R&D Centers in Israel: Transfer Pricing, the Cost-Plus Method, and Income Tax Circular 8/2025

 

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Israel as a Global Research and Development Hub

Israel is considered one of the world's leading innovation powerhouses and serves as a major hub of activity for international technology companies. Hundreds of multinational corporations in the fields of software, cyber, artificial intelligence, medical devices, semiconductors, communications, and fintech operate Research and Development (R&D) Centers in Israel, which form an integral part of their global value chain.

The combination of high-quality human capital, an advanced technological ecosystem, leading universities, an entrepreneurial culture, and government support for R&D has made Israel an attractive destination for companies looking to establish a development center or expand existing operations.

Alongside the business opportunities, the operations of an R&D center in Israel raise complex questions regarding Transfer Pricing, profit attribution, ownership of Intellectual Property (IP), and compliance with local and international tax requirements.

In light of the growing importance of this field, the Israel Tax Authority Published Income Tax Circular 8/2025, which provides guidance on the method of attributing income to R&D centers in Israel and the conditions under which the Cost-Plus model can continue to be applied while creating greater tax certainty.

 

How is a Foreign Company's R&D Center in Israel Typically Structured?

•  In most cases, the Israeli R&D center operates under a standard Transfer Pricing model:
•  A foreign company holds an Israeli company.
• The Israeli company provides research and development services.
•  The foreign company funds the R&D activities.
•  The foreign company owns the intellectual property or the economic rights in the intangible asset.
•   The Israeli company is compensated based on a Cost-Plus Method.

This model is considered one of the most common operational structures among multinational groups operating in Israel.

 

What is an R&D Center in Israel from a Transfer Pricing Perspective?

An R&D center in Israel is typically an Israeli company that provides research and development services to a related company outside of Israel.

In many cases, the Israeli company operates as a Limited Risk Service Provider, while the foreign company bears the development and funding risks and has the capacity to control and manage those risks.

Consequently, the remuneration to the Israeli company is generally calculated according to the Cost-Plus method, which is considered an accepted method both in Israel and under the OECD Transfer Pricing Guidelines.

 

What Is the Group's Tax Risk in Israel Arising from the R&D Center?

To the extent that significant decision-makers for the multinational group are located within the R&D center, the Israel Tax Authority tends to reject the Cost-Plus Method and chooses to use the Profit Split Method instead.

 

Income Tax Circular 8/2025: What Is Its Objective

The Israel Tax Authority Published Income Tax Circular 8/2025 regarding the attribution of income to R&D centers and the requirement to attach a Transfer Pricing study and an intercompany agreement to the tax return.

The objective of the circular is to provide an option increase certainty in Transfer Pricing for R&D centers in Israel, while establishing a clear working framework for both taxpayers and assessing officers.

The circular applies to situations where inter alia:

• The Israeli company provides research and development services to a related company outside of Israel.
•  The transaction is subject to Section 85A of the Income Tax Ordinance.
• The Israeli company reports as a limited risk R&D service provider.
• The foreign company bears the funding and R&D risks.
• The foreign company controls and manages the business risks.
• The remuneration is set according to the Cost-Plus model.

 

The New Documentation option: Attachment of a Transfer Pricing Study

One of the key aspects of the circular is the emphasis on the quality and depth of documentation that the Israeli company must maintain and attach to its tax return.

To comply with the circular's terms, and enjoy the circular benefits, the company must attach the tax return:

1. R&D Services Agreement - A copy of the intercompany agreement governing the research and development services between the Israeli company and the foreign company.
2. Full Transfer Pricing Study - The study must include, among other things:

•  Functional analysis.
•  Risk analysis.
•  Economic analysis.
•   DEMPE analysis.
•  Examination of the selected Transfer Pricing method.
• Comparable Companies Matrix - Both selected and rejected comparable companies must be presented, including the rationale for acceptance or rejection. These provisions reflect the Tax Authority's trend toward raising the required level of documentation in Transfer Pricing matters.

What Are DEMPE Functions and Why Are They So Important?

A DEMPE analysis is currently one of the core elements of any Transfer Pricing study relating to intangible assets.

The term DEMPE refers to:

• Development
• Enhancement
• Maintenance
• Protection
• Exploitation

According to OECD guidelines, one must examine not only who the legal owner of the IP is, but who performs the DEMPE functions and who bears the economic risks.

Therefore, a comprehensive DEMPE analysis has become a primary tool in determining the remuneration mechanism for R&D centers in Israel.

 

Restrictions on Altering the Pricing Method by the Assessing Officer and the Advantage for the Multinational Group

The circular establishes an internal procedure that may, in certain cases, restrict the ability to deviate from the Cost-Plus model and move to other methods such as Profit Split. This is the benefit of using the circula.

Key conditions include for using the circular:

• The ultimate parent company was incorporated outside of Israel.
• The parent company is a resident of a country that has a tax treaty with Israel.
• Israeli residents do not hold 10% or more of the parent company.
• The Israeli company maintains and submits all required documents.

These provisions can contribute to increased certainty and reduced disputes with the Tax Authority.
 

What Happens When the Assessing Officer Seeks to Determine a mark up Higher Than 14%?

The circular establishes that when the assessing officer seeks to attribute a Cost Plus higher than 14% to the company, and provided the terms of the circular are met, certain restrictions apply to the decision-making process within the assessment.

This mechanism is designed to generate a higher level of certainty for multinational companies operating R&D centers in Israel. This is apply only to companies thay choose to use the circular.

 

R&D Centers in Israel and Transfer Pricing

For international companies, proper Transfer Pricing management is an integral part of operating an R&D center in Israel.

Key areas include:

• Determining the operating model.
• Defining economic risks.
• Functional analysis.
• DEMPE analysis.
• Determining the Cost Plus margin.
• Preparing a Transfer Pricing study.
• Supporting tax returns.

Errors in any of these areas can lead to significant tax exposures in Israel and other countries.

 

Pre-Ruling for R&D Centers in Israel

The circular allows Israeli companies providing research and development services to a non-resident related company to apply to the Professional Division of the Tax Authority to request a Pre-Ruling.

The tax ruling may confirm that the remuneration paid for the services complies with arm's length conditions in accordance with Section 85A of the Income Tax Ordinance.

 

APA: Advance Pricing Agreements with Tax Authorities

Taxpayers conducting significant international operations are entitled to apply for an Advance Pricing Agreement (APA).

An APA may be:

• Unilateral.
• Bilateral (Bilateral APA).
• Multilateral (Multilateral APA).

The main advantage of an APA is creating certainty with all tax authorities involved in the transaction.

 

Acquiring an Israeli Startup and Converting It into an R&D Center

One of the most common models in Israel is the acquisition of an Israeli technology company by a foreign corporation.

In many cases:

• The IP is sold to the acquiring group of companies.
• The business activity transitions from an entrepreneurial model to an R&D services model.
• The Israeli company continues to employ the R&D personnel.
• Profits are attributed under the Cost-Plus model.

The circular provides a framework for applying to the Tax Authority to obtain a tax ruling regarding these types of transactions, including valuation of the IP and the continued attribution of profits post-transaction.

 

What Is the Practical Significance for Multinational Companies? Companies operating R&D centers in Israel must ensure that:

• Up-to-date intercompany agreements are in place.
• Transfer Pricing studies include a comprehensive DEMPE analysis.
• Full support exists for the selection of comparable companies.
• The Cost-Plus rate is based on market conditions.
• The option of obtaining an APA or tax ruling is considered in complex cases.
• Transfer Pricing is evaluated as early as the setup phase, company acquisition, or business model change.

 

Summary

Income Tax Circular 8/2025 constitutes a significant milestone in Transfer Pricing for R&D centers in Israel. The circular provides a clearer framework for reviewing the Cost-Plus model, strengthens documentation requirements, highlights the importance of the DEMPE analysis, and offers avenues to increase certainty through tax rulings and APA procedures.

For multinational companies, CFOs, legal counsels, tax managers, and R&D center executives, understanding the provisions of the circular and properly preparing for its requirements can reduce tax risks, improve business certainty, and enable more efficient management of R&D operations in Israel.

 

How Does BDO Israel Assist Companies Operating R&D Centers in Israel?

The detailed requirements set forth in Income Tax Circular 8/2025, alongside the complexity of international Transfer Pricing laws, require multinational companies to undertake thorough professional preparation provided by BDO regarding international transaction documentation, DEMPE analyses, pricing model determinations, and global and local reporting compliance.

 

What Is BDO Israel's Working Method and What Is the Advantage of the Global BDO Network?

BDO Israel's Transfer Pricing Department, headed by CPA (Adv.) Amit Shalit, has extensive experience accompanying Israeli and international companies across a wide range of intercompany transactions and Transfer Pricing projects.

The preparation of Transfer Pricing studies is executed from a holistic view of the multinational group, focusing on minimizing international tax burdens, meeting reporting requirements, evaluating interfaces with other tax disciplines, and providing solutions tailored to the group's operations and business goals.

Another significant advantage lies in BDO Israel's membership in the global BDO network. Ongoing collaboration with BDO Transfer Pricing departments worldwide enables the delivery of uniform, coordinated solutions to clients while considering various tax authority requirements and current developments in the field of Transfer Pricing.

 

What Transfer Pricing Services Does BDO Israel Offer?

BDO Israel's Transfer Pricing Department offers a wide range of services, including:

• Planning and formulating Transfer Pricing policies tailored to the multinational organization's needs.
• Performing market studies and determining arm's length pricing for international transactions between related parties.
• Preparing Transfer Pricing studies in accordance with legal requirements in Israel and worldwide.
• Preparing Local Files, Master Files, and additional documentation per OECD guidelines.
• Conducting functional analyses and DEMPE analyses.
• Supporting and preparing for tax authority audits in Israel and abroad.
• Assisting with Pre-Rulings / Tax Rulings.
• Guiding APA procedures with the Israel Tax Authority and foreign tax authorities.
• Advising on transactions related to R&D centers, IP, business model transformations, and acquisitions of tech companies.

 

Frequently Asked Questions (FAQ)

Is every R&D center in Israel required to prepare a Transfer Pricing study?

When international transactions exist between related parties subject to Section 85A of the Income Tax Ordinance, maintaining Transfer Pricing documentation in accordance with Israeli law is mandatory.

What is the Cost-Plus Method?

The Cost-Plus model is a pricing method under which the R&D center receives full expense reimbursement plus a profit margin aligned with market conditions.

What are DEMPE functions?

Development, Enhancement, Maintenance, Protection, and Exploitation functions through which the economic ownership of intangible assets is evaluated.

Can an APA be obtained with the Tax Authority?

Yes. Unilateral, bilateral, or multilateral Advance Pricing Agreements can be requested depending on the circumstances.

How does Income Tax Circular 8/2025 impact its tech companies?

The circular provides a clearer framework for handling Israeli R&D centers, establishes detailed documentation requirements, and offers greater certainty regarding the implementation of the Cost-Plus Method.