Transfer Pricing Issues for Israeli R&D Centers

William Hoke reported in Tax Notes on a recent discussion of how the Israel Tax Authority (ITA) intends to address the transfer pricing for multinationals that employ Israeli R&D centers. A 2017 discussion by Invest in Israel noted the importance of the Israeli R&D sector:

The number of multinational corporation (MNC) R&D centers in Israel is among the world’s highest, and is the highest per capita …The flourishing Israeli startup scene is one of the leading factors in the formation of successful R&D centers, since many of the acquired companies transform fairly quickly into an Israeli R&D center for the global company. This is how Apple, Facebook and HP started their R&D centers in Israel, to name a few. In many cases, the development done at the Israeli center goes far beyond the acquirer’s original intentions and beyond the original acquired technology.

The discussion notes both the sectors and the specific multinationals that rely on the 325 R&D centers in Israel. These sectors include nanotechnology, life sciences, and agritech.

A typical fact pattern is that when a foreign based multinational acquires an early state Israeli R&D center, it acquires the in-process R&D and converts the Israeli affiliate to a contract R&D affiliate receiving its ongoing R&D costs plus a reasonable markup. The ITA is questioning whether such arrangements are at arm’s length, proposing to have the profits from successful R&D ventures split between the foreign based multinational and the Israeli affiliate on the basis that this affiliate provides a unique and valuable contribution to the multinational.

This controversy has a long history, including situations where U.S. affiliates provided R&D services to foreign parent corporations. I will note how the Westreco v. Commissioner litigation provided a seminal approach to not only the issue of ownership of intangible assets developed by R&D activity, but also a framework for evaluating the appropriate markup in a contract R&D arrangement. I will also note a recent controversy in the agritech sector.

Ownership of the Intangible Assets from Successful R&D

The OECD Guidelines provide insights into issues surrounding the ownership of intangible assets, including DEMPE (Development, Enhancement, Maintenance, Protection and Exploitation) considerations. DEMPE focuses on which entity controls the research and which entity incurred the upfront risk of funding early- stage R&D.

Pfizer and Johnson & Johnson are life science multinationals with Israeli R&D centers. Research in the biopharmaceutical sector occurs in multiple stages, including Phase I, Phase II and Phase III clinical trials. Consider an Israeli startup that has successfully completed Phase II trials on a potential treatment for COVID-19. If a foreign life science multinational acquired this Israeli entity before Phase III trials commenced, the transfer pricing structuring could take many forms.

If the acquisition left the ownership of the in-process R&D with the Israeli affiliate, then compensation would have to include more than ongoing R&D plus a markup. If the parent corporation, however, compensated the Israeli affiliate for the fair market value of the in-process R&D, then cost plus compensation is appropriate,  so long as the markup is reasonable. The Westreco litigation was a seminal case where the ownership of intangibles resided with the Swiss parent and the substantive issue was whether the markup was adequate.

The Westreco Markup Issue

Nestle SA is a Swiss multinational that develops, manufacturers, and sells food products, including instant milk, coffee, tea, and cocoa products. Westreco is one of 17 contract R&D affiliates. Nestle has clear intercompany contracts that compensate their affiliates at fully loaded costs plus a markup.

The court decision noted the composition of Westreco’s costs in detail, including salaries, fringe benefits, and material costs. Salaries and fringe benefits represented approximately half of total operating costs. The inclusion of fringe benefits in the cost base is interesting in light of a 2018 Israeli Supreme Court decision involving the contract R&D arrangements for Kontera Technologies Ltd. and Finisar Israel Ltd., where the Supreme Court ruled that the cost with respect to employee stock options must be included in the cost base. The markup in the Kontera case was 8%.

Table 1 presents the key financial data for the Westreco litigation. Operating profits represented 3.75% of total costs, which translates into a 7.5% markup over labor costs. Westreco’s operating assets were approximately 50% of total costs, which implies that the return on operating assets was 7.5%. Dr. Clark Chandler used the financials for four third-party service providers to justify this intercompany (I/C) pricing policy. These four companies had similar operating assets to cost ratios to Westreco and their operating profits relative to operating assets were just over 10%.

Table 1: Key Financials (in Millions) for Westreco Under Three Alternative Markups

The IRS relied on a confusing analysis presented by Dr. Dennis Carlton and Dr. Richard Leftwich. The median markup over total costs for their 15 alleged comparables was just over 13%, which would imply a return to operating assets in excess of 26% for Westreco. The IRS experts did not justify this extreme result by any claims that Westreco owned valuable intangible assets or provide any other reason the book value of Westreco’s operating assets was not a fair reflection of their market values. In fact, they presented a separate analysis suggesting that the return to capital should be near 12%, which would be consistent with a 6% markup over total costs. Table 1 also notes that the return to labor costs for each of the three scenarios was the same as the return to operating assets as the ratio of operating assets to labor costs was approximately 100%.

A Recent Agritech Controversy

Syngenta AG is a Swiss based multinational that competes with BASF, Bayer and Monsanto in the agribusiness sector. It develops, manufactures and sells products designed to improve crop yields and food quality. Syngenta also has an Israeli R&D center. The following discussion is based on a competent authority dispute involving a US contract R&D affiliate for one of its competitors, but the logic in our illustration could apply to Syngenta’s R&D affiliate.

The contract R&D affiliate incurred $150 million in labor or valeu-added expenses (VAE) and $100 million in material of pass-through costs (PTC). Its intercompany policy was to compensate PTC with no markup and to compensate VAE with a 5% markup. Table 2 presents this intercompany policy as granting the affiliate with $257.5 million in intercompany revenue, which results in $7.5 million in profits. In terms of profits relative to total costs (TC), this intercompany policy can be expressed in terms of a 3% return to total costs.

Table 2: Financials for Agritech Contract R&D Affiliate Under Alternative Markups (in Millions)

The IRS accepted the premise of marking up only VAE, but argued that this markup should be 15%, which would increase profits from $7.5 million to $22.5 million. This controversy became a battle of what should be seen as comparable companies.

The multinational tried to justify its 5% markup using North American publicly traded engineering services providers. Table 3 presents the key financials for four companies based on their average annual income statement over the 2017 to 2019 period. Total costs for these companies include subcontractor costs, which is a form of PTC, which in many cases is nearly 25% of total costs. Table 3 shows both profits relative to total costs (P/TC) and profits relative to VAE (P/VAE). While the markup over total costs may be seen as representing a 5% markup, this evidence suggests the appropriate markup over VAE is closer to 8%. If these companies were accepted as comparables, then intercompany revenue should be $262 million and profits would be $12 million.

Table 3: 2017-2019 Financials for Four Engineering Services Companies (in Millions)

Contract research organizations in the life science sector, however, have profits that tend to be near 15% of VAE. The IRS position was that life science contract research organizations and not engineering services companies were the more appropriate comparables. 

A recent Biovia discussion noted the need for developing new crop protection products as well as the cost of R&D in this sector. Manufacturers are facing pressures from regulatory agencies to demonstrate the environmental and health safety of crop products. The cost of agritech R&D has increased to almost $300 million per product, as this research often takes more than a decade to develop a new product. This discussion suggests that agritech R&D requires greater expertise than the provision of engineering services.

Concluding Remarks

Hoke noted that the ITA officials justified profit split approaches on the basis of the education of Israeli R&D personnel. If a multinational, however, properly constructs a contract R&D arrangement and properly compensates for the transfer of in-progress R&D at fair market value, then cost plus arrangements may be appropriate if the markup over R&D expenses is appropriate.

We noted the seminal transfer pricing case with respect to benchmarking the appropriate markup as well as a recent controversy in the agritech sector. The old canard that contract R&D providers should receive 5% markup over costs glosses over several considerations, including what is included in the cost base and what is the asset intensity of the contract R&D affiliates. While economists are notorious for examining the return to the book value of operating assets, we should recognize the possibility that a contract R&D provider also owns valuable intangible assets necessary to adequately conduct their services. These considerations must be taken into account when selecting third party companies as possible comparable companies.

References

“Israeli Tax Agency Considering Profit-Split Rule for R&D Centers,” Tax Notes, Feb. 18, 2021

R&D Centers Investment Model in Israel.

Westreco, Inc. v. Commissioner, 64 T.C.M. 849 (1992).

“Streamlining Agrochemical R&D to Advance Crop Protection,” September 10, 2018.