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 Parent. The Court concluded that employee options are a method of remuneration and are, by their very nature, expenses incurred in the provision of the service and the generation of the Subsidiary's income. Therefore, the Supreme Court stated that as a rule, this cost should be considered part of the cost base to calculate payments to Parent in a cost plus transaction.

The second test is whether unrelated parties conducting a similar transaction tend to include the cost of allocating employee options as part of the cost base in a cost plus transaction. It was noted by the Supreme Court that most of the comparable companies surveyed in market studies that were filed by the parties to the litigation as part of their filings to the Tax Authority applied American accounting standards in their financial statements that were comparable to the Israeli standards. According to both of these standards, expense in allocating employee options should be recognized as an operating expense in the profit and loss statement in the amount of the value of the options on the date of grant and in accordance with various valuation methods. Therefore, the claim that the cost of allocating the options should not be included in the cost basis of cost plus transactions is inconsistent with the market research studies submitted by the Parent and Subsidiary.

Another issue that was addressed in the ruling is the entitlement of a company to deduct from its income its expenses in an amount equal to the total value of options allotted to a trustee under the capital gains track under Section 102 of the Income Tax Ordinance. The companies' position was that there must be symmetry between the inclusion of the cost of the allocation of options in the cost base and the deduction thereof: if the expense was included in the cost base, the expense should be deductible. However, it was determined that the option expense is not deductible, even though the cost of option allotment constitutes an expense in the production of income. This is due to a section of the Income Tax Ordinance that explicitly prohibits the deduction of an expense in respect of allotment of shares and options under the capital gains track of Section 102 of the Income Tax Ordinance.

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