Supreme Court Strikes Big Tax Blow Against Foreign R&D Centers

New ruling requires them to count employee stock options as an expense, in effect raising the profits of businesses that use cost-plus accounting

High-tech park in Ra'anana.
Tomer Appelbaum

Hundreds of multinational research and development centers operating in Israel, as well as many Israeli companies, face a much bigger tax bill after the Supreme Court ruled this week that employee stock options must be included in future assessments.

The ruling, issued by justices David Mintz, Uzi Vogelman and Anat Baron, regards a technical matter connected with how R&D centers account for costs and pay taxes.

However, the ruling could wind up more than doubling the tax bills of R&D centers, which are operated in Israel by most of the biggest names in global high-tech, including Apple, Google, Intel and Microsoft. It will also affect Israeli companies that operate on the business model of locating their headquarters in the United States and operating an R&D unit in Israel.

The ruling could have a significant effect on Israel’s high-tech sector. According to a 2017 Dun & Bradstreet report, some 307 multinational R&D centers are in operation today and although they account for only 4.5% of all high-tech companies in Israel, they employ 71,000 people — a quarter of the country’s tech workforce.

The R&D centers enhance Israel’s global reputation as a high-tech center, contributes to better political relations with foreign countries and serve as a training ground for aspiring startup entrepreneurs, D&B said.

Recently the government has been weighing options for easing the tax burden on foreign companies operating in Israel out of fear that the U.S. tax reform could cause businesses to relocate to America.

The decision came in an appeal after Tel Aviv District Court Judge Magen Altuvia ruled in December 2015 against Kontera Technologies, a unit of U.S.-based Amobee, and the Israeli R&D arm of the California company Finisar in their court challenge to an Israel Tax Authority ruling.

The two appeals were combined into a single one and brought to the Supreme Court, where they were rejected again. The ruling allows the Israel Tax Authority to reassess back taxes going back four years.

The issue deals with the cost-plus pricing system used by R&D centers. The centers are paid by their overseas parent company for the costs of conducting research, such as salaries, rent and subcontractors.

For accounting purposes, the center are assessed as if they are earning a profit of between 5% and 15%. On that they ordinarily pay a 23% corporate tax rate, or lower if they are entitled to a special rate as an approved investment.

In their appeal, Kontera and Finisar contended that the stock options are paid by the parent company, not by the local R&D unit, and therefore don’t count as an expense that should be added to the cost element of the cost-plus accounting system.

The tax authority maintained that the options were in effect a component of the employees’ overall compensation, like a salary, and should be counted as a cost.

In his opinion, Mintz noted that while Section 102 of the Income Tax Code doesn’t recognize the cost of stock options as a business expense it should recognized as a cost for calculating profit.

Anat Shavit, who heads the tax department at the Tel Aviv law firm Fischer Behar Chen Well Orion & Company, said the ruling was fundamentally unfair because it doesn’t apply to businesses in Israel that don’t use the cost-plus model. Employee stock options are an important incentive in the high-tech industry for attracting and retaining staff, she said.

“It’s created a distortion. Only R&D centers will be hurt and their costs will rise,” she said.

Shavit said that R&D centers could get around the problem by booking stock options as a salary expense, but then employees would have to pay the full tax rate on them rather than the lower capital gains rate they enjoy now. She said that given the severe competition to attract the best staff, few centers are likely to take that route.