Transfer pricing is often associated with large multinational groups, public companies, and corporations with complex operations across dozens of countries.
In practice, transfer pricing issues can also arise in small and medium-sized businesses, private companies, and even relatively simple business structures
An Israeli company that established a subsidiary in the United States, a shareholder who holds companies in two countries, an Israeli company that provides development services to a related company abroad, or a company that financed the activity of a sister company through a loan – all of these may find themselves required to examine the terms of the transaction under transfer pricing rules.
The important question, therefore, is not necessarily how large the company is, but whether there is a transaction between related parties and what terms apply to that transaction.
What Makes a Transaction a Transfer Pricing Transaction
Transfer pricing deals with the pricing of transactions between parties that have special relationships. In Israel, the main framework in this area is set out in Section 85A of the Income Tax Ordinance. The Israel Tax Authority explains that when parties are not related to each other, their opposing interests are generally expected to lead to a price and terms that reflect market conditions. By contrast, when related parties are involved, it is necessary to examine whether the transaction terms in fact reflect market terms.
The principle underlying this field is known as the arm’s length principle. In simple terms, this principle asks: what terms would have been agreed if the transaction had been carried out between two independent parties?
This principle also underlies the OECD Transfer Pricing Guidelines and constitutes the accepted international standard for examining cross-border transactions between related companies.
For example, if an Israeli company provides development services to a related company in the United States, it is not enough for the two companies to agree between themselves that the Israeli company will receive cost reimbursement plus a 5% profit. It is necessary to examine whether the pricing mechanism and the profit margin reflect the nature of the activity and the terms that would have been agreed in a similar transaction between independent parties.
Who Usually Needs a Transfer Pricing Review
There is no particular list of companies for which transfer pricing is "relevant" and companies for which it is not. The starting point is the business structure and the transactions carried out between the parties
An Israeli company with a subsidiary, parent company, or sister company abroad
This is the classic case. Once money, services, products, rights, or financing pass between the Israeli company and a related company in another country, the terms of the transaction should be examined.
For example, an Israeli software company establishes a U.S. company that will be responsible for sales in the United States. The Israeli company develops the product, and the U.S. company markets it to customers. The question of how the profit should be allocated between the two companies is, at its core, a transfer pricing question.
An Israeli company that is part of an international group
An Israeli company held by a foreign group may also be required to address transfer pricing. This may be the case, for example, when the Israeli company serves as a development center, provides marketing services, makes sales, or provides other services to group companies. In such a case, it is necessary to examine the appropriate compensation for the activity performed in Israel.
Shareholders holding companies in several countries
A business does not have to be a “multinational corporation” in the commonly understood sense. An Israeli entrepreneur may hold a company in Israel and another company in the United Kingdom, the United States, Cyprus, or another country. If transactions take place between the companies – such as services, loans, or the use of intellectual property – a transfer pricing issue may arise even where the group is relatively small.
Companies that carry out one-off transactions with related parties
A one-off transaction may also be significant. The sale of an asset to a related company, the transfer of an activity, the granting of a loan, or the transfer of intellectual property rights does not become less relevant simply because it is not carried out every month. In some cases, a one-off and material transaction may in fact justify a particularly detailed review.
Type of transaction between related parties | Common examples | Key questions for transfer pricing review |
Management services and intercompany services | Management, finance, human resources, IT, legal, strategy, and headquarters services | Was the service actually provided and did it benefit the recipient company? How should the costs be allocated? Should a profit margin be added, and at what rate? |
Research and development services | An Israeli company employing a development team and providing services to a related company abroad | What is the relevant cost base? What functions and risks does the Israeli company bear? What is appropriate compensation for the development services? |
Marketing, sales, and distribution services | Local marketing, sales to customers, product distribution, and customer support for a related company | What functions does the local company perform? What risks does it bear? Is it a limited-risk distributor or does it carry out broader commercial activity? |
Loans and financing between related companies | Loans, credit facilities, guarantees, cash management, and internal financing | Does the interest rate reflect market terms? What are the terms of the loan, its term, the collateral, the credit rating, and the borrower’s repayment capacity? |
Intellectual property, royalties, and licenses | Patents, software, brands, technology, know-how, and licenses to use rights | Who developed the intellectual property? Who holds it legally and economically? Who funds the development and bears the risks? What is the appropriate royalty or license fee rate? |
Sale of products between group companies | A manufacturer in one country selling to a related distributor in another country | How should the profit be allocated between the manufacturer and the distributor? What are the functions, assets, and risks of each party? What is the arm’s length intercompany sale price? |
Allocation of expenses between group companies | Software, management, marketing, professional consulting, and headquarters costs paid centrally | Is the expense related to the activity of the company being charged? What is the appropriate allocation key – revenue, number of employees, actual use, or another measure? Is there any duplication of charges? |
Transfer of assets or activities between related companies | Transfer of employees, lines of business, tangible assets, intellectual property, or an entire business activity | Was an asset or business of value transferred? Is a valuation required? What is the appropriate compensation for the transfer, loss of future profit, or transfer of functions and risks? |
Not Every Case Requires the Same Transfer Pricing Work
One common source of confusion is the use of different terms in transfer pricing work: Transfer Pricing Study, Benchmark, Local File, and Master File. Some assume these are all the same document. In practice, they are different types of work and documentation, and not every company needs all of them.
Transfer Pricing Study
A transfer pricing study is an analysis of the transaction and the parties involved. As part of the study, the activity of each party is examined, including the functions it performs, the assets it uses, and the risks it bears. The appropriate transfer pricing method is then selected, and data that may assist in determining arm’s length terms is reviewed.
Benchmark
A benchmark, or benchmarking analysis, is usually a quantitative component intended to examine how similar transactions between independent parties are priced. For example, when an Israeli company provides development services to a related company using the cost-plus method, a benchmark can be performed to examine the profitability margins of independent companies with similar activities.
It is important to understand that a benchmark alone is not a substitute for a full transfer pricing analysis, and a transfer pricing study is required from the perspective of the Israel Tax Authority’s requirements. In addition, without understanding what each party actually does, what risks it bears, and what assets it has at its disposal, even a numerical comparison range may fail to truly reflect the transaction.
Local File
The Local File is a document that focuses on the local entity and its material transactions with related companies. In accordance with the OECD documentation model, it includes, among other things, information about the local company, the intercompany transactions, financial information, a comparability analysis, and the selection of the transfer pricing method.
Master File
The Master File looks at the international group from a broader perspective. It is intended to provide an overall picture of the group’s structure, its business activity, its sources of value creation, its intellectual property, and its transfer pricing policy.
The question, therefore, is not only "do we need a transfer pricing study?" but also what type of work is appropriate for the group's structure, the transaction, and the relevant reporting obligations
When Should the Issue Be Reviewed?
A very common mistake is to wait until the annual tax return is prepared or, worse, until an audit by the Israel Tax Authority. It is highly recommended, and may even be required, to review the issue already when the business structure is created or changed.
For example, when:
- A new company is established in another country;
- Charges between group companies begin;
- An Israeli company begins providing services to a related company abroad;
- A loan is granted between related companies;
- An R&D center is established in Israel;
- A foreign company begins operating through a marketing or sales company in Israel;
- Intellectual property is transferred or made available for use by another company;
- A material change is made in the way activity and profits are allocated within the group;
- An acquisition, sale, or transfer of an asset between related parties is carried out.
An early review not only makes it possible to prepare appropriate documentation but also helps ensure that the way the transaction is implemented in practice is consistent with the selected model.
Transfer Pricing Is Not a “Retrospective Document”
It is important for us to explain that transfer pricing is not merely a document prepared to "explain" a number that has already appeared in the financial statements
Assume that an Israeli company provided services throughout the year to a related company abroad. At the end of the year, it turns out that the companies never defined which expenses should be included in the cost base, what profit margin should be added, who bears certain risks, or even how often invoices should be issued.
It may be possible to try to regulate matters retrospectively, but it is usually more appropriate for the transaction mechanism to be determined in advance and implemented consistently.
As part of proper planning, it is possible to examine, among other things: what the transaction actually is, what role each party performs, how the price should be determined, which costs are included in the calculation, how and when charges are made, whether an intercompany agreement is required, and whether the actual result continues to align with the policy that was set.
The Israeli and International Framework
In Israel, Section 85A of the Income Tax Ordinance and the regulations promulgated thereunder govern the examination of arm’s length terms in international transactions between parties that have special relationships.
At the same time, the OECD Guidelines are a central source for understanding and applying the arm’s length principle worldwide. The guidelines address, among other things, identification of the transaction, analysis of the functions, assets, and risks of the parties, selection of the pricing method, comparability analyses, intangible assets, services, financing, and transfer pricing documentation. The OECD updates these guidelines from time to time, with the most recent update made in 2022.
A good transfer pricing study does not end with searching for a “standard percentage” or copying a model from another group. It should begin with an understanding of the actual economic activity.
So, Do You Need a Transfer Pricing Study?
You can start with a simple question:
Do you carry out an international transaction with a company, shareholder, or another party with whom you have special relationships?
If the answer is yes, it is advisable to examine the transfer pricing implications.
This does not mean that every business necessarily needs the same scope of work. A company that provides a single service to a related company abroad is not necessarily in the same position as an international group that holds many companies, intellectual property, and activity in different countries.
How Can We Assist?
Nimrod Yaron & Co. specializes in Israeli and international taxation. Our team is composed of professionals with years of experience at the Israel Tax Authority, alongside experience at leading firms and law offices, bringing together a legal and economic perspective.
We advise Israeli and foreign companies on intercompany transactions, the development of transfer pricing policies, the preparation of Transfer Pricing studies, Local Files, Master Files, and Benchmarks, and the review of the tax implications of international structures and transactions.
Frequently Asked Questions
Does every transaction between related companies require a transfer pricing study?
Not necessarily. The need for, and scope of, the work depends, among other things, on the nature of the transaction, its scope, the countries involved, the holding structure, and the relevant documentation obligations. However, when an international transaction is carried out between parties with special relationships, it is advisable to examine the transfer pricing implications in advance.
Is a loan between related companies also considered a transfer pricing transaction?
Yes. A loan, credit facility, guarantee, or other financing arrangement between related companies may be considered a transaction that requires an examination of arm’s length terms. The review may include, among other things, the interest rate, the term of the loan, collateral, the currency of the loan, the credit rating, and the borrower’s repayment capacity.
Is an intercompany agreement enough to meet transfer pricing requirements?
An intercompany agreement is an important component, but it is not sufficient in and of itself. The agreement should reflect the actual business activity and the terms of the transaction, and it should be implemented consistently. In appropriate cases, an economic analysis and documentation are also required to support the conclusion that the terms were determined in accordance with the arm’s length principle.
When should an existing transfer pricing study be updated?
As a general rule, a transfer pricing study may be valid for a period of up to three tax years, provided that there has been no material change in the circumstances on which it was based. It is advisable to update or re-examine the study when there is a material change in the activity, functions, assets, risks, group structure, contractual terms, or transaction volumes. A renewed review may also be required when the economic data on which the analysis was based changes materially.
What are the risks of not having transfer pricing documentation?
Lack of appropriate documentation or pricing that does not meet market terms may expose the company to tax adjustments, interest, linkage differentials, and sanctions, as well as disputes with tax authorities in Israel or in other countries. Early planning and documentation may reduce the risks and help present the business and economic basis for the terms of the transaction.
Is a transfer pricing study required only for Israeli tax purposes?
No. In international transactions, it is also necessary to examine the tax and documentation requirements in the country in which the related company operates. Different countries may apply different documentation and reporting requirements. It is therefore important to review the overall picture of the transaction and the group.
