Legal Update: Tax – May 2018

By Anat Shavit | May 2018 | Legal Update

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Supreme Court Ruling – Taxation of Israeli R&D Companies in connection with Stock Option Allocations

We would like to bring to your attention a recent decision of the Israeli Tax Authority (“ITA”), which has considerable impact on taxation of employee stock option grants made to employees of Israeli R&D companies by their parent companies.

In Conitra Technologies Ltd. v. Tel – Aviv Tax Assessor, the Supreme Court considered two questions in connection with employee stock option grants made by the foreign parent company of Contira Technologies Ltd. (“Contira”) to employees of Contira: (1) whether all costs regarding such employee option allocations must be part of the cost plus pricing mechanism agreed between Contira and its parent company with respect to services provided by Contira; and (2) whether the ITA has the authority to change intercompany agreements and determine a different profit rate for tax purposes.
With respect to both questions, the Court ruled in the affirmative.

Relevant Facts:
Contira is an Israeli company that provides research and development services (“Services”) to its parent company, a US resident company that holds 100% of Contira’s share capital (the “Parent Company”). The parties had signed a services agreement stating that, for the provision of the Services, Contira will be reimbursed on a cost plus basis with a markup of 7% (the “Cost Plus Agreement”). For tax purposes, Contira had not included the cost of employee option allocations by the Parent Company to Contira’s employees in its cost basis under the Cost Plus Agreement. According to the ITA, the exclusion of option allocation costs from the cost plus pricing mechanism is not consistent with Section 85A of the Israeli Income Tax Ordinance – 1961 (the “Ordinance”) which sets the guidelines for transfer pricing between related parties (“Section 85A”), and therefore, the ITA included the option allocation costs in the cost plus pricing mechanism. In addition, the ITA increased Contira’s markup to 9.1%.

The Supreme Court’s Decision:
In its decision, the Supreme Court based its analysis on the provisions of Section 85A and the Income Tax Regulations (Determination of Market Value), 2006 (the “Regulations”). The Court ruled that the burden of proof with respect to whether the agreed transfer price and Cost Plus Agreement were consistent with acceptable market conditions lay with Contira and not with the ITA, and that Contira had not met its burden of proof. Moreover, the Supreme Court accepted the ruling of the District Court that, pursuant to the Ordinance, the cost of stock option allocations is, in essence, an integral part of the cost of the Services provided to the Parent Company and must therefore be included in the cost plus pricing mechanism.
In addition, the Supreme Court ruled in the appeal that since the pricing under the Cost Plus Agreement was not at “arm’s length”, the tax assessor has the authority to tax the transaction according to the median rate of the acceptable interquartile range in accordance with Section 2(c) of the Regulations. Consequently, the Supreme Court ruled that Contira would be taxed on a profit rate of 9.1% of its cost basis, which shall include all costs related to employee option allocations.

Conclusion:

  1. With respect to whether intercompany agreements are on arm’s length terms, the burden of proof lies with the taxpayer. Therefore, in appropriate circumstances, the pricing of an intercompany transaction should be reflected in a services agreement supported by a relevant market study.
  2. Option allocation expenses must be included in the cost basis with respect to the relevant intercompany agreement.
  3. Since the cost of options granted pursuant to the capital gains route of Section 102 of the Ordinance is not a deductible expense, as a consequence of the Contira ruling, such expense in effect becomes part of the taxable income of the Israeli R&D company for purposes of determining corporate tax liability (as the Israeli R&D company is reimbursed for such expense by the Parent Company under the intercompany agreement, without the ability to deduct the expense) with the result that the tax liability of the Israeli R&D company with respect to employee option grants is calculated based on option cost plus the applicable markup (instead of only the markup).

For further information please feel free to contact:

Adv. Anat Shavit   |    ashavit@fbclawyers.com  |  +972.3.6944203