Safe Harbor in Israel for Multinationals

The Israeli Tax Authority (ITA) has published two Circulars which specify safe harbors for transfer pricing in low tech multinational groups (11/2018, 12/2018). Transfer pricing is a hot topic, as any disagreement in different countries about the “right” pricing can result in double taxation.

Israeli Tax Law

Israeli transfer pricing tax rules are a hybrid between OECD guidelines and Section 482 of the US Internal Code. Section 85A of the Israeli Income Tax Ordinance and related regulations require the use of arm’s length (market-based) terms with respect to cross-border transactions between related parties (50% or more control of one party over another or by a common third party).

The prescribed transfer pricing methods, in order of preference are:

1) Comparable uncontrolled price (CUP) method – applying the price in other comparable transactions;

2) Comparable profitability – cost plus or gross profit (resale minus);

3) Rate of operating profit OR rate of return on assets, liabilities or capital OR other profit indicator;

4) Profit split method;

5) Other appropriate method.

The taxpayer must sign a declaration (Form 1385) each year that related party transactions are indeed on market terms.

Transfer pricing studies must be available for inspection by the Israeli Tax Authority within 60 days after any request.

The Safe Harbors

The new ITA tax circulars specify safe harbor rates of profitability. Transfer pricing studies are still needed, including a functional analysis, but without analyzing economic environment and risks. The safe harbors are not available if intellectual property (IP) is substantially used or generated.

For low value-added services, the ITA stipulates a safe harbor of cost plus 5%. Cost includes direct and indirect costs, including any stock option benefits, according to generally accepted accounting principles.

For marketing services, the ITA stipulates a safe harbor of cost plus 10% to 12%.

For low-risk distribution services (“low risk distributor” or LRD), the ITA stipulates a safe harbor of 3% to 4% of sales revenues.

A taxpayer who disagrees with these safe harbor rates is free to prepare a full supporting transfer pricing study. What are low-value added services?

The ITA says they must meet all the following criteria: intercompany services of a supportive nature, not part of the core activity of the multinational group, not using or generating IP, don’t involve taking or controlling risks, not supplied to unrelated parties. Examples include HR, IT, legal, tax and clerical services. The services do not include: R&D, production, purchasing raw materials, sales, marketing, distribution, financial services, seeking or processing natural resources, insurance services or management services.

Distributors

A fully-fledged distributor has full responsibility for a transaction with a customer, not the manufacturer.

A limited risk distributor (LRD) sells and invoices to customers in Israel, understands customer needs, bears low inventory (stock) risk and may be indemnified for slow moving inventory, other risks, bad debts and various costs by the principal (the foreign group supply company). The LRD may take part in customer negotiations even if the sale agreement is signed elsewhere. The LRD is informed about inventory levels, deals with local logistical service providers. Sales employees may be highly paid and experts in their field of sales. Marketing strategy and related costs are “sometimes” determined and financed by the principal abroad.

Marketing

A local marketing entity conducts, among other activities, publicity, market research and economic studies related to sales. Characteristics include: few customers in the local market, no tender bids in partnership with others, few employees, employees are low paid and not compensated on the basis of sales and are not professional enough to assist sales, they merely establish contact with sales staff at the principal abroad.

If there is another official marketeer in the local market and all the local marketing entity does is to “sell” to the marketeer, the ITA will check that the local entity isn’t in practice a distributer.

In any event, the ITA says that functions described for certain activities may also suit other activities. In such cases, the ITA says transfer pricing should be determined according to the majority of applicable tests. And a tax ruling may be requested.

Comments and tips

These safe harbor profit rates will be helpful for marketing and other support operations. They expressly apply to imports, but are likely to be relevant to exports and e-commerce that do not generate or use substantial IP, e.g., selling Chinese products to Americans from Tel Aviv. It is advisable to first review the group structure – both entities and transactions. Then transfer pricing studies should be done at group or regional level, to help ensure consistency and optimization.

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