Your Taxes: You won't soon forget 'Form 1385'

The new Form 1385 apparently must be filled out for each international transaction between related parties and attached to the annual income tax return.

By LEON HARRIS
October 24, 2007 08:27

 
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Things are starting to move. On November 29, 2006, new transfer pricing regulations were published. We called this a "tax earthquake" in a write-up in this column at the time. Last week, on October 17, the Israeli Tax Authority issued a short but significant transfer pricing form number 1385 entitled "Declaration of International Transactions." It may well have you burning the midnight oil each year. So what is the fuss all about? Transfer pricing is the term used to describe trade and transactions "within the family," i.e. within a group of related companies. If the price is not on market terms, more profit may end up with one company and less with another. This may well affect the tax liability of each. So most countries including Israel now have "transfer pricing" regulations. Section 85A of the Israeli Income Tax Ordinance requires "international transactions" to be reported for Israeli tax purposes on arm's length (market-based) terms. This covers asset, service or credit transactions between related parties if one party is a foreign resident or if the resulting income is also taxable abroad. This applies even to the smallest start-up operations with an international element. For example, Techo Ltd. of Tel-Aviv conducts research and development for its Californian parent Techo Inc. Total costs in Tel-Aviv amount to $1 million - is $1m. a fair price to charge Techo Inc., with no profit? Probably not - that's what sunk communism. Related parties covered by this requirement include those that control 50% of the other party or those that are 50% or more commonly controlled. The means of control is determined by reference to any of the following rights and powers: * profits * appointment of a director or CEO or similar * voting rights * liquidation surplus * rights to direct how the above rights and powers will be applied In practice, some international business is conducted via unrelated dealers but much is also conducted via dedicated production and distribution subsidiary companies supported by group research, administration and finance companies. Does it matter? According to data from the Central Bureau of Statistics, annual Israeli imports plus exports are currently running at around $90 billion. Let's assume, rightly or wrongly, that: (1) 50% of this business is via subsidiaries of multinational Israeli or foreign corporations (2) assumed 10% transfer pricing inaccuracy in the taxpayer's favor on average and (3) the average tax rate after tax losses and tax incentives is say 22% (the regular Israeli rate of company tax is currently 29%). That could perhaps imply a tax shortfall for the Israeli treasury of around a billion dollars a year (NIS 4b.) given those assumptions. The new Form 1385 apparently must be filled out for each and every international transaction between related parties and attached to the annual income tax return. It requires the following details: * Tax year * Transaction number * Description (type of asset or service and field of activity) * Details of the related party involved in the transaction * Place of residency of the related party * Total price of the transaction * Signed declaration: "I hereby declare that the price of the transaction with related parties abroad is valued on market terms as defined in Section 85A of the Income Tax Ordinance and supporting regulations." * Name and identity number of the person signing, and the date This signed declaration is a heavy responsibility requiring a detailed knowledge of the Israeli transfer pricing legislation and regulations. Moreover, the market price for many transactions is not known in practice - the product may be unique or part of a chain of transactions with one known price at the end. In practice, a range of market prices can usually be calculated according to various different methods - see below. Informal discussions with Tax Authority officials indicate that a tax circular with explanatory guidance for the Form 1385 is on the way. Such a form apparently may be required for each contract, not each invoice. Also, it seems that taxpayers will be expected to comply with the transfer pricing regulations commencing January 1, 2007, even though the regulations formally became effective upon publication on November 29, 2006. The form does not say who has to sign the form but the regulations require a "report" (not declaration) in this regard to be made by the "taxpayer." Since Form 1385 must be attached to the annual income tax return, an office holder of each taxpayer company must sign the form. The new regulations require 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 minus" (gross profit) method OR the profit split method - splitting profit between companies based on what each contributes 3) Rate of operating profit or loss or rate of return on assets, liabilities or capital 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. 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, UK or Canada. What should you do if your Israeli firm conducts any international transactions with related parties? First, finalize all intercompany contracts and get an up to date transfer pricing study. Second, monitor developments in this area including the issuance of a tax circular. Third, if you want greater certainty, consider requesting an advance pricing agreement (APA) from the Israeli Tax Authority. There are two main types: a unilateral APA is relevant for Israeli tax purposes only and a bilateral APA will involve Israel and another country which has a tax treaty with Israel, such as the US. Since Israel is not a member of the EU or any other similar economic grouping, multilateral APAs are not yet available. To sum up, Israeli and foreign firms should check their readiness for the new Israeli transfer pricing regulations. Professional advisers in each country certainly should be consulted. leon.harris@il.ey.com Leon Harris is an International Tax Partner at Ernst & Young Israel.

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