing transfer of IP to a centralised IP entity of the group. The ITA often views these intercompany transactions as a transfer of the functions, assets and risks (FAR) of the Israeli company in a transaction that is subject to the arm’s length standard.
There are two notable court rulings to be considered with respect to business restructuring. The first is the Gteko v. Tax Assessor ruling, which was issued in 2018. In the Gteko case the ITA challenged a transaction reported as a sale of IP by Gteko, a company that was acquired by Microsoft shortly before the IP sale. In addition, Gteko transferred its entire workforce to another Israeli subsidiary of Microsoft. The ITA stepped these transactions together and argued that Gteko transferred its FAR to the Microsoft group. The benchmark for the valuation of the enterprise value transferred was the consideration paid for Gteko shares. The Gteko court affirmed the ITA’s position, ruling that Gteko was left as an “empty corporate shell” after the transactions.
Following the Gteko ruling, the ITA published a circular in which it provided its guidelines to taxation of business restructuring. The circular was based on the Gteko ruling and Chapter 9 of the OECD transfer pricing guidelines, although arguably it deviates from the guidelines in some significant points. The circular presented a relatively aggressive approach by the ITA according to which any business restructuring may constitute a taxable FAR sale.
More recently in 2019, this aggressive position of the ITA was again challenged in court in Broadcom Semiconductors v. Tax Assessor. In this case, the recently acquired Israeli subsidiary of Broadcom entered into several agreements immediately after the share transaction, pursuant to which it began providing cost plus marketing and R&D services to other Broadcom entities, and licensed its legacy IP to another Broadcom entity. The ITA argued that the change in business model – from a company that develops, manufactures and sells products to an R&D center – constitutes a taxable FAR sale.
The Broadcom court denied the ITA's position, while emphasising the fact that the Israeli company retained its workforce (and hired additional employees over the years), experienced an increase in income and continued to grow. The court refused to accept that the essential functions of the Israeli company had been sold merely because the income-generating model of such a function was changed.
The Gteko and Broadcom cases provide important guidelines of the dos and don’ts for multinational groups with respect to changing a business model of a newly acquired Israeli entity. The issue of business restructuring still comes up frequently in tax assessments of multinational groups and we expect additional guidance and case law to be published in upcoming years.
Permanent establishment of internet companies
The ITA published a circular in 2016 in which it has taken a relatively aggressive approach with respect to companies offering services or products to Israelis via the internet (internet companies). The circular states that an internet company may be considered to have a permanent establishment even where there is no internet server located in Israel, and notes that certain activities of representatives and employees of an Israeli affiliate of multinational group (e.g. identifying potential customers, marketing activities and client relationship management) when conducted with assistance from, or through, a place of business in Israel may create a permanent establishment.
We note that ITA circulars serve merely as guidance with respect to the ITA’s position and do not constitute legally binding authority in Israel.
Transfer pricing methods relating to local distribution, sales and marketing
In 2018 the ITA has published a circular describing its position regarding the appropriate transfer pricing method with respect to various types of local distribution, sales and marketing transactions. The ITA’s position is that (a) full-fledged distributors are required to report their income based on the resale price method or the profit split method; (b) low-risk distributors are required to report their income based on the transactional net margin method (TNMM); and, (c) marketing companies are required to report their income based on the cost plus method or the TNMM. However, the circular acknowledges that these guidelines can be deviated from in appropriate cases. The ITA circular further notes that these guidelines do not apply with respect to internet companies.
In another circular published in 2018, the ITA provided taxpayers with safe harbours regarding the profitability margins of Israeli entities providing low added-value services. According to this circular, certain reporting requirements (including a requirement to furnish a full transfer pricing study to the ITA) will not apply with respect to a low-risk distributor that reports operational profitability of 3% - 4% (based on TNMM) or with respect to a marketing entity reporting operational profitability based on a cost plus 10%-12% method.
In 2020 the ITA published yet another circular with respect to transfer pricing, in which it addressed the validity of transfer pricing studies. The ITA circular provides that the burden of proof regarding the transfer pricing methodology will be shifted to the ITA only if the transfer pricing study meets certain minimal requirements. In this respect, the ITA requires taxpayers to provide “reasonable explanation” regarding the transfer pricing method used and to provide certain ancillary documents as stated in applicable regulations. The circular further states that the list of documents is not exhaustive and the failure to provide additional documents requested by the ITA may result in a rejection of the transfer pricing study.
