INTERNATIONAL TAX NEWSLETTER

2/2006

ITALY'S TAX ADMINISTRATION HAS RULED ON APPLICATION OF TAX TREATIES TO FISCALLY TRANSPARENT ENTITIES.

1.Introduction.

Italy's tax administration, in Resolution 17/E, issued on January 27, 2006, has ruled on the application of tax treaty benefits (specifically, reduced source-based withholding tax) to Italian-source portfolio income (dividends) paid to a foreign fiscally transparent entity [1]. To better illustrate the relevance of the ruling, its analysis below is preceded by a brief summary of the general principles reflecting the international consensus reached in this area of law.

2.General International Tax Principles on Application of Tax Treaties to Fiscally Transparent Entities.

The OECD model income tax treaty (including the 2005 version) does not contain a general fiscally transparent entity provision. However, the matter has been discussed in an extensive report (entitled “The Application of the OECD Model Tax Convention to Partnerships”) prepared by the OECD Committee on Fiscal Affairs and published in 1999 (the “OECD Report”). The report provides a comprehensive analysis of tax treaty issues relating to partnerships, and the accompanying Commentary to the OECD model income tax treaty incorporates several of its conclusions.

The U.S. Model Income Tax Treaty contains several provisions directed at hybrid entities. In particular, article 4(1)(d) contains the rules that establish when an item of income derived through an entity that is fiscally transparent (under the laws of either contracting state) is entitled to treaty benefits. Treasury regulations issued under IRC Section 894 follow and expand the approach taken in article 4(1)(d) of the 1996 U.S. Model Income Tax Treaty.

The view both at the OECD and U.S. level is that treaty-reduced withholding rates for payments made to an entity that is fiscally transparent under the laws of either the source country, the entity’s residence country or the residence country of an owner of the entity are denied unless the payment is treated as “derived by” (U.S. approach) or “subject to tax” in the hands of (OECD approach) a resident of the applicable treaty partner. That requires either that: (i) the entity itself is a nontransparent entity of the treaty partner under its tax rules (i.e., it is taxed on its income in its country of residence), or (ii) the entity is transparent under the rules of the country in which it is organized, and the payment flows through currently, regardless of whether it is distributed, to the owner of the entity (both as to character and source) under the tax rules of the treaty partner where the owner reside (which means that the entity is fiscally transparent and the owner is not fiscally transparent under the rules of that country). With respect to payments to a regular hybrid entity [2], in the first case above, the treaty (if any) with the entity’s home country, would apply. In the latter case, the treaty (if any) with an entity owner’s home country would apply. If the entity is treated as fiscally nontransparent in its home country but as fiscally transparent in the home country of some of its owners, and an owner is not itself treated as fiscally transparent in its home country, then the treaty between the source country and the entity's residence country on one side, and any treaty between the source country and an owner's home country would apply concurrently. In this case, the source country would be bound by both treaties at the same time and in orderto comply with all of them simultaneously, the payer should apply the lower of the rate provided by the entity's home country treaty and the owner's home country treaty (i.e., either the entity's home country treaty rate to the entire amount of the payment, or the owner's home country treaty withholding rate to the owner's distributive share of the payment, whichever is lower). If the entity is fiscally transparent in its home country, then only the treaties (if any) between the source country and the entity's owners home country would apply (provided that an owner is not itself fiscally transparent under the laws of its home country). In this case, when the rates provvided by various treaties with the entity's home country differ, the payer should apply the specific treaty withholding rate to an owner's distributive share of the entity's income as provided under the treaty with that owner's home country.

For payments to a reverse hybrid entity [3], treaty benefits are available only to an owner of the entity (if the owner’s home country treats the entity as fiscally transparent and the owner as fiscally nontransparent) or to none at all (if the owner’s home country treats that entity as fiscally nontransparent or the owner as fiscally transparent). However, if a reverse hybrid is formed under the laws of the state of source (a domestic reverse hybrid) the savings clause of the treaty precludes treaty benefits regardless of transparency in the owner’s home country [4].


3.Italy’s Tax Principles.

In Italy, there are no statutory or regulatory provisions on the application of tax treaties to fiscally transparent entities. The experience on that subject is very limited, and administrative or judicial guidance on the topic are almost nonexistent. As a matter of Italian internal law (tax Code section 73(1)(d)), all foreign entities are classified as separate taxable entities regardless of their classification and tax treatment under the laws of the foreign country in which they are organized. The ruling in consideration represents probably the only case in which Italy’s tax administration has expressly tackled the problem and, for that reason, it deserves special attention.

4.The Ruling.

The ruling was requested on behalf of an investment fund (the Fund) organized as a limited liability company under Irish law. According to the (limited) facts submitted by the taxpayer and reported in the ruling, the Fund is established in Ireland as a common investment open fund operating in compliance with EU law, and invests in the stock of Italian companies. Its participants consist mainly of foreign pension funds. The Fund is used as a vehicle to diversify investments and save costs, and the portfolio income received by the Fund is not subject to tax in Ireland. The taxpayer applied for the ruling in Italy to obtain administrative guidance on Italy’s tax treatment of dividends paid by Italian companies to the Fund. The taxpayer’s position, as outlined in the ruling, is that the Fund is classified as a separate taxable entity for Italian tax law purposes (in accordance with Tax Code section 73(1)(d)), and therefore Italian-source dividends paid to the Fund would be subject to a statutory 27% withholding tax (in accordance with article 27(3) of Presidential Decree 600 of 1973). The taxpayer correctly observed that, despite the classification of the Fund as a separate taxable entity under Italy's domestic tax law, the Ireland-Italy income tax treaty does not apply because the Fund is not subject to tax in Ireland on its income when earned and, therefore, it does not qualify as a resident of Ireland for the purposes of the treaty [5].

However, the taxpayer argued that the benefits of tax treaties (if any) concluded between Italy and Fund participants’ home countries should apply because the Fund is a fiscally transparent entity in its own country of organization and its income flows through to the participants of the Fund (and, presumably, it is taxed upon the participants in their own country of residence) [6]. No reference is made in the ruling as to the tax classification and treatment accorded to the Fund and its participants under the tax laws of participants’ home countries (that is, if and how the participants are taxed on their distributive share of Fund’s income in their home countries). It would seem that the taxpayer did not submit any specific information in that regard.

According to the tax administration, and as stated by the taxpayer, the Italy-Ireland tax treaty does not apply because the Fund is not subject to tax in Ireland on its income. That conclusion holds true regardless of the fact that the Fund is classified as a separate taxable entity under Italian internal tax law, and reflects the general principles on application of treaties to fiscally transparent entities. Moving one step further in its analysis, the tax administration argued that in order to establish whether any tax treaty between Italy and a participant’s residence country applies (with respect to the share of Fund’s income allocable to that participant), due regard must be given to the way in which the Fund’s income is treated in the hands of the participant. In that respect, Italy’s tax administration pointed out that as a matter of Irish tax law, the income of the Fund is not allocated to the Fund’s participants in proportion to their distributive share of the Funds’ profits and subject to tax in the hands of the participants. Therefore, according to the tax administration, the benefits of any tax treaty between Italy and the state of resident of a participant of the Fund cannot apply. The tax administration expressly refers to paragraphs 3 and 5 of the Commentary to article 1 of the OECD Model income tax treaty to support its conclusions.

The tax administration’s analysis is defective to the extent that it fails to inquire how the Fund and its participants are treated under the laws of participants’ residence country. Indeed, according to the general principles analyzed in the 1999 OECD Report and thereafter incorporated in the Commentary to the OECD Model (to which Italy’s tax administration refers to in the context of its analysis), the treatment of the entity and its owners in the owners' residence country is determinative of the application of any treaty between such country and the source country.

In other words, for the purposes of establishing whether, in case of income paid to an entity that is treated as fiscally transparent under the laws of its home country, an entity’s owner may be entitled to the benefits of a treaty between the country of source of the income (in the case, Italy) and the owner’s residence country, reference must be made to the tax treatment of the income in the owner’s country of residence regardless of how the entity is treated in its home country) [7]. If, under the laws of the owner's residence country, the entity is treated as fiscally transparent and the owner is subject to tax on its distributive share of the entity’s income, then the benefits of a treaty between the owner’s residence country and the source country would apply [8]. If, under the same circumstances, the entity’s home country treats the entity as fiscally nontransparent and taxes the entity on its income, the benefits of the treaty between the entity’s state of residence and the state of source would apply concurrently [9]. In the latter case, the source country would apply the lowest rate provided for under the two treaties.

Despite the flaws in the tax administration's analysis, the ruling is extremely important for taxpayers and their advisers. Indeed, the tax administration conducted its analysis by plainly referring to the general principles agreed at the OECD level and established in the Commentary to the OECD model income tax treaty. Therefore, the ruling confirms that the Commentary in its current version, constitutes valid guidance on the matter and in general for the purpose of interpretation and application of tax treaties (even if negotiated and entered into before the current version of the Commentary existed) [10].

5.Application of EU Directives to Fiscally Transparent Entities.

Similar problems arise in the application to fiscally transparent entities of benefits derived from EU Directives. Under both the 1990 parent-subsidiary directive [11] (as amended by Directive 2003/123/CE of December 22, 2003) and the 2003 interest and royalties directive (2003/49/EC of June 3, 2003 [12], for the benefit of eliminating the withholding tax at source on dividend and interest-royalty payments to apply, the payee (which, in case of the interest and royalties directive must also be the beneficial owner of the income) must be a company resident in a EU member state under the internal laws of this state (and may not be considered resident of a third country under any income tax treaty between its state of residence and such third country), and must be subject to corporate income tax therein with no limitations or possibility to opt out.

Moreover, with respect to the parent-subsidiary directive, the payee must own at least 25 per cent of the capital of the payer, while under the interest and royalties directive there must be a direct or indirect 25 percent stock ownership between the payer and payee (beneficial owner). Clearly, the subject-to-tax requirement is not met with respect to an entity that is treated as fiscally transparent in its own state of residence [13]; therefore, in this case, the directive benefits do not apply.

The question is whether the benefits may apply in principle when, under the laws of another EU member state, such an entity is treated as fiscally transparent (regardless of whether it is fiscally transparent under the laws of the country from which income is derived) and the payments made to it are treated, for tax purposes, as flowing through to another entity resident in such other state that satisfies the requirements (that is, to a company resident and subject to corporate income tax in that state on such payments). In that case, a parallel issue would be to determine how the stock ownership requirement is applied in the case of stock owned through a fiscally transparent entity. The taxpayer did not submit any comments in this respect, so the ruling does not address any of these problems.


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[1] In general terms, a fiscally transparent entity is an entity whose income is treated as income of its owners and is taxable in the hands of the owners (that is, is treated like a partnership under U.S. tax law). By contrast, a fiscally non transparent entity is an entity that is taxed on its own income (that is, is treated like a corporation under U.S. tax law).
[2] A regular hybrid is an entity that is treated as fiscally transparent under the laws of the source country, and as fiscally nontransparent under the laws of the country in which the entity is organized, or the country of residence of the entity’s owners.
[3] A reverse hybrid entity is an entity that is treated as fiscally nontransparent under the laws the source country, and as fiscally transparent under the laws of the country in which the entity is organized (or in which the entity’s owners reside).
[4] The general principles on application of tax treaties to partnerships and hybrid/reverse hybrid entities are set out in the Commentary to the OECD model income tax treaty, particularly in paragraphs 5 and 6 (6.1 to 6.7) of the Commentary to article 1 and paragraph 8.4 of the Commentary to article 4. The OECD report also contains various practical examples illustrate the application of the such principle. Example 4 deals with payment made to a foreign reverse hybrids (and illustrates the case in which benefits of the treaty between the source country and the entity owner’s home country apply). Example 5 deals with payment made to a foreign regular hybrid (and illustrates the case in which the benefits of the treaty with the entity’s home country applies). Example 6 deals with payment to a domestic regular hybrid (and illustrates the case in which no treaty benefits apply because the entity’s owners are not subject to tax with respect to the payment in their home country, which views the entity organized in the state of source as fiscally nontransparent and does not tax the owners on the entity’s income). Example 17 deals with payment made to a domestic reverse hybrid (and illustrates the case in which no treaty benefits apply under the treaty’s savings clause). Example 7 deals with the case of double denial of treaty benefits for payments made to an entity treated as fiscally transparent in its home country and fiscally nontransparent in its owner’s home country. Example 9 deals with the case of double application of treaty benefits (that is, benefits of the treaty between the source country and (i) the entity’s home country and (ii) the entity owner’s home country) for payment made to an entity treated as fiscally nontransparent in its home country and as fiscally transparent in its owner’s home country. Under U.S. tax law, the rules are set forth under Treasury regulation section 894-1(d). The general understanding is that a treaty reflects a source country’s agreement to relieve source-based taxation of income with the expectation (and on the condition) that the residence country will exercise its right to tax the income at home.
[5] That analysis is supported by article 3 of the Ireland-Italy tax treaty (which corresponds to article 4 of the OECD model) and is confirmed in paragraph 8.4 of the commentary to article 4 and in paragraph 5 of the commentary to article 1 of the OECD model income tax treaty. It should be noted that the way in which the entity is classified under the laws of its home country prevails, regardless of the classification under the laws of the state opf source.
[6] According to the analysis in paragraph 5 of the Commentary to article 1 and paragraph 8.4 of the Commentary to article 4 of the OECD model, a tax treaty between the source country (that is, the country where income is derived) and the country of residence of an entity’s owner can apply only if, under the laws of the owner’s country of residence, the entity is treated as fiscally transparent and the entity’s owner is subject to tax on its distributive share of the entity’s income. The taxpayer does not seem to have made any specific submissions with respect to those requirements.
[7] See paragraph 5 of the Commentary to article 1 and paragraph 8.4 of the Commentary to article 4 of the OECD model. The same principles apply under U.S. tax law (article 4 of the U.S. Model income tax treaty and regulations under IRC section 894).
[8] That is illustrated in example 4 of the OECD report on the application of tax treaties to partnerships.
[9] This is a case of double application of treaty benefits, which is illustrated in example 9 of the OECD report on the application of tax treaties to partnerships.
[10] This is particularly significant because the Ireland-Italy tax treaty was negotiated and entered into force before the adoption of the commentary language that the tax administration refers to in the ruling.
[11] Implemented in Italy through Legislative Decree 136 of March 6, 1993.
[12] Implemented in Italy through Legislative Decree 143 of May 30, 2005.
[13] By definition, such an entity would not be subject to corporate income tax in its home country.