By Adv. (Eco.) Eyal Bar-Zvi (Partner and Head of Transfer Pricing, Herzog Fox & Neeman)
The Israel Tax Authority, on September 5, 2018, published two safe harbor Circulars (which remained in draft mode for several months), noting the tax authority’s expected profit levels for marketing services and for low-risk distributorship activities carried out in Israel by multinational entities (MNEs), and providing guidance on non-value-added services.
The first Circular 11/2018 (available in Hebrew here) details the expected transfer pricing methods to be used for different distributorship and marketing services transactions performed by an MNE in Israel through a related party. The Circular does not present any new paradigms or transfer pricing methods and merely reiterates the differences between applying the transactional net margin method (TNMM) on marketing services and/or on distributorship activity, and the required application of the customary functions, assets, and risks analysis (FAR), to resolve the nature of the activities carried out in Israel by the MNE’s subsidiary.
Circular 11/2018 also details the differences between a full-fledged distributor and a low-risk distributor (whereby a profit margin is normally the appropriate profit-level indicator), and the provision of marketing services (for which the customarily referred to “cost plus” method is normally the appropriate method in accordance with both the Israeli and foreign transfer pricing legislation). The circular also refers to the profit-split method, which may be applicable in certain distributorship models such as a full-fledged distributor (and to certain R&D or marketing services, pending, inter alia, the FAR analysis).
Thus, Circular 11/2018 is of an informational nature, though it does hold some weight, as it notes that it does not apply to digital economy marketing activities in Israel and does not address the permanent establishment issue created as a result of these activities.
Circular 12/2018 (available in Hebrew here), on the other hand, is of more importance. This Circular begins by describing the customary reasoning for the arm’s-length requirements, and then details the safe harbor rules for several types of transactions.
In accordance with the OCED rules, Circular 12/2018 adopts the five percent markup for low-value-added services. The circular describes certain examples of value-adding or low-value-adding services, and of importance is the fact that procurement services which relate to the manufacturing (of the relevant products) are not considered low-value-added services, while recruiting (HR) and general IT services are. The general criteria for evaluating whether the services are considered low-value are prescribed in the Circular.
For marketing services, the “plus” for the “cost plus” application of the TNMM should be set between 10-12 percent. The Circular also reiterates the requirement to include the costs associated with options granted to the employees of the Israeli subsidiary providing the marketing services in the cost basis.
For a distributor, only the low-risk distributor model is mentioned, for which an operating margin of between 3-4 percent is expected. Those percentages do not come as a surprise, as the financial benchmarks yielded similar results in recent transfer pricing studies conducted by HFN.
MNEs not bound by safe harbor rules
Similar to other countries, these circulars do not rule out the option of the MNE proving that a lower benchmark should be applied, based upon an applicable transfer pricing study and the presentation of relevant comparables or other relevant methods. It should be noted, in this respect, that the practice of “secret comparables” is not adopted in Israel.
Transfer pricing study still required
Even if the MNE decides to adopt the safe harbor rules, the MNE is still required to prepare a transfer pricing study or equivalent in accordance with the Israeli legislation. However, instead of performing the comparables benchmark, that study would include the choice (and application) of the applicable safe harbor rules.
Do safe harbor rules apply to outbound intercompany transactions?
The Israel Tax Authority has not given a formal answer to this question, and thus a transfer pricing study for any similar activity would still be required (both in accordance with Israeli and foreign legislation), for any outbound transactions (that is, where a foreign entity provides the services in question to an Israeli MNE or related party). However, in terms of the practical application of the services often benchmarked by HFN, the recent results in OECD countries would, in any event, be similar to the safe harbor rules laid out in the circulars.
Is a “master file” next?
In short, yes. A proposed law, which includes transfer pricing provisions adopting anti-base erosion and profit shifting (BEPS) measures, passed the first reading (out of three) in the Israeli Parliament in January 2017 and is awaiting further approvals before being brought in front of the Israeli Parliament for the second and third reading (that is, voting). The proposed legislation aligns transfer pricing documentation requirements with BEPS Action 13, and updates the Israeli legislation in this respect. Additionally, during audits, tax officials tend to inquire as to whether a “master file” already exists within the MNE’s group.