An Israeli court has just ruled in the Kontera case that an Israeli R&D company that bills a foreign-related company on a cost-plus basis must include the value of stock options in its operating costs.Kontera was a digital-content intelligence and marketing technology group. In 2014 the US corporation was itself reportedly acquired by Amobee, part of the SingTel telecom group of Singapore.The judge in this case was the much-respected Magen Altuviah, but the result seems controversial and may be appealed.[email protected] Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.Here is a summary of the case: The main facts An Israeli company provided research and development (R&D) services to its US parent corporation. For its efforts the Israeli company received fees based on a transfer-pricing study at the rate of cost plus 7 percent. That means a fee of 107% of the Israeli company’s operating costs.This was based on a transfer-pricing study that found in comparable cases a “plus” on cost ranging from 4.5% to 15.3% in the interquartile range (i.e., disregarding data in the top and bottom quarters).The employees of the Israeli company participated in a stock-option plan according to the capital-gain track in Section 102 of the Income Tax Ordinance (ITO). The options were issued by the US parent corporation to the Israeli employees. If various conditions are met, Section 102 enables the employees to pay a maximum of 25% Israeli tax on their gain when they sell their options or ensuing stock, provided an approved trustee holds the options or stock until then, after a vesting period of at least two years. In such a case, Section 102 denies the Israeli company an expense deduction for that gain.The issue The Israel Tax Authority (ITA) accepted that the cost-plus-7% basis of compensating the Israeli company met the “arm’slength” test in Israel’s transfer-pricing rules for transactions between related parties (in Section 85A of the Income Tax Ordinance and related regulations).But the ITA argued that operating costs should include the value of stock options in its operating costs. The Israeli company countered this by producing another external study that reviewed 355 transactions between other unrelated parties and found that none of them included stock-option gains in their operating costs.The judgmentThe judgment upheld the cost-plus-7% basis and agreed with the ITA position that stock-option gains should be included in operating costs for this purpose to meet the arm’s-length test.Here are the main reasons cited in the judgment: • First, the stock-option gains represent costs for the Israeli company, even if they are nondeductible under the special rules of ITO Section 102. They represent costs incurred wholly and exclusively in the production of taxable income, so they would meet the general-expense deductibility rule in ITO Section 17. This is despite the fact the employees are deemed to enjoy capital gains.• Second, although the US corporation issues the options and the stock, the Israeli employees enjoy a benefit in lieu of salary that motivates them by making them owners “this way or that way.” All this was pursuant to an intercompany service agreement.• Third, if the shareholders of the US corporation ended up “paying” for it all merely by being diluted, the court said it seems reasonable to assume they agreed to this, and their shares appreciated thanks to the benefit derived by the corporation from issuing the options to the employees.• Fourth, the external study of 355 transactions related to transactions that were not cost plus transactions and, therefore, not relevant in determining what is arm’s length.• Fifth, there was an intercompany service agreement, but it was amended AFTER the relevant tax years to strip out stock-option gains from operating costs on the grounds that such accounting expenses would not have been shared by unrelated parties. The court found no reason for this.• Sixth, the court rejected the precedent in the US case of Xilinx, Inc. v. Commissioner of Internal Revenue. This was because the Xilinx case related to a cost-sharing arrangement rather than a cost-plus arrangement. Also, the judgment quotes the taxpayer as saying the OECD has not yet pronounced on stock-option plans.• Seventh, the financial statements of the Israeli company did how the stock-option costs in accordance with international accounting standard IAS 24, but they added them back for Israeli tax purposes.• Eighth, the Israeli company used the Black-Scholes method of valuing the options. The taxpayer claimed it had received an opinion from a professor that IAS was not appropriate because it did not take into account that options on the capital-gains track (of Section 102 presumably) have a limited vesting period and are therefore worth less than other options. But the court found this was accepted practice and the taxpayer “could only blame itself” for using the Black-Scholes method and not some other method.Comments The ITA has gone out on a limb on a thorny issue and is known to be forcing other Israeli R&D companies to include stock-option gains in their operating costs. This is unfortunate because the issue is still evolving around the world.The issue is whether it is accepted arms-length (market- based) practice to bill out stock-option gains (also known as stock-benefit costs). The arm’s-length standard is paramount in transfer-pricing rules in Israel, the US and the OECD.The Kontera judgment makes reference to the Xilinx case in the US, which the taxpayer won in 2005. The IRS countered by enforcing new 2003 regulations that require “all costs” relating to the development of intangible property to be shared in a cost-sharing arrangement between related parties.But in a remarkable twist, the US Tax Court ruled in 2015 in the Altera case that the US 2003 regulations issued by the IRS were arbitrary and capricious and therefore invalid. This was because the IRS ignored that unrelated parties generally do not include stock-benefit costs in their cost pool, so the regulations did not meet the arm’slength standard.Turning back to the Kontera case in Israel, a study based on 355 cases reached a similar conclusion, that it is not arm’s length to include stock-option gains in operating costs.It is not clear why the Israeli judge thought that a costplus arrangement (Kontera) should be treated differently to a cost-sharing arrangement (Xilinx/Altera). Costs ought to be allocated from one related party to another on an arm’s-length basis in all cases.Therefore, an appeal to the Israeli Supreme Court seems almost inevitable in the Kontera case. It remains to be seen what will happen.All this creates tremendous uncertainty for many Israeli R&D companies. In their 2015 tax returns, they should consider applying the Kontera judgment while reserving the right to change their position should the case be overturned.As always, consult experienced tax advisers in each country at an early stage in specific cases.