On October 30, 2006, a tax earthquake occurred that may affect many companies in a big way. On that date, the Knesset Finance Committee passed detailed transfer pricing regulations, known formally as Income Tax Regulations (Determination of Market Terms), 5767-2006. The regulations are similar but not identical to the proposals discussed in this column on June 28, 2006.
These regulations take effect for international transactions done between related parties once the regulations are formally published in the Israeli Gazette (Reshumot), so the regulations partly apply to financial statements and Israeli tax returns for 2006.
What is transfer pricing all about? We hardly ever buy products directly from the manufacturer, rather products usually pass down a line of distributors or "middlemen." For example, a US software supplier may sell software to its Israeli distribution subsidiary at a "transfer price" of $100 to sell on to the Israeli public for $120, resulting in a profit of $20 for Israeli tax purposes for the Israeli distribution subsidiary (before expenses).
The Israeli Tax Authority now wants the software group itself to check that the $20 profit and $100 transfer price are the same as unrelated parties would have accepted on the open market - no monkey business. If the transfer price should have been 5% less ($95 instead of $100), the profit for Israeli tax purposes would be 25% more ($25 instead of $20).
This is not so easy. One transfer pricing specialist I know says this is like saying if you had an extra sister and if she liked cheese, how much would she eat?
In addition to pricing, the other terms of these transactions should also be market based, such as period of credit, warranty terms, etc.
The aim is to avoid too low a profit being taxed in Israel on international transactions involving related companies. This is done by applying a market-based yardstick - also known as "the arm's length" standard.
International transactions covered by the regulations are asset, service or credit transactions between related parties if one party is a foreign resident or if resulting income is also taxable abroad.
The tax law requires such international transactions to be reported for Israeli tax purposes on arm's length (market-based) terms. The new regulations reinforce this by requiring a transfer pricing study to be prepared to check the transfer pricing, applying a prescribed method. The prescribed methods, in order of preference are:
1. Comparable uncontrolled price (CUP) method - applying the price in other comparable transactions.
2. "Cost plus" method or the "resale price method" (gross profit) method.
3. Rate of return on assets, liabilities or capital, or the profit split method - splitting profit between companies based on what each contributes.
4. Other appropriate method.
These methods are not defined in the regulations, but they are understood to be similar to those prescribed in the transfer pricing principles of the OECD (Organization for Economic Cooperation and Development). They are also fairly similar to the US transfer pricing rules - but the US requires the best (most reliable) method to be applied without specifying any order of preference.
Taxpayers must be able to supply their transfer pricing study within 60 days after any demand by the Israeli Tax Authority and a prescribed form will need to be attached to the annual tax return.
Time will tell how the new regulations work in practice. At this stage, please note the following:
* The regulations apply to import and export transactions between related firms.
* The regulations apply to large and small firms.
* No specific penalties are prescribed, but there are penalties for incomplete tax returns. Moreover, there is a risk of double taxation if the Israeli Tax Authority changes the transfer pricing in any tax audit.
* In the first two years, it will be sufficient to use a transfer pricing study prepared according to the principles of the OECD or the rules of an OECD member country such as the US.
* No-interest loans and capital notes may no longer be acceptable - clarification is awaited in this regard.
* For greater certainty, consider requesting an advance pricing agreement (APA) from the Israeli Tax Authority.
To sum up, Israeli and foreign firms should check their readiness for the new Israeli transfer pricing regulations, which apply to 2006 and onwards. Professional advisors in each country should be consulted.
The writer is an International Tax Partner at Ernst & Young Israel