What expenses should be included in the cost base for Transfer Pricing Purposes

Insights from the Kontera Technologies Ltd. Ruling

Transfer Pricing and proper intercompany Pricing are a complex challenge for international companies. One of the key questions that concern them is how the cost base should be determined. Which costs should be included, and which should not? The answer to this question has a significant impact on intercompany payments and on the companies’ profits. The Kontera ruling provides an answer, at least partially, to this question.

Kontera Technologies Ltd. Ruling

The Kontera ruling is the first Israeli ruling about transfer pricing and one of the most significant in the field. The ruling is essentially a consolidation of two appeals. “Kontera Technologies Ltd.” V. Assessing Officer Tel-Aviv 3 and “Finisar Israel Ltd.” V. Assessing Officer Tel-Aviv Rehovot. The issues discussed in both appeals were very similar; therefore, the Supreme Court decided to consolidate them into one ruling.

We will focus primarily on matters relating to Kontera.

Kontera is a company whose main activity is providing R&D services to its American parent company. The payment for these services was outlined in an intercompany agreement signed in 2005. According to which, the payment would be based on Konterra’s costs for providing the services, minus social benefits expenses, and plus a markup of 7%.

In other words, pricing is calculated under the cost-plus method, which divides the payment into two components: the relevant costs (“cost”) and a fixed profit markup (“plus”). The Transfer Pricing study prepared by the company established an interquartile range of 4.5% to 15.3%. Meaning, the study supported the company’s pricing.

In 2009 and 2010, the parent company granted stock options to Kontera’s employees. Following this, an amendment was made to the intercompany agreement, which stipulated that these expenses should not be included in the cost base. Kontera chose to report the options under the Capital gains track with a trustee pursuant to Section 102 of the Israel Income Tax Ordinance (the ITO). Thus, it was able to record the costs as an accounting expense, but not as a tax-deductible expense, which prevented it from deducting the costs as salary expenses.

The Assessing Officer relied on Section 85A of the ITO, which allows him to intervene when the pricing between two related companies is not done in accordance with market prices and to modify it. His main arguments were:

• The cost base was calculated incorrectly – in his view, there is no justification for omitting the social benefits expenses and stock option allocation costs from the cost base. Neutralizing these expenses significantly reduces the profit margin. Rather than remaining at 7%, the rate declined to 1.73% in 2009 and further to 0.97% in 2010, indicating a deviation from the accepted interquartile range.
• The profit margin selected is inappropriate – in his view, the company should have used the median rate, 9.1%, and not 7%.

The Assessing Officer increased the profit that Kontera should have received in two ways. On the one hand, by increasing the amount to which the markup is applied, and on the other, by increasing the profit margin itself.

Kontera did not agree with these arguments and filed an appeal with the District Court. The District Court dismissed Kontera’s appeal. Therefore, Kontera appealed to the Supreme Court.

The Supreme Court Ruling

The Supreme Court divided its discussion into two levels, examining the economic substance of the expense and how unrelated parties would’ve acted in such a situation.

From an economic substance perspective, stock option allocation costs are an expense incurred in the production of income for Kontera. The options are part of the employees’ compensation package intended to incentivize them. Thus, all components of the compensation package, whether cash, options, or other equity instruments, are expenses incurred in the production of income. Therefore, there is no substantive justification for not including them in the cost base.

However, this does not necessarily mean that the Assessing Officer can intervene in the intercompany agreement between the parties. This is only possible if the company fails to prove that its pricing was done in accordance with market conditions. In our case, Kontera failed to shift the burden of proof to the Assessing Officer, and therefore he is entitled to intervene in the pricing. The transfer pricing studies submitted by the company show that the comparable companies took into account the value of the options. In other words, the company did not act in accordance with market conditions.

Additionally, regarding the profit margin, the Supreme Court refers to Regulation 2(C) of the Regulations for Determining Market Conditions. This regulation stipulates that if a transaction falls outside the range, its price shall be reported according to the median value. Since Kontera was not within the range, the transaction shall be reported and taxed according to the median value, 9.1%, meaning the Assessing Officer’s argument is accepted.

The Supreme Court did not allow the deduction of stock option allocation costs against its taxable income. This is because such a deduction is inconsistent with Section 102 of the ITO. Kontera’s argument that the section refers to a deduction upon exercise of shares and not upon allocation of options was not accepted. This is because in this case, the specific provision (namely Section 102) prevails over the general provisions of Section 17 of the ITO.

Allowing the deduction would grant Kontera a double benefit, on the one hand, a lower tax rate for the employees, and on the other, the deduction of the expenses. This is because reporting under the capital gains track, in which employees are taxed at a rate of 25%, does not allow for the deduction. Had the company chosen the employment income track, under which employees are taxed at their marginal tax rate, it would have been able to deduct the costs.

Summary of Arguments

The Cost-Plus Method in Transfer Pricing

Using pricing based on the costs associated with providing services is a common practice across many industries and in numerous intercompany agreements. This pricing method determines that the payment for the services will be calculated as follows: the service provision costs plus a profit markup. For example, if a company’s expenses amount to 100 and the agreed profit margin is 5%, the payment it will receive would be 5+100=105.

When the parties are unrelated, the profit margin is determined according to industry standards and the outcome of negotiations between the parties. However, when the parties are related, the margin must be determined based on a transfer pricing study that examines how unrelated parties would have acted in the same transaction.

In examining intercompany pricing for transfer pricing purposes, several methods may be applied, one of which is the cost-plus method. Despite its name, this method is not typically used in cases such as the one described above, as it compares net profit margins. A metric that is very difficult to compare across companies. Instead, the TNMM (Transactional Net Margin Method) is generally applied, which compares profit margins between companies.

For further reading on the cost-plus method, click here.

Insights from the Kontera Technologies Ltd. Ruling

This ruling was delivered in 2018 and was considered highly significant, leading to the publication of Circular 1/2020. Although several years have passed since its issuance, it continues to influence corporate transfer pricing policies, the positions of the Israeli Tax Authority, and broader tax practices.

At a time when Transfer Pricing assessments and litigation are on the rise in Israel and worldwide, it is increasingly important to be familiar with court rulings in this field. Doing so provides a clearer understanding of the approach taken by the courts and the tax authorities.

The main conclusion from the Kontera ruling is that stock option allocation costs should be included in the cost base for determining intercompany payments for transfer pricing purposes.

When deciding which costs should be included, the key question is whether the costs constitute an expense directly related to the provision of the services. In other words, the analysis should focus on the economic substance of the services and the expenses, examining whether these costs are connected to the provision of the services or not.

In addition, the mere existence of a transfer pricing study is not sufficient to shift the burden of proof to the Assessing Officer. If the study does not support the company’s actual activity, the burden of proof remains with the company. Therefore, it is essential to carefully examine both the study and its implementation to ensure consistency between them.

Nimrod Yaron & Co., Israeli and International Taxation – specializes in transfer pricing and provides clients with comprehensive assistance on the matter – from the planning stage of the intercompany arrangement to supporting accountants in its practical implementation.
To contact a representative from our firm, click here.

FAQ