Israeli High-tech Sector Warns Tax Change May Harm R&D Centers and Economy

Proposal would tax some of the centers based on their parent companies’ global profits ■ Tech executives warn that the move could hurt sales of Israeli startups and lead parent companies to move management elsewhere

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The Matam high-tech industrial park in Haifa
The Matam high-tech industrial park in HaifaCredit: Rami Shllush

High-tech executives are warning that the Israel Tax Authority could undermine the work of many of the hundreds of multinational research and development centers in the country if it goes through with plans to revise the way many of them are taxed.

The authority is weighing a plan to stop calculating taxes based on the cost-plus system, in which a fixed rate of profit is derived from the center’s costs. Instead, it would tax them based on their parent company’s global profits and the local center’s estimated contribution to them.

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R&D for foreign companies is a big business in Israel. Startup Nation Central, an industry-tracking organization, estimated that in 2018 there were close to 350 such R&D centers, and since then the number has grown. One study estimated that the R&D centers, a major source of tech employment and high salaries, account for 16% of all the direct taxes collected by the Israeli government.

Industry leaders first heard publicly of the proposed change at a conference of the Fair Value Forum held last week at the Herzliya Interdisciplinary Center. Roland Am-Shalem, the tax authority’s senior deputy director general, said the proposed policy change would affect R&D centers that in effect own the intellectual property generated by their research activities.

He referred to some cases in which officials believed that was the case. Among these, the intangible asset not only originated in Israel but was first used there, the centers engage in other activities other than R&D, the parent company’s headquarters are also in Israel and/or the Israeli R&D center provides a unique and valuable contribution to its multinational parent company.

Am-Shalem, whose brief covers the digital economy, said that as a rule the bigger the role the Israeli R&D center played in generating IP for its parent, the greater the odds that it would be taxed on a global basis.

On the flip side, Am-Shalem said that the cost-plus system would be employed if, among other things, an R&D center was established by a wholly foreign company, decisions about the use of IP developed in Israel were made by the company’s overseas headquarters, the local R&D center didn’t share any of the business risks involved in R&D and didn’t have accumulated tax losses from its R&D.

An Intel R&D center in JerusalemCredit: Intel Spokesperson

A senior executive at a local R&D center, who spoke to TheMarker on condition of anonymity, said Am-Shalem’s criteria didn’t reflect the reality of how local R&D centers operate.

“The fact is I have no autonomy – we’re like a puppet on a string. The company back in the United States funds us and makes the decisions,” the executive said. “The minute there’s a tax assessment or a more concrete declaration – and certainly if it’s anchored in legislation – the parent company will move all its senior managers from Israel so that the tax authority can’t claim that we need to pay tax.”

The executive warned that such a move would hurt the local R&D industry. “The managers in Israel are the ones who do the hiring here and look at local startups to buy. It’s important for them to be in the same time zone as their employees. If they are forced to work in the U.S., it will hurt the Israeli industry,” he said.

Karin Mayer Rubinstein, CEO of the Israel Advanced Technology Industries, a tech trade group that opposed the tax change, warned that it could not only damage the Israeli tech industry but the entire economy, especially as the world economy struggles with the coronavirus.

“At such a complex time, certainty in the business environment is a fundamental condition for high-tech industry in Israel. CEOs need a supportive hand, not someone putting a spoke in their wheels,” she said.

Under the cost-plus system, the centers’ chief costs of rent and labor are assessed, to which another 5% to 15% (the “plus” component) is added and taxed at the normal corporate rate. An R&D center with a 50 million shekel ($15.4 million) annual budget and a cost-plus agreement with the tax authorities that set its “plus” component at 10%, would be subject to a corporate tax on 5 million shekels.

The advantage of the system is that the government gets a steady stream of annual tax revenues. The disadvantage is that if Israeli R&D results in a highly successful product or service that generates huge profits for the parent company, Israel tax collectors get no extra revenues. The profit-split system the authority is proposing would solve that problem.

Participants in last week’s forum were generally opposed to the proposal, saying it would create needless uncertainty for many companies. Many said Israel should wait to see what the Organization for Economic Cooperation and Development does vis a vis global taxation and what policies the new Biden administration pursues.

A Western Digital R&D center in Kfar SavaCredit: Shlomi Yosef

Michael Bricker, a partner in the Tel Aviv law firm Meitar and a member of the IATI’s tax committee, said Am-Shalem hadn’t provided enough information for companies to fully understand the implications of the proposed change but expressed concern about how they would be implemented.

“How, for example, does one estimate whether [Israeli R&D] makes a unique contribution of value added? What does it mean that the intangible asset originated in Israel? …. We’re worried that all this will be subject to the interpretation of tax assessors in the field and that they will continue making baseless assessments of companies,” Bricker said.

Bricker recounted that Am-Shalem and other tax officials had admitted to him that the proposed policy isn’t being used elsewhere in the world, but they defended by saying other countries were heading in that direction.

“There’s an international consensus – we don’t have to always be the pioneers,” Bricker said. “The problem is that if the Israel Tax Authority doesn’t coordinate its policies with the U.S. tax authorities, the American companies – which account for the majority of the relevant ones – will end up paying double tax.”

He warned that the proposed policy could hurt the sale of Israeli startups whose operations are split between Israel and the U.S. to American companies (exits).

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