In recent years, the Israeli Tax Authority (ITA) has been considering the appropriate transfer pricing method for the taxation of research and development (R&D) centers of multinational enterprises (MNEs) in Israel.

Traditionally, R&D centers in Israel have been remunerated under the cost-plus method. However, the ITA’s position as expressed recently is that, in many cases, the appropriate profit allocation method should be based on the profit split model.

At a recent public conference in which the professional department of the ITA participated (the Conference), a senior official identified the criteria that would be used for such a determination.

The ITA is currently drafting a tax circular, which will be published in the coming weeks, that will address this issue. It is anticipated that these criteria will identify situations where an R&D center might share the economic ownership of the intangible assets that it is a partner in creating.

This classification has significantly broader implications than just profit allocation, as it may lead to ownership claims when an intangible asset is transferred, for example upon a change of a business model within the group. In some cases, it may also lead to tax implications for foreign residents upon their sale of shares in a foreign company that operates an R&D center in Israel.

The following are the criteria that the ITA has stated are indicative of economic ownership of intangible assets by the R&D center:

Both the origin of the intangible asset and its activity began in Israel

There are other activities conducted in Israel besides R&D

The group's headquarters is located in Israel

The R&D center in Israel bears some of the significant risks relating to R&D activities

The R&D center conducts activities that creates a unique and valuable contribution to the MNE

On the other hand, these criteria may indicate the R&D center lacks economic ownership of intangible assets:

The local R&D center was established as an initiative of the foreign MNE

Decisions regarding intangibles are made by the MNE headquarters’ employees, located outside of Israel

The local R&D center does not bear any business risks

The local R&D center does not have the ability to fund an activity that establishes economic ownership of the intangible

The local R&D center has no accumulated losses for tax purposes due to intangible R&D

The R&D center does not have an activity that creates a unique and valuable contribution to the MNE

The official concluded that even in cases where there is no economic ownership of an intangible asset by the R&D center, it is possible that the existing cost-plus remuneration is too low and not aligned with the contribution of the R&D center in Israel, and that the purpose of the ITA is to find the balance point for fair taxation of R&D centers in Israel.

Implications

Multinationals with R&D centers in Israel should follow the anticipated developments on this issue. While written guidance has not been published, taxpayers should be prepared to review the facts and transfer pricing policies of their R&D centers. Companies that are uncertain about the transfer pricing treatment of their R&D center, may want to consider an Advance Pricing Agreement (APA) to obtain certainty.

A detailed Tax Alert will be issued once the circular is officially published.

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For additional information with respect to this Alert, please contact the following:

EY Israel, Tel Aviv

• Sharon Shulman | sharon.shulman@il.ey.com
• Lior Harary-Nitzan | lior.harary-nitzan@il.ey.com

Ernst & Young LLP (United States), Israeli Tax Desk, New York

• Lital Haber | lital.haber1@ey.com