Israel: Related-party cross-border services | KPMG | GLOBAL

Israel: Related-party cross-border services; markup of costs (“cost plus”) remuneration

Israel: Related-party cross-border services

The Israeli Supreme Court on 22 April 2018 issued a judgment in proceedings concerning the tax treatment of cross-border services involving private Israeli subsidiaries of private U.S. companies that maintained equity-based (option) compensation programs for their Israeli employees and that implemented a markup on costs (“cost plus”) as the model of payment for intra-group services rendered by the Israeli affiliates.

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The Supreme Court held that the expenses associated with the employee options (i.e., the value of the options) must be included in the markup cost base. The Supreme Court accepted the position of the Israel tax authority that the transactions were subject to a higher markup because the taxpayers’ failure to include the value of the options in the cost base resulted in a deviation from the acceptable range of markup in the transfer pricing benchmark analysis.

Background

The cases were appealed to the Supreme Court from a lower district court. The central issue on appeal related to accounting for expenses (i.e., the value of the options) associated with options granted by the U.S. parent companies to their respective Israeli subsidiaries’ employees. Specifically, at issue was whether such expenses would be regarded as part of the overall cost (“cost base”), as being representative of the Israeli subsidiaries’ rendered services, that in turn would then be marked-up to achieve the appropriate taxable profit within their “cost plus” arrangements.  

An additional issue on appeal was, in the event the value of the granted options must be included in the cost base, whether the associated options expense would be considered deductible for tax purposes.

Supreme Court’s decision

The main points of the Supreme Court’s judgement are as follows:

  • The costs associated with the granted options are to be included in the cost base. The grounds for this conclusion are based on an understanding that options granted to employees are a form of compensation that are in essence a cost incurred in the provision of a service, and as such must be included in the cost base.
  • The costs associated with the granted options are not necessarily deductible for tax purposes. It was determined that expenses associated with options granted to employees are revenue-generating expenses (as defined in section 17 of the Israeli Tax Ordinance (ITO)) and as such, in accordance with the general rule, generally would be deductible for tax purposes.  Nevertheless, section 102(D) of the ITO specifically addresses the deductibility of employee option expenses and overrides the general rule of section 17. Under section 102, options can be granted to employees in various forms and may be subject to differing tax treatment and deductibility, at the discretion of the employer. In the cases on appeal, the employers had chosen to issue the options per the “equity track” method, with the associated expense then being rendered as non-deductible for tax purposes. The Supreme Court found that the relevant options expenses were non-deductible—without regard to their inclusion for purposes of calculating the arm’s length intercompany payment.
  • The Supreme Court accepted the position of the Israel tax authority to apply a markup of 9.1%—instead of 7.0%. The cost base to which the original markup (7%) was applied as remuneration for the intercompany services did not include the relevant options’ expense. While the 7% markup was within the accepted interquartile range, the exclusion of the options’ expense led to an overall result that deviated below the lower end of the interquartile range. As such, the Supreme Court accepted the position of the Israel tax authority to follow Transfer Pricing Regulation 2(C)—i.e., to apply the median result of the relevant transfer pricing benchmark analysis when the taxpayer’s transfer pricing results deviate from the achieved range of accepted results.

To conclude, the Supreme Court rejected the taxpayers’ arguments on appeal and held that the expenses associated with the options (i.e., the value of the options) granted to the employees must be included in the marked-up cost base. Further, the Supreme Court found that deductibility of the options expense was not dependent on the inclusion of the options within the cost base, and was to be determined entirely under the relevant tax law provision (section 102 of the ITO). In addition, the Supreme Court accepted the position of the Israel tax authority that the transactions were subject to a higher markup (the median) because the failure to include the value of the options in the cost base resulted in a deviation from the accepted range of markup results achieved in the transfer pricing benchmark analysis.

 

Read a May 2018 report (Hebrew) [PDF 99 KB] prepared by the KPMG member firm in Israel

 

For more information, contact a tax professional with KPMG’s Global Transfer Pricing Services practice in Israel:

David Samson | +97 236 84800 | dsamson@kpmg.com

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