Multinational corporations employ a range of business strategies, which may include producing good products, marketing them around the world and tax planning. One controversial tax planning technique involves the parent company selling its goods to its foreign sales subsidiaries at inflated "transfer prices" to leave as much profit as possible in the home country. The effect can be huge in dollar terms - a sizable percentage of world trade. In the 1980s the US tried initiating tax audits and even court proceedings against some well known Asian car and electronic producers without success. Finally, the US issued transfer pricing regulations requiring foreign multinationals to check whether they sell to their US subsidiaries on "arm's length terms" - in other words applying market prices and other market terms. To avoid trouble with the US Internal Revenue Service, many multinationals started tilting their intercompany transfer prices in favor of the US at the expense of the treasuries of other countries such as Canada, the EU countries, Japan, Korea, Brazil et al. Consequently, to redress the balance, most countries have now issued their own transfer pricing regulations. Somewhat late in the day, Israel is joining the party. The Israeli Tax Authority recently circulated draft proposed Israeli Transfer Pricing Regulations. The proposed regulations will become effective if and when they are approved by the Finance Committee of the Knesset. Once passed, these regulations seem likely to impose significant new requirements on foreign and Israeli multinational groups. Failure to prepare comply could be costly - more profits taxed in Israel and no assurance of a corresponding adjustment in the other countries concerned - i.e. double tax exposure unless the other countries concede by taxing less profits. Consistent international recognition of cross-border transfer prices can be achieved in advance, but it is well nigh impossible to achieve retroactively some years later after a tax audit in one country. In other words, prevention is better than cure. Many multinationals are publicly traded on a stock exchange or aspire to this - their directors would not want to be considered negligent on such a potentially material matter. For example, in 2007 an Israeli multinational company reports Israel widget sales to its US subsidiary of $50 million and shows a profit of $10m. The US subsidiary sells those widgets to unrelated US customers for $60m. and reports in the US a profit of $10m. ($60m. minus $50m.). But, in 2009, the Israeli Tax Authority conducts a tax audit and concludes that market price of the widgets in 2007 was more and adds another $20m. to the Israeli company's sales and profits for Israeli tax purposes. ill the IRS acquiesce if the US subsidiary files an amended US return for 2007 showing a $10m. loss instead of a $10m. profit? And will the IRS refund US tax paid on the originally reported profit? The US-Israel tax treaty says the tax authorities of the two countries may discuss the matter and "endeavor to reach agreement" to prevent double taxation, but they don't have to reach agreement. That was US federal tax - there's also US state and local tax and sales taxes to consider. The proposed transfer pricing regulations work both ways. For example, in 2007 a US multinational company reports sales of widgets to its Israeli subsidiary of $50m. The Israeli subsidiary sells those widgets to unrelated Israeli customers. But, in 2009, the Israeli Tax Authority conducts a tax audit and concludes that the US multinational should have billed its Israeli subsidiary a lower wholesale market price of only $30m. and adds another $20m. to the Israeli company's sales and profits for Israeli tax purposes. Will the IRS in the US acquiesce? You get the idea. Israel has always had a general requirement that related parties should conduct transactions on an arm's length basis for Israeli tax purposes. The proposed regulations are drafted pursuant to Section 85A of the Income Tax Ordinance, which grants the Minister of Finance the authority to issue far more detailed regulations in this regard. Section 85A also allows the Israeli Tax Authority to enter into Advance Pricing Agreements with multinationals that want upfront clearance for their intercompany transfer pricing methodology. The proposed Israeli transfer pricing regulations are based on both the US Transfer Pricing Regulations and the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. These Regulations and Guidelines are applied in many countries. Therefore, the proposed Israeli regulations are expected to be broadly familiar to Israeli companies and their foreign trading partners, but burdensome all the same. So what are the key principles of the proposed Israeli transfer pricing regulations? The proposed regulations will apply only to "international transactions" and not to domestic transactions entirely within Israel. An "international transaction" is defined as a transaction taking place between parties having a "special relationship" where one or more of the parties is a foreign resident or where part or all the income from the transaction is taxable outside of Israel. Unfortunately, the term ''special relationship" is not clearly defined - the law refers to various family relatives, partners and company affiliations. Nevertheless, the proposed regulations will not apply to a "one-time" international transaction, provided that an arm's length price is still applied and approval is obtained from the Israeli Tax Authority (more work required, not lessâ€¦). The remainder of this article is technical but has been kept brief as the concepts will be broadly familiar to multinational groups. To determine whether an international transaction is on arm's length terms, the proposed regulations stipulate that the taxpayer must apply one of the following methods. In declining order of preference, the transfer pricing methods prescribed in the proposed regulations are: 1. Comparable Uncontrolled Price (CUP) Method, applying the price determined in a review of other comparable transactions. 2. Comparable Profit Method or Profit Split Method. 3. Other methods approved by the Israeli Tax Authority. If a comparison is made to similar transactions, the CUP method is used and no adjustments are necessary, an international transaction will be considered to be at arm's length, if the result falls within any part of the range of results for the comparable transactions. If any other comparison method is used, the transaction will be considered arm's length if it falls within the interquartile range (the middle 25%-75% range of values of comparable transactions). If an international transaction is not considered to be at arm's length, as outlined above, the transaction's price to be reported for Israeli tax purposes will be the median (middle) price. A transaction is considered to be comparable to the tested controlled transaction if all or at least a majority of specified comparison criteria are met and adjustments are made for any differences. The proposed regulations specify the following comparison criteria: field of activity, including manufacturing, marketing, sales, distribution, research and development and consulting; type of product or service rendered; risks associated, including credit, financial and geographic risks; economic climate; transaction terms; the effect of goodwill or other intangible assets held. In practice, most Israeli tech companies developing something new and unique face difficulty finding data about market prices billed by other comparable companies - there may be none or they may not publish their prices. Therefore, Israeli tech companies will usually resort to a profit method or a profit split method. Therefore, the proposed regulations specify several profit level indicators depending on the particular industry and environment. For example, a cost plus mark up may be applied to a company's direct costs (not defined) when this is the most acceptable method in the tested party's field of operations (i.e. unable to apply the CUP method). A gross profit margin may be applied when this is the most acceptable method, based on sales. Other profit level indicators listed are: operating profit or loss applicable for comparable transactions; the profit/loss derived as a proportion of the firm's assets or liabilities or capital; or other measures considered appropriate in the circumstances. What transfer pricing documentation will be needed? According to the proposed regulations, a taxpayer must submit to the Assessing Officer, upon demand and within 60 days, a transfer pricing study containing data regarding the following: 1. The taxpayer itself, detailing, taxpayer's ownership structure, parties to the international transaction, their residence, special relationships. 2. Contractual terms, field of activity, economic climate, intangible assets. 3. Details about all relevant transactions. 4. Economic analysis. Consequently, any taxpayer engaged in international transactions involving related parties must prepare a transfer pricing study - with recent comparable data - dating back no more than the three preceding years under the comparison method selected. A transfer pricing study is a market pricing study usually prepared by professional economists and/or accountants. The taxpayer also must attach documents, such as transactional and other agreements, supporting the transfer pricing study data, transfer pricing studies prepared for foreign tax authorities, etc. Are there any transitional provisions in the proposed regulations? Yes, there are. For two years after the publication of the final regulations, it seems taxpayers will be allowed to use transfer pricing studies prepared prior to the publication date, if the studies conform to the principles of the Organization for Economic Cooperation and Development (OECD) or a member country of the OECD (such as the US, Canada, UK, etc). What else is important in the proposed regulations? First, the regulations will apply not only to transfer prices for goods but also intercompany services credit transactions. Therefore, it seems that non-interest bearing loans and capital notes - commonly used in Israel - will have to be replaced by loans bearing a market rate of interest. If a parent company guarantees bank or other finance for its subsidiaries, the parent company will have to receive a market-based guarantee fee for its efforts. Such fees and interest may trigger income tax and VAT issues, among others, both in Israel and abroad, not to mention stamp duty in some countries (stamp duty was repealed in Israel this year). Second, a form - not yet published - will need to be attached to the annual tax return disclosing international transactions effected in the tax year. Third, intercompany management or advisory fees exceeding NIS 2 million or asset sales at a loss of NIS 2 million will be reportable tax planning acts under separate proposals aimed at aggressive tax shelter transactions. To sum up, the proposed Israeli transfer pricing regulations, are expected to be finalized and issued soon. Their impact on multinational groups could be material - from big conglomerates to modest start-ups with some import or export transactions via related companies. firstname.lastname@example.org The writer is an International Tax Partner at Ernst & Young Israel.