Option Value is Part of Cost + Basis
In Finisar Israel Ltd. v Tax Assessor Rehovot, the Tel Aviv District Court discussed whether a subsidiary company which provided services to its foreign parent company on a Cost+ basis (Cost+ is a method in which the service provider is reimbursed for all its expenses, plus an additional percentage of profit), is obligated to consider the value of the options granted to its employees by the parent company as part of its expenses.
Since the profit of the service provider in a Cost+ model increases as the cost increases (since the “+” factor is not fixed, but rather a percentage on top of the cost) this question directly impacts the taxable income of the service provider. Since the Cost+ basis is a common structure in the Israeli hi-tech market (as many foreign companies have Israeli R&D subsidiaries that develop technology for the benefit of the foreign company), this issue has an industry-wide significance.
The appellant, Finisar Israel, was a fully-owned subsidiary of a foreign company (incorporated in Delaware), which provided research and development services to the foreign parent on a Cost + basis. The foreign parent granted Finisar’s employees exercisable options to purchase shares of the foreign parent company. The granted options accounted for a significant portion of the employees’ remuneration.
The Tel Aviv District Court accepted the position of the Tax Assessor and held that the options granted to Finisar’s employees were granted with the purpose of motivating them to invest in the services granted (i.e. in this case research and development) as part of their compensation package, and should thus be classified as an expense geared towards increasing Finisar’s profits. Therefore, the option grants are part of the company’s expenses in order to produce income, and should be taken in to account in the evaluation of the company’s cost, and the company’s profits under the Cost+ formula. Accordingly, the value of the options are part of the cost basis, and thus the profits and the derived income taxes are to be evaluated accordingly.
The District Court ruled that, as any other expense, Finisar was entitled to charge the foreign company to pay the “+” factor percentage on top of the value of the options, and that factor should be deemed part of its taxable income. Therefore Finisar was obligated to pay tax for those deemed profits.
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