A key player in world trade is the multinational group. Local populations often prefer to do business with the local subsidiary company of a group, which then buys whatever is needed from other companies in the group. According to Israeli legislation introduced in 2003, the "transfer pricing" of international transactions between related parties must be on "arm's length" market-based terms for Israeli tax purposes (Section 85A of the Income Tax Ordinance). On November 29, 2006, detailed transfer pricing regulations were issued. The Israel Tax Authority (ITA) has just published its Circular on Transfer Pricing (Circular 3/2008 of July 14, 2008). The circular points out that the United States and the Organization for Economic Cooperation and Development have embraced similar rules. Following are a few highlights from the transfer pricing circular and regulations: Transfer pricing study In order to show whether an international transaction is on arm's length terms, a "transfer pricing study" must be prepared comparing a taxpayer's international transactions to other comparable transactions. The only exception is in the case of one-time transactions approved by the ITA; the circular indicates they should represent no more than 10 percent of the taxpayer's revenue from the field concerned (business, finance, etc.) and no more than NIS 4 million. What is an international transaction? This is a transaction between "parties with special relations" (related parties); and one of the parties is a foreign resident or the income is also taxed abroad. Special relations - extended meaning Special relations "include" relations between relatives; and 50% or more control by one party over another, or by another over both parties, directly or indirectly, alone or together with another. The circular interprets this to include parties "controlled directly or indirectly by the same interest" (i.e. mutual interests) as found in Section 482 of the US Internal Revenue Code. Where an assessing officer claims that mutual interests exist, he must prove it, according to the circular. A deemed dividend may trigger a substantial company tax liability for "approved enterprises" and "privileged enterprises" on a tax holiday for undistributed profits. This may impact many Israeli industrial, technological and hotel operations. Secondary adjustment According to the circular, if a transaction is wrongly labeled, it may be re-characterized for Israeli tax purposes. Furthermore, if the transaction was not reported on market terms, the difference (if no money was paid regarding the difference) is treated as an additional transaction, such as the grant of a loan and/or the distribution of a dividend, depending on the circumstances. Available methods When checking transfer pricing, the regulations and circular prescribe methods in the following order of priority: 1. Comparable uncontrolled prices (CUP); 2. Comparable profits: (a) profit split, or (b) cost plus or resale price, or - failing these - rate of operating profit on sales, or return on capital or assets or liabilities, or other most appropriate profit indicator. 3. Other most appropriate method. Statistical techniques are used. Under the CUP technique, if no adjustments are necessary, the taxpayer's transfer pricing may fall anywhere within the range of values from comparable transactions. In all other cases, the taxpayer's transfer pricing must fall within the inter-quartile range - in the middle 50% of values from comparable transactions, after excluding the top 25% and bottom 25%. If the taxpayer's transfer pricing does not fall within these ranges, the ITA will adjust the pricing to the middle value. Loan notes Israeli groups make extensive use of interest-free loan notes ("capital notes" or "subordinated loans"). This was allowed under the Income Tax Law (Inflationary Adjustments) until its repeal at the end of 2007. But are cross-border interest-free loan notes allowed the transfer pricing regulations? The circular reiterates earlier ITA announcements that they will be allowed in certain circumstances according to an amendment to be legislated. In the meantime, the transfer pricing rules will not be applied to capital notes allowed under the Inflationary Adjustments Law before its repeal. Nevertheless, for cross-border loans, the transfer pricing rules will override other rules requiring an annual interest rate equivalent to the rise in the Israeli consumer price index plus 4%. The circular states that loan finance losses cannot be offset against other income; tax practitioners disagree. Advance pricing agreement (APA) For added certainty, taxpayers may request an advance ruling from the ITA regarding their transfer pricing. The ITA has 120 days to respond once all required documents have been submitted, but this can be extended up to 180 days. If the ITA still does not respond, the taxpayer's request is deemed to be accepted. Reporting Taxpayers must sign and attach Form 1385 to their annual tax returns confirming that each international transaction with related parties are on arm's length terms. In practice, this reinforces the need for a transfer pricing study. The study must also be produced within 60 days after any demand by the ITA. As always, consult experienced tax advisors in each country at an early stage in specific cases. [email protected] Leon Harris is an international tax partner at Ernst & Young Israel.