As we indicated on our Tax News Alert of August 25, 2008 the Israeli transfer pricing (“TP“) rules, which became effective on November 29, 2006 apply to cross border transactions in which one party is an Israeli tax resident.

Loans between related parties are generally subject to Section 3(j) of the ITO. Section 3(j) imposes an income tax “deemed interest” income from loans which were provided with an insufficient interest rate (index linked amount plus 4% annual interest rate): deemed interest income is allocated to the lender in an amount equal to the difference between the “sufficient” interest rate that should have applied and the interest rate which was actually adopted by the parties.

In many cases financing between related parties is performed through the use of a capital note – an unsecured loan with capital (rather then debt) characteristics and usually bearing no interest. In principle, both ITO provisions (85A and 3(j)) may apply to a capital note financing arrangement.

However, according to a recent (February 18, 2009) announcement of the ITA, that follows a previous detailed announcement(March 12, 2008) – cross border financing transactions between related parties, while using capital notes, should only be subject to the Israeli TP rules under Section 85A (and the TP Regulations) and Section 3(j) would not apply. As long as an adequate legislation is not in force or until December 31, 2009 (the earliest), such capital notes should meet the following requirements:

1. The issuance of the note was performed no later then December 31, 2008.
2. It bears no interest or indexation; and
3. In case the capital note is foreign-currency linked – the actual interest rate per annum must not exceed the exchange rate difference between the Israeli Shekel and the relevant foreign currency.

The ITA has expressly indicated its intention to initiate a legislative process in order to adopt the above also with respect to capital notes issued after December 31, 2008.