Israel Tax Authority targets tech development centers

Eran Yaacov  / Photo: Shlomi Yosef , Globes

Multinational tech companies are considering their options after Israel has changed its policies to squeeze higher taxes out of development centers.

Development centers set up by multinational companies have been flourishing in Israel in recent years and the Israel Tax Authority wants a bigger piece of their revenue pie. In recent months the Israel Tax Authority has moved forward with its new interpretation on the issue of transfer payments, which allows it to collect higher taxes. In the tech industry there are those who insist that the new interpretation is far reaching and diverges from practices in other countries, including the US and EU.

The tax issue revolves around the connection between the development center in Israel and the international parent company. The taxation method used today for development centers is "cost plus." In other words if the development center has expenses of $100 million and 10% cost plus is calculated, then the revenue of the center is $110 million and the profit calculated for tax is $10 million.

The Israel Tax Authority now wants to tax the development centers, or at least some of them, with a different method in which the profit that would be attributed to the development center would be the result of Profit Split, or in other words the contribution of the operations in Israel to the profits of the international company.

For example, if the foreign company develops a substantial part of a device here that it then launches on the market, the Israel Tax Authority wants to know what the contribution from Israel was, to understand what were the profits from the device, and collect tax accordingly. In the past two years several cases on this matter have gone to the Israeli courts but ended in a compromise, and "Globes" understands that an additional such case has just gone to court.

According to Sharon Shulman, tax managing partner at accounting firm EY Israel, "In the OECD and as part of the Base Erosion and Profit Shifting (BEPS) plan, which is meant to combat tax planning by companies and change the distribution of profits between the companies involved, they say that there are cases in which the tax pie has to be divided but these examples are completely inappropriate for development centers."

"They are relevant, for example, in cases in which two pharmaceutical companies, each come with their patent and say let's launch a joint drug. That's not the situation of the development centers, which receive instructions from the company in the US."

Shulman added, "The Israel Tax Authority, after examining the issue through the most senior professional levels, drew the conclusion that the price transfer method for at least some of the development centers in Israel should be Profit Split. They are trying to prove that the managers in the development center have a unique and significant contribution, and therefore the profit in Israel is special." Shulman stresses that among other things the significance is that these companies will pay double taxation.

Meitar law firm tax department partner Michael Bricker added, "The use of the profit split method is possible when talking about integrated and combined operations between the company in Israel and the foreign company as one economic unit and both companies bear the substantial risks and losses together or when each of the companies has unique and significant IP, but that is not what usually happens."

"In addition there are differences between development centers and the Tax Authority doesn't relate to that. There are R&D centers in which people sit and code software and there are those that invent new things. In centers that work according to instructions from the foreign company, and the map ahead and the budget are set outside of Israel, then it is completely not an issue of profit split. We can also learn this from the instructions of the OECD and EU, which state clearly that if there is no central function of control and risk subject to the development, then this is not a suitable method. And those are countries that behave aggressively regarding digital tax," said Bricker.

Israel is deviating from the norm

Shulman warns about repercussions from the new interpretation in relation to what happens elsewhere in the world. "It's a very new issue in the tax world and the Tax Authority is the first to jump in with the interpretation and in the US and EU they are opposed to it. Maybe in four more years, the rest of the world will adopt the policy but why does Israel have to be the first country in the western world to do it?"

He added, "If it becomes clear that the Tax Authority's position is completely wrong, it might cause damage that will prove to be irreversible. We don't have to be pioneers in everything, we should be looking at what the courts in other countries around the world are accepting and then decide. We must understand that there is no clear methodology around the world and in this case Israel is rather inventing the wheel and investing a lot of effort in order to understand how significant Israel's development centers are, for example by interviewing former managers."

Bricker says, "The (tax) authority is coming to foreign companies and saying to them. "I don't accept your position but it does not present research to the contrary on transfer prices but it is based many times only on interviews with several people and assumptions based on the consolidated financial reports of the foreign parent company. You've thrown a stone into the well and now the multinational company has several options: to compromise, or to say that it doesn't seem right and go to court, at the same time as turning to the tax authority in the other country because the company is exposed to double taxation."

Bricker adds his own opinion. "To say that the development centers will close if the authority continues this policy is far reaching. However, I can say that multinational companies look on Israel as the wild west, in terms of the issue of transfer prices. They don't understand the basis of Israel's conduct and even foreign tax authorities very often don't understand Israel's policies. In many things in the field of transfer prices, Israel deviates from international norms."

Will companies leave Israel?

Israel Advanced Technology Industries (IATI), the umbrella association for Israeli advanced technology and life science companies, if fighting the Israel Tax Authority's policy on this issue, and among other things it coordinates the activities of the through the forum of the multinational companies operating in Israel.

Two weeks ago IATI president and CEO Karin Mayer Rubinstein wrote a letter to Israel Tax Authority chief and acting Ministry of Finance director general Yaacov Eran, which has been seen by "Globes." She wrote, "This interpretation might bring about immediate relocation, outside of Israel of the senior management (the finest minds) from these development centers. In the mid to long term, as a result of this interpretation, could bring about the drastic reduction of the development centers and in certain cases, even their full closure."

The concern expressed in Rubinstein's letter is that a legal process that will take several years will lead to uncertainty at international companies and will influence their decisions. "The State of Israel does not have the privilege to hang around and test this innovative issue in the courts," Rubinstein wrote.

Rubinstein told "Globes." "It is important to understand that international companies make quick decisions based on profit and loss considerations, and to the extent that the rules of the game regarding taxation in Israel are changing detrimentally overnight, an irreversible decision might be made, which would inevitably be bad for the Israeli economy. A beneficial taxation policy is not a loss of income or expenditure but a long-term investment."

A source at one of the international tech companies who asked to remain anonymous told "Globes," "Israel is an unstable country and the costs here are not low, and even so there are instances where they need to persuade the company's management why to expands operations in Israel. As I understand it, with this new approach, the Tax Authority is saying the opposite of what it said in the past. Now a company which in the past made an acquisition and left its activities and IP in Israel - now they are pushing it in the opposite direction. If the reason is that the decisions are being made here, then in contradiction of what we want to happen, we cannot expand the responsibilities of the Israeli center or even give it responsibility over other centers around the world."

The Israel Tax Authority said, "The field of transfer prices is permanently handled by the price of the transaction, division of the income pie, according to market conditions between the parties involved. This is to prevent the erosion of the tax base in various countries. The policy of the authority on the issue of transfer prices is in accordance with OECD instructions, which are published in its circulars and as part of its taxation decisions. In the natural order of things setting the price of a transaction can be influenced by circumstantial data."

The Israel Tax Authority declined to comment on the specific claims raised in the IATI letter.

Two methods for calculating tax

Cost Plus - If the development center has expenses of $100 million and the cost plus calculation rate is 10%, then its income is recorded as $110 million and the profit calculated for tax is $10 million.

Profit Split - The profit attributed to the development center is the result of its contribution of the activities in Israel to the foreign company's profits.

Published by Globes, Israel business news - en.globes.co.il - on October 29, 2020

© Copyright of Globes Publisher Itonut (1983) Ltd. 2020

Eran Yaacov  / Photo: Shlomi Yosef , Globes
Eran Yaacov / Photo: Shlomi Yosef , Globes
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