The Court Case
In December 2015, the Tel Aviv District Court issued a ruling (the “Kontera decision”) that could have significant implications for companies that have a cost-plus structure in Israel and grant equity awards to employees of the Israeli entity. Under a cost-plus transfer pricing method, the parent company (or another entity in the company group) compensates the local entity with a fee that equals its direct and indirect costs related to the service provided by the local entity (the “cost base”) plus a mark-up (usually, a percentage of the cost base). The total fee is treated as taxable income to the local entity. It is therefore critical that all expenses that comprise the cost base are deductible expenses for local tax purposes. If they are, then the taxable income will equal only the amount of the “plus.”
In most countries, companies can determine the amount of their intercompany service fees under the cost-plus approach without including the “cost” of equity awards in the cost base. This is based on the argument that, absent a recharge payment by the local entity, there is no actual cost incurred by the local entity. In this case, the amount of the “plus” is minimized and it is less critical to ensure that the amount of the notional equity compensation “cost” is a locally deductible expense.
However, the Tel Aviv District court rejected this argument in the Kontera decision: in a case where the Israeli entity was being compensated under the cost-plus method, the court ruled that the expense related to the grant of options to employees of the entity had to be included in the cost base. The “cost” to be included was equal to the accounting expense of the options, not the value of the shares issued to employees (minus the exercise price paid by employees).
In addition, the court ruled that the local entity was not entitled to a tax deduction for the option costs because the options were granted under the trustee plan capital gains tax route (more on this below). This part of the decision had a greater tax effect than the fact that the amount of the “plus” increased due to the broader cost base: by requiring the “cost” to be included in the cost base, but disallowing a deduction for that same “cost”, the amount of taxable income increased by the full amount of the “cost.”
One important factor in the Kontera decision seems to have been that Kontera amended its services agreement with the Israeli entity retroactively to expressly exclude cost for equity-based compensation (perhaps after spotting this issue). It is not clear whether the court intended to merely enforce the original agreement of the parties, or whether the court was concluding as a matter of law that such costs should always be included in the cost base, regardless of what is provided in the services agreement.
It is expected that the decision will be appealed to the Israeli Supreme Court, but it could take years for a final decision to be issued.
Mitigating the Impact of the Kontera Decision
Assuming that the Israeli tax authorities follow the court decision (which is likely because they have been taking the same position in recent tax audits), cost-plus entities in Israel are at a significant risk for being challenged to pay additional taxes in Israel due to the increased cost base and lack of deduction for those “costs.”
Most companies will therefore be anxious to offset the additional services fee income with a tax deduction. Unfortunately, obtaining a tax deduction for equity awards in Israel is not easy.
For public companies, tax deductions are available, provided the local entity reimburses the parent company for the cost of the shares subject to the equity awards and provided the awards are offered under an Israeli trustee plan. This requires engaging an Israeli trustee to assist with the administration of the awards/shares and to obtain approval from the Israeli Tax Authority for an Israeli sub-plan to the equity plan.
An Israeli trustee plan can be offered under two different routes: the capital gains tax route and the income tax route. Under the income tax route, the lesser of (a) the reimbursement payment, and (b) the sale proceeds minus any purchase price paid by the employees (the “gain”) is deductible.
However, under the income tax route, the entire gain is subject to tax as ordinary work income for the employee which is not very favorable to the employee (tax rates in Israel are up to 50%, plus social taxes).
Under the capital gains tax route, the lesser of (a) the reimbursement payment, and (b) the market value of the underlying shares at grant minus any purchase price (the “discount”) is deductible. Only the discount is taxed as ordinary work income in the hands of the employees, while any remaining gain will be taxed as capital gain (at a rate of 25%). This obviously makes the capital gains tax route a lot more popular with employees. However, for the company, any deduction for stock options will be limited or non-existent, given that options are typically granted at a price that is equal to the market value of the shares at grant (i.e., there is no discount). For RSUs, on the other hand, companies are able to deduct the market value of the shares at grant, which will be more meaningful. One important note here is that, to avoid a taxable dividend in the U.S., the reimbursement payment cannot exceed the value of the shares issued at vesting of the RSUs. Therefore, if the value of the shares at grant exceeds the value of the shares at vesting, the reimbursement payment would have to be limited to the value of the shares at grant. Consequently, the tax deduction would be limited to this amount.
If awards are granted under a non-trustee plan or if a private company offers a trustee plan under the capital gains tax route, a local tax deduction generally will not be available, regardless of a reimbursement payment.
Alternatively, companies could consider granting cash-settled awards to employees in Israel which are paid out by the local entity. These awards likely will be viewed as an additional compensation item and, thus, be deductible by the local entity. However, as for awards under the trustee plan income tax route, the entire payment would be taxed as ordinary work income. In addition, under US GAAP, a cash-settled award is treated as a liability award and will therefore be subject to mark-to-market accounting which may introduce more volatility for financial statement purposes.
Any ability to obtain a tax deduction to at least partially offset the effect of the Kontera decision will therefore come at a price: for equity awards, a deduction is available only for companies granting awards under the trustee plan income tax route or pubic companies granting RSUs under the trustee plan capital gains tax route, or for cash-settled awards paid through local payroll.
Changing Transfer Pricing Methodology
A completely different solution would be for companies to switch from a cost-plus transfer pricing method in Israel in favor of another method such as the comparable uncontrolled price (or CUP) method. In general, under the CUP method, the fees payable to the local entity would be set by reference to third party prices, instead of to the cost base of the Israeli entity. If that method is accepted, the transfer pricing focus then turns to the comparability of the third party transaction, as opposed to the deductibility of the equity awards. It is beyond my tax expertise to explain the details of what would be needed to defend a CUP-based pricing method, but your tax folks will hopefully be able to determine if this is a viable solution.
As described above, the Kontera decision could have far-reaching consequences for the way companies grant equity awards to Israeli employees. At this time, it does not seem that any other country requires as a matter of law the inclusion of equity-based compensation in the cost base for cost-plus entities (aside from the U.S.), but the decision is a scary reminder of the issues that companies could face if other countries take a similar stance.
I would like to thank Gary Sprague, a partner in B&M’s Tax group, and Shachar Porat, a partner at the Israeli law firm Herzog Fox & Neeman, for their help with this blog entry.