ATTRIBUTION OF INCOME TO R&D CENTRES IN ISRAEL
On 27 February 2025, the Israel Tax Authority (“the ITA”) published a draft Circular for public comments on the attribution of income to R&D centres. This Circular, to the extent it becomes binding, is expected to have considerable importance for multinational groups operating R&D centres in Israel.
As is known, many multinational companies choose to operate in Israel through Israeli subsidiaries that engage in the provision of R&D services for members of the group (which do not conduct any other independent activity), and where the foreign parent companies fully bear the R&D-associated risks as well as provide them with financing. For Israeli tax purposes, a transaction between an Israeli subsidiary and its foreign parent company constitutes an international transaction with special relations existing between the parties, and thus is subject to the provisions of section 85A of the Income Tax Ordinance, 5721-1961 (“the ITO”).
Section 85A of the ITO generally provides that an international transaction in which special relations exist between the parties will be reported in accordance with market conditions and will be taxed accordingly. Thus, the purpose of the draft Circular is to provide those multinational companies with certainty regarding market conditions and transfer pricing that will apply on their engagement with R&D centres in Israel.
At the outset, the draft Circular details the audit mechanisms applicable for assessing international transactions of this scope. It was thus proposed to determine (subject to fulfilment of the conditions as stipulated in the Circular) that insofar as the assessing officer believes that a transfer pricing methodology applies to the said international transaction which is not “a cost-based profitability margin” methodology, as defined in the Income Tax Regulations, contrary to the report submitted by the Israeli subsidiary, exceptional approval in this regard will need to be obtained from the relevant high-ranking officials at the ITA. Thus, for example, issuance of an assessment by order with regard to any change in the said transfer pricing methodology will require the approval of the Director of the ITA.
Moreover, the draft Circular proposes to determine that an Israeli company that engages in the development of intangible property which is then sold to a foreign corporation prior to it being acquired by that same corporation and becoming a subsidiary that supplies R&D services to members of the group, will be entitled to receive an individual tax ruling confirming that the transfer pricing methodology applicable to the acquiring company for R&D services to be supplied to members of the group will be “a cost-based profitability margin” methodology and that the consideration attributable to the sale of intellectual property owned by the Israeli company was done according to market conditions. all subject to fulfilment of the conditions as stipulated in the Circular.
In addition, the draft Circular directs that an Israeli resident taxpayer who transacts with a resident of a Convention country may seek to reach a bilateral advance pricing agreement, that combines a binding agreement between Convention countries with an agreement between the ITA and the taxpayer, in a way that will bind both countries.
We have no doubt that turning the draft Circular into a permanent procedure that binds the ITA is an important and welcome step on the way to increasing the scope of activities of multinationals in Israel by establishing local R&D centres. This initiative should therefore be welcomed.
On 4 March 2025, the Jerusalem District Court published a ruling (Tax App. (Jerusalem) 9172-12-21 Avraham Ben Ami v. Jerusalem Value Added Tax Manager) in the case of Mr. Avraham Ben Ami. This important ruling reinforces the borders of separation between private/capital investment and business/fruitful activities in the realm of real estate. Below are the principal facts of the ruling.
The appellant, Mr. Ben Ami, was holder and owner of the company Al Ami Entrepreneurship, Investments and Construction Ltd., that engages in the field of building renovations and construction works, as well as the company H.Y.B. Protection, Entrepreneurship and Construction Ltd. (“HYB”), which engages in real estate construction. During the course of 2010, HYB purchased land in Tel Aviv for the purpose of establishing a construction project. During the course of 2016, the appellant purchased from HYB 36% of its rights in the land, which constituted rights relative to 6 apartments in the project, as well as the roofs of the building and future building rights. Within the context of the collaboration agreement entered into between Mr. Ben Ami and HYB, it was determined that a building comprising 18 housing units would be constructed on the land, out of which Mr. Ben Ami would receive 6 units. It was likewise agreed that the parties would jointly bear the construction costs pro rata to each party’s share in the land and that they would transact with one building contractor for the purpose of carrying out the construction together. Upon completion of the project, Mr. Ami received 6 apartments, divided them into 8 apartments, and then rented them out for residential purposes for a period of more than 24 months. Mr. Ben Ami did not pay VAT for this activity.
During the course of 2021, the Jerusalem Value Added Tax Manager issued an assessment whereby, in its best judgment against Mr. Ben Ami, it was determined that Mr. Ben Ami satisfies the definition of “a land dealer” and that the rental of apartments for residential purposes falls within the realm of “use for one’s own purpose”, within the meaning of such expression in the Value Added Tax Regulations, with the implication being the imposition of value added tax with respect to the apartments held by Mr. Ben Ami in his personal capacity in the project as a “sale” for the value of the apartments on the date of making “use for his own purpose”. Mr. Ben Ami objected to the assessment arguing that his activity in his private capacity should not be regarded as a “dealer” for VAT purposes, and that even if he would be recognized as a “dealer”, this speaks of rental which is VAT-exempt in light of the provisions of section 31(1) of the Value Added Tax Law, 1975 (“the VAT Law”). Since Mr. Ben Ami’s objection was rejected, he filed an appeal in the matter with the Jerusalem District Court.
When opening its deliberation on the subject, the court clarified that for the purpose of classifying the rental of apartments by Mr. Ben Ami as a “business transaction” for the purposes of the VAT Law it would be necessary to first address the question – whether there is place to consider Mr. Ben Ami as a “dealer” who rents out the apartments “during the course of his business”? In order to decide on this question, the court was assisted by a number of tests that have been crystallized in Israeli case law over the years, in order to distinguish between a fruitful transaction and a capital transaction. In so doing, the court held that “the test of knowledge and proficiency” has clearly been met in the appellant’s case, as he has broad knowledge, experience and expertise in the real estate field. It was likewise held that “the organization and management test” has also been met in the appellant’s case, as he operated a sophisticated business mechanism, that served him both for the business purposes of the companies under his ownership as well as for managing his private business. With regard to the “test of the frequency of the transactions and their monetary scope” – it was held that in the relevant years, Mr. Ben Ami, in his private capacity, entered into numerous transactions of considerable monetary scope, a fact that teaches that this entails clear business activity. The court added and held that, even “the betterment test” has been met in Mr. Ben Ami’s case, as he acted in a proactive, planned and systematic manner to improve the property, including by dividing the residential apartments. It was further held that the fact that Mr. Ben Ami received foreign financing and encumbered the property in favour of a bank also supports the conclusion that this speaks of business activity of a commercial nature, according to the “financing test”. The court concluded its deliberation on the subject and ruled that since all the objective and subjective circumstances clearly point to the fact that this speaks of business activity for all intents and purposes, then also implementation of the “roof test” leads to the conclusion that the rental of apartments by the appellant should be perceived as purely business activity.
After determining that the appellant is a “dealer” in the real estate realm and that the apartments were purchased during the course of his business, the court turned to consider whether in the circumstances of the case in question it concerns “use for one’s own purpose” for VAT purposes, and if the appellant should be perceived as having effected a “sale” of the apartments for which VAT is chargeable. After reviewing the relevant provisions of the law and regulations in this regard, the court summarized the conditions which, if satisfied, would be considered as activity engaged in by the taxpayer “for his own purpose” that is subject to VAT: (a) the rental is for business purposes; (b) the land being leased constitutes part of the assets of the business; (c) the person leasing the land is also engaged in the building works. The court held that these three conditions were found to have been met in the appellant’s case and he is therefore liable to pay VAT for his “own use” of the land.
In our view, the ruling ignites a warning light over the heads of entrepreneurs and owners of companies in the real estate realm, and reinforces the need for intelligent planning when separating the private activity from the business activity, by implementing the tests as prescribed in case law in this regard.
As previously written by us, on 26 December 2024 the Economic Efficiency Law (Legislative Amendments for Attaining Budgetary Objectives for the 2025 Budget Year), 5785-2024 (“the Economic Efficiency Law”) was published. Within the context of the Economic Efficiency Law, and with the aim of increasing state revenues and reducing the deficit, section 121B of the ITO concerning “surtax” was amended. It was thus determined that an individual will be charged new tax in the rate of 2% on income generated from capital sources that exceed the amount specified in the section (NIS 721,560 in the 2024 tax year), and this in addition to the surtax imposed pursuant to customary law in the rate of 3%, prior to the Economic Efficiency Law having entered into effect (1 January 2025). What this means is that portion of the taxable income generated from a capital source that exceeds the ceiling as prescribed in the section will be subject to surtax in the rate of 5%.
On 25 February 2025, the ITA published Directive No. 5/2025, aimed at detailing the ITA’s stance regarding implementation of the provisions of section 121B of the ITO and the amendments applicable to it.
It is clarified in the Directive that an individual whose taxable income in the tax year exceeds the ceiling, will be liable to pay surtax on portion of such taxable income in the rate of 3%. In this respect, taxable income includes: (a) income generated from any of the sources specified in sections 2 and 3 of the ITO, as well as amounts determined in any law as constituting income for the purposes of the ITO (such as: income from lotteries and prizes pursuant to section 2A of the ITO); (b) capital gains, save for the inflationary amount; (c) appreciation, within the meaning of such term in the Real Estate Taxation Law, 5733-1963, save for the inflationary amount. However, with regard to appreciation sourced from the sale of rights in land in a residential apartment – only if the value of the sale exceeds NIS 5,385,285 (as of the tax year 2025) and the sale is not tax-exempt pursuant to any law. Within the ambit of the Directive, it is emphasized that when the value of the sale exceeds this ceiling, the amount of the real appreciation will be added to the entire taxable income of the taxpayer in order to determine the liability for surtax.
The Directive further provides that in light of the amendment to section 121B of the ITO, taxable income from capital sources, such as dividends, interest, capital gains – including income sourced from the allotment of shares to employees that is classified as a capital gain pursuant to section 102 of the ITO, rental and the like, which does not amount to a business, will be subject to the additional tax of 2%, such that portion of the taxable income from capital sources that exceeds the ceiling will be subject to cumulative surtax in the rate of 5%.
The Directive ends with the inclusion of several numerical examples regarding the application of its provisions.
On 11 March 2025, the ITA published a position paper on the subject of acceleration of the vesting period for employee share options upon the occurrence of an exit event or flotation of shares (“the Position Paper”). We believe this to be an important publication, in that it conveys certainty and stability for the general public of option holders in Israel.
As is known, section 102 of the ITO regulates the manner of taxation and reporting duties that apply upon exercise of the share options that are issued to employees, as well as the conditions which, once fulfilled, the profit deriving from such exercise will be taxed at the capital level. Nevertheless, the provisions of section 102 of the ITO do not address the matter of the vesting period and the various acceleration mechanisms, that are common in the Israeli economy.
Within the context of the Position Paper, the ITA clarified its stance that in a vesting acceleration mechanism classified as “single trigger” acceleration, whereby unvested options will be accelerated and become fully vested upon the sale of all or a majority of the company’s shares or assets (“an Exit Event”) or when the company’s shares are first listed for trade (“an IPO”) – the accelerated vesting will not be perceived as a violation of the provisions of section 102 of the ITO and the profit deriving from sale of the shares will be taxed at the capital level.
Moreover, the Position Paper clarifies the ITO’s stance with respect to the vesting mechanism classified as “double trigger acceleration”, whereby unvested options will be accelerated and become fully vested upon the satisfaction of two cumulative conditions: (a) the occurrence of an Exit Event; and (b) termination of the employee-employer relations due to the Exit Event. The Position Paper thus clarifies that the application of this type of acceleration mechanism will also not lead to a violation of the provisions of section 102 of the ITO. For amplification on calculation of the tax liability deriving from options accelerated due to the implementation of this mechanism, view the detailed article published by Ophir Kaplan, Adv., partner and member of the Tax Department, by accessing the following link [https://s-horowitz.com/news-events/employee-stock-options-mechanisms-for-accelerating-the-vesting-period/].
The Position Paper duly emphasizes the importance of tax planning when crystallizing employee compensation plans. As can be discerned, intelligent tax planning, that takes into account, among other things, the conditions enumerated in the Position Paper, may lead to a significant reduction in tax that will apply on the date of exercise of the share options and their vesting.
* The newsflash is intended to provide subscribers with general information only and should not in any way be regarded as firm professional advice and/or a definitive legal opinion.
