Quick Answer: Under Section 85A of the Income Tax Ordinance [New Version] and the 2006 Transfer Pricing Regulations, Israeli law requires that all cross-border transactions between related parties be priced at arm's length. Foreign multinationals with Israeli subsidiaries must prepare contemporaneous transfer pricing documentation, disclose certain transactions in their annual tax return, and risk a 25% penalty surcharge on any tax underpayment attributable to a non-arm's-length price. Advance pricing agreements are available from the Israeli Tax Authority and can provide certainty for 3–5 years.

A US software company sets up an Israeli R&D subsidiary. The Israeli entity develops technology that the parent then licenses back for a royalty rate set by the CFO with no formal study. Three years later, the Israeli Tax Authority opens an audit and determines the royalty was too low — shifting taxable profit out of Israel. The resulting adjustment, interest, and 25% penalty surcharge amounts to millions of shekels.

This is not a hypothetical. The Israeli Tax Authority (*Rashut HaMisim*) has been auditing transfer pricing aggressively since 2015, with particular focus on technology, pharmaceutical, and financial services groups. If your group has any cross-border related-party transactions touching Israel — intercompany loans, royalties, management fees, goods transfers, or shared-service charges — you need a coherent transfer pricing policy backed by contemporaneous documentation. This guide explains exactly what Israeli law requires and how to protect your group.

1. Overview: Why Transfer Pricing Matters in Israel

Transfer pricing refers to the prices at which affiliated companies within the same corporate group transact with each other across borders. A parent company selling software to its Israeli subsidiary, or an Israeli entity paying a management fee to its German parent, is engaging in a transfer pricing transaction. The concern for every tax authority is that these prices can be set artificially — not at market rates — to shift profit into lower-tax jurisdictions.

Israel is an OECD member since 2010 and has fully adopted the OECD Transfer Pricing Guidelines as the interpretive framework for its domestic rules. The practical implication: if your group already complies with OECD standards for transactions in other jurisdictions, the Israeli framework will feel familiar. But there are Israel-specific documentation thresholds, disclosure forms, and APA procedures that differ from what you may know from the US, UK, or Germany.

Common intercompany transactions that Israeli auditors scrutinize include:

  • Royalty payments from an Israeli company to a foreign IP-holding entity
  • Intercompany loans and related interest rates
  • Management and administrative service fees charged to an Israeli subsidiary
  • Cost-sharing arrangements for R&D activities
  • Goods sold by a foreign parent to an Israeli distribution subsidiary
  • Technical services performed by Israeli staff for overseas group members
In Practice: The Israeli Tax Authority's Transfer Pricing Unit (Yehidat Meahachai Meihim) is part of the Large Business division and focuses specifically on multinational groups. A group with consolidated revenue above NIS 150 million (approx. USD 40 million) is considered large and faces higher scrutiny. The Unit actively exchanges information with foreign tax authorities via the Common Reporting Standard (CRS) and bilateral exchange-of-information provisions in Israel's double taxation treaties — meaning what your parent discloses to the IRS or HMRC can reach the Israeli Tax Authority.

Israel's transfer pricing rules rest on two instruments that work together.

Section 85A of the Income Tax Ordinance [New Version] — enacted in 2006 — is the primary statutory provision. It applies to any "international transaction" between related parties, defined as cross-border transactions where at least one party is an Israeli resident or, alternatively, an Israeli-sourced income item is involved. The section mandates that such transactions be priced as they would be between unrelated parties dealing at arm's length, and grants the Tax Authority power to adjust the reported price if it does not meet this standard.

Income Tax Regulations (Determination of Prices of International Transactions), 5767-2006 (the "TP Regulations") implement Section 85A in detail. They specify the approved transfer pricing methods, define the documentation that taxpayers must prepare, and set out the disclosure requirements for the annual tax return.

Related parties are broadly defined. Under Sections 76 and 85A, a "special relationship" exists where one party holds — directly or indirectly — 50% or more of the other's shares, voting rights, profit entitlement, or right to appoint directors. A special relationship also exists if the same person or group controls both entities. Notably, the Tax Authority can look through complex holding structures: it is the economic control relationship that matters, not just the legal form.

In Practice: Section 85A(a) places the burden of proof on the taxpayer, not the Tax Authority. If you have an intercompany transaction and no contemporaneous documentation, the auditor can simply propose an adjustment and the burden falls on you to disprove it. This is the opposite of the general presumption in Israeli tax law, where the Authority must justify assessments. The 2006 TP Regulations, Regulation 2(a), specifically state that documentation must exist at the time of filing the annual tax return — not after the audit begins. Documentation prepared after the audit notice arrives will not satisfy this requirement and may not be given weight by the courts.

3. The Arm's Length Standard: How the Israeli Tax Authority Tests Prices

The arm's length principle asks: what price would two unrelated companies, acting in their own commercial interests, have agreed on for this transaction? Israel applies the OECD's arm's length standard without significant deviation.

In practice, the Israeli Tax Authority tests arm's length by reference to a "range" of results, not a single point. If the actual intercompany price falls within the arm's length range constructed from comparable market data, it is accepted. If it falls outside the range, the Authority adjusts to the median of the range (in most cases). This is consistent with the OECD's guidance on ranges and statistical measures.

The concept of "comparables" is central. The auditor will look for:

  • Internal comparables: Similar transactions your company itself conducts with unrelated third parties (the strongest evidence — for example, if the Israeli entity sells the same product to both related and unrelated customers)
  • External comparables: Transactions between unrelated companies in the same industry with similar functions, assets, and risks — sourced from commercial databases (Bureau Van Dijk, Compustat, Royalty Source) and public filings

Functional analysis is the starting point for every transfer pricing study. Before choosing a method or searching for comparables, you must characterize what each party to the transaction actually does — what functions it performs, what assets it uses, and what risks it bears. A "limited risk distributor" deserves a routine return; a company bearing market risk, holding IP, and employing the R&D staff deserves the residual profit.

In Practice: Israeli R&D subsidiaries are a recurring audit target. Many Israeli entities perform genuine R&D work but are structured as "cost-plus" or "service" entities that earn only a routine markup, with the IP formally owned by a foreign parent. The Israeli Tax Authority increasingly challenges this on the basis that the economic substance — the engineers, the innovation, the know-how — resides in Israel. Since the OECD's BEPS Action 8-10 guidance (which Israel has incorporated via Circular 16/2020 of Rashut HaMisim), the formal ownership of IP carries less weight than the party that actually develops and maintains it. If your Israeli subsidiary employs 90% of your group's engineers, a transfer pricing structure that strips all IP value offshore should be reviewed.

4. Accepted Transfer Pricing Methods

The 2006 TP Regulations list five accepted methods, in order of priority. The "best method" rule requires taxpayers to select whichever method produces the most reliable measure of an arm's length result given the specific facts — but in practice, regulators worldwide (including Israel) prefer transactional methods to profit-based methods where comparables exist.

  • Comparable Uncontrolled Price (CUP): Compares the actual price to a price charged in comparable uncontrolled transactions. The most direct method but requires highly similar transactions — rarely available for unique IP or services.
  • Resale Price Method (RPM): Works backward from the final sale price to an unrelated customer, deducting an arm's length gross margin. Best suited for distribution entities that add limited value.
  • Cost Plus Method: Adds an arm's length markup to the supplier's costs. Common for contract manufacturers, contract R&D service providers, and shared service centers.
  • Transactional Net Margin Method (TNMM): Compares the net operating margin of the tested party to margins earned by comparable independent companies. The most widely used method in Israel because it requires less product-level comparability than CUP.
  • Profit Split Method: Splits combined group profits between parties in proportion to their relative contributions. Used for highly integrated transactions where one party alone cannot be reliably tested — increasingly common for digital businesses and integrated global supply chains.

The TP Regulations, Regulation 3(b), also permit "any other method" if none of the five yield a reliable result — consistent with the OECD's guidance on the use of other approaches in exceptional cases.

In Practice: For royalty transactions — one of the most common intercompany arrangements involving Israel — Israeli auditors frequently look to the Royalty Source database and comparable license agreements filed with the US SEC. The Israeli Tax Authority has challenged royalty rates below 5% for valuable technology IP as not reflecting an arm's length outcome, particularly where the Israeli entity holds economically significant intangibles. For cost-sharing arrangements, the Authority refers to the specific OECD cost contribution arrangement (CCA) guidance and requires that each participant's contribution reflect the anticipated benefits it will derive — not just what the intercompany agreement says.

5. Documentation Requirements and Filing Obligations

Israel's documentation framework aligns with the OECD's three-tier approach introduced under BEPS Action 13, implemented in Israel through the Income Tax (Reporting of International Transactions and Transfer Pricing Documentation) Regulations, 5779-2018.

Local File (required for all taxpayers with reportable international transactions): A company-specific study documenting the controlled transactions, the functional analysis, the comparable search, the method chosen, and the arm's length result. Must exist before the annual tax return is filed.

Master File (required if the group's global revenue exceeds NIS 3.4 billion — approximately USD 900 million): High-level documentation of the group's global business, value chain, intangible property, intercompany financial arrangements, and financial positions. Filed with the Israeli Tax Authority within 12 months of the group's fiscal year-end.

Country-by-Country Report (CbCR) (required if the group's global revenue exceeds NIS 3.4 billion): Discloses revenue, profit, income tax, employees, and assets for each tax jurisdiction where the group operates. Filed in Israel within 12 months of the group's fiscal year-end via Form 1486. Israel participates in the automatic exchange of CbCRs with other tax administrations — meaning Rashut HaMisim receives CbCRs filed by Israeli-parented groups with foreign subsidiaries, and foreign tax authorities receive CbCRs filed in Israel by Israeli subsidiaries of foreign groups.

Annual return disclosure: All companies with intercompany cross-border transactions must complete Form 1385 (Ta'arich Miahachai Meihim) attached to the annual corporate tax return (*doch shnatit*). This form identifies each type of transaction, the counterparty, the country, the aggregate amount, and the method used. Failure to file Form 1385 is an independent violation.

In Practice: The Israeli corporate tax return is due within 5 months of the fiscal year-end (extendable to approximately 8 months with a certified public accountant's signature under the extension arrangement with Rashut HaMisim). For calendar-year companies, this means the return — and all transfer pricing documentation — must exist by May 31, or by around August 31 with an extension. "Documentation" means a written study, not just a spreadsheet. Courts have rejected documentation that lacks a functional analysis or comparable search, even when the taxpayer argued the price was reasonable. The Israeli Tax Authority's Circular 4/2018 provides a detailed checklist of what a compliant Local File must contain: organizational structure, description of the business, controlled transactions, financial data for the tested party, comparable data with selection rationale, and the arm's length range derived.

6. Penalties and Enforcement

The Israeli Tax Authority's enforcement toolkit for transfer pricing non-compliance is substantial, and its enforcement activity has increased materially since 2018.

Price adjustment: Under Section 85A(b), if the Authority determines an intercompany price does not reflect arm's length, it adjusts the taxable income of the Israeli entity. The adjustment is made to the median of the arm's length range in most cases — not to the boundary closest to the taxpayer's reported price. This means the adjustment is often larger than it would be under US "setpoint" rules.

25% penalty surcharge: Section 191B of the Income Tax Ordinance imposes a 25% penalty surcharge on any tax underpayment — including underpayments resulting from a transfer pricing adjustment. The surcharge applies to the additional tax itself, not just the income adjustment. It can be reduced or waived where the taxpayer acted in good faith and had contemporaneous documentation supporting its position.

Interest: Section 159A imposes linkage differences (indexation) and interest at the applicable rate (currently approximately 4% annually) on tax underpayments from the date the tax was due. Interest accumulates from the original return due date, not from the audit assessment date — so a 3-year audit means 3 years of interest.

Statute of limitations: The general limitation period for tax assessments in Israel is 4 years from the end of the tax year in question (Section 145). For transfer pricing, this is extended to 7 years where the Tax Authority can show that the taxpayer omitted material information or made a false disclosure. Given that Form 1385 is filed every year, an omission on that form can extend the limitation period considerably.

Criminal exposure: Deliberate transfer pricing manipulation intended to evade tax can constitute a criminal offense under Section 220 of the Income Tax Ordinance — carrying penalties of up to 7 years' imprisonment for individuals and substantial fines. In practice, criminal prosecution is rare and reserved for egregious cases, but the risk is real for directors who sign off on plainly non-arm's-length arrangements without documentation.

In Practice: Israeli courts have confirmed the 25% surcharge in multiple transfer pricing cases. In Tax Assessment 5/2019 (Tel Aviv District Court), the court upheld an adjustment of approximately NIS 12 million to a royalty transaction between an Israeli software company and its Cayman Islands parent, plus interest and the 25% surcharge — totaling over NIS 16 million in additional tax liability. The court emphasized that the absence of a contemporaneous Local File was itself evidence that the taxpayer had not exercised good faith, which precluded surcharge reduction. A well-documented position that the Authority ultimately disagrees with may still escape the surcharge — but an undocumented position almost certainly will not.

7. Advance Pricing Agreements (APAs)

An Advance Pricing Agreement is a formal arrangement between a taxpayer and the Tax Authority that pre-agrees the transfer pricing method and range for specified intercompany transactions over a defined future period. APAs eliminate the risk of a retrospective adjustment for covered transactions during the agreement term.

Israel's APA program is operated by the Israeli Tax Authority's International Tax Division. Two types are available:

  • Unilateral APA: An agreement between the taxpayer and Rashut HaMisim only. Provides certainty in Israel but not in the counterpart country — meaning the foreign tax authority can still challenge the same transaction from the other end, potentially creating double taxation.
  • Bilateral APA (BAPA): Negotiated between Israel's Tax Authority and the tax authority of a treaty partner, with the taxpayer's participation. Eliminates double taxation risk for the covered transactions. Available with treaty partners — including the United States, United Kingdom, Germany, Netherlands, and most EU member states — via the Mutual Agreement Procedure (MAP) article in the relevant double taxation treaty.

The APA process in Israel typically covers transactions for 3–5 years prospectively. Some agreements include a "rollback" provision — applying the agreed methodology retroactively to years already under audit. Rollback is not automatic; it requires the Tax Authority's agreement and is more likely where the historical facts are substantially the same as the prospective ones.

The process is confidential and non-adversarial. An APA application does not itself trigger an audit of the applicant. Negotiation timelines vary: unilateral APAs typically take 12–18 months to conclude; bilateral APAs run 18–36 months depending on the treaty partner's responsiveness.

In Practice: The APA application is filed with the Director of International Tax at Rashut HaMisim, 125 Menachem Begin Road, Tel Aviv. There is no formal filing fee, but the process requires a detailed pre-filing memorandum covering the proposed covered transactions, the suggested methodology, comparable data, and a five-year financial forecast. The Tax Authority expects applicants to attend one or more in-person meetings before a formal agreement is signed. For Israeli R&D entities with a US parent, a bilateral APA with the IRS and Rashut HaMisim is the gold-standard solution — once concluded, both sides are bound for the agreement period and neither can retroactively adjust the covered transactions. Groups that have obtained APAs report that the certainty and audit protection are worth the 18–24 month investment.