Israel: Proposed "Green Track" for R&D centers

As part of Israel’s legislative process surrounding the proposed budget currently pending in the Knesset, the government has included instructions for the creation of a “Green Track” providing certainty on the transfer pricing treatment of local research and development (R&D) centers providing services to foreign multinational enterprises (MNEs).

The pending legislation is currently under markup at the Knesset Finance Committee, with the overall budget expected to be brought for final approval in the coming weeks.

Hundreds of foreign groups currently maintain some form of captive R&D services in Israel, with the majority applying transfer pricing treatment based on a “cost-plus” recharge of expenses in line with accepted transfer pricing practice (Transactional Net Margin Method in the parlance of the OECD TP Guidelines and Comparable Profits Method under US Treas. Reg. § 1.482-5). A recurring area of controversy with the Israel Tax Authority (ITA) has been whether a cost-plus is acceptable (as opposed to ITA claims of possible profit sharing or even IP ownership) and at what level.

The legislative proposal would direct the ITA to provide a formal tax circular within 60 days determining the terms of a Green Track outlining the criteria whereby a typical cost-plus approach would be automatically accepted and precluding claims of profit split or local IP.

The following is the (translated) language from the Ministry of Finance formal Economic Plan for 2025:

Multinational companies operating in Israel play a significant role and make a substantial contribution to the industry. These companies serve as a major source of employment and provide a fertile ground for knowledge that supports the growth of many Israeli companies. This growth occurs both through entrepreneurs who leave these multinational firms to establish new startups and through skilled employees and managers who join existing Israeli companies. As of 2024, approximately 515 multinational companies are active in Israel, employing nearly 90,000 individuals. These companies currently operate primarily in two sectors: software and semiconductors, which employ about 72% of the workforce within the [inbound] multinational companies. The life sciences sector employs around 10% of workers, while 8% are employed in telecommunications firms.

Due to their size and the global scope of their operations, these companies manage their tax policies on a global scale, assessing their competitiveness worldwide and factoring in the stability of the business environment, particularly tax stability, as a key consideration in their operations. In Israel, the Israel Tax Authority (ITA) establishes pricing methods to determine the tax base of multinational companies according to the OECD transfer pricing principles. Pricing methods range from a unilateral approach commonly used for service provisions, similar to a cost-plus method, to a bilateral approach involving profit-split components. For global companies' R&D centers in Israel that do not hold intellectual property, the unilateral pricing mechanism, primarily based on the cost-plus method, is more prevalent. However, because the OECD’s principles, as applied by the ITA, provide qualitative guidelines rather than definitive quantitative criteria, significant uncertainty arises regarding the appropriate pricing method for R&D centers in Israel.

During recent discussions held by representatives from the Ministry of Finance and within the ITA’s work, concerns were raised by global companies operating in Israel about the risk of a change in pricing method within tax assessments and the potential attribution of profits to Israel using a non-unilateral pricing approach for development centers. Currently, the ITA allows procedures for advance pricing agreements (APAs), both unilateral and bilateral, for each company. However, given the complexity of these processes and the specific treatment required for each company, APAs take a considerable amount of time, often exceeding a year.

In light of these issues, it is recommended that the ITA publish an Income Tax Circular within 60 days, outlining the terms of a “Green Track” based on the cost-plus method. The objective of the Green Path is to provide certainty to multinational groups whose primary activities are outside Israel and whose presence in Israel primarily stems from acquisitions and the operation of R&D centers. This Green Track would also protect these companies from claims of profit sharing or “economic ownership” attribution. Simple, quantifiable criteria would be outlined in the Green Track for such multinational groups, allowing them to self-declare compliance with the established criteria, thereby eliminating the need for approval from the ITA Director. It should be noted that the criteria would not create adverse incentives for companies to move human capital or activities outside of Israel.

KPMG observation

As stated, local R&D centers are exceedingly prevalent, and the associated ITA controversy has historically been a key source of uncertainty and local tax risk.

Efforts by the government to address and resolve this uncertainty are seen by tax professionals as a welcome and positive development.

It remains to be seen, however, what specific criteria would be formulated by the ITA, and whether a practicable framework covering a sizable of proportion of relevant cases can be developed.

Additionally, it will be important to monitor whether any formal Green Track would result in a de facto ITA position on where a cost-plus is acceptable, to the practical exclusion of other cases that do not fall within the prescribed safe harbor. Perversely, such an outcome could result in further increased tax controversy and uncertainty going forward.
 

For more information, contact a KPMG tax professional in Israel:

David Samson | dsamson@kpmg.com