TAX LEGAL UPDATE | January 2016

Equity Based Compensation for Cost Plus Companies

Background

One of the most popular transfer pricing methods for multinational companies operating in Israel is a ‘cost plus’ mark-up (the “Mark-Up“), which generally determines the profitability of the local entity as part of the worldwide group.

The Mark-Up is computed based on the local entity’s expenses for accounting purposes. These expenses generally include, among others, an allocation of the amount of stock-based compensation granted to employees, which is expensed in accordance with the relevant accounting principles. However, from an Israeli tax perspective, no expense is permitted if the local entity is privately held, and if it is a subsidiary of a publicly traded company, only a portion of the expense is allowed under certain terms and conditions under the Israeli Tax Ordinance of 1961 (the “Ordinance“).

Due to the harsh results of applying these accounting and Israeli tax rules, some companies have adopted an approach according to which the expenses associated with the stock-based compensation should not be part of the transfer-pricing Mark-Up.

The Decision

In a decision last week in the case Kontera Ltd. v. Assessing Officer Tel-Aviv 3, the Tel-Aviv District Court ruled in favor of the Israeli Tax Authority (“ITA“) adopting the view that equity based compensation should be included in the transfer-pricing Mark-Up.

This is a significant decision, especially for multinational companies, as this is the first Israeli court decision addressing the question of if and how transfer pricing may be affected by equity-based compensation. The unofficial position of the ITA  for a long time has been that equity based compensation should be taken into account in determining the cost basis for purposes of setting the inter-company services charges under the “cost +” model. This approach has two principal results:

• Taxing the markup on such equity-based compensation expenses (i.e., the “plus” component);
• To the extent that the equity-based compensation was granted under the Capital Gains Route (which is the common scenario), applying an “expense adjustment” to the entire book expense amount (the “cost” component). For example, for an Israeli subsidiary applying a mark-up of 7% on its costs, the total impact of this position will be an additional taxable income of 107% of the book equity-based compensation expenses.

Although the District Court has generally confirmed the above approach of the ITA, it is worthwhile to highlight two aspects which may assist companies in similar circumstances:

• The court did not rule out the possibility of excluding equity-based compensation expenses from the cost basis if and when the transfer pricing documentation supports such exclusion, usually by applying a higher mark-up. Although the court ruled in that specific case that the company did not meet the burden of proof when arguing that stock-based compensation should not be part of the transfer-pricing Mark-Up, other companies still have the opportunity to demonstrate the existence of arm’s length conditions.
• The court ruled that the language of the inter-company agreement was not consistent with the tax position taken by the company; however this may not be the case for other companies.

It should be also noted that this decision is only the first court ruling on this issue and there are at least two more similar cases still pending in other courts. It therefore appears that the final word in this highly significant issue has yet to be determined.

For more details, feel free to contact:
Yaniv Erlich, Adv., Head of the GKH Tax Department at yanive@gkh-law.com;
and/or Elad Brauner, Adv., at eladbr@gkh-law.com

This alert is prepared as an informational service to clients and colleagues of Gross, Kleinhendler, Hodak, Halevy, Greenberg & Co. (GKH) and the information presented is not intended to provide legal opinions or advice. Readers should seek professional legal advice regarding the matters about which they are particularly concerned.

.