Executive summary

Following Israel's enactment of Qualified Domestic Minimum Top-up Tax (QDMTT) legislation effective for income from 1 January 2026, the Knesset Finance Committee approved the legislation of Chapter 10, "Law for the Encouragement and Incentivization of Research and Development, 2026" (the Law) on 15 March 2026. The Law was published as final legislation on 13 April 2026. (For background on the QDMTT legislation, see EY Global Tax Alert, Israel implements Qualified Domestic Minimum Top-up Tax effective beginning in 2026, dated 14 January 2026.)

The Law aims to maintain the attractiveness of Israel's tax incentive regime for research and development (R&D) companies in light of Pillar Two rules, while it also is designed to allow R&D incentives to qualify as Qualified Refundable Tax Credits. It should be noted, however, that the framework is not limited to companies subject to Pillar Two.

Key highlights of the legislation

Scope and effective date

The Law applies to corporate groups consisting of Israeli Qualifying Companies that jointly meet all of the following cumulative conditions:

1. The group generates income in Israel of at least 100 million New Israel sequels (NIS100m) from a Preferred Enterprise or Preferred Technological Enterprise.
2. At least 55% of the aggregate income of the Israeli companies in the group, excluding intercompany dividends, must derive from such enterprises. Income from marketing assets are treated as preferred income for these purposes.
3. The group must employ at least 200 full-time employees in Israel, or alternatively employ at least 150 employees in the current year with an average of at least 200 employees over the preceding three years. All employees are counted for this purpose, regardless of whether they are engaged in R&D activities.

Credit rates

The tax credit is calculated after determining the qualifying R&D expenses. A Special R&D Enterprise or an industrial plant located in Development Area A is entitled to a credit of 25% of qualifying R&D expenses up to a cap of NIS1.05b, and 30% for qualifying R&D expenses exceeding that cap. A standard R&D enterprise is entitled to a credit of 3% of qualifying R&D expenses up to the cap, and 4% for qualifying R&D expenses above the cap.

The Law's benefits apply to qualifying R&D expenses incurred from the 2026 tax year onward. The Minister of Finance may amend the caps and credit rates.

Components of qualifying R&D expenses

Qualifying R&D expenses include R&D expenditures reflected in the financial statements, including expenses not classified as R&D for accounting purposes and that may appear under cost of goods sold or general and administrative expenses, provided they meet the criteria of qualifying R&D expenditures. Grants are deducted, except for grants relating to the acquisition of buildings.

These expenses include:

• Payroll costs for R&D employees as per Form 126 (excluding equity-based compensation), along with related social costs
• Depreciation on productive assets used for R&D, excluding depreciation allocated due to capitalization of R&D costs
• R&D-related expenses for equipment and consumables
• 65% of R&D expenses paid to an unrelated Israeli subcontractor, provided that the subcontractor's corporate group does not also claim a credit for those expenses
• 65% of R&D expenses paid to a foreign subcontractor for clinical trials conducted abroad or for other activities defined by the Minister of Finance as activities that could not have been performed in Israel

R&D expenses paid to a related Israeli subcontractor may be included in full, provided that the expenses qualify as R&D expenses and the subcontractor's group does not claim a credit for them. Overhead expenses, excluding rent or building depreciation, may also be included up to 20% of the payroll cost of R&D employees, including payroll of a related subcontractor. The Minister of Finance may expand the definition of qualifying R&D expenses through regulations.

Tax credit and grants

A Qualifying Company may apply the credit either against corporate income tax payable in the tax year following the year after the R&D activity occurred or, at the company's election, against local top-up tax (such as a QDMTT) payable in Israel for income derived in the year the qualifying R&D expenses were incurred. The credit is refundable, meaning that if it is not utilized within four years, the remaining balance will be paid to the company as a government grant. Companies may also choose in advance to forgo using the credit to offset tax and instead receive the credit amount as a grant at the end of the four-year period.

Additionally, the Minister of Finance has authority to issue regulations concerning the Israeli Angels Law, including the potential conversion of depreciation or deduction incentives relating to the acquisition of companies into a credit mechanism.

Submission process

• Representative company: Eligibility for the credit requires all Qualifying Companies within the group to submit a power of attorney document, authorizing one entity to serve as the representative taxpayer for purposes of reporting and credit application.
• IIA approval: The representative company must obtain approval from the Israel Innovation Authority (IIA) regarding the classification of qualifying R&D expenses. The company must submit its request for approval within 24 months of the end of the year in which the expenses were incurred, and the IIA is required to issue its decision within 150 days.
• Centralized report: The representative company must also file a centralized report with the Israel Tax Authority in the approved format. Each qualifying company must then submit its own application for the tax credit and indicate its chosen method for utilizing the credit.

Next steps

The legislation applies to R&D expenses incurred from 1 January 2026. This marks a significant development for multinational groups operating in Israel. Given the Minister of Finance's authority to adjust rates, caps and certain operational elements of the regime, further refinement of the framework is anticipated as the legislative process progresses.

Given the potential for a significant impact on multinational groups, in-scope groups and stakeholders should:

• Assess the potential impact of the regime on financial statements, including interactions with Pillar Two calculations, effective tax rate modeling and QDMTT exposures.
• Evaluate structural considerations such as mid-year reorganizations, acquisitions and integration activities that may affect the eligibility or classification of R&D expenditures.
• Begin preparing internal processes for identifying, mapping and documenting qualifying R&D expenses, including alignment with Innovation Authority requirements and the representative-company filing model.