In April 2018 a (unanimous) ruling was handed down by the Supreme Court on two different appeals, which deal, inter alia, with the application of the section that deals with transfer pricing, in respect of the question of whether the cost of the allocation of the options to employees of a subsidiary company should be included as part of the cost basis for determining the market price of an international cost+ type transaction between related parties.
Approach to the representatives
The Tax Authority’s position, as presented in the ruling, has also been included as “a position that requires reporting”, and it has been determined in it that income is also to be included under the Cost+ method, in respect of options based costs, and also in respect of expenses that have been adjusted in the statement of adjustment for tax purposes, or which have not been required in the financial reporting but which had to be required in accordance with generally accepted accounting principles.
In December 2018, the Tax Authority published an circular to the representatives, pursuant to which, following the ruling by the Supreme Court that “The cost of the allocation of options must be included in the cost basis for the purpose of calculating the profit for tax purposes, “it is expected of companies that they correct their reports in accordance with the ruling and the position adopted by the Tax Authority and if they do not do so, assessment processes will be instituted within the context of which a higher “transaction price” than the reported transaction price may be determined (in accordance with the median inter-quarterly range), and in certain cases, deficit fines may even be imposed.
Is every company required to correct reports “automatically” or is it still required to consider each case individually?
We would mention that in both of the rulings, the cases concerned an Israeli subsidiary that provides research and development services to an American parent company on the basis of the Cost+ method. The appellants granted options to their employees for the purchase of shares in the parent company on the preferential “capital gain path” in accordance with Section 102 of the Israeli Tax Ordinance. It was determined in the ruling that “…the very fact of the inclusion of the cost of the allocation of the options in the cost basis, does not lead to the assessing officer being entitled automatically to interfere in the parties’ agreements, as expressed in the report regarding the transactions. This interference is only possible in a case in which the assessee has not met the burden of persuasion by showing that the transaction price, which includes the value of the options accords with the price that is acceptable in the market for similar transactions…” and also, in relation to the case in question “the theory that is presented by the assessees, pursuant to which the cost of the allocation of the options should not be included in the cost basis, within the context of the transactions in question of a cost plus type – does not fit with investigations of the conditions in the market that have been submitted on their behalf. This is because the profitability rates of the comparative subsidiary companies, in accordance with which the assessees sought to extrapolate the value for the case before us, take the value of the
options into account”.
We conclude that the inclusion of the cost of the options in inter-company services transactions does not lie within the bounds of “something that is unavoidable” and that the fact of their inclusion or of the avoidance of their inclusion is dependent upon the circumstances of the case, the inter-company agreements and the transfer pricing method that is implemented.
A demand to correct the reports raises a number of questions: Is it required to correct reports if the transaction price that has been set still lies within the range of prices that would have been set whilst implementing the Tax Authority’s position? Within the framework of the correction of the reports is it only required to update the cost basis (which is to include the cost of the options as aforesaid), or is it possible to consider electing for a different pricing method that is still implementable in the circumstances in hand, if it provides a better reflection of the inter-company economic model?
In summary, the inter-company services agreements should be checked thoroughly and if the cost of the options has not been included in an inter-companies services agreement, proper consideration should be given as to whether to correct the previous tax reports. In any event, we would recommend receiving professional advice before taking any action.