YOUR TAXES: The ITA is playing hardball with multinationals that must prepare accordingly.
By LEON HARRISCalculating taxes(photo credit: INGIMAGE)
The Israel Tax Authority (ITA) has issued a Circular (1/2020 of June 2) on transfer pricing between related parties that aims to clarify what proof a multinational group must file with the ITA. The ITA is playing hardball with multinationals that must prepare accordingly. This is important for hi-tech and low-tech groups.All this follows the spectacle witnessed in the Broadcom Case (Broadcom Semiconductors Ltd vs. Kfar Saba (263423-01-16, 2268-04-17, December 9, 2019).The Broadcom caseIn 2012, the Broadcom Corporation of the US acquired all the shares of Broadlight Inc, another US corporation that had an Israeli subsidiary, for around $200 million. Three months later, the Israeli company sold its intellectual property (IP) to a foreign affiliate for only $59.5 million. But the ITA taxed $168.5 million based on FAR – functions, assets and risks – transferred, based on OECD transfer pricing guidelines.The taxpayer initially appealed to the Supreme Court arguing that the burden of proof was on the ITA to justify its figure. The Supreme Court ruled that if an unreported sale of FAR indeed occurred, the burden of proof lay with the taxpayer and passed the case to the District Court for consideration. The District Court found that there was no sale of FAR, merely a change of business model which increased activity and employment in Israel.The tax circularThe ITA circular aims to clarify in which instances a transfer-pricing study filed by a taxpayer will be considered to fulfil the requirements in the tax law, thereby shifting the burden of proof in the assessment procedure from the taxpayer to the ITA.As discussed below, the burden of proof is a hot potato that the ITA tries to push back to the taxpayer.Israeli transfer-pricing rules apply the principles underlying both OECD guidelines and the rules of Section 482 of the US Internal Revenue Code. A transfer pricing study is required to review whether related parties applied arm’s length terms.The circular quotes one of the sub-sections in the law on the burden of proof: “A taxpayer must provide the Assessing Officer, upon request, the documents and data in its possession regarding a transaction or foreign resident party and the method of determining the transfer price” (ITO Section 85A(c )(1).Unfortunately, the ITA circular does not quote the next all-important subsection and only briefly mentions it at the end (ITO Section 85A(c)(2). For the benefit of readers and the ITA, this says: “If the taxpayer provided such documents... and the documents in the regulations, the burden of proof lies with the Assessing Officer if he determines things differently from the agreements between the parties”.The Circular says the Assessing Officer might not dispute the work done regarding a transfer pricing study but might claim that a transaction is omitted from the study.What does the circular require from the taxpayer?The circular says, among other things, that a transfer-pricing study should include: what is recorded in the reports of the taxpayer, the tested party and the group; the calculation of adjustments; the method selected; documents showing that other related parties applied the same pricing (the circular omits to mention that an explanation is enough if they use different pricing); comparable companies; and non-comparable companies “manually” rejected. If each party has IP, the circular requires an explanation if cost plus pricing is used instead of the profit split methodWhat if something is missing?If a compliant transfer-pricing study is not submitted, the circular says the assessing officer does not need to prepare his own study – he can issue a “best judgment” assessment based on “estimates, approximations and personal experience.”If a compliant transfer pricing study is submitted, the burden of proof passes to the assessing officer. In this case the circular says the assessing officer must prove using clear and convincing evidence that his method of calculation meets the threshold of the “balance of probabilities”.CommentsIt seems the ITA may push back the burden of proof to the taxpayer by continually claiming something is missing. The taxpayer may be bewildered – if no transaction occurred, as in the Broadcom case, nothing is missing.In such an impasse, the circular instructs assessing officers to issue best judgment assessments (which may in reality be poor estimates) and impose penalties.Multinationals, Israeli and foreign, should prepare full-length transfer pricing studies. “Mini studies” that save professional fees may not save them!As always, consult experienced tax advisers in each country at an early stage in specific cases. The writer is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd. leon@h2cat.com
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