Transfer Pricing

Transfer Pricing Israel: A Guide for Development Centers, Distribution Companies, Marketing Companies, Sales Companies and Permanent Establishments

What is Transfer Pricing?

Transfer Pricing refers to the rules governing how transactions between related parties operating in different countries should be priced. These transactions include, among others, the sale of products, management services, research and development services, intercompany financing, royalties, and the use of intellectual property. The purpose of these rules is to ensure that the profits of a Multinational Enterprise (MNE) are allocated among the different countries in accordance with the economic value created in each country.

The fundamental principle in the field of Transfer Pricing is the Arm's Length Principle, which has been adopted both under Israeli law and under the OECD Transfer Pricing Guidelines.

Under this principle, the price charged between related parties should be comparable to the price that would have been determined between unrelated parties operating under similar market conditions.


What is Section 85A of the Israeli Income Tax Ordinance and how is it relevant to Transfer Pricing?

Section 85A constitutes the primary legal basis for Transfer Pricing in Israel. The section authorizes the Israel Tax Authority to intervene in international transactions between related parties when the prices determined do not reflect market conditions. In addition, the section serves as the basis for the Transfer Pricing regulations and the documentation requirements currently applicable to Israeli companies.


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Transfer Pricing in Israel compared with the OECD Transfer Pricing Guidelines

Israeli law is largely based on the OECD Transfer Pricing Guidelines. Accordingly, when examining international transactions, the Israel Tax Authority makes extensive use of OECD principles, particularly Functional, Assets and Risks analysis (FAR Analysis), the examination of the global value chain, and the determination of the entity entitled to profits arising from intellectual property.



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Who is required to prepare Transfer Pricing documentation in Israel?

Any Israeli company conducting an international transaction with a related party may be required to prepare Transfer Pricing documentation.

Common examples include:

  • Development centers in Israel
  • Distribution companies in Israel
  •  Marketing companies in Israel
  •  Sales companies in Israel
  •  Service companies
  •  Companies holding intellectual property
  • Companies providing or receiving intercompany financing


Is every Israeli company required to prepare a Transfer Pricing Study?

Every company conducting transactions with a related party abroad should examine whether it is required to prepare a Transfer Pricing Study and report Form 1385 of its tax return.


What are the Transfer Pricing documentation requirements in Israel?

Documentation requirements in Israel have been significantly expanded in recent years in accordance with the OECD BEPS project and include the requirement to prepare a Transfer Pricing Study, Master File, and CBCR.



How should a Transfer Pricing Study be prepared?

A professional Transfer Pricing Study primarily includes:

  •  A business overview of the group.
  • A description of the international transactions.
  •  FAR Analysis (Functional Analysis).
  •  Benchmark Study, as part of the economic analysis.
  •  Selection of the Transfer Pricing method.
  •  Conclusions regarding compliance with the Arm's Length Principle.


What is FAR Analysis?


FAR Analysis (Functions, Assets and Risks Analysis) is one of the most important components of any Transfer Pricing Study. Its purpose is to identify which entities within the group perform the significant functions, own the important assets, and bear the relevant economic risks.


What is a Benchmark Study?


A Benchmark Study is an economic analysis used to compare the company's activities with those of independent companies operating under similar conditions. This study often constitutes a central focus of discussions during a Transfer Pricing audit.


What is a Master File?

A Master File is a group-level document containing information about Multinational Enterprise, its value chain, ownership structure, financing arrangements, intellectual property, and more. It clarifies the group's Transfer Pricing policy and provides an overall view of Transfer Pricing within the group.


What is CBCR?

Country-by-Country Reporting is an international reporting framework that discloses, among other things, quantitative information regarding the Multinational Enterprise, including the allocation of revenues, profits, employees, and other data among different countries.


What is Form 1385?

Form 1385 is the principal disclosure form included in the Israeli tax return through which a company declares that it has conducted international transactions with related parties and that a Transfer Pricing Study exists. The form includes a declaration that the Israeli company has prepared an up-to-date Transfer Pricing Study.



How does the Israel Tax Authority Audit Transfer Pricing?

In recent years, Transfer Pricing has become one of the Israel Tax Authority's key enforcement areas.

As part of a Transfer Pricing audit, the following are examined, among other matters:

  •  Intercompany agreements
  •  The Transfer Pricing Study
  •  The group's value chain
  •  The roles of employees in Israel and abroad
  •  The location and role of the intellectual property
  • The allocation of risks and profits within the group

The Israel Tax Authority no longer relies solely on written documentation. It also examines what is carried out from a business perspective and, for example, interviews company employees.

It should also be noted that as part of the Israel Tax Authority's efforts to improve its capabilities through AI, the number of taxpayers selected for examination is expected to increase, and the Israel Tax Authority's ability to review Transfer Pricing Studies is expected to advance significantly.



Transfer Pricing and Permanent Establishment in Israel: What is a Permanent Establishment?

A Permanent Establishment is a situation in which a foreign company is conducting significant business activities in Israel that are subject to tax in Israel.


How are Transfer Pricing and Permanent Establishment related?

While Transfer Pricing examines how transactions between companies should be priced, Permanent Establishment concerns the question of whether a portion of the foreign company's own profits should be attributed to the Permanent Establishment in Israel.


When can activity in Israel creates a Permanent Establishment?

When employees located in Israel perform, among others, the following activities:

  •  Conducting substantive negotiations.
  •  Contracting with key customers.
  •  Managing part of the business activity.
  •  Developing key intellectual property.
  • Making strategic decisions.

In such cases, the Israel Tax Authority may argue that a Permanent Establishment exists.



Transfer Pricing for a Development Center in Israel

The most common model is Cost Plus, under which the development center receives reimbursement for its costs plus a fixed markup. However, the Israel Tax Authority is currently examining whether the Israeli development center provides services only, or whether it is a significant contributor to the creation of the group's intellectual property or plays a significant role in the group's management. In such cases, the Israel Tax Authority may require the development center to report profits under the Profit Split method.


Cost Plus versus Profit Split


Where significant management, engineering, and product development teams are in Israel, the Israel Tax Authority may argue that the Cost Plus model does not adequately reflect the contribution of the Israeli company and may prefer a Profit Split approach.


DEMPE Model


One of the key issues today is the examination of the DEMPE functions of intellectual property: Development, Enhancement, Maintenance, Protection, and Exploitation.

The more these functions are performed in Israel, the greater the exposure to Profit Split tax assessments in Israel.



Tax exposures of Distribution Companies in Israel

Distribution companies are primarily examined based on their level of profitability compared with independent distributors.


What are the customary profit margins?

This depends on the industry, the market, and the results of the specific Benchmark Study.


What is the difference between a Limited Risk Distributor and a Full Fledge Distributor?

A Limited Risk Distributor is generally expected to earn a lower level of profitability but is also expected to bear fewer business risks.



Year-End Adjustments


One of the key issues today is the performance of Year-End Adjustments in order to align the actual results with the range of results determined in the Transfer Pricing Study.


Tax exposures of Marketing Companies in Israel

Marketing companies in Israel have become a significant focus of Transfer Pricing audits. The Israel Tax Authority examines whether marketing teams create significant economic value for the group, particularly whether they contribute to the creation of intangible assets such as goodwill, customer relationships, and penetration into new markets.

The Israel Tax Authority also examines whether the company performed marketing activities only, which may justify a Cost-Plus model, or whether sales activities were also conducted in Israel. In the latter case, it may be justified for the profits attributable to the Israeli entity to be determined based on the results of the Israeli entity's sales activities, for example, profit based on sales.




Tax exposures of Sales Companies in Israel

Sales activities receive particular attention in the international tax and Transfer Pricing fields.

When sales personnel in Israel:

  •  Conduct negotiations.
  • Close transactions.
  •  Influence contractual terms.
  •  Develop new markets.

The Israel Tax Authority may argue that the profitability attributable to the Israeli company should be increased.


Common Transfer Pricing mistakes

  •  Failure to prepare a Transfer Pricing Study.
  •  Use of an outdated Benchmark Study.
  •  Failure to perform Year-End Adjustments.
  •  A gap between the intercompany agreements and the actual activities.
  •  Failure to address Permanent Establishment issues.
  • Lack of DEMPE documentation.
  •  Failure to update the FAR Analysis.



Frequently Asked Questions (FAQ)

  • Every company conducting transactions with related parties abroad is required to prepare a Transfer Pricing Study.

If it conducts transactions with related parties abroad, it should prepare a Transfer Pricing Study. It is advisable to do so as early as possible in order to establish the group's approach from the outset and understand how it affects Transfer Pricing and the overall multinational tax burden.

  • The exposure to audits, adjustments, and tax assessments increases significantly. In addition, the Israel Tax Authority may challenge the tax return filing process itself and potentially disqualify the return. It may also challenge the individual who signed the tax return due to deficient representations in the return, among other matters.
  • Certainly, where it provides development services to a related foreign company.
  • Certainly, where it provides services to a related foreign company abroad.
  • Business activity conducted by a foreign company in Israel that is subject to tax in Israel.

What is BDO Israel's approach and what is the advantage of the global BDO network?

BDO's Transfer Pricing department, headed by CPA (ADV.) Amit Shalit, has extensive experience in the field of Transfer Pricing. Transfer Pricing Studies are prepared from a comprehensive perspective, with an emphasis on minimizing the multinational tax burden, complying with reporting obligations, addressing interfaces with other tax disciplines, and maintaining ongoing and up-to-date cooperation with Transfer Pricing departments across the global BDO network.


What do BDO Israel's Transfer Pricing services include?

  •    Transfer Pricing policy planning based on the needs of Multinational Enterprise
  •     Preparation of a Benchmark Study: examining the relevant market price for an international transaction between companies, both for the purposes of tax authority requirements and for internal accounting purposes
  •     Documentation: preparation of the documentation required under Transfer Pricing regulations in Israel and worldwide
  •      Preparation for audits by tax authorities in Israel and worldwide
  •      Obtaining a Pre-ruling from tax authorities in Israel and worldwide


Summary

Transfer Pricing in Israel has become in recent years one of the key areas of tax risk management for international groups. Whether the activity involves a Development Center in Israel, a Distribution Company in Israel, a Marketing Company in Israel, a Sales Company in Israel, or activity that may create a Permanent Establishment, comprehensive and up-to-date documentation that complies with the requirements of the Israel Tax Authority and the OECD Transfer Pricing Guidelines is now required.

Adopting an appropriate Transfer Pricing policy, preparing a high-quality Transfer Pricing Study, and regularly reviewing the business operating model may significantly reduce the risk of tax assessments and provide long-term business certainty.


Amit Shalit

Amit Shalit

Partner, Transfer Pricing
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