Reducing the risk of Profit Split assessment for some development centers in Israel of multinational

Recently, we have witnessed significant tension in tax assessment discussions revolving around the issue of Israeli development centers (IDC) (providing development services to related foreign entities). On one hand, these discussions create a potential for substantial additional tax burden by the Israeli Tax Authority ("ITA")¹ (while also creating a potential for tax leakage requiring treatment due to double taxation). On the other hand, the Ministry of Finance and the ITA aim to enhance the Israeli high-tech sector and maintain Israel's attractiveness in the global high-tech arena.

To balance these interests, the ITA recently published a draft circular intended to provide tax certainty for multinational technology companies operating in Israel. If the IDC meet certain conditions (mainly the nature of the activity, attaching a detailed Transfer Pricing analysis to the tax return, etc.), then the ITA will self-impose certain limitations during the tax assessment stage, which will grant some certainty to the IDC.

The main dispute in the tax assessment discussions revolves around transfer pricing, where the IDC provides development services to a foreign entity and charges it for its services. Since the IDC is a related party to the foreign entity, it is required to prove that the charge is according to market conditions (arm's length) (i.e., indirectly, that the profit remaining in Israel is appropriate for the activity performed).

If the IDC provides a simple development activity, it seems that the ITA will be able to approve a profit based on the cost-plus mechanism. If the activity of the IDC is more complex, the ITA may argue that an attribution based on the Profit Split method should remain in Israel. In other words, a percentage of the "global" profit of the multinational high-tech group should be attributed to Israel and taxed accordingly in Israel.

It should be noted that the IDC is required in its tax return to declare, inter alia, the pricing method it chose, and to state that it prepared a Transfer Pricing analysis (supporting the charge it issued to the foreign entity).
According to the draft circular, IDCs that meet certain conditions will be able to limit the tax assessor's ability in determining an assessment different from the pricing method chosen by the IDC (for example, if an IDC chose to apply the cost-plus method, then the tax assessor will be restricted in a certain manner in issuing a Profit Split assessment).

If the IDC did not meet these conditions (for example, did not prepare a transfer Pricing analysis that meets the draft circular's rules, or the IDC provides significant non-routine development services), then no limitation is imposed on the tax assessor in issuing an assessment according to the pricing method chosen (of course, within the general tax law limitations).

Here are the main conditions for IDCs eligible to benefit from the draft circular's conditions:

• The development services provided are routine, the IDC bears limited risk, it does not perform additional activities in Israel, and the IDC has no activities/assets unrelated to the provision of development services (for example, the IDC has no intangible property (IP)).

• The foreign service recipient bears the development and financing risks and can control and manage these risks (if its consolidated revenue exceeds 10 billion NIS, additional limitations will apply to the tax assessor).

• The ultimate parent company of the foreign service recipient is a foreign entity resident in a country which signed a tax treaty with Israel. The ultimate parent company that owns the group, holds all/most rights, directly or indirectly, both in the IDC and in the company to which the IDC provides services (Israeli residents do not hold together more than 10% of any controlling rights in the ultimate parent company).

• The IDC's income from providing development services is preferred income under the Israeli Encouragement Law, and it meets all the conditions required for eligibility for a reduced tax rate.

• The relevant Transfer Pricing analysis for the tax year that the IDC must prepare (as part of its legal requirements) will include, inter alia, a functional analysis according to DEMPE² principles supporting the transfer pricing method, a matrix of comparison companies accepted or rejected for determining the cost-plus mark-up etc.

• In the annual tax return, the IDC declared that it operates under the cost-plus method, and this is consistent with its financial statements.

• The IDC will attach to the annual tax return a copy of the intercompany agreement, and the Transfer Pricing analysis.

The draft circular's provisions apply to the years 2025-2028 and certain other open tax assessment discussions.

Additionally, the draft circular allows for a specific tax ruling (within a set timeframe) determining that the cost-plus margin is at arm's length conditions, provided that the IDC meet's the draft circular's requirements. It is also possible to request for a bilateral agreement (between countries) regarding the transfer pricing methodology if the foreign country signed a double tax treaty with Israel.

The draft circular also mentions the possibility of applying for a specific tax ruling in cases where an Israeli company is acquired by a foreign corporation and becomes a limited-risk development service provider after the acquisition. Among the conditions allowing for this decision:

The acquired company is defined as a preferred technological enterprise, it owns the IP, it is fully acquired by the acquiring company, shortly after the acquisition the acquired company sells its IP to a related foreign company, and then the acquired company becomes a company providing solely development services to a related foreign company. The value attributed to the sold IP will be in proportion to the "Shares" transaction consideration as defined in the draft circular, there will be no significant reduction in the development team, and certain additional conditions should be met. Meeting the specific tax ruling conditions will allow the use of the cost-plus method for roughly 8 years.

Although it is a draft circular, it is recommended to prepare accordingly.