Global Tax Alert (News from Transfer Pricing) | 13 February 2018
Israel’s Tax Authority releases draft circulars for comments on transfer pricing methods and profitability ranges
The Israeli Tax Authority (ITA) recently released for consultation two draft circulars on transfer pricing (TP), dated 18 December 2017. One circular focuses on appropriate TP methods relating to distribution, marketing, and sales by multinational enterprises (MNEs) in the Israeli market, while the other focuses on specific profitability ranges for certain transactions. The circulars provide the ITA’s position regarding methodology and profitability of various types of transactions, while facilitating documentation and reporting requirements.
Multinationals with operations in Israel should review these draft circulars and examine their level of compliance with the ITA’s positions on methodology and profitability. Those with TP strategies not in line with the ITA’s positions should consider either aligning themselves with the ITA position or managing the risks involved, including the impact on the tax provision.
Draft Circular on TP Methodology
In this draft circular, the ITA describes its position regarding the means to identify and analyze the TP methods most appropriate for distribution, marketing and sales activities in Israel. The ITA emphasizes that when an analysis of functions, assets, and risks (FAR) indicates sales activity using significant marketing intangibles, the Profit Split Method (PSM) should be used. In this manner, the ITA implies the PSM as the most appropriate.
In cases where the local sales entity does not own significant marketing intangibles, the most appropriate transfer pricing method according to the ITA is the Comparable Profits Method (CPM)/Transactional Net Margin Method (TNMM), with a profit level indicator based on revenue from sales in the local market.
In cases where the FAR analysis indicates marketing and advertising activities have taken place rather than actual sales activities, the most appropriate transfer pricing method according to the ITA is the CPM/TNMM with a profit level indicator based on operational costs.
The following transfer pricing methods are described in the circular: Comparable uncontrolled price method, Cost plus method, Resale price method, CPM/TNMM, and PSM.
The circular states that a functional analysis should begin with the contract between the parties, but the contract cannot be accepted as true until it is verified that the parties’ actual behavior is aligned with the terms of the contract. Further, in order to determine the nature of the local entity, it is not sufficient to identify who is the signatory of the transaction, but rather who conducted the sales activity in practice, who established the conditions of the transaction, who solicited and generated the demand by direct contact with specific clients as opposed to broad marketing activity to the general public. As per the arm’s-length principle, the extent of the local entity’s FAR should be proportional to its share of the return from operations.
The circular presents a list of criteria for the division of activity and responsibility between the local entity and its MNE affiliates. An example illustrates the impact of characterization of a transaction as marketing activities vs. distribution on profitability. Examples are provided for sales models and their respective pricing.
The ITA presents a summary table illustrating the most appropriate TP methods for common sales and marketing models, along with their definitions: full-fledged distribution, low risk distribution, and marketing activity.
Draft Circular on Profitability Ranges
In this draft circular, the ITA presents a list of appropriate profitability ranges for certain transactions, as follows.
Low value added services
For low value added services that meet the criteria listed in the circular, the ITA adopts Chapter 7 of the Organisation for Economic Co-operation and Development’s (OECD’s) Guidelines,1 which establishes a markup of 5% on total operating expenses (including stock options).
For marketing services as specified in section 4.3 of the circular, the ITA adopts a markup between 10%-12% on total operating expenses (including stock options). The wider the scope of activity, the higher the rate.
For low risk distribution activities as specified in section 4.2 of the circular, the ITA adopts an operating margin between 3%-4% on total revenues generated in the relevant markets by the Israeli entity. The wider the scope of activity, the higher the rate.
Relief in reporting requirements
Multinationals that choose to adopt the ITA’s profitability ranges are relieved from the obligation to prepare benchmark analyses for these types of transactions, but still need to prepare TP documentation, including an economic and functional analysis. The documentation should conclude that each transaction is conducted and priced according to the ITA’s position and hence no benchmark analysis was conducted.
Advance approval can be requested from the ITA’s TP department for meeting the conditions and requirements.
The circulars should be read together, along with the ITA’s third recent draft circular on business restructuring.2 These circulars serve as an indication of high scrutiny by the ITA of MNEs operating in Israel and their activity with respect to the Israeli market. The simultaneous publication of these three circulars emphasize that TP methodology and pricing is at the crosshairs of the ITA’s radar.
Multinationals with operations in Israel should examine their level of compliance with the ITA’s positions. They should also consider taking advantage of the alleviation in reporting requirements as provided by the ITA, by adopting the ITA’s profitability ranges instead of preparing benchmark analyses for certain types of transactions. Multinationals with TP models and strategies that are not in line with the ITA should consider either aligning themselves with the ITA position or managing the risks involved with non-compliance, including the impact on the tax provision.
1. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2017.
2. See EY Global Tax Alert, Israel’s Tax Authority releases draft circular for comments on business restructuring in multinational groups, dated 1 February 2018.
For additional information with respect to this Alert, please contact the following:
EY Israel, Kost Forer Gabbay & Kasierer, Tel Aviv
- Sharon Shulman
- Lior Harary-Nitzan
- Eyal Gonen
Ernst & Young LLP, Israel Tax Desk, New York
- Rani Gilady
EYG no. 00833-181Gbl