March 2019
The Israeli Tax Authority (ITA) recently released three income tax circulars:
This Circular discusses the issue of activities related to sales, marketing, and distribution of a MNE performed by means of an Israeli entity ("the local representative") that operates in Israel on behalf of a foreign entity.
The purpose of the circular is to specify:
The arm's length status of the local representative will be determined after performing an analysis of the functions, assets, and risks ("the FAR analysis") which are divided between the local and related foreign entities.
It should be noted that the circular does not apply to the economic activities of e-commerce and services provided via the local representative in Israel.
Insofar as the FAR analysis indicates that the sales activity is being carried out and the local representative does not have material marketing intangible assets, the appropriate transfer pricing method will be the transactional net margin method (TNMM) and a profit level indicator (PLI) based on sales (e.g., operating margin) should be implemented.
Insofar as the local representative carries out activities such as marketing and/or advertising activities, the appropriate transfer pricing method will be the TNMM, and a PLI based on the component of the costs involved in the activity itself (e.g. net cost plus) should be implemented.
In addition, the ITA argues that FAR should begin with examining the legal contract between the parties. However, the economic behaviour of the parties must be examined, which may be different from what is stated in the contract.
The following table classifies the activity carried out by the local Israeli entity along with its accepted transfer pricing method (the examples are presented in summary only and do not constitute a substitute for perusal of the circular itself):
|
Israeli entity's functions |
Appropriate transfer pricing method according to the type of activity |
PLI Value |
Functions (examples) |
Assets of local representative |
Risks of local representative |
|---|---|---|---|---|---|
|
Marketing and advertising |
Method: TNMM. PLI : Net Cost Plus |
Performing a benchmark or safe harbour of 10%-12% net cost plus as stated in circular 12/2018 (Disadvantage: double taxation) |
Advertising, market research and economic analyses related to sales. Small number of employees. The employees are not compensated on the basis of sales in Israel. The employees are not professional enough to engage in sales; their role is to create contacts with potential clients. |
There are no assets in the local market |
There are no risks derived from the selling activities in the local market |
|
Sales activity - "limited-risk distributor" |
Method – TNMM PLI – Operating Margin
|
Performing a benchmark or safe harbour of 3%-4% operating margin as stated in circular 12/2018. (Disadvantage: double taxation) |
Seller does not contribute intrinsic value to the inventory; Ownership of the inventory is sometimes transferred to the limited-risk distributor; Presents the product to potential customers, its customisation for the customers, notifying customers about developments (e.g., upgrades); Constructing the transaction; Customer retention Involvement in the negotiations with customers, etc. |
There are no significant intangible marketing assets. |
Might face collection and inventory risk, but in the event of a significant bad debt, the foreign managing entity would assist. |
|
Sales activity - Full-fledged distributors |
Resale price method; TNMM; Profit split method |
Performing a benchmark |
The functions of a full-fledged distributor includes, inter alia, the activities of a limited-risk distributor plus can set the price of the transaction under economic restrictions. Is involved in the product or service characterisation process for the customer, etc. |
Inventory, employees, client lists, suppliers, etc. The fully-fledged distributor may or may not own intangible assets. |
Bears all risks in the transaction, does not perform manufacturing activities. Bears all risks involved in the sales process. It bears the inventory risk, customer credit risk. |
General comments
Insofar as the comparable uncontrolled price (CUP) method is available, it is preferable to the above- mentioned methods, as the CUP method is the most direct and reliable method.
The purpose of this circular is to present the ITA's position regarding a few types of transactions, while providing simplifications in the documentation and reporting requirements by way of a safe harbour.
The circular does not provide full exemption from preparing market research. However, it does provide full exemption from preparing a benchmark, in certain cases.
Group 1 Activity
When low value-adding services are provided, a markup of 5% net cost plus can be applied. It should be noted that the circular specifies a list of services that are not low value-adding services (e.g. management services, R&D, manufacturing or production services, purchasing raw materials, sales, marketing, or distribution, etc.).
Group 2 Activity
This circular states that marketing services, as stated in Section 4.3 of Circular 11/2018, should result in a net cost plus markup between 10% - 12% as long as the local representative is the service provider.
Group 3 Activity
This circular states that limited-risk distribution, as stated in Section 4.2 of Circular 11/2018, should result in an operating margin between 3%-4% as long as the local representative is the distributor.
The following information should be included in a market research study:
Low value-adding services are supportive in nature; they are not part of the core activity of the multinational enterprise (MNE), do not require the use of unique and significant intangible assets and do not lead to the creation of unique and significant intangible assets. Low value-adding services do not involve the taking and/or control of risk by the service provider. These services are not provided to unrelated parties, etc. Low value-adding services may include activities relating to human resources, maintaining computer systems (as long as this is not a main activity of the organisation's core business), legal services, tax services, etc.
It should be noted that the circular specifies a list of services that are not low value-adding services (e.g., management services, R&D, manufacturing or production services, purchasing raw materials, sales, marketing, or distribution, etc.).
If there is a mixed transaction involving low value-adding services and other services (e.g. management services), the types of services must be separated, as the management services are not exempt from the existence of Regulation 5 (A) (8).
It should be noted that the safe harbour has many disadvantages, (e.g., double taxation).
The ITA also recently released circular 13/2018: Low interest loans with respect to Sections 3.9, 3.10 and 85A of the Israeli Income Tax Ordinance (New Version). This circular discusses the issue of interest-free loans within Israel and worldwide. International interest-free loans must meet certain conditions, such as that the loan was issued for five years, or that the loan has the lowest priority of repayment.
Amit Shalit
amits@bdo.co.il