In this proceeding an Israeli subsidiary ("Subsidiary"), wholly owned by an US parent company ("Parent"), served as a research and development center for the Parent. The two companies were parties to an agreement pursuant to which the Subsidiary provided the Parent with research and development services on a "cost plus" basis (i.e. payment of the cost of providing the service plus a fixed rate). It was also agreed that the Parent would grant employees of the Subsidiary options to purchase stock of the Parent at a predetermined price. The allotment of the options was made within the framework of the "capital gains track" of Section 102 of the Israeli Income Tax Ordinance. The dispute at hand was whether the "cost" of allotting employee options could be omitted from the Subsidiary's cost base from which the amount payable by the Parent was calculated.
In this ruling, the Israeli Supreme Court ("Supreme Court") noted that international transactions between companies with "special relations" are characterized by a difficulty of estimating the real economic value of the transaction and that there is a risk that income is being improperly channeled to countries with a lower tax rate. The Supreme Court remarked that the accepted criterion for determining the real economic value in "special relations" transactions is the economic value of such a transaction that would be determined between unrelated companies each of which wishing to maximize its profits. This principle is also reflected in the Israeli Income Tax Ordinance, which establishes three cumulative conditions to allow the tax assessor to object to the reported value of a transaction and to impose tax in accordance with market conditions: (i) the existence of an international transaction; (ii) the existence of "special relations" between the parties to the transaction; (iii) out of market price or provisions for the transaction due to the special relations between the parties. The issue in dispute in this case is the existence of the third condition.
The Supreme Court discussed two tests to determine whether the cost of allocating options to the Subsidiary's employees should be included in the cost base according to which the payment by the Subsidiary to the Parent in the cost plus transaction is calculated.
The first and principal test is to examine the nature of employee option expense and whether it should be considered as part of the Subsidiary's costs of providing services to the...