Israeli Tax Update: the Kontera Case

Tax Authority|cost plus|subsidiary|stock option|R&D
Dr. Avi Nov, Adv

January 2016
The Tel Aviv District Court ruled recently in the tax case law of Kontera Technologies Ltd vs. Tel Aviv 3 Assessing Officer on the application of employee stock option in “cost plus” agreements. This issue is relevant for Israeli research and development companies that service foreign related companies on a cost plus basis. In the Kontera case, the judge, Magen Altuviah, ordered that expenses incurred by an Israeli subsidiary of a US parent in relation with an employee stock option plan should be included in the cost basis in calculating the cost plus payment despite the fact that such expenses are disallowed as tax deductions for Israeli tax purposes. The court accepted the position of the Israeli Tax Authority in this case, which resulted in a significant increase in the taxable income of the Israeli R&D subsidiary. For other tax cases, see: Israel Case Law 
The facts
The Kontera tax case discusses an appeal of an Israeli company which is a wholly owned subsidiary of Kontera Technologies Inc, a US corporation. In the year 2005, the Israeli company and the US corporation entered into an agreement under which the Israeli company would provide R&D services to the US corporation in exchange for the costs plus a 7% markup, based on a transfer pricing study. Later, in the years 2009 and 2010, the US Corporation granted stock options to employees of the Israeli company. In the year 2010, the agreement was amended to keep out the stock options part from the cost plus agreement.
The employees of the Israeli company participated in a stock option plan according to the capital gain track as specified in Section 102 of the Income Tax Ordinance (in such a case, the Income Tax Ordinance denies the Israeli company an expense deduction for that gain). The stock options were issued by the US parent corporation to the employees of the Israeli company. Accordingly, in this case the Israeli company did not claim the costs as a deduction in its tax returns.
The issue before the court
The Israel Tax Authority accepted in principle that the 7% cost plus basis of compensating the Israeli company met the “arm’s length” test as required by Section 85A of the Income Tax Ordinance and related regulations. However, the Israel Tax Authority claimed that operating costs should include the value of stock options in its operating costs. The Israeli company disagreed and also provided another external study that reviewed more than 350 transactions between other unrelated parties and found that none of these transactions included stock option gains in their operating costs.
The Decision by the Court
The court dismissed the appeal of the Israeli company and ruled that the stock options component should be included in the cost plus under the R&D agreement with the US corporation. The court reviewed the transfer pricing study that supported the Israeli company’s cost plus calculation and said it was irrelevant. Consequently, the court ruled that the company did not meet its obligation to prove the arm’s length of the transaction, as ordered by the Israeli transfer pricing regulations.
It seems that an appeal to the Israeli Supreme Court will be submitted soon. In any case, multinationals that operate in Israel via R&D companies need to reconsider their intercompany service agreement.
See also: Israel Taxation of Multinational Companies
Dr. Avi Nov Law Offices, Israeli & international tax law 
*This article is intended for informative purposes only and is in no way to be construed as tax advice or a legal opinion
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