The Israel Tax Authority (“ITA”) published its first tax circular for the 2020 year, Tax Circular 1/2020 (the “Circular”) on June 2, 2020. The Circular focuses on the burden of proof (and the potential shift thereof) within the context of transfer pricing (“TP”) audits and the documentation required to be presented within such context.
TP aspects of international transactions are governed by Section 85A of the Israeli Income Tax Ordinance (“ITO”) and the 2006 Income Tax Regulations promulgated thereunder (the “TP Regulations”). ITO Section 85A(c)(1) provides that upon demand by an ITA assessment officer, a taxpayer must provide all the documents and data they have that relate to a transaction or to a foreign resident party to the transaction, and that relate to the manner in which the price of the transaction was determined (the “TP Documents”).
The established ITA position on the issue of burden of proof within a TP audit had been, based on a prior ITA tax circular, that once the taxpayer delivered the TP Documents in accordance with the ITO and the TP Regulations requirements, then the TP arrived at by the parties to the transaction had a presumption of being correct. Then if the ITA assessment officer concluded that the TP should be other than that as arrived at by the parties, the ITA assessment officer would bear the burden of proof for such determination, i.e., the burden shifted from taxpayer to ITA.
The ITA’s currently held position, reaffirmed in the Circular, follows on the heels of its interpretation of the 2018 and 2019 decisions, respectively, in Kontera Technologies Ltd. and Broadcom Broadband Access Ltd. Such position is that the burden of proof does not shift from the taxpayer to the ITA until the ITA assessment officer confirms that the TP Documents submitted complies with the requirements of the ITO and the TP Regulations. The ITA assessment officer can claim for example that based on their review, the facts of the international transaction are in dispute, or that the TP Documents lack certain important details provided in an open yet non-exhaustive list in the Circular such as information related to the companies chosen to serve as comparable companies as part of a TP study. This leads to the conclusion that an ITA assessment officer is granted the broad discretion to act as if the taxpayer has failed to submit any TP Documents and therefore, there is no shifting of the burden of proof to the ITA to provide its own economic study but instead the ITA assessment officer can rely on its own subjective judgment to decide the correct TP within the context of a TP audit.
Although as stated above, the Circular simply reiterates the ITA’s previously held position, the Circular does serve to emphasize the importance of selecting the correct TP method and providing the correct TP Documents. Mere omission of an item from the non-exhaustive list of documents mentioned in the Circular that are required to be submitted in a TP audit can be grounds for the rejection of the TP method by the ITA assessment officer. Therefore, it is highly advised to follow the recommendations of the Circular and submit complete TP documentation within a TP audit, including but not limited to the intercompany agreements and documentation related to the nature of the specific transaction, the financial transactions involved, the monetary amount of the transaction, the arm’s length value of the transaction, the quantity of units covered by the transaction, the TP method used, the type of comparable used (external or internal) and whether the application of the method results in any adjustment to taxable income, in accordance with requirements the ITO and TP Regulations. We note however, that the ITA’s position expressed in the Circular is instructive and not legally binding and therefore such position might not be upheld within the context of judicial proceedings.
We disagree with the Circular. The rationale behind the shift of this burden to the ITA tax assessment officer (to back up and present evidence of its claims against the TP Documents presented by the taxpayer) is to incentivize taxpayers to carry out their investigative work on the method of TP they choose and use the appropriate TP study and TP Documents to support their position. In our view, even if the burden of proof does not shift to the ITA tax assessment officer in the event that the ITA tax assessment officer claims that the TP Documents are incomplete (as claimed by the Circular and the court in Kontera Technologies Ltd.), the burden of proof should still be applied with respect to the ITA tax assessment officer’s allegations against the TP Documents. Accordingly, the position taken in the Circular that the ITA tax assessment officer must employ a well-reasoned basis for disqualification of the TP Documents is not sufficient in our opinion, but rather the ITA tax assessment officer must present forensic evidence in relation to the claims it has against the TP Documents presented by the taxpayer. As an example, the Circular states that the TP Documentation must provide a list of companies that were disqualified from being used as comparable companies for purposes of the TP study. We disagree and do not think the TP Documentation must provide such a list and if the ITA tax assessment officer believes that the TP Documentation is flawed because of such omission, then the ITA assessment officer must provide proof that such comparable companies exist and should have been included in the TP Documentation.
Furthermore, we note that there are two different terms in the law of evidence: “the burden of persuasion” and “the burden of proof”. Generally, the “the burden of persuasion” is a material burden that revolves around the question of who is required to prove their claim at trial. In civil law (including in audit proceedings), the burden of persuasion rests with the plaintiff. The “burden of proof”, on the other hand, is not a material burden but rather a secondary burden to the burden of persuasion, and it relates to who is required to bring and present their evidence at a specific point in the legal process. A plaintiff who has not met the burden of proof does not necessarily fail to meet the burden of persuasion required by civil law. The burden of proof stated in ITO Section 85A is essentially procedural, and therefore, even in the event that the burden of proof has not shifted to the ITA tax assessment officer (as stated in the Circular), a court can still conclude that the burden of persuasion has been satisfied via the TP Documents submitted by the taxpayer.
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For further information regarding this update, please contact Adv. Oren Biran, Partner, Head of Tax Practice, at oren@gkh-law.com or 03-6074514.
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