Tax Authority spoils the party: Cost-plus includes options

The Supreme Court has just issued a judgment of interest to the Israeli hi-tech and industrial sectors and their employees (Kontera Technologies Ltd v Tel-Aviv 3 Assessing Office 943/16, Finisar Israel Ltd v Rehovot Assessing Officer 1728/16).

Transfer Pricing in Israel

The Supreme Court handed down a combined judgment relating to two similar cases. In each case, an Israeli subsidiary company carried out research and development for a foreign-related company, for a fee based on the operating costs of the Israeli company plus a profit margin. This is typically referred to as “cost plus.”

This is acceptable under international transfer pricing rules regarding transactions between related parties if it corresponds to arm’s length (marked-based) terms.

To make sure this is the case, the related parties are required to commission a transfer pricing study, usually from a reputable professional firm.

This was done in the two cases before the Supreme Court.

For example, in the Kontera case, the transfer pricing study reviewed a sample of comparable unrelated cases and concluded that the profit “plus” should be in the “interquartile” range of 4.5% to 15.3% of operating costs, so cost plus 7% was adopted in an intercompany agreement. (The interquartile range excludes the results of the top quarter and bottom quarters of the sample reviewed, leaving two middle quarters.)

Israeli transfer pricing rules in Section 85A of the Israeli Income Tax Ordinance (ITO) are similar to international rules laid down by in Section 482 of the US Internal Revenue Code and transfer pricing guidelines published by the OECD.

Stock options in Israel

Employees in the hi-tech sector usually enjoy not only a cash salary but also stock options – typically options to acquire shares (stock) in the foreign parent company at a cheap price. Section 102 of the ITO allows employees to postpone tax on the benefit until they cash it in, if certain conditions are met. An approved trustee must hold the options or resulting shares until the tax is paid.

Better still, the tax to the employee is limited to 25% if the employer agrees to forgo an expense deduction regarding the employee benefit – this is known as the capital track.

The alternative is the income track in which employees pay tax at rates ranging up to 50%, and the employer company receives an expense deduction.

Needless to say, the capital track is far more popular in Israel – employees want 25% tax and R&D companies need happy employees.

The issue

The big issue was whether companies must include stock option benefits in operating costs when calculating the “cost-plus” income. These benefits do not have a cash cost to the Israeli or foreign companies concerned.

The judgment

The Supreme Court ruled that stock option benefits must be included in operating costs used to calculate the cost-plus income of each company.

This is because the employee benefit would be a deductible cost incurred in the production of income, if the income track is elected.

Also, Israeli and US accounting rules require the stock option cost to be estimated in the financial statements presented to shareholders (Israeli Accounting Standard 24, US FAS 123R).

Consequently, the court ruled that transfer pricing studies were incomplete by omitting the stock options, resulting in a plus of only 0.09% to 1.73% in the Kontera case, which was outside the required interquartile range.

In such cases, the ITA is required (under ITO Section 85A ) to correct the reported income and use the median value in the middle of the interquartile range. In the Kontera case this meant cost plus 9.1%

Moreover, the court added a sting in the tail. Because the foreign company underpaid the cost-plus fees, an intercompany debt built up on which imputed interest was also taxable, according to the Court.

Comment

With all due respect to the Supreme Court, neither the Israeli company nor the foreign company concerned pay the price of the options – their shareholders merely have their interest diluted by the shares issued cheaply to the employees.

The shareholders of course don’t mind if the employees are motivated to work and be innovative.

The Israeli Tax Authority is spoiling the party by effectively taxing the shareholders’ dilution, which is not usually a taxable event.

Readers are invited to send us their comments.

As always, consult experienced tax advisers in each country at an early stage of specific cases.

The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.