In 2012, the government spent NIS 39 billion more than it took in, mostly because the slowing economy meant fewer tax revenues. This was double the expected deficit. Now the general election is over, and the new government must produce a budget for 2013 that benefits the people but balances the books. This is a tall order; can it be done? It will be tempting to mortgage the expected future gas-tax revenues.

Another way of raising state revenues

A more prudent approach might be to take a look at Britain, which has its own deficit and has pinpointed one of the root causes.

According to the British Parliament’s website, MP Margaret Hodge, chair of the Committee of Public Accounts, said on December 3: “Corporation tax revenues have fallen at a time when securing proper income from taxes is more vital than ever... The inescapable conclusion is that multinationals are using structures and exploiting current tax legislation to move offshore profits that are clearly generated from economic activity in the UK... We consider that paying an appropriate amount of tax in the country in which profits are made is not only a matter of basic economics. It is also a matter of morality... there is a moral case on top of the basic economic case that taxation of economic activity should transparently reflect where that activity occurs.”

And British Prime Minister David Cameron reportedly told the G-8 earlier this month: “We all have a common interest in being able to tell our taxpayers, who work hard and pay their fair share of taxes, that we will make sure others do the same.”

The importance of transfer pricing

The above brings us to a subject known as “transfer pricing.”

Most international trade is done via related corporations.

For example, if an US corporation wants to sell widgets to Israelis, it will do well to set up an Israeli subsidiary corporation that employs Israelis to sell the widgets to other Israelis. They will share the same language and culture and be on the same time line.

But first the US producer must sell the widgets to the Israeli subsidiary at a “transfer price” that is a market-based “arm’s-length” price. This is a theoretical requirement in most countries’ tax laws that applies to most global trade.

But it is easier said than done as many factors affect market pricing, such as quality, credit terms, functions needed in each country, whether a premium is due for know-how or use of a brand name, inventory risks, currency risks, etc.

How are transfer prices arrived at?

In practice, a multinational corporation will from time to time conduct a “transfer-pricing study” to determine what is a fair transfer-pricing policy. This involves seeing what other corporations charge and/or how much profit they make from comparable transactions. If the multinational corporation applies Israeli transfer-pricing rules, it is allowed to use any transfer price falling within a range of prices from comparable transactions, but it must merely ignore the top 25 percent and the bottom 25% of those comparable transactions. (This is known as the “interquartile range.”) So transfer pricing is more of an art, not a statistical science, and there is a lot of wiggle room. Most multinationals will set their transfer prices in a way that: (a) optimizes their tax planning, and (b) avoids trouble with tax authorities that are awake and alert to these possibilities (for example, the United States).

So Britain has just woken up to transfer pricing, but Israel has not. The transfer-pricing unit at the Israel Tax Authority has a handful of personnel who can only do what they can do. Few know they even exist.

How much tax is at stake?

There is little information on how much is at stake, but it is possible to make a rough estimate. Israeli exports totaled $90 billion (not shekels), and imports totaled $93b. in the year to September 2012, according to the latest data from the Central Bureau of Statistics. So Israel’s trade with the rest of the world amounts to about $183b. a year.

Suppose, hypothetically, the transfer prices could have been on average 25% more in Israel’s favor applying Israeli transfer-pricing tax rules (anecdotal evidence suggests this might be possible). That would imply additional Israeli-source corporate profits of $45b., liable to 25% company tax in many cases, resulting in $11.4b., or NIS 42b., more tax for Israel. Hey Presto! This is only an estimate subject to assumptions. Nevertheless, even some of that would go a good way toward painlessly plugging Israel’s budget deficit, until the gastax revenues arrive and beyond.

International businesses

If your business has an international dimension, make sure you have a transfer-pricing study in case you are asked about your pricing policy.

As always, consult experienced tax advisers in each country at an early stage in specific cases.

leon@hcat.co

Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.

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