An Israeli company wholly owned by a US company acted as a research and development center for the parent company in exchange for reimbursement of costs with a defined profit (Cost Plus model). In addition, the parent granted the employees of the Israeli subsidiary options to purchase shares of the parent company. The Tax Authority demanded to tax the Israeli company for the cost of the options granted to its employees in the mother company.
The Supreme Court held that the term "transfer pricing" refers to the price charged by a particular company from another company related to it, because of the connection between the companies there is an apprehension that the price will not appropriate to the market price and therefore the Tax Authority examines the prices meticulously to ensure that true tax is collected by taxing the transaction according to the real economic price inherent in it, especially with regard to multi-national related companies operating in different jurisdictions and subject to various tax regimes. In such companies there is an apprehension that the price will be designed in such a manner as to enable the routing of revenues to the company which jurisdiction is of lower tax burden and diverting expenses to the company which jurisdiction is of higher tax burden. Section 85 of the Israeli Income Tax Ordinance allows the Tax Authority to tax a transaction at its true price when it comes to an international transaction with special relations between the parties to the transaction and for which the price or terms are not on market terms. The cost of allocating the options to the subsidiary's employees is, by its very nature, part of the cost base for carrying out the research and development services of the subsidiary for the parent company and therefore is a component that must be taxed.