Israel transfer pricing guidance addresses documentation and burden of proof

Jordan Stotland

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By Jordan Stotland, CPA (Isr), Stotland | Consulting, Israel

The Israel Tax Authority on June 2^nd issued its first tax circular for 2020 (Tax Circular 1/2020), addressing the burden of proof in transfer pricing audits and the technical factors required for regulatory compliant transfer pricing documentation.

The tax circular follows up numerous transfer pricing judicial proceedings in the Israeli District and Supreme Courts from recent years.

Tax Circular 1/2020 reaffirms the Israel Tax Authority’s position concerning whether and when the burden of proof in transfer pricing audits is shifted from the taxpayer to the Israel Tax Authority.

According to Section 85A(c)(1) of the Israeli Income Tax Ordinance (ITO), the taxpayer must deliver to the appointed Israel Tax Authority inspector, upon request, all necessary documentation and supportive data pertaining to international transactions conducted with related parties.

This information package, included and annexed to transfer pricing studies, is to be prepared in accordance with the directives articulated under the transfer pricing Income Tax Regulations (Determination of Market Terms) – 2006.

The purpose of the current circular is to present the Israel Tax Authority’s formal position as to when a transfer pricing study filed during an audit process effectively shifts the burden of proof (which otherwise squarely lies with the taxpayer) to the Israel Tax Authority.

The Israel Tax Authority’s position, illustrated in Circular 1/2020, follows of both the 2018 Kontera Technologies Ltd Supreme Court Appeal Case # 943/16; and, the 2019 Broadcom Broadband Access Ltd District Court Appeal Case # 17419-02-18 rulings.  

Following those rulings, Tax Circular 1/2020 states that the preparation and subsequent submission of a transfer pricing study, in and of itself, does not shift the burden of proof from the taxpayer to the Israel Tax Authority.

The transfer pricing study will first be reviewed by the Israel Tax Authority to verify that it, in fact, complies with the documentation requirements and that it includes the supporting annexed information articulated under the ITO directives.

Transfer pricing method selection

For example, paragraphs 10-11 of the circular illustrates that a transfer pricing study which implements the transactional net margin/comparable profits methods (i.e., under a “net cost plus” arrangement), even though both parties hold valuable intangibles, will not shift the burden of proof if the study fails to substantiate why the profit split method was rejected (following the Revised Guidance on the Application of the Transactional Profit Split Method – BEPS Action 10 issued in 06/21/2018).

For example, paragraphs 10-11 of the circular illustrates that a transfer pricing study which implements the transactional net margin/comparable profits methods (i.e., under a “net cost plus” arrangement), even though both parties hold valuable intangibles, will not shift the burden of proof if the study fails to substantiate why the profit split method was rejected.

In their example cited above, the Israel Tax Authority might come to the conclusion that the taxpayer has not met the required minimum documentation compliance standard to effectively shift the burden of proof to the Israel Tax Authority, as the new guidance states.

Incomplete transfer pricing study

A further example of a technical documentation deficiency is cited in paragraph 12 of the circular. In this case, the Israel Tax Authority provides an example of a situation where the burden of proof is not shifted from the taxpayer to the Israel Tax Authority because the taxpayer has submitted transfer pricing documentation in an abridged format.

This example is referred to as an incomplete transfer pricing study. Such studies might be missing a complete search process, the reasoning for choosing the selected transfer pricing method over other prescribed methods, insufficient reasoning for the selection or elimination of comparable companies (including the full accept/reject annexed matrix), lacking the inclusion of comparable companies’ financial data, or any quantified explanation as to reliability adjustments that were performed.

This example is referred to as an incomplete transfer pricing study. Such studies might be missing a complete search process, the reasoning for choosing the selected transfer pricing method over other prescribed methods, insufficient reasoning for the selection or elimination of comparable companies (including the full accept/reject annexed matrix), lacking the inclusion of comparable companies’ financial data, or any quantified explanation as to reliability adjustments that were performed.

The tax circular thus eliminates the admissibility of “abridged documents” (i.e., high-level presentations, memorandums, mini-memorandums, etc.) developed over time as an acceptable norm in the local tax jurisdiction.

It has been a common practice in Israel to use abridged documents to reduce the taxpayer’s local documentation preparation burdens because Section 85A to the ITO applies to require documentation even if a controlled transaction fails to reach minimum statutory thresholds commonly legislated in other tax jurisdictions that heed to the guidance maintained by the OECD – that tax authorities should be aware of compliance burdens imposed on taxpayers to demonstrate the arm’s length nature of their controlled party transactions.

Nonetheless, a clear takeaway from Tax Circular 1/2020 is that if the Israel Tax Authority were to reject the transfer pricing study filed by the taxpayer based on the premise of incompleteness or, in the extreme case where the taxpayer has not prepared and submitted a transfer pricing study at all, even if the taxpayer were to apply an arm’s length return for the controlled transaction in question, the formal position of the Israel Tax Authority is that on a technical basis they could dismiss the policies adopted by the taxpayer and set a “tax assessment based on judgement” to their deemed arm’s length result qualified by professional experience, without the need to substantiate their position by preparing a complete study on behalf of the taxpayer.

That being clarified, Circular 1/2020 is a de facto indication that the Israel Tax Authority has the sole discretion prior to escalating matters to the judicial level, to decide whether and under what documentative circumstances should the burden of proof between the taxpayer and the tax authority actually shift.

A further indication of the gravity of the Israel Tax Authority’s position is the reiteration that any deemed tax deficiencies can (at the sole discretion of the tax authority) be subject to sanctions articulated under Section 191 to the ITO which, under certain circumstances, can reach a penalty rate of up to 30% plus the imposition of interest and statutory indexing calculations on back taxes due.

Some conclusions

Fact-gathering and selecting the correct transfer pricing method have always been important in any tax jurisdiction that has transfer pricing legislation; however, Tax Circular 1/2020 illuminates the harsh local results of willful or technical noncompliance with documentation requirements articulated under the ITO and the regulations thereunder.

Clearly, the Israel Tax Authority has adopted a formalistic approach, and it is highly recommended that taxpayers prepare compliant transfer pricing documentation in accordance with the Israeli transfer pricing regulations to substantiate their international controlled transactions and steer clear of preparing any abridged documentative formats.

Clearly, the Israel Tax Authority has adopted a formalistic approach, and it is highly recommended that taxpayers prepare compliant transfer pricing documentation in accordance with the Israeli transfer pricing regulations to substantiate their international controlled transactions and steer clear of preparing any abridged documentative formats.

One would expect that, given the tax authority’s position in the new circular, the legislature may consider adding additional transfer pricing penalty protection by means of offering taxpayers the ability to prepare contemporaneous transfer pricing compliant documentation similar to that allowed in other leading global jurisdictions.