What Interests the Tax Authority, and How Can Exposure Be Reduced?
When a company operates only in Israel, it is usually quite clear where the income is generated and where tax is paid on it. But in an era in which companies operate globally, and sometimes across several countries, the picture becomes more complex. There may be a parent company in one country, a development center in another, marketing and sales in a third, and sometimes even intellectual property registered in a fourth.
In such a situation, there are almost always intercompany transactions between related entities within the same group. For example, an Israeli company may provide development services to a foreign parent company, a European company may provide marketing services to an Israeli company, or intellectual property held in one country may be used by the group as a whole. These transactions sit at the heart of one of the key issues in international taxation: how to determine the appropriate price between related companies, and how much profit should remain in Israel for tax purposes?
The good news is that the rules exist. The less good news is that choosing an inaccurate pricing model, or maintaining insufficient documentation, can lead to costly disputes with the Israel Tax Authority. As a result, a company that has not acted in accordance with the rules may find itself paying linkage differences, penalties, and sometimes significant interest as well.
This article is for general informational purposes only and does not constitute legal or tax advice. A case-specific review is recommended based on the relevant facts and applicable law
The Arm’s Length Principle: The Price Should Resemble a Genuine Market Transaction
The foundation of this entire area is the Arm’s Length principle. The idea is simple: even if the transaction is between two companies in the same group, the Tax Authority expects the price to be similar to the price that would have been agreed between two unrelated parties in the market through a genuine negotiation.
Why does this matter? Because without this rule, multinational groups could decide where profit is reported simply by setting convenient internal prices. For example, they could price development services in Israel very low, so that the profit would be reported in a country with a lower tax rate. On the other hand, the Israel Tax Authority, like tax authorities in other countries, will seek to ensure that Israel receives the share of tax it is entitled to based on the real contribution made in Israel.
In practice, this means asking a substantive question: what is actually being done in Israel, what value is created here, and what is the contribution of the local activity to the group’s global success? Generic services are not the same as activity that creates a real competitive advantage.
Choosing the Appropriate Method for Attributing Income
In practice, there are several accepted methods for pricing and attributing income between related companies. One of the most common methods, especially where there is a services or development center, is the cost-plus method: the costs of the Israeli company are taken into account, such as salaries, rent, and operating expenses, and an agreed profit margin is added.
The problem is that the cost-plus method is not always suitable. Why?
- Sometimes the company in Israel is not a regular “service provider,” but rather a key driver of innovation, know-how, and intellectual property.
- Sometimes the people in Israel make key decisions, lead the product, or develop a component that is at the core of the business.
- And sometimes the group’s structure has changed over time, so the cost-plus method that was set at the beginning no longer reflects the current reality.
In such cases, the Tax Authority may argue that the chosen model “reduces” the profit that remains in Israel, and that a higher amount of income should therefore be attributed to the Israeli company. The direct result is an increase in the tax liability in Israel, and sometimes demands for payment for prior years as well, including high interest.
For further reading about the cost-plus method for income attribution, click here.
In addition, in certain situations the Tax Authority may promote a different method, for example a Profit Split method or other models that attempt to reflect genuine partnership in value creation. It is important to understand that the question always comes back to substance: what does each company contribute, which entity bears the risks, and which entity truly created the value from which the income is derived.
When There Is a Dispute, the Cost Can Be High: The “SentinelOne” Example
A recent example illustrating how significant this issue can be is the dispute between cybersecurity company SentinelOne and the Israel Tax Authority. According to publications, the dispute concerned the relationship between the Israeli subsidiary and the parent company, and the question of how to calculate the income that should be reported in Israel.
The parties reached a significant payment arrangement, but what stood out in particular was the interest component: the company committed to annual interest of 7% over several years, so the amount of debt grew materially. For companies operating internationally, this is a clear message: even if a settlement is ultimately reached, the financing costs of a prolonged dispute can make the event far more expensive than it appears at the outset.
What Happens When There Is No Documentation or the Model Does Not Meet the Requirements
The SentinelOne case illustrates that when transfer pricing is not handled properly, the exposure is not reflected only in a “tax shortfall.” In certain situations, and depending on the circumstances, there may also be: significant penalties, demands to amend prior tax returns, disputes that take time and create managerial, legal, and financial costs, and damage to business certainty. This is especially true if the company is planning a fundraising round, an initial public offering (IPO), an acquisition, or a sale.
It is important to understand that the Tax Authority examines not only the final number, but also the process. Was an economic analysis prepared in accordance with the legal requirements? Was there a genuine functional analysis? Is there justification for the selected method? And do the documents “tell a story” that is consistent with the business reality?
Companies with international operations should comply with the rules on intra-group transactions to help avoid retroactive tax assessments and high interest charges
How to Do It Right: Transfer Pricing Based on Substance
To reduce disputes, the key is a well-structured Transfer Pricing Analysis based on a real economic analysis. The goal is not to set an arbitrary number, but rather to:
- map the activity: who does what in each country, who bears risks, who holds assets (including intellectual property), and where decisions are made;
- choose the appropriate method: sometimes cost-plus is correct, and sometimes it is not. Sometimes profit split or other models may be appropriate;
- build supporting documentation: enabling the company to explain to the Tax Authority why this is the reasonable price under the Arm’s Length principle;
- think ahead: especially where there is a change in the group’s structure, a transfer of intellectual property, the opening of centers in additional countries, or a material change in the functions carried out in Israel.
When this work is done properly, it creates greater certainty regarding the tax to be paid in Israel, allows risks to be managed, and reduces the likelihood of unpleasant surprises after the fact.
Nimrod Yaron & Co. specializes in Israeli and international taxation. Our team includes professionals with years of experience at the Israel Tax Authority, as well as experience at leading firms and law offices, and brings together legal and economic perspectives. We advise private and public companies, Israeli and foreign companies, global venture capital funds, and clients seeking focused advice in clear and accessible language. We also work with a professional network of accounting and law firms around the world to provide full support in cross-border matters.
We advise entities with international operations on all aspects of transfer pricing and tax arrangements מול the Israel Tax Authority [not sure]. This includes understanding the business model and analyzing functions, determining intercompany pricing policy and supporting documentation, and representing and assisting in tax assessment proceedings and settlement discussions with the Tax Authority, where needed.
The advantage of this approach is not just to “tick the box.” It is a process designed to present the true substance of the activity and to reduce as much as possible any retrospective argument that the price was not appropriate. In this way, the company can be protected against tax exposure, penalties, and also interest costs that may accumulate to material amounts.
In a multinational group, transactions between related companies are part of day-to-day business, but their taxation is not merely a technical accounting matter. It is a substantive question: where is value created, and where should the profit be taxed? Those who address this in advance, with an appropriate method and proper economic documentation, can turn the issue from a point of risk into a point of stability, and operate in the business world with greater confidence.
FAQ
What is the Arm's Length principle?
The Arm’s Length principle provides that the price in an international transaction between related parties should be determined in accordance with market terms.
Is the cost-plus method suitable for all types of transactions?
No. The method is mainly suitable for manufacturing, assembly, or simple service activities. In addition, it requires a very high degree of similarity between the tested transaction and the comparable transactions. In most cases, achieving such similarity is very difficult.
What is the significance of setting an incorrect price?
An incorrect price may lead the Tax Authority to assert an additional tax liability, which may in turn result in tax differentials, linkage differences, and particularly high interest.
