The Israel Tax Authority (ITA) on February 27, 2025 released a draft Tax Circular for public comment laying out various criteria and requirements for certain local research and development (R&D) centers, as well as for post-acquisition sales of intellectual property (IP), for which the ITA may provide certainty.
Background
Many foreign multinational enterprises (MNEs) currently maintain some form of captive R&D services in Israel, with the majority applying a “cost-plus” recharge of expenses in line with accepted transfer pricing practice (i.e., Transactional Net Margin Method in the parlance of the OECD TP Guidelines and Comparable Profit Method under U.S. Treas. Reg. § 1.482-5). A recurring area of controversy with the 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.
Another area of perennial local ITA controversy concerns a common scenario where a local entity has been acquired by a foreign MNE and the local IP is sold (or otherwise transferred) elsewhere within the group. The ITA has taken various valuation positions that reach amounts far in excess of that reported by the local taxpayer, and often in excess of the original acquisition price.
Draft circular
The draft circular covers two primary areas:
- Local R&D centers compensated with a cost plus: An ITA exam team will only be permitted to raise a claim of an alternative transfer pricing method if they have prior and ongoing involvement and approval of the ITA's dedicated technical teams that handle the relevant transfer pricing topics, when the taxpayer has met the relevant criteria, including (not an exclusive list):
- A foreign ultimate parent entity (UPE) that has full direct/indirect control of the local entity
- Israeli tax residents (or former tax residents) do not exercise more than 10% control of the UPE
- The local entity engages solely in contract R&D activity that meets the criteria in the local Encouragement Law covering provision of R&D services to a foreign resident
- The local entity is compensated for all its costs and also receives a markup or margin
- The entity attaches to its annual corporate tax return the relevant intercompany agreement, together with a full transfer pricing study including a DEMPE analysis and benchmarking with the associated accept/reject matrix
- Sale of IP post-acquisition and subsequent conversion to contract R&D: The ITA will provide a formal ruling affirming the IP value and the go-forward cost-plus treatment for a period of eight years, if the taxpayer has met various criteria, including:
- Prior to acquisition, the local entity met the criteria of a “Preferred Technology Company,” with its IP meeting the definitions of a “Beneficial Asset” under the local Encouragement Law
- The acquiring entity did not have material shareholding in the local entity prior to acquisition
- The local IP is sold within 30 days of the acquisition closing
- The IP is sold at a value that is not less than 85% of the adjusted enterprise value (inclusive of off-balance sheet "liabilities" such as employee bonuses and expected grant repayments to the Israel Innovation Authority (IIA)), plus a “gross-up” calculation for the expected tax
- The company will continue to provide R&D services for the complete duration of the eight-year ruling period
- The local workforce will continue to remain consistent with the workforce levels prior to acquisition
The efforts by the ITA to provide clarity and certainty are welcome. At the same time, the draft criteria potentially include elements that continue to be contentious in the local context, and the local comment phase can hopefully provide a framework to incorporate constructive changes.
Read an unofficial translation of the draft Tax Circular.
For more information or to provide input and comment to the draft circular, contact a tax professional with the KPMG Global Transfer Pricing Services practice in Israel:
Itay Falb | itayfalb@kpmg.com
David Samson | dsamson@kpmg.com