The hi-tech sector is the main engine of growth in Israel and seems likely to lift the local economy out of the rut into which it has sunk due to the global economic crisis. The Israeli hi-tech sector has two main features. What drives Israeli hi-tech?First, most of the companies operating in Israel have international links: overseas parent company, overseas subsidiaries, etc. Often this is for marketing reasons, but sometimes it is to facilitate R&D or production.Second, the success of the hi-tech sector is mainly due to the recruitment and development of skilled people who help their employers forge ahead and achieve tough goals. Compensation packages in hi-tech include relatively high base salaries combined with stock options in the employing company or a related company in the group. Stock options act as an incentive to employees to progress personally and to share in the success of the company or group.Are stock options a free lunch?The benefit to the employee has a hidden cost since the employee may, subject to the conditions of the stock plan, exercise an option at a fixed price (usually below market value) to buy shares in the company. So the company receives less than it would if the shares were issued to someone else. But the hidden cost may be difficult to quantify until the option is exercised, if it is exercised at all.More complex scenarioIn a number of cases, there is a complex combination of events. The employee in Israel receives options of a publicly traded US parent corporation rather than its Israeli subsidiary, AND the Israeli and US corporations participate together in a hi-tech joint venture known as a "cost-sharing arrangement." In such a case, the two corporations (and/or others in the group) pool their resources - intellectual property, labor, etc. - and share out revenues pro rata to the resources each corporation contributed.What is transfer pricing all about?But both the Israel and the US have "transfer pricing" regulations, which require taxpayers to check that all transactions with related parties are on "arm's-length" market-based terms. This includes cost-sharing arrangements between related companies. The US has detailed rules regarding cost-sharing arrangements, and the Israel Tax Authority has upheld the concept of a cost-sharing arrangement in a published Israeli tax ruling.If a taxpayer does not have on hand appropriate documentation showing that related party dealings are on arm's-length terms, the relevant tax authority (IRS
, Israel Tax Authority) can retroactively adjust the price of such dealings for tax purposes, usually resulting in a much higher tax liability, penalties and possible double taxation in the two countries on the same income. Do stock-option costs have to be shared?The question of whether stock-option hidden costs must be shared out in a cost-sharing arrangement was resolved in the US last May in a decision from the Ninth Circuit of the United States Court of Appeals in the case of Xilinx, Inc. vs. the Commissioner. To underline its importance, IRS Commissioner Douglas Shulman reportedly called the verdict a "real victory" because it overturned a decision of the US Tax Court in 2005.The Tax Court had accepted the taxpayer's claim that a grant of option does not need to be included in a cost-sharing arrangement since, in similar circumstances, unrelated companies would not share out stock-option grant costs.But the IRS's position was accepted upon appeal, as mentioned above. The Court of Appeal ruled that while employee stock-option costs might not be shared in an arm's-length deal, the cost-sharing regulations in the US specifically require the inclusion of such costs, and the specific provisions of cost-sharing regulations trump the more general arm's-length requirement.Furthermore, at the beginning of 2004, the US transfer-pricing regulations were tightened up to make clear that employee stock-option costs must be shared out in a cost-sharing arrangement, and the US Court of Appeals applied this rule from 1995 onward.Nevertheless, in a cost-sharing arrangement between unrelated parties, there is no requirement to share out stock-option costs.ImplicationsThe ruling of the US Court of Appeals and the amendment to the US transfer-pricing regulations in 2004 have broad implications for Israeli hi-tech firms and other firms that issue employee stock options and enter into cost-sharing arrangements with US corporations. Failure to comply may result in penalties in the US and perhaps in Israel. Specialist advice should be obtained.As always, consult experienced tax advisers in each country at an early stage in specific email@example.com@gmail.comYariv ben-Dov is a transfer-pricing specialist. Leon Harris is an international tax specialist.