Increased Transfer Pricing Scrutiny Israel ~ Cross Border Financing

• Published date: 11 November 2020
• Subject Matter: Tax, Income Tax, Transfer Pricing, Tax Authorities
• Law Firm: Pearl Cohen Zedek Latzer Baratz
• Author: Mrs Henriette Fuchs

In the third week of October, the District Court in Jerusalem released its decision in connection with the - very tax relevant - difference between a "loan" and a "capital note", a hot topic also in the eyes of the Israeli tax authorities in the arena of 'transfer pricing' as also clearly stated in recent proposals for amendment and expansion of transfer pricing legislation and regulations.

Loan or capital instrument; inclusion interest income or not

A parent company in Israel - B Ltd - had provided interest-free financing to foreign subsidiaries shaping the commitments in what it believed to be "capital notes". Financing provided by an Israeli company to a (domestic or foreign) subsidiary which qualifies as a "capital note" releases the creditor from having to report interest income in its annual tax return in relation to the financing involved. Certain high risk long term loans may qualify as a "capital notes" when the principal is not linked to any index, does not carry an interest or any other 'yield', is not repayable within 5-years and the standing of the creditor subordinate to other obligations of the recipient of the loan. For a debt to qualify as a "capital note" the mentioned terms and conditions must be cemented in to the terms of the "debt note" (the 'I owe you') which the debtor will generally issue.

In the case at hand, the Israel tax authorities positioned that the parent company had not financed the affiliated Romanian group companies against issuance of "capital notes", but that it had provided plain "loans".

When the tax assessor argued that the parent company should have recognized interest income in relation with the loans and issued his tax assessments in accordance, the District Court supported the view of the tax authorities and confirmed that the mere use of the wording "capital note" on documents do not turn a 'loan' - which does not meet all of the defining terms of a "capital note" as in Income Tax Ordinance - into a 'capital instrument'. In the case at hand most of the 'notes' did not meet the terms and therefor fell within reach of the transfer pricing chapters of the Income Tax Ordinance and required that an arms' length percentage of interest should have been reported by the Israeli parent-lender. An unfortunate circumstance for the taxpayer had been that the financial statements of the Romanian subsidiaries had described the loans as 'short term' (rather than 'long term').

The court rejected the explanations of the...