Your Taxes: Living like royalty

A key question in the Israeli business world is when can you deduct a royalty expense for tax purposes?

September 10, 2008 10:03
2 minute read.
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taxes good 88. (photo credit: )

This article has nothing to do with Queen Elizabeth nor any other reigning monarch. It concerns royalties in the realm of intellectual property rather than palatial mansions. A key question in the Israeli business world is when can you deduct a royalty expense for tax purposes? This was the issue in the Jerusalem District Court case Ideal Tours (1982) Israel Ltd v. Jerusalem 1 Assessing Officer (Tax Appeal 9054/05). In this case, the taxpayer was an Israeli resident company owned by a United States company. The latter company was around since the 1950's and conducted a travel agency business in the United States; the Israeli subsidiary was incorporated in 1982 and since then ran a travel agency business in Israel. When the Israeli subsidiary was first founded, an agreement was signed between the two companies granting exclusive permission to the Israeli subsidiary to form a sub-agency in Israel. The US company also granted the Israeli subsidiary consent to use its name - Ideal Tours - and the goodwill associated with it, and also use of various services. Over the years, the US company amassed considerable professional knowhow in the tourism sector as well as commercial ties with many airlines around the world. It applied effective management and marketing techniques and generated a positive image of itself within the American public, especially the religious Jewish community. The US company let the Israeli subsidiary enjoy these achievements. The Tax Authority claimed the Israeli subsidiary did not provide solid evidence of the need to pay royalties and did not prove the reasonableness of the amount of the expense. The Court ruled that the reasonableness of royalty payments is more than a bookkeeping matter. There is no doubt that giving a right to use the US company's goodwill justifies a reasonable payment, commonly referred to as a royalty. The payments paid to the US company could be considered royalties, regardless of whether they are for the use of a name or for other services. As for the reasonableness of the royalties and their deductibility for tax purposes, the Court and the Assessing Officer must act with reserve, due to the difficulty in estimating the amount of royalties and the lack of comparative evidence regarding the level of royalties charged in similar circumstances. In the present circumstances, the Court ruled that the taxpayer managed to prove that the royalties were expenses incurred wholly and exclusively in the production of taxable income and were a deductible expense for Israeli tax purposes. It remains to be seen whether the case will be appealed to the Israeli Supreme Court. Note that current Israeli tax legislation requires tax to be withheld from royalty payments at rates ranging up to 25% in practice. Under the US-Israel tax treaty, this rate is reduced to 10% (film and copyright royalties; 15% for other royalties), provided advance clearance is obtained from the Tax Authority. The amount of international transactions with a related party must be confirmed periodically by a transfer pricing study that meets certain criteria. As always, consult experienced tax advisors in each country at an early stage in specific cases. [email protected] Leon Harris is an International Tax Partner at Ernst & Young Israel.

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