Israel Supreme Court rules stock-based compensation must be added to cost base for transfer pricing

by Shlomo Hubscher & Jacky Houlie, JH & Co. Law Office

Israel’s Supreme Court on April 22 ruled that companies that use the cost plus transfer pricing method must include stock-based compensation in the cost base. The decision is expected to significantly increase the tax bills of many multinational firms that have research and development operations in Israel.

In the joined cases of Kontera Technologies Ltd. and Finisar Israel Ltd., the Supreme Court also addressed the relevancy of deductibility, transfer pricing, adjustments, and burden of proof.

The case grew out of disputes between the Israeli Tax Authority and two Israeli research and development subsidiaries of multinational firms.

In each case, the Israeli Tax Authority won judicial decisions in the courts that concluded that expenses incurred for employee stock option plans should be included in costs under a cost plus transfer pricing arrangement.

In both cases, this decision was reached despite the fact that the stock option plan was qualified under a capital gains track under section 102(D)(2) of the Income Tax Ordinance and thus the Israeli employer could not deduct any expenses in relation to the options.

The two cases, Kontera Technologies Ltd v the Assessing Officer Tel Aviv, 2016 and Finisar Israel Ltd v the Assessing Officer Rehovot, 2016, were then appealed to Israel’s highest court.

Both Kontera and Finisar argued before the Supreme Court that the lower court rulings were based on misinformation and, in their view, can unjustly lead to economic double taxation. However, the Supreme Court thoroughly reviewed these appeals and disagreed with these conclusions.

The Supreme Court reasoned that stock-based compensation is an integral part of the compensation package of the Israeli subsidiaries’ employees with the objective of improving the quality of services rendered and strengthening the bond between the companies’ and employees’ cohesive goals.

Therefore, it is indeed confirmed that such compensation should be included in the cost base.

It should be noted that the benchmarks used by the taxpayer in both cases included companies that prepare their financial statements based on the US standard FAS123R. This financial accounting standard provides that costs associated with equity payments for employee services are to be expensed on financial statements to reflect the economic transaction taking place between a company and its employees.

Therefore, it can be assumed that if the companies used as benchmarks offered stock-based compensation, these amounts would have already been included in the companies’ cost base.

Although the court ruled that stock-based compensation costs must be included in the cost base, the tax authority does not automatically possess the right to make transfer pricing adjustments. Adjustments are only warranted if the economic results as agreed by the parties and reported by the taxpayer deviate from the arm’s length range.

The Israeli regulations recognize that the term “arm’s length” may be reflected in a range of values, not a singular point in the list of values from the benchmark companies. Such a range would include an interquartile range, which is a measure of statistical dispersion based on dividing a data set into four equal quartiles.

The Supreme Court concluded that the economic results of the intercompany service transactions in both cases deviated from the arm’s length principle because the effective markup in those cases was lower than the second quartile of the interquartile range after including stock-based compensation costs.

Therefore, a transfer pricing adjustment was required in both cases, the court said.

According to the Israeli regulations, if an economic result is outside of the range, an adjustment would be to the median point within the first quartile range. In the Kontera case, therefore, the Supreme Court upheld the Israeli Tax Authority’s counter-appeal with respect to the extent of the adjustment and ruled that such adjustment would be to the median value of the interquartile range (i.e., from initially reported 7% to 9.1%).

The Supreme Court also upheld the two lower courts’ rulings that stock-based compensation may not be deducted for Israeli corporate tax purposes while under a capital gains track under section 102(D)(2) of the Income Tax Ordinance since this section provides a specific exception to the main deductibility rule specified in Section 17 to the Income Tax Ordinance.

Thus, the result of this final binding ruling of the Israeli Supreme Court is that, for Israeli tax purposes, stock-based compensation is included in the cost base of cost plus arrangements even in cases where it is not deductible for tax purposes by the service provider.

This would apply even in a case that the effective tax rate may be considered as excessive since, on one hand, the stock-based compensation increases the subsidiary’s tax base, and on the other hand, is not viewed as a deductible expense.

Finally, the Supreme Court addressed the burden of proof in relation to transfer pricing disputes.

Section 85 A (c) (2) provides that the burden of proof is with the income tax authority if the taxpayer submitted all required documentation, including transfer pricing study.

The Supreme Court ruled that to shift the burden of proof to the Israeli Tax Authorities, it is not sufficient to cooperate and submit the documentation to the tax assessor; rather, this requires that the documentation that is presented “adequately substantiate” the taxpayer’s claim.

With all due respect to the Court’s ruling in this matter, we find this determination too restrictive an interpretation of the law

It should be noted that the Supreme Court mentioned as an obiter dictum that it is not analyzing the prudence of Israel’s tax policy or legislation and has rather focused its analysis on appropriate interpretation to the relevant law.

–Jacky Houlie, LL.M, is founder Managing Partner at JH & Co. Law Office. He can be reached at [email protected] or phone: +972528512569.

–Shlomo Hubscher is a partner at JH & Co. Law Office. He can be reached at [email protected] or phone: +972526006804.