Recharge Agreement

On January 27, 2021, Income Tax Circular 1/2021 was published. The purpose of the circular is to regulate the issue of payments to a parent company for granting options or shares to employees of the subsidiary (an agreement known colloquially as the Recharge Agreement).

The circular specifies when payments by a subsidiary to the parent company, which allocated options or shares for the benefit of employees, constitute compensation for the allocation and when these payments are classified as dividends.

Intercompany liability for the allocation of a financial instrument (allocation of options or shares) between the subsidiary and the allocating parent company.

What does Income Tax Circular 1/2021 stipulate regarding the Recharge Agreement?

Income Tax Circular 1/2021 concerning the Recharge Agreement establishes four conditions under which a payment is considered a debt repayment – compensation and not a dividend.

Any payment that does not meet these rules will be considered a dividend and will be subject to tax.

These rules are relevant and significant for many Israeli companies in the high-tech, pharmaceutical, and medical equipment sectors.

Additionally, the rules are relevant for all types of companies operating with the cost-plus method with international companies. Although this is a strict circular, there is an advantage in increasing certainty in the field. Since there are quite a few disagreements between the tax authority and representatives and taxpayers, certainty is beneficial.

Our Transfer Pricing Department will proactively contact relevant clients during the next week to explain the implications of the circular in each case.

Recharge Agreement – Background:

One of the most common forms of employee compensation is equity compensation through stock options. Often, the compensation is not provided through shares of the employing company itself but through shares of the parent company or another company within the same group.

The Supreme Court’s ruling in the Kontira case of 2018 established that when a portion of employees’ salaries is paid in options, the expense of the salary for the options component, as recorded in the accounting, should be seen as a cost in calculating the income that the company must declare.

Meaning, the cost of allocating options to employees of a subsidiary generally forms part of the cost base on which the subsidiary’s profit, providing services to the parent company, is calculated.

For example, in an international transaction between related companies with special relations, the transaction must be reported according to market conditions. Meaning the pricing of the service provided by the company must be by what is accepted in market prices, known as “cost+”.

The Kontira ruling states that the pricing of the service cost must include the component of employee compensation through options because it is considered a payroll cost. Therefore, this component will be calculated in cost+ according to the percentage of pricing set in the market for the said service.

However, the Kontira ruling did not address cases where the options themselves belong to a foreign company – thus leading us to the tax issue. The question arises in which cases payments by the employing company (usually Israeli) to the parent company that allocated the financial instruments given to employees, constitute compensation for the allocation that the parent company bore on behalf of the company, and when these payments are classified as dividends.

Frequently, the Tax Authority has discovered that the compensation was made in much higher amounts than what was reported in the profit and loss statements of the employing Israeli company. A difference that, in the opinion of the Tax Authority, could be classified as a dividend distribution subject to tax. It’s important to note that according to the Tax Authority’s position, compensation from an Israeli company to a foreign company within the framework of a debt repayment that is not subject to tax is a position requiring reporting (see Reporting Required Positions 2019). The purpose of the circular, as mentioned, is to regulate when the compensation is taxable and when it is not.

What are the conditions for a reimbursement to be considered as an expense for labor costs incurred by the contracting company on behalf of the employing company, and not as a dividend?

• The reimbursement must be up to the amount of labor expenses recorded in the financial statements of the employing company for the provision of capital equipment.
• It should be final and not contingent upon further work and agreed upon in advance. This means that the companies must sign a reimbursement agreement before the work begins.

In addition to the payment, several other conditions must be met:

• The payment to the contracting company will be made only for options or shares that have vested.
• The payment for each vested option or share is according to the value established in the records, following accepted accounting rules.
• The payment to the contracting company is made under an agreement that was signed in writing before the provision of the capital equipment.
• All expenses related to the provision of the capital equipment are included as expenses/costs following the rules of Section 85A of the Ordinance and the customary accounting practices.

If the payment exceeds these conditions, it is classified as a dividend and taxed accordingly. It is important to emphasize that these conditions apply not only to payments to a parent company but also to payments to another company belonging to the same group (due to the special relationships between the companies).

What are the practical implications?

The purpose of the circular is to regulate the working methods between related companies and to encourage them to operate in an organized manner according to predefined and fixed agreements, to prevent the misuse of the reimbursement mechanism to reduce the tax liabilities of the companies in Israel.

The circular clearly outlines the boundaries of the sector and defines cases in which payments from a recharge agreement are either non-taxable debt repayment or when they are dividends.

Even in cases where a payment exceeds the provisions of the circular and is taxable as a dividend, at least it will not be subject to an alternative assessment, providing some certainty to the taxpayers.

In such cases, the importance of a professional in the field of taxation is highlighted. To schedule an initial consultation, click here.