Israel: Increased Control of Transfer Pricing Israel ~ Cross-Border Funding

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In the third week of October, the Jerusalem District Court issued its ruling on the – very tax-relevant – difference between a “loan” and a “capital note”, a hot topic as well. Israeli tax authorities in the “transfer pricing” arena, as is also clearly indicated in recent proposals to amend and expand transfer pricing laws and regulations.

Loan or capital instrument; whether or not to include interest income

A parent company in Israel – B Ltd – had provided interest-free financing to foreign affiliates shaping the liabilities into what it believed to be “capital notes”. The financing provided by an Israeli company to a subsidiary (domestic or foreign) qualified as a “capital note” releases the obligee from the obligation to declare the interest income in its annual tax return in relation to the financing concerned. Certain high-risk long-term loans may be qualified as “equity securities” when the principal is not linked to any index, does not bear interest or other “yield”, is not repayable within 5 years and the creditor’s reputation subordinated to other obligations of the loan recipient. In order for a debt to qualify as a “capital note”, the terms and conditions mentioned must be linked to the terms of the “debt note” (the “I owe you”) that the debtor will generally issue.

In the present case, the Israeli tax authorities claimed that the parent company had not financed the companies of the Romanian affiliate group against the issuance of “equity securities”, but that it had provided mere “loans”.

When the tax expert argued that the parent company should have recognized the interest income from the loans and issued its tax opinions accordingly, the district court supported the tax administration’s point of view and confirmed that the mere use of the phrase “capital note” on the documents does not transform a “loan” – which does not meet all the terms defining a “capital security” as in the tax ordinance on income – into an “instrument of capital”. In this case, most of the “notes” did not meet the conditions and therefore fell under the transfer pricing chapters of the Income Tax Ordinance and required a percentage of interest. arm’s length was declared by the Israeli parent company. lender. An unfortunate circumstance for the taxpayer was that the financial statements of the Romanian subsidiaries had qualified the loans as “short term” (rather than “long term”).

The court rejected the taxpayer’s explanations that the loan agreements had been executed in error and that the intention – for a long time – had been to provide “long-term capital against the issuance of capital notes”. Not only because the legal rules in Romania do not recognize intercompany financing instruments – such as equity notes – but also because of factual considerations, the Court supported the views of the tax expert. The Court also rejected the taxpayer’s secondary argument that the tax expert’s calculation of an arm’s length rate for interest income did not comply with transfer pricing rules, and again accepted the tax expert’s calculation of interest income that should have been postponed.

The district court ruled that the transfer pricing study provided by the taxpayer was written for loans granted in 2008 and was not sufficient, and could not be applied, with respect to loans granted long after. 2008. The District Court further ruled that the amount of interest chosen by the taxpayer in the transfer pricing study did not match the economic environment in the jurisdiction of the debtors of the related companies, and that the comparable transactions selected were not appropriate.

A rather concerning detail of the proceedings was that the initial assessment issued contained a hefty fine for misrepresentation by the taxpayer – in addition to a 4% interest charge on the additional corporate tax claimed. When the taxpayer argued that the imposition of these punitive fines was truly excessive, the district court actually pointed out that the taxpayer’s behavior had gone far beyond “mere negligence”.

Something to think about

Currently, an amendment to Israeli transfer pricing legislation is under consideration (see link). The proposal explicitly places the burden of proof on the taxpayer and it is only when the taxpayer has satisfactorily fulfilled the “documentation requirements” that the burden of proof will be transferred to the tax assessor. This is no small feat, especially when the burden of proof will often be subject to the benevolent opinion of the tax assessor. Cross-border intergroup finance should be underpinned by detailed written agreements, appropriate qualification of the nature of the transactions involved and supported by a transfer pricing study in accordance with national (and OECD) guidelines. The determination of financial terms and interest on “debt” – which cannot be characterized as “quasi-equity” (as a “capital note” can) is also subject to scrutiny and increasing pricing. transfer; When was the loan granted, what are the loan repayment dates, what is the inherent risk of the loan, and whether an unrelated third party would have granted a (similar) loan. In light of the growing transfer pricing ambitions of the Israeli tax authorities and the heavy burden of proof proposed for the taxpayer in Israel, the financial management of international groups that are managed – or active – in Israel should carefully define their 2020 intercompany financing models and transfer pricing strategy. Optimal use of the right financial instruments, whether loans or quasi-capital ”, or a mixture of these, should support sound planning for long-term cross-border financing.

The development of a transfer pricing strategy in relation to cross-border financing must be best developed by weighing the group’s cash flow capacities and forecasts; and all should be assiduously supported by well-drafted legal and economic documentation, enabling finance management and the taxpayer company to claim good faith, face the obligation to prove its positions and evade sanctions Administrative matters of a clearly serious nature, as they brought the case at hand.

Originally posted by Pearl Cohen, November 2020

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