Transfer Pricing “Do’s and Don’ts” When Establishing an Israeli Entity
Transfer Pricing “Do’s and Don’ts” When Establishing an Israeli Entity
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SAMMERY
When establishing an Israeli entity, multinational companies should address transfer pricing from the outset to ensure compliance with Israeli tax regulations. The transfer pricing model must accurately reflect the entity’s actual activities, functions, and value creation in Israel, particularly regarding intellectual property and DEMPE functions. Companies should implement robust benchmarking studies, document financing and management fees, and prepare intercompany agreements before operations begin. Special attention should also be given to senior management functions and potential permanent establishment (PE) risks. Comprehensive, Israel-compliant transfer pricing documentation is essential, as it is required for corporate tax filings and helps reduce audit exposure. Early planning, strong documentation, and alignment between business operations and transfer pricing policies significantly minimize tax risks and provide greater certainty for multinational groups operating in Israel.
As multinational enterprises (MNEs) continue to expand globally, Israel remains an attractive destination for technology, innovation, R&D, and regional business operations. Whether establishing a subsidiary, branch, R&D centre, marketing operation, sales support entity, or shared services centre, transfer pricing should be addressed from day one.
One of the most common reasons for Israeli transfer pricing disputes is the gap between the documented transfer pricing model and the actual business activities carried out in Israel. Below are several practical “do’s and don’ts” that foreign finance and tax leaders should consider when setting up an Israeli presence.
1. Define the Israeli Operating Model Correctly
The first question that should be asked is simple: What does the Israeli entity actually do? An Israeli operation may function as an contract R&D provider, marketing hub, sales support centre, distributor, service provider, or even a regional headquarters. Each model carries a different arm’s length remuneration profile and expected level of profitability.
Do: Ensure that the transfer pricing model reflects the actual functions performed in Israel.
Don't: Automatically classify the Israeli entity as a routine cost-plus service provider. In many cases, Israeli employees are involved in strategic decision-making, possess unique know-how, or manage key customer relationships. Where this is the case, the Israeli Tax Authority (ITA) may argue that a simple cost-plus model does not adequately reward the value created in Israel and may seek alternative pricing mechanisms, including revenue-based compensation models or profit split approaches.
Do: Ensure that the transfer pricing model reflects the actual functions performed in Israel.
Don't: Automatically classify the Israeli entity as a routine cost-plus service provider. In many cases, Israeli employees are involved in strategic decision-making, possess unique know-how, or manage key customer relationships. Where this is the case, the Israeli Tax Authority (ITA) may argue that a simple cost-plus model does not adequately reward the value created in Israel and may seek alternative pricing mechanisms, including revenue-based compensation models or profit split approaches.
2. Understand Who Really Owns the Intellectual Property
Intellectual property (IP) is often the most sensitive transfer pricing issue in Israel and can significantly impact the amount of profit attributed to the Israeli entity.
Do: Carefully ask questions like who funds development activities, who makes key development decisions, where the key engineers and developers are located, who bears development risks, and who owns both the legal and economic rights to the IP.
Don't: Assume that legal ownership alone determines where profits should be allocated. If key value-creating functions are performed in Israel, the ITA may challenge a low routine return and seek to allocate a larger share of the group's profits to Israel.
Do: Carefully ask questions like who funds development activities, who makes key development decisions, where the key engineers and developers are located, who bears development risks, and who owns both the legal and economic rights to the IP.
Don't: Assume that legal ownership alone determines where profits should be allocated. If key value-creating functions are performed in Israel, the ITA may challenge a low routine return and seek to allocate a larger share of the group's profits to Israel.
3. Perform a Robust DEMPE Analysis
Particularly in technology-driven businesses, the DEMPE framework remains one of the most important areas of transfer pricing scrutiny.
Do: Identify where the Development, Enhancement, Maintenance, Protection and Exploitation functions relating to the IP are actually performed.
Don't: Rely solely on contractual arrangements stating that the IP is owned abroad. During audits, ITA frequently focuses on where DEMPE activities are carried out in practice rather than where the IP is legally registered.
Do: Identify where the Development, Enhancement, Maintenance, Protection and Exploitation functions relating to the IP are actually performed.
Don't: Rely solely on contractual arrangements stating that the IP is owned abroad. During audits, ITA frequently focuses on where DEMPE activities are carried out in practice rather than where the IP is legally registered.
4. Establish a Defensible Cost-Plus Mark-Up
Where the Israeli entity operates as a service provider, a well-supported benchmark is essential.
Do: Use an up-to-date benchmarking analysis, ensure the cost base is appropriately defined, carefully consider the treatment of share-based compensation (SBC) and bonuses, and assess whether the selected profit level indicator is suitable for Israeli market conditions.
Don't: Rely on outdated benchmark studies, regional analyses that do not adequately address Israeli economic circumstances, or comparables that may be appropriate in other jurisdictions but not in Israel.
The treatment of share-based compensation remains a recurring issue in Israeli tax audits. In addition, where no mark-up is applied to certain costs, this position may need to be separately disclosed to the ITA as a tax position adopted by the taxpayer.
Do: Use an up-to-date benchmarking analysis, ensure the cost base is appropriately defined, carefully consider the treatment of share-based compensation (SBC) and bonuses, and assess whether the selected profit level indicator is suitable for Israeli market conditions.
Don't: Rely on outdated benchmark studies, regional analyses that do not adequately address Israeli economic circumstances, or comparables that may be appropriate in other jurisdictions but not in Israel.
The treatment of share-based compensation remains a recurring issue in Israeli tax audits. In addition, where no mark-up is applied to certain costs, this position may need to be separately disclosed to the ITA as a tax position adopted by the taxpayer.
5. Pay Attention to Senior Management Functions
The presence of senior executives in Israel can have significant transfer pricing implications.
Do: Analyze where strategic decisions are made, who controls key risks, how reporting lines are structured, and whether significant business functions are effectively managed from Israel.
Don't: Dismiss the importance of C-suite executives or senior decision-makers located in Israel. Where substantial management functions are carried out locally, the ITA may argue that the Israeli entity performs economically significant functions that warrant a higher level of remuneration than a routine cost-plus return.
Do: Analyze where strategic decisions are made, who controls key risks, how reporting lines are structured, and whether significant business functions are effectively managed from Israel.
Don't: Dismiss the importance of C-suite executives or senior decision-makers located in Israel. Where substantial management functions are carried out locally, the ITA may argue that the Israeli entity performs economically significant functions that warrant a higher level of remuneration than a routine cost-plus return.
6. Prepare Intercompany Agreements Early
Intercompany agreements should reflect operational reality and should be implemented from the outset.
Do: Put appropriate agreements in place at the beginning of the activity and ensure that they accurately reflect the actual conduct of the parties.
Don't: Wait until a tax audit begins to formalize intercompany arrangements. The absence of contemporaneous agreements often gives tax authorities greater flexibility to interpret the facts and challenge the group's transfer pricing position.
Do: Put appropriate agreements in place at the beginning of the activity and ensure that they accurately reflect the actual conduct of the parties.
Don't: Wait until a tax audit begins to formalize intercompany arrangements. The absence of contemporaneous agreements often gives tax authorities greater flexibility to interpret the facts and challenge the group's transfer pricing position.
7. Properly Document Intercompany Financing
Many Israeli entities receive funding from foreign group companies, participate in cash pooling arrangements, or become involved in intercompany lending.
Do: Establish arm's length interest rates supported by transfer pricing analysis, document financing arrangements properly, and ensure that long-term balances are backed by the appropriate legal and economic support.
Don't: Allow significant intercompany receivables or payables to remain outstanding for long periods without documentation and don't ignore interest free balances. The Israeli Tax Authority has significantly increased its focus on financing transactions in recent years.
Do: Establish arm's length interest rates supported by transfer pricing analysis, document financing arrangements properly, and ensure that long-term balances are backed by the appropriate legal and economic support.
Don't: Allow significant intercompany receivables or payables to remain outstanding for long periods without documentation and don't ignore interest free balances. The Israeli Tax Authority has significantly increased its focus on financing transactions in recent years.
8. Substantiate Management Fees and Shared Service Charges
Management fees remain one of the most frequently challenged intercompany transactions in Israel.
Do: Be able to demonstrate that services rendered to the Israeli entity were actually provided, that the Israeli entity derived a genuine economic benefit from those services, that supporting evidence exists (such as emails, reports and time records), and that there is no duplication between local services and services charged from abroad.
Don't: Assume that management fees are deductible merely because they have been allocated across the group. A robust transfer pricing analysis should directly address the benefit test and other relevant requirements.
Do: Be able to demonstrate that services rendered to the Israeli entity were actually provided, that the Israeli entity derived a genuine economic benefit from those services, that supporting evidence exists (such as emails, reports and time records), and that there is no duplication between local services and services charged from abroad.
Don't: Assume that management fees are deductible merely because they have been allocated across the group. A robust transfer pricing analysis should directly address the benefit test and other relevant requirements.
9. Monitor Permanent Establishment (PE) Risks
Permanent establishment risks can arise even before a formal Israeli entity is incorporated.
Do: Assess whether personnel operating in Israel on behalf of a foreign group company, negotiate or conclude contracts, represent the foreign enterprise before Israeli customers, or perform activities that could create a taxable presence under an applicable tax treaty.
Don't: Assume that pre-incorporation activities are risk-free. In some cases, a foreign group company may create a taxable PE in Israel before the local entity is formally established.
Do: Assess whether personnel operating in Israel on behalf of a foreign group company, negotiate or conclude contracts, represent the foreign enterprise before Israeli customers, or perform activities that could create a taxable presence under an applicable tax treaty.
Don't: Assume that pre-incorporation activities are risk-free. In some cases, a foreign group company may create a taxable PE in Israel before the local entity is formally established.
10. Prepare Israeli-Compliant Transfer Pricing Documentation
Israel has detailed transfer pricing documentation requirements that should be addressed proactively.
Do: Prepare a transfer pricing analysis in accordance with Israeli regulations and Israel Tax Authority guidance. The analysis should include inter alia, a robust FAR (Functions Assets Risks) analysis, a reliable benchmarking study, a discussion of the people functions performed by key employees in Israel and abroad, and a fact pattern that accurately reflects the Israeli business. Ideally, the documentation should be prepared from the commencement of operations to ensure alignment between the transfer pricing policy and the functions actually performed.
Don't: Rely solely on regional or global documentation in which the Israeli entity receives little or no attention. Similarly, multinational groups should not assume that documentation prepared for another jurisdiction will automatically satisfy Israeli requirements or adequately address Israeli tax authority guidance.
In addition, consistency should be maintained between the transfer pricing documentation, financial statements, corporate tax returns (especcialy forms like 1385, 1485, 1585).
In Israel, taxpayers are required to explicitly declare in their corporate tax return whether they maintain transfer pricing documentation supporting their related-party transactions. As a result, multinational groups should avoid finding themselves in a position where no transfer pricing study exists.
If no transfer pricing documentation has been prepared, the taxpayer will generally be required to disclose this fact in Form 1385. Such a declaration may increase the likelihood of scrutiny by the Israeli Tax Authority and create a reporting exposure both for the Israeli entity and for the individual signing the tax return. This is particularly relevant where the signatory is a foreign resident executive of the group, as personal responsibilities may arise in connection with the accuracy and completeness of the tax filings submitted in Israel.
Accordingly, preparing contemporaneous transfer pricing documentation is not only a best practice from a transfer pricing perspective, but also an important risk management measure from a tax compliance standpoint.
Do: Prepare a transfer pricing analysis in accordance with Israeli regulations and Israel Tax Authority guidance. The analysis should include inter alia, a robust FAR (Functions Assets Risks) analysis, a reliable benchmarking study, a discussion of the people functions performed by key employees in Israel and abroad, and a fact pattern that accurately reflects the Israeli business. Ideally, the documentation should be prepared from the commencement of operations to ensure alignment between the transfer pricing policy and the functions actually performed.
Don't: Rely solely on regional or global documentation in which the Israeli entity receives little or no attention. Similarly, multinational groups should not assume that documentation prepared for another jurisdiction will automatically satisfy Israeli requirements or adequately address Israeli tax authority guidance.
In addition, consistency should be maintained between the transfer pricing documentation, financial statements, corporate tax returns (especcialy forms like 1385, 1485, 1585).
In Israel, taxpayers are required to explicitly declare in their corporate tax return whether they maintain transfer pricing documentation supporting their related-party transactions. As a result, multinational groups should avoid finding themselves in a position where no transfer pricing study exists.
If no transfer pricing documentation has been prepared, the taxpayer will generally be required to disclose this fact in Form 1385. Such a declaration may increase the likelihood of scrutiny by the Israeli Tax Authority and create a reporting exposure both for the Israeli entity and for the individual signing the tax return. This is particularly relevant where the signatory is a foreign resident executive of the group, as personal responsibilities may arise in connection with the accuracy and completeness of the tax filings submitted in Israel.
Accordingly, preparing contemporaneous transfer pricing documentation is not only a best practice from a transfer pricing perspective, but also an important risk management measure from a tax compliance standpoint.
Final Thoughts
Israel offers significant opportunities for multinational groups, particularly in technology, life sciences, innovation and advanced business services. However, transfer pricing should not be viewed as a compliance exercise to be performed after operations begin.
The most successful structures are those where the transfer pricing model accurately reflects the commercial reality of the Israeli business from day one. Early planning, sound documentation, properly drafted intercompany agreements and a thorough understanding of Israeli transfer pricing requirements can significantly reduce tax risk and provide greater certainty for both the multinational group and its Israeli operations.
At BDO Israel, our Transfer Pricing team regularly assists multinational groups entering the Israeli market with designing compliant operating models, preparing transfer pricing documentation, conducting benchmarking studies and managing interactions with the Israeli Tax Authority.