Eighteen months ago, the Israel Tax Authority declared its intention of raising the rate of tax collected from international technology companies that maintain development centers in Israel. This declaration stemmed from the perception that the development centers were critical to the companies' products and profits. The new rules were formulated in a special draft circular of the Tax Authority, and sent for review to tax inspectors in direct contact with the companies concerned. In the end, publication of the new rules was halted, and they did not officially come into force.
Nevertheless, sources inform "Globes" that in the past year the Tax Authority has been operating in accordance with the new guidelines. That is to say, it has been interpreting existing legal provisions stringently, and taking advantage of the boom in the Israeli technology sector. Because of this, several US technology companies have been assessed for Companies Tax on profit calculated as 15% or 20% of the cost of operating their development centers, instead of 10% as in previous years.
Similarly, companies founded overseas by Israeli entrepreneurs have been instructed to raise the amount of profit attributed to their development centers in Israel, which in many cases are a company's only development center. "Globes" has also learned that secondary financing rounds, in which founders transfer shares to giant funds keen on taking part in the Israeli high-tech boom, have started to suffer from a higher tax burden, and sales of Israeli companies are being impeded by disputes over the risk that the buyer and seller will bear of a higher tax liability.
Tax hikes through strict interpretation
Through strict interpretation of tax law, tax inspectors in areas with a concentration of technology companies, such as the Sharon and Tel Aviv, are taking more extreme stances in negotiations with companies on their annual tax liabilities.
The tax inspectors' tougher stances relate to four main areas: attributing a higher profit than in the past to international development centers; a change in the division of profits between different locations of Israeli companies managed from the US; higher taxation of secondary financing rounds in which company founders sell shares to venture capital funds; and attribution of Israeli intellectual property in a foreign company to the local development center, which can impede negotiations on company acquisitions.
At present, international companies active in Israel are required to pay tax on their development activities on the "cost plus" method. Under this method, the companies pay tax not on the actual profit reported overseas, but only on the research and development activity in Israel.
Since the Israeli center is supposedly not a profit center, the company's accountants and the Tax Authority come up with a notional profit calculated as a percentage of the company's total expenditure on it. In recent years, that percentage became fixed at 10%, so that the Companies Tax paid by giants such as Google, Facebook and Amazon in Israel was imposed not on their global profits, but only on 10% of their expenditure on their Israeli development centers.
Critical to the companies
Now, some tax inspectors have started to take a stricter approach to calculating the development centers' notional profits, resulting in the figure rising from 10% of the investment in a center to 20%.
The Tax Authority's assumption is that the Israeli development centers have a greater impact on the companies' actual profits. According to the OECD, the development centers that should be taxed at low rates are service and support centers, while technology development centers are seen as critical to the ability of enterprises to develop new products and maintain higher rates of profitability. That, after all, is what makes them technology companies, and not providers of a service or product.
The rise in attributable profit comes in addition to calculating options given to employees as part of the investment in the development center, which can sometimes raise the profit for taxation purposes to as much as 30% of the expenditure on the center. The grant of stock options to employees became a very significant benefit in 2021, with the total value of options held by workers in the Israeli companies alone estimated at some $15 billion.
Many Israeli entrepreneurs have chosen to found companies in the US, with the aim of benefitting from grants to those founding companies there, or in order to make it easier to raise capital from US-based venture capital funds. But the Tax Authority's current moves are giving them sleepless nights. More and more of these companies, whose sole development center is usually in Israel, are being required to recalculate the profit attributable to the Israeli center and to the intellectual property located in it.
In many cases, the Tax Authority has discovered intellectual property that was developed in Israel but held in the US or in a tax shelter, and the companies concerned have been required to pay tax on the transfer of intellectual property from Israel. In a situation like that, acquisition deals by foreign or Israeli companies become stuck when the risk of double taxation in Israel and the US becomes a factor.
The amount of capital that changed hands last year between founders and venture capital funds seeking to participate in Israeli technology companies by buying part of the founders' stakes, rather than investing directly in the companies themselves, is estimated at 20-30% of the financing rounds that took place over the year, or several billion dollars. Up to now, the Tax Authority has viewed such transactions (in which common shares are bought and turned into preferred shares) as subject to capital gains tax of 25%, but "Globes" has learned that many transactions were partly taxed as income.
An Israeli founder of a company managed from the US with a research and development center in Israel says that the uncertainty is alienating companies from Israel. "When there's no certainty in Israel, you recruit overseas. We have recently recruited more workers in the US, and we've set up a development center in Eastern Europe."
"Prolonged processes with no certainty"
"We're seeing tax inspectors stepping up their claims in relation to technology companies in the course of discussions over tax assessments," Dina Pasca-Raz, partner and head of technology at accounting firm KPMG Israel, told "Globes". "The Tax Authority sees the boom in Israel's high-tech sector, and is looking for ways of raising tax collection accordingly, and rightly from its point of view. Only it's not being done under an orderly policy - there's no legislative amendment or official circular - but through expansion of existing tools, transfer pricing and reclassification of income as fruits of labor.
"This creates uncertainty on the part of the companies, and it would make sense to publish an official policy on the matter. The lack of certainty, and frequently also inconsistency between different tax inspectors, creates especially problematic situations when giant international concerns have difficulty in planning and in estimating in advance the tax consequences of deals with Israeli technology companies."
The Tax Authority's positions could place the Israeli companies in a problematic situation vis-à-vis the US Internal Revenue Service. The companies report a certain profit arising in Israel or in the US as they see it, but the Tax Authority can claim that the share of profit arising in Israel is much higher, and this is sometimes liable to result in double taxation in the two countries.
"Companies exposed to the problem of double taxation because of tax assessments in Israel can deal with the issue by amending their tax filing in the US. That is liable to mean a prolonged discussion with the IRS, which in many cases takes a very different position from that of the Israel Tax Authority on questions of transfer pricing," says Michael Bricker, a tax partner at the law firm of Meitar Liquornik Geva Leshem Tal.
"Every year, the substantial gap between the US approach and that of the Tax Authority leads many companies to embark on a mutual agreement procedure between the US and Israeli authorities, in which the sides are meant to thrash out the issues," says Bricker. "It's good that the two authorities talk to each other, but for the companies it's a matter of a prolonged, expensive process, with no certainty as to the result."
Published by Globes, Israel business news - en.globes.co.il - on January 12, 2022.
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