Rulings to Raise Taxes on Multinational R&D Centers in Israel

The 250 or so multinational research and development centers in Israel may face higher tax bills in the wake of two rulings issued in recent months by Tel Aviv District Court Judge Magen Altuvia.

The rulings strike a blow to the structure used by overseas companies to calculate their tax liability, called cost-plus. The system takes the actual cost of running the center, such as salaries, rent, supplies and subcontractors. It imputes a profit of between 5% and 15% on these components, on which the companies pay the standard Israeli corporate income tax of 25%.

Thus an R& D center with annual costs of 50 million shekels and an agreement with its parent company to be paid that amount plus 10%, it will be liable for tax on 5 million shekels and will pay 1.25 million shekels.

But in two decisions issued in December and January, Altuvia took the side of the Israel Tax Authority in appeals filed by Kontera Technologies and Finisar, two California-based multinationals with operations in Israel.

The judge said the cost to the company of stock options it gave to its Israeli employees must be considered taxable income and not as a tax-deductible expense.

Anat Shavit, who heads the tax department of the Tel Aviv law firm Fischer Behar Chen Well Orion & Company, said that companies will now have to pay tax on the full value of the options and any profits accruing to them, which adds up to between 105% and 115% of the options’ value.

Thus, an R&D operation with expenses of 50 million shekels that issued 5 million shekels in employee stock options will be regarded as having total income of 60.5 million shekels, including the 10% cost-plus factor. But actual deductible costs are only 50 million shekels because the value of the options is no longer recognized as deductible under Altuvia’s ruling.

As a result, the R&D center will be liable for tax on 10.5 million shekels, which works out to 2.6 million shekels, or more than double what it was liable for under the old system.

For many of the multinational R&D centers in Israel, the tax bill could end up being considerably more. Nearly every leading global tech company conducts R&D in Israel, including Google, Facebook, Apple, SAP, IBM, Microsoft and Intel, employing tens of thousands of people.

Kontera and Finistar contended in their petition that the options are granted not by the R&D unit but by the parent company directly, and aren’t a direct expense. The Israel Tax Authority argued that options are part of an employee’s compensation package, which the parent company is paying the center to cover its staffing costs.

Altuvia agreed with the authority, noting that employees with options had the incentive to work harder and ensure their employers’ success because they would benefit from the rising value of its shares. But he also ruled that the cost belonged to the parent company, not the R&D center, which was therefore not entitled to deduct it.

Shavit said Altuvia’s ruling will cause many R&D centers to issue options as taxable wage income when the employees cashes it in. That means the company will only be able to book the cost at the time of the sale.

In any case, Altuvia offered no guidelines about how the options should be valued for tax purposes.