The overarching goal that runs through the various regulatory approaches to address this concern is to bring about true tax collection by taxing the transaction on the basis of the actual economic price contained therein. The generally accepted measure for assessing the actual economic price is the arm's length principle. According to this principle, the actual economic price of a transaction between related companies is the price that would have been set between unrelated companies, when each of them is seeking to maximize its profits and in accordance with the market forces in which the transaction is carried out. Although the approval of the market price is not a precise science and is done according to a variety of economic, financial, and accounting assessment methods based on subjective estimates, the arm's length principle is generally seen as an indication for setting the appropriate transfer price for the purpose of an appropriate allocation of the tax revenues of the countries in the international arena.
The arm's length principle has been expressed in Israeli law in Section 85A of the Ordinance. Section 85A of the Ordinance is the main statutory source for the regulation of transfer pricing in Israeli law. The section provides that if three cumulative conditions are met, the Tax Authority will be entitled to intervene in the transaction declared by the parties and tax it in accordance with market conditions and the arm's length principle: the first – the existence of an international transaction. The second – the existence of special relations between the parties to the transaction. The third – that due to those special relations a price or terms that are not market-related were set for the transaction, in a way that less profits were generated from it than would have been generated from it in the circumstances if the price or terms had been set between unrelated parties.
For the purpose of determining the "market price" or "market terms" to which the international transaction involving related parties must be compared, the legislator enacted the Income Tax Regulations (Setting Market Terms). The Market Terms Regulations include provisions that specify how to determine the market price and market terms and establish valuation and comparison methods between similar transactions. In the case of Contara Technologies Ltd., it was determined that Regulation 2(a) of the Market Terms Regulations provides that for the purpose of determining whether the international transaction was carried out in accordance with market conditions, according to the following ranking: first, a "market terms research" must be conducted, in which the transaction under review will be compared to similar transactions according to the price comparison method. If the price comparison method cannot be applied, a method of comparing the profitability rate between the international transaction and a similar transaction or a method of comparing the division of profit or loss customary between the parties to the international transaction and the parties to a similar transaction will be adopted. If one of the methods listed cannot be applied, another method that is appropriate to the circumstances will be applied, which compares the international transaction to a similar transaction.
In conclusion, we emphasize that the purpose of "transfer pricing" is to ensure that transactions between related entities will be in accordance with market conditions and the rules set by the legislator. However, by maintaining the rules and legitimate and effective tax planning, related entities can maintain the flexibility and efficiency of their business structure and avoid non-compliance, which can lead to costly consequences for the group of companies and disputes with the various tax authorities.
