A recently published Tax Ruling (4306/26) sheds light on one of the most critical issues in the Israeli tech-industrial sector: When does income from patent licensing (royalties) qualify as "Preferred Income," eligible for reduced corporate tax rates (7.5% or 16%)? The Israel Tax Authority (ITA) has signaled a "green light" for such benefits, but with strict caveats regarding workforce stability and revenue caps.
‍

The Bottom Line:
Industrial companies developing Intellectual Property (IP) can now enjoy reduced tax rates on royalty income, not just on physical product sales. However, this benefit is contingent on maintaining a "manufacturing core" in Israel (no more than a 20% decrease in workforce) and is capped at 25% of total sales revenue. Exceeding these thresholds will trigger the full corporate tax rate (23%) on the excess income.
‍

Key Findings:

• Patent as a Qualified Asset: The ITA recognizes patents developed in-house as "Qualified Intangible Assets" under the Encouragement of Capital Investments Law.
• Activity Maintenance Test: A reduction of 20% or more in the number of manufacturing employees or their salary costs (relative to a two-year average) will disqualify the royalty income from tax benefits.
• The 25% Revenue Cap: The tax benefit applies only to royalties that do not exceed one-quarter of the company’s "Preferred Income" from direct product sales.
  ‍

Background: Manufacturing vs. Licensing

The case involved an Israeli company that develops and manufactures advanced fire and gas detection systems. The company’s revenue model is hybrid: it generates income from direct sales of patent-based products and from licensing those same patents to third parties in exchange for royalties.

The company sought to ensure that the "smart money" derived from royalties would also be classified as "Preferred Income," granting it significantly lower tax rates compared to the standard 23% corporate tax.
‍

The Legal Issue: When is a Royalty "Industrial"?

The legal question hinges on Section 51 of the Law for the Encouragement of Capital Investments. The challenge is to distinguish between a passive "IP shell company" (which is ineligible for benefits) and an active "Industrial Enterprise" that uses its patents as an integral part of its manufacturing activity. The ITA was required to determine the correct "dosage" between physical production and IP utilization.
‍

The ITA’s Decision and Legal Analysis

The ITA approved the request but established a "restraint mechanism" to ensure the company remains a productive growth engine in Israel. The key conditions are:

1. The Manpower Test (The 20% Rule): The company must maintain its manufacturing workforce in Israel. If the number of employees or their salary costs drop by more than 20% compared to the average of the two years preceding the licensing agreement, the royalty income loses its "Preferred" status.
2. The Proportionality Test (The 25% Cap): The ITA ruled that royalties are "ancillary" to production. Therefore, the benefit is capped at 25% of the Preferred Income derived from the sale of the products themselves. Every shekel received beyond this cap will be taxed at the full corporate rate under Section 126 of the Ordinance.
   ‍

Practical Takeaways for Executives

For tech-industrial companies integrating IP into their business model, this ruling necessitates strategic tax management:

• Workforce Planning: Before implementing efficiency measures or layoffs in manufacturing departments, evaluate the impact on your IP tax benefits. Operational streamlining could prove costly in tax terms.
• Revenue Mix Balance: Companies planning to pivot toward a "Licensing Only" model must understand that they risk losing the benefits of the Encouragement Law if they do not maintain a proper ratio between physical sales and royalties.
• IP Development Documentation: To qualify, you must prove the patent is a "Qualified Intangible Asset" developed within the company. This highlights the importance of real-time R&D documentation.
  ‍

FAQ

Q: Can a Software-as-a-Service (SaaS) company benefit from this ruling?
A: This specific ruling focused on a "classic" industrial plant manufacturing physical products. While the principles of "Qualified Intangible Assets" are relevant to software, SaaS companies are typically governed by the specific definitions of a "Technological Enterprise" (Mif'al Technologi).

Q: What happens if my royalty income exceeds the 25% cap?
A: You will not lose the entire benefit. The portion up to 25% will be taxed at the reduced rate, and only the surplus above the cap will be subject to the full corporate tax rate (23%).

Q: Does the workforce test include outsourced contractors?
A: The ruling specifically refers to "manufacturing employees in Israel." Generally, this implies direct employees, but each case should be examined based on the specific definitions in the individual ruling (Ruling) granted to the company.

‍