Supreme Court Upholds that Stock-based Compensation is Included in Cost Base

On April 22, 2018, the Israeli Supreme Court ruled on appeals brought by Kontera Technologies Ltd. and Finisar Israel Ltd. and counter-appeals by the respective Assessing Officers with regards to the inclusion of stock-based compensation in the cost base for cost plus arrangements. The ruling also addressed relevancy of deductibility, transfer pricing (“TP”) adjustments and burden of proof (the latter of which may be discussed separately in a future TP alert).

 

Background

Kontera Technologies Ltd. (“KT-IL”) has appealed the first judicial decision on transfer pricing matters by Israeli courts [case of Kontera Technologies Ltd v the Assessing Officer Tel Aviv, 2016]. The district court case had considered whether equity-based employee compensation should be included in the costs under a cost plus arrangement. KT-IL, an Israel-based R&D subsidiary of Kontera Technologies Inc., was issued stock-based compensation. In that case, the Israeli Tax Authority (“ITA”) had accepted KT-IL’s position on a 7% markup on costs as representing an arm’s length remuneration, however, asserted that the cost base should also include the employee stock option plan issued by the Kontera group. Moreover, the employees of KT-IL enjoyed a tax favorable stock option plan (qualified under a capital gains track under section 102(D)(2) of the Income Tax Ordinance), which denied the Israeli employer the right to deduct any expenses in relation to the options. The Tel Aviv District Court ruled that expenses incurred for an employee stock option plan by KT-IL must be included in the cost base when calculating reportable income. While the Israeli company is not allowed to deduct expenses related to the employee stock option plan for corporate income tax purposes, the acceptance by the District Court of the tax assessor’s position resulted in a significant increase in KT-IL’s taxable income.

 

Similarly, Finisar Israel Ltd. (“FIL”), an Israeli R&D subsidiary of Kailight Photonics Inc., also appealed a parallel ruling that the employee stock option plan must be included in the cost base when calculating reportable income [case of Finisar Israel Ltd v the Assessing Officer Rehovot, 2016].

 

Discussion

Both KT-IL and FIL had appealed these rulings, equipped with counter-arguments that the District Court rulings were based on misinformation and, in their view, can unjustly lead to economic double taxation. However, the Supreme Court has thoroughly reviewed these appeals and has arrived at the following binding rulings:

 

  1. Stock-based compensation is viewed as an integral part of the compensation package to the Israeli subsidiary’s employees, with the objective of improving the quality of services rendered and strengthening the bond between the company’s and employees’ cohesive goals. Therefore, it is indeed confirmed that such compensation should be included in the cost base.
  2. Nevertheless, though it must be included in the cost base, the ITA does not possess the right to automatic transfer pricing adjustments, unless the economic results deviate from the Arm’s Length Range, as defined below.
  3. The benchmarks in both cases that were identified by the tax payers and their representatives included companies that prepare their financial statements based on the US standard FAS123R (which states that costs associated with equity payment for employee services are to be expensed on financial statements in order to reflect the economic transaction taking place between a company and its employees). Therefore, it can be assumed that if there were stock-based compensation to these benchmarks, they have already been included in their cost base.
  4. The Israeli regulations recognize that the term “arm’s length” may be reflected in a range (e.g. Interquartile range, [“IQR”], a measure of statistical dispersion, based on dividing a data set in four equal quartiles) of values and not a singular point in the list of values from the benchmark companies. The Supreme Court concludes that the economic results of the intercompany service transactions in both cases deviate from the arm’s length principle as the effective markup in those cases, including stock-based compensation costs, is lower than the 2nd quartile of the IQR. Therefore, a transfer pricing adjustment is required. According to the Israeli regulations, if an economic result is outside of the range, an adjustment would be to the median point within the IQR. In the Kontera case, therefore, the Supreme Court upheld the ITA counter-appeal with respect to the extent of the adjustment and ruled that such adjustment would be to the median value of the IQR (i.e. from initially reported 7% to 9.1%).

 

The Supreme Court also upheld the ruling that the stock-based compensation may not be deducted for Israeli corporate tax purposes while under a capital gains track under section 102(D)(2) of the Income Tax Ordinance, since this section provides a specific exception to the main deductibility rule specified in Section 17 to the Income Tax Ordinance.

 

Conclusion

The result of this final binding ruling of the Israeli Supreme Court is that, for Israeli tax purposes, stock-based compensation is included in the cost base of cost plus arrangements, even in cases where it is not deductible for tax purposes by the service provider. This would apply even in a case that the effective tax rate may be considered as excessive since, on one hand the stock-based compensation increases the subsidiary’s tax base, and on the other hand, is not viewed as a deductible expense.

 

It should be noted that the Supreme Court has mentioned as an obiter dictum that it is not analyzing the prudence of Israel’s tax policy or legislation and has rather focused its analysis on appropriate interpretation to the relevant law.