If your business is on a cost plus basis, that may soon change.
The Israeli Tax Authority (ITA) has just won a significant victory in the Israeli District Court against the use of the “cost plus” basis of compensation (Ebay Marketing Israel Ltd vs. Netanya Assessing Officer, civil appeal 54654-05-19, handed down April 5, 204).
Cost plus means charging costs plus a fixed percentage profit margin on costs e.g. costs NIS 100 plus say 10% profit margin equals NIS 110.
Cost plus can mitigate the amount of profit subject to tax in Israel when a multinational group is involved, but only when appropriate. It will now be considered inappropriate in many cases in Israel.
Israel has transfer pricing legislation which is based on both OECD guidelines and the rules in Internal Revenue Code section 482 in the USA.
Background:
Ebay operates an international platform for buying and selling a wide range of products online. There are two types of user – a minority (300-400) with a managed account and the majority (around 30,000) with an unmanaged account. Users are buyers or sellers, but Ebay only collects commission from sellers. Ebay’s Israeli subsidiary (“Ebay Israel”) has a business department which cultivates the managed account holders to help them understand the Ebay policy (code of conduct) and do more business on Ebay.
The Issues:
Ebay Israel contended its functions are marketing in nature and that a cost plus basis of compensation is appropriate. Ebay Israel has no IP (intellectual property), faces minimal risks, and does not own any products,
The ITA sought to treat Ebay Israel as a limited risk distributor (LRD). An ITA Circular says an LRD may pay Israeli tax on 3%-4% of sales, not a percentage of costs.
The judgment:
The Court found that the business department conducted substantial activities with managed account users beyond pure marketing in order to promote sales, optimize profits and retain customers, including:
- Presenting products to potential new customers;
- Updating clients about upgrades;
- Understanding, the customer’s needs bad on individual data;
- The business department employees had no product expertise but knew all about Ebay’s work methods;
- Determining marketing strategies;
In short, marketing to specific users, not generally. As for unmanaged account users, the business department gave them only limited general marketing support, such as seminars, general mail, newsletters twice per year and workshops. If they wanted more, they had to go to the Ebay group abroad.
Because the Business Department cultivated specific clients on the managed account side, the Court ruled that such specific cultivation necessitates LRD compensated calculated as a percentage of sales, not general marketing compensated on a cost plus basis.
The taxpayer cited example 8 of the OECD transfer pricing guidelines in which a company is compensated on a cost plus basis for marketing watches. The Court said the business department focuses on a specific class of customers so example 8 does not apply.
Calculation errors:
The ITA won in a major victory in principle. However the Court ordered the ITA to fix several errors in its calculations:
- The ITA apparently counted users, both buyers and sellers, resulting in double taxation when calculating the Israeli portion of global sales. Ebay only collects commission from sellers.
- The Ebay group enjoyed rising revenues because of natural worldwide growth in internet traffic unrelated to the efforts of Ebay Israel.
- Other foreign companies also contributed to the revenues. Their contribution needed to be excluded.
- The ITA picked bad comparables for its transfer pricing work to arrive at a large enough sample – food distributors, other companies with far more employees, companies with inventory (not just service re-sellers). The OECD allows adjustments to be made where appropriate, the ITA didn’t do so.
Comments:
Cost plus may now be off limits for many Israeli subsidiaries of international groups where marketing (and other activities?) is specific not general.
Distributors and e-commerce operators in Israel can expect inquiries from the ITA to see if they fit Ebay’s circumstances.
Separate new OECD rules for baseline distributors may help – check them out.
It remains to be seen whether this District Court judgment is appealed.
Not mentioned in the judgment are possible Israeli VAT consequences, i.e. not only 23% Israeli company tax on profit but also 17% Israeli VAT (18% in 2025) on revenues, unless an exception applies.
What about hitech operations in Israel, including R&D centers? Many of them are compensated on a cost plus basis. In such cases the ITA has been known to argue that the profits-split method (PSM) should apply. In this case, the judgment says the ITA initially intended applying the PSM but switched to the LDR basis of calculating taxable profits in Israel, after receiving an analysis from the taxpayer’s advisors.
Next Steps:
Please contact us to discuss any of the above matters further, or any other matter.
As always, consult experienced legal and tax advisors in each country at an early stage in specific cases.
(c) Leon Harris, 10.6.24
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