Israel, known as the “Startup Nation,” has long been recognized as a global leader in technological innovation, attracting multinational enterprises (MNEs) that seek to leverage its highly skilled workforce and dynamic startup ecosystem. Such MNEs play a vital role in shaping the Israeli high-tech landscape, contributing to economic growth, job creation, and technological advancements. Many MNEs elect to establish a local subsidiary in Israel that provides research and development (R&D) services. Other MNEs may opt to acquire a local Israeli startup to utilize its already-developed intellectual property (IP), which is often transferred to the parent company, while the Israeli entity transitions into an R&D service provider.
Due to the international nature of these transactions, Israeli tax laws, stipulated under Section 85A of Israel’s Income Tax Ordinance, impose strict transfer pricing regulations to ensure that intercompany transactions reflect market conditions, i.e., intercompany pricing is done at arm’s length. Such measures help the Israel Tax Authority (ITA) fight tax evasion and ensure proper revenue allocation to the local entity.
On February 27, 2025, the ITA issued Draft Circular, Attribution of Income to R&D Centers (Circular), for public review and commentary.1 The Circular provides guidance on these two major aspects of transfer pricing/intercompany dealings: 1) how the R&D activity in Israel is rewarded/compensated, and 2) how IP migration should be treated. Below are specific details.
- R&D Services – “Cost Plus” Model:
R&D centers that meet certain criteria may benefit from a level of certainty as to their transfer pricing, i.e., reduced risk of examination/scrutiny from the ITA:2
- Taxpayer’s only activity is the provision of R&D services and there is no ownership of IP;
- Taxpayer is compensated on a “cost plus” basis, where all costs are included in the cost base for compensation and an arm’s-length markup is added;3
- Taxpayer declares (via Tax Form 1385) that the transfer pricing method selected is the Transactional Net Margin Method;
- Taxpayer prepares (and submits with tax return) annual transfer pricing documentation, which includes a detailed DEMPE4analysis and benchmark analysis, as well as the relevant intercompany agreement as support.
- IP Acquisition/Migration:
The ITA proposes a mechanism by which an acquired taxpayer, if certain criteria are met, may apply for a tax ruling (collaboration between the valuation and transfer pricing departments at the ITA) that is valid for eight years (approved period), including that:5
- Post acquisition and throughout the approved period, taxpayer will continue to provide R&D services to the acquiring company (or affiliates);
- Post acquisition, workforce and labor costs (specifically related to R&D) will not be reduced by more than 20% throughout the approved period compared to the two years prior to acquisition;
- The sold IP (“TPIP”) value must equal at least 85% of the sum of total acquisition value, plus excess balance sheet liabilities and off-balance sheet obligations to the Innovation Authority, or employee bonuses, divided by 1 minus the taxpayer’s tax rate.
The Circular aims to provide MNEs (and specifically the local Israeli entity) with increased tax certainty about R&D activities and IP migration by outlining specific internal audit procedures (valid until 2028). So long as the above criteria are met, the following procedures should take place if, during an examination, the tax examiner believes the transfer pricing method is incorrect (and needs changing):
- Prior to making a claim with the taxpayer, a representative (at the ITA’s Professional Department) will examine this claim.
- The audit must be approved by a senior field manager and then issued by a senior unit manager.
- For companies with revenue (as reported by ultimate parent) that exceeds NIS 10B (approximately USD 2.5B), audit issuance requires approval of the unit director.
- An audit is ultimately issued by the director of the ITA.
Summary
The Draft Circular provides important insight to the ITA’s approach to transfer pricing, and, specifically, related to R&D activities and IP migration. These are longtime areas of focus for the ITA, and it is anticipated that these will continue to be top priorities. Once the official guidance is published, MNEs will have a clear road map for managing transfer pricing risk related to IP transactions and activities in Israel.
Key Takeaway
Transfer pricing continues to be a top priority as tax authorities around the globe continue their efforts toward ensuring fair shares of taxes are paid in their countries, without adding undue administrative burden and uncertainty for taxpayers. Simplified approaches and paths to incentivize compliance, such as those proposed by the ITA, may serve as inspiration for tax authorities as they work to achieve these goals.
Specifically for R&D and IP migration, it is important to keep in mind the following:
- Ensuring R&D activities are compensated at arm’s length: it is recommended to perform a benchmark and identify the arm’s-length range of markups the R&D service provider earns on an annual basis, to ensure remuneration remains in line with tax authorities’ expectations. Some countries provide “safe harbor” rates, which can be applied for and agreed upon with the tax authority, e.g., India.
- When acquiring a company for its IP, ensure a robust DEMPE analysis is conducted, to delineate and distinguish the responsibilities of each party to that IP.
- Documentation is key: any time there is a change, e.g., new functions or a new entity, it is recommended to document such changes and ensure the new policies adhere to arm’s-length guidance.
Forvis Mazars has a global network of transfer pricing professionals who are ready to assist with the above or other transfer pricing issues our clients are facing. If you have any questions or need assistance, please reach out to one of our professionals.
- 1Commentary period ended March 23, 2025.
- 2Besides the criteria listed herein, additional criteria include: a) ultimate parent company is nonresident (of Israel) and fully owns (directly or indirectly) the Israeli taxpayer and the entity(ies) to which services are being provided; b) no Israeli resident holds more than 10% control of the ultimate parent company; and c) income from the R&D activity must qualify as “preferred income” as defined in Section 51 of the “Capital Investment Encouragement Law” of 1959.
- 3This methodology is typically priced under the Transactional Net Margin Method (TNMM), and the markup on total costs (MTC) is the measured profit indicator.
- 4DEMPE is an initialism that refers to the functions of “Development, Enhancement, Maintenance, Protection, and Exploitation” of an intangible, as defined in Chapter VI of the OECD Guidelines. A DEMPE analysis refers to the division of responsibilities among the group entities as it relates to the intangible.
- 5Besides the criteria listed herein, additional criteria include: a) prior to the acquisition, taxpayer was defined as a “Preferred Technological Enterprise” under the “Capital Investment Encouragement Law” of 1959; b) acquisition funds are sourced outside of Israel (and must be sourced by the acquiring company); c) ultimate parent company does not have ownership in the acquired company prior to the acquisition (nor does the acquired company own any interest in the acquiring company); d) within 30 days of the acquisition (closing date), the acquired company sells all its rights in the acquired IP to the acquiring entity; and e) all required paperwork is filed with the authorities.