The transfer pricing branch belongs to the field of international taxation and deals with situations where there are international transactions between related parties. In the context of these transactions, the question arises as to which portion of the profit should be attributed to each of the countries involved in the transaction.
Section 85A of the Income Tax Ordinance stipulates that the terms of an international transaction between related parties should be similar to those of an identical transaction between unrelated parties. Under this section, in November 2006, the Income Tax Regulations (Market Terms) 2007 – 2006 were enacted. The regulations specify how to examine whether a transaction was made in accordance with market terms, the rules for documentation and reporting on transfer pricing research, and they also address one-time transactions.
In the context of the annual tax report that companies submit, Form 1214, they are required to indicate whether the company had international transactions with related parties abroad as defined in Section 85A of the Income Tax Ordinance. If such transactions occurred, the company must attach Form 1385 as an annex to the annual report. Form 1385 includes information about the intercompany international transaction, such as the nature of the transaction, its amount, and more.
In 2022, the Tax Authority updated Form 1385 and added a requirement to report on the existence of a transfer pricing study. The person filling out the form must indicate whether “there is a market terms investigation report in accordance with Regulation 5 of the regulations, as of the date the report is submitted.” The significance of the update is that, in effect, the Tax Authority is tightening the enforcement of conducting transfer pricing studies.
If the taxpayer has not conducted a transfer pricing study and declared as such on the form, the case will definitely lead to an audit by the Tax Authority. If the taxpayer did not conduct a transfer pricing study but falsely declared that such a study exists, this constitutes a false entry with all its implications. According to Section 215 of the Income Tax Ordinance, a person who unreasonably provides an incorrect report or submits incorrect information is liable to a penalty of two years’ imprisonment or a monetary fine as stated in Section 61(a)(3) of the Penal Law, or both. In addition to the mentioned fine, there is also the possibility that the taxpayer may receive an additional deficit penalty.
Important points for filling out Form 1385
- Details of the Parties to the Transaction: It is necessary to provide details of both the Israeli and foreign entities involved in the transaction.
- Details About the International Intercompany Transaction:
- Description of the Transaction: Provide a clear explanation of the nature of the transaction.
- Method Adopted: Specify the transfer pricing method used. If a method that compares the profitability ratio between the international transaction and a similar transaction was selected, the chosen profitability ratio should also be mentioned.
- Transaction Amount: Indicate the monetary value of the transaction.
- Declaration and Signature: There must be a statement and signature confirming that the international transaction was conducted under market conditions.
What is a market conditions investigation according to Regulation 5 of the Income Tax Regulations (Market Terms)?
Regulation 5 outlines the guidelines for a full market conditions investigation and the information it must include:
- Details of the taxpayer
- Description of the taxpayer’s organizational structure
- Information about the parties to the transaction including their residencies and the nature of their special relationships with the taxpayer.
- The contractual terms of the international transaction
- The taxpayer’s field of activity
- The economic environment in which the taxpayer operates and the risks they are exposed to
- The main competitors of the taxpayer (if any)
- Use of intangible assets
- Detailing all the transactions the taxpayer conducted with the transaction party (including the amounts of the payments)
- Detailing similar transactions, the comparison method, and the comparison characteristics used for preparing a range of values
- The manner of reporting in the country of the transaction party
Benchmarking work, unlike a complete transfer pricing study, includes only information about the analysis conducted in the database and its results, and does not include the other detailed information mentioned above, does not meet the regulations, and is not considered a full market conditions investigation. Therefore, if only benchmarking work was performed, it would not be possible to declare that there is a market conditions investigation on the form. If the taxpayer nevertheless declared that a market conditions investigation exists, this declaration would be considered a false report.
What is an up-to-date market conditions investigation?
An up-to-date market conditions investigation, according to the Income Tax Regulations (Market Terms), requires that transfer pricing work be updated annually. This differs from the OECD guidelines, which state that a transfer pricing study is valid for three years. Due to the high costs associated with conducting a new transfer pricing study every year, our office proposes to clients a transfer pricing work that will be valid for the next two years, with a new study only performed after the third year. The validation is done by examining the circumstances and terms of the transaction to see if they remain unchanged.
Our office specializes in Israeli and international taxation and offers a professional and comprehensive package in the field of transfer pricing. Our transfer pricing department supports many companies from the correct filing of the form to the planning of reporting and tax payments in the most optimal way. To schedule an initial consultation with a representative from our office, click here.
