Your Taxes: Technological versus marketing income

Dividends are generally taxed at 20%. The resulting combined tax burden on distributed profits is generally 26%-32.8%, subject to any tax treaty. Lower rates are possible for certain large enterprises with annual revenues over NIS 10 billion.

The OECD has embarked on a campaign against base erosion and profit shifting (BEPS), i.e., shifting profits offshore. An OECD pronouncement against phony preferential tax regimes (BEPS Action 5) allows a country to give tax breaks for substantial activities within that country.

It says the only IP assets that could qualify for tax benefits under an IP regime are patents and other IP assets that are “functionally equivalent to patents” if those IP assets are both legally protected and subject to similar approval and registration processes, where relevant. IP assets that are “functionally equivalent to patents” are: (i) patents defined broadly, (ii) copyrighted software, and (iii) in certain circumstances, other IP assets that are nonobvious, useful, and novel.

With the OECD in mind, the Encouragement Law makes eligibility for the Israeli hi-tech tax breaks conditional on the existence of a “preferred intangible asset,” which does NOT include a marketing asset.

Income derived from marketing IP is not eligible for Israeli tax breaks. Marketing income needs to be split out from hi-tech income.

Regulations dating back to 2017 say marketing income need not be stripped out if it does not exceed 10% of total technological income.

The new tax circular makes it easier to come within the 10% exception.

According to the new tax circular, the following types of income need NOT be allocated to marketing IP in these circumstances:

• First, income from business to business (B2B) sales or business to government (B2G).

• Second, purchases of products from the company that are based on technical or functional parameters.

• Third, purchases based on regulatory requirements.

• Fourth, sales of components for inclusion in a final product and/or subcontract activities if the component loses its own separate identity in the production process.

• Fifth, grant of usage rights for an extended period to another company that develops a preferred intangible asset – where the company’s revenues stem from royalties – “tend” not to be marketing income.

• Sixth, little or no substantial competition in the market for the product due to its being unique.

• Seventh, where marketing expenditure is low compared to R&D expenditure. The circular says this does not say what the ratio should be; it all depends on the circumstances.

• Eighth, other instances are possible, subject to the ITA confirming them in writing.

The circular says in view of the complexity involved in identifying marketing assets and income arising from them, a local tax office should refer the allocation of income or gains to marketing IP to the ITA’s national-level Professional Division. Likewise, any “best judgment” estimated assessment must be approved by designated senior officials at the Professional Division.

This should put the brakes on local-level initiatives to assess marketing income without national-level approval, thereby providing the hi-tech industry with a degree of tax uniformity and certainty.

Comments: The ITA's effort to avoid controversy over taxing marketing income in an objective way is commendable. This should reassure Israeli hi-tech investors and multinational groups that use Israeli R&D.

Moreover, multinationals can compensate Israeli R&D subsidiaries on a cost-plus-10% basis under the above Encouragement Law regulations in applicable circumstances.