Cost+13% Pricing for R&D Services Provided to a Foreign Company
and Implementation of a Cost Sharing Agreement between Companies Owning Intellectual Property
Background
The Israel Tax Authority has published two tax rulings concerning research and development activities and intellectual property within multinational groups. Tax Ruling 5007/26 addresses the pricing of limited-risk R&D services provided by an Israeli company to a foreign company. Tax Ruling 7216/26 concerns an arrangement for sharing development costs and anticipated benefits between an Israeli company and a US company, each of which owns intellectual property.
The rulings address two different business models: providing development services in return for reimbursement of costs plus a profit margin, and sharing development costs and the resulting economic rights.
Pricing of Limited-Risk R&D Services at Cost+13% – Tax Ruling 5007/26
Key Facts
The ruling concerns an Israeli company providing limited-risk R&D services to its foreign parent, which heads a multinational group with annual revenues exceeding US$10 billion.
The Israeli company acts as a subcontractor and participates in developing the foreign company’s intellectual property in return for reimbursement of its operating expenses plus a margin (Cost Plus).
The foreign company owns all rights to the intellectual property, controls the R&D risks and funds the Israeli company’s operations. Strategic decisions are made by senior management outside Israel.
The Israeli company employs, among others, mid-level and junior R&D personnel, senior technical personnel and managers who are not members of senior management. It participates in developing the core products, but is not their sole developer.
The Tax Ruling
Based on the Israeli company’s representations, the Israel Tax Authority approved the use of the transactional net margin method (TNMM), with a mark-up on total costs (MTC) as the profit level indicator, to assess whether the price charged for the R&D services meets the arm’s length standard under the transfer pricing rules.
On that basis, the method for calculating income and the margin specified in the agreement were approved as arm’s length, with a mark-up of 13% on costs (Cost+13%).
The profitability range was determined by reference to the characteristics of the operations, including the business sector, economic environment, level of competition in the industry, and scale and complexity of the R&D activities.
Tax Ruling 7216/26 – An Arrangement for Sharing Development Costs and Intellectual Property
Key Facts
The ruling concerns an Israeli company that develops, markets and distributes technology products and services and owns the intellectual property associated with its business. Following its acquisition by a US company, the two companies entered into a Cost Sharing Agreement (CSA), intended to provide mutual economic benefits through joint development and sales activities.
The arrangement distinguishes between each company’s pre-existing intellectual property and new intellectual property to be developed or acquired in the future.
Pre-existing intellectual property remains owned by the company that held it, with reciprocal licences granted and royalties paid.
For new intellectual property, the companies share development costs and economic rights according to an allocation of territories. Shared intangible development costs (IDC) are allocated in proportion to each company’s reasonably anticipated benefits (RAB), based on projected revenues from its allocated territories. The cost-sharing percentages are updated annually.
The Tax Ruling
The Israel Tax Authority approved the characterisation of the transaction as a cost-sharing arrangement and the cost allocation mechanism under Section 85A of the Income Tax Ordinance and the OECD Guidelines. It expressly clarified, however, that the approval does not cover the pricing of payments, receipts or profits between the companies, nor does it determine how the cost allocation mechanism is to be priced.
The ruling also confirmed that entering into the arrangement would not constitute a change in business model giving rise to a taxable capital gain for the Israeli company, subject to the limitations and conditions specified in the ruling.
As for intercompany payments, the ruling provides that payments for pre-existing intellectual property are to be classified as royalties for the purposes of Israeli law and the Israel–US Tax Treaty, and sets out the applicable withholding tax arrangements. By contrast, payments representing contributions to the development costs of new intellectual property (IDC) will not be subject to withholding tax.
The ruling also approved a mechanism for incorporating additional intellectual property into the arrangement following acquisitions of companies or intellectual property. It also defined events constituting a material breach of the arrangement, including changes to the territories, the sale of intellectual property covered by the arrangement and the admission of a new participant. These events also include incorporating new technology in a manner that could materially undermine the arrangement and amount to abandonment of the activities on which it is based.
Practical Implications of the New Tax Rulings
For R&D centres in Israel, Tax Ruling 5007/26 provides an example of approval of cost-plus remuneration where the intellectual property rights and control over risks are attributed to the foreign company.
For Israeli companies that own intellectual property, Tax Ruling 7216/26 illustrates the possibility of establishing arrangements for sharing costs and rights within a multinational group without triggering a taxable capital gain solely by entering into the arrangement, subject to the approved circumstances and conditions. The Israel Tax Authority emphasised that the ruling should not be regarded as approval in principle of other CSAs that have not been specifically submitted and examined.
Accordingly, companies considering establishing or changing their R&D and intellectual property arrangements within a multinational group need to examine not only the amounts payable, but also the allocation of functions, risks and rights, the tax implications of the change and withholding tax obligations. Where appropriate, an advance ruling request may be considered to obtain certainty from the Israel Tax Authority regarding the structure of the arrangement and its implications.
The above content is a summary provided for informational purposes only and does not constitute legal advice. It should not be relied upon without obtaining further professional legal counsel.
