R&D Centers and Companies Acquired by Foreign Companies: Two New Tax Rulings

Dear Clients,

We would like to update you that the Israel Tax Authority recently published two tax rulings relevant to Israeli companies that are part of a multinational group, particularly R&D centers and companies acquired by foreign companies. The first ruling (5007/26) addresses the question of how much profit an Israeli R&D center operating for its parent company should report. The second ruling (7216/26) deals with a scenario in which an Israeli company and its U.S. parent company share development costs of new technology and the profits derived therefrom.

The bottom line: The Israel Tax Authority primarily examines the actual substance of the arrangement. It evaluates who makes the decisions, who finances, who bears the risk, and who owns the technology, rather than merely what is stated in the agreements. A group whose agreements reflect actual reality and are backed by appropriate documentation reduces its exposure to tax disputes.

First Ruling: How Much Profit Should an Israeli R&D Center Operating for its Parent Company Report (Tax Ruling 5007/26)

(To view the summary of the tax ruling – click here)

The first ruling concerns an Israeli company that develops technology for its foreign parent company. The parent company finances the activities, approves the budget, makes the strategic decisions regarding development, and holds all intellectual property. Consequently, the Israeli company bears virtually no risk. It operates like a subcontractor that is reimbursed for all of its expenses, plus a profit markup.

The Israel Tax Authority approved that the consideration to the Israeli company be determined as a reimbursement of all costs plus 13%. For example: if the Israeli company’s expenses are NIS 100 million, it will receive NIS 113 million from the parent company and pay tax in Israel on a profit of NIS 13 million. The rate was determined based on a benchmark study of comparable companies, considering the field of activity, economic conditions, industry competitiveness, and the scope and complexity of the R&D activities (in professional terms: the TNMM method, based on a cost-plus markup).

It is important to emphasize: the 13% rate is tailored solely to the specific circumstances of this case and does not automatically apply to every R&D center in Israel. Furthermore, the ruling contains additional conditions that have not been published. The appropriate rate for each company depends on its actual activities and risk profile.

Second Ruling: An Israeli Company and its U.S. Parent Company Share Development Costs (Tax Ruling 7216/26)

(To view the summary of the tax ruling – click here)

The second ruling deals with an Israeli company holding technology, which was acquired by a U.S. company that also holds its own technology. Following the acquisition, the companies entered into a Cost Sharing Agreement (CSA), which regulates two matters: the treatment of the pre-existing technology each company owned prior to the acquisition, and how the costs and profits from the development of new technology are shared.

Under the agreement, each company retains ownership of the technology it held prior to the acquisition. Each grants the other the right to use its technology in exchange for royalties. Each company was allocated its own sales territories. The companies jointly fund the new development, with each contributing based on the revenue it is projected to generate in its designated territories. Accordingly, each company benefits from the new technology in its respective territories. The cost-allocation key is updated annually.

What the Israel Tax Authority approved:

• Valid Structure: The arrangement complies with the requirements of Israeli law (Section 85A of the Income Tax Ordinance) and international guidelines (OECD). However, the Authority did not approve the specific figures—namely, the royalty rate and the calculation methodology for cost sharing. Therefore, these amounts remain subject to audit and must be supported by an appropriate economic analysis.
• No Tax at Inception: Typically, when an Israeli company transfers rights in its technology to a foreign entity, concerns regarding capital gains tax arise, often involving substantial amounts. Here, it was determined that entering into the arrangement is not deemed a taxable sale, subject to the conditions set forth in the ruling.
• Withholding Tax: Payments for the use of pre-existing technology will be treated as royalties under Israeli domestic law and the Israel-U.S. Tax Treaty, and the ruling also regulates the applicable withholding tax mechanism. Payments made for cost sharing in the new development are not subject to withholding tax at source.

Important to note: Material changes to the arrangement may void the protections provided by the ruling, including the tax exemption granted at inception. The ruling lists, among other things, the following triggers: alteration of the sales territories allocated to each company, sale of technology covered by the arrangement, accession of an additional company to the arrangement, or acquisition of new technology and its integration into the group in a manner that materially impairs the arrangement. Conversely, the ruling includes an approved mechanism for adding companies or technologies that the group may acquire in the future. Therefore, prior to taking any such step, its implications on the arrangement should be carefully examined.

The Israel Tax Authority emphasized that the ruling was issued for the specific transaction and its particular facts, and does not constitute general approval for every arrangement of this type.

What Should Be Reviewed Now

Israeli companies that are part of a multinational group must ensure that their intercompany agreements accurately reflect actual practice: where decisions are made, who finances the operations, who bears the risks, and who owns the technology.

Specifically, it is recommended to review:

1. R&D centers: Whether the profit rate reported in Israel is reasonable and supported by an up-to-date economic benchmark study comparing comparable companies.
2. Acquired companies or companies sharing development costs with the parent company: Whether the cost and revenue allocation, royalty levels, and withholding tax are properly structured.
3. Prior to an acquisition, merger, or corporate restructuring within the group: Whether the transaction could affect an existing arrangement or a previously obtained tax ruling.

The Tax Department at Shibolet & Co. is at your disposal to examine the implications of these rulings on your operations and to assist with the necessary preparations tailored to each group’s specific circumstances.

This client update contains general information only and does not constitute legal advice or a substitute for legal advice. In any specific case, the relevant circumstances must be examined and individualized advice obtained.

Sincerely,

Tax Department, Shibolet & Co.