INTERNATIONAL TAX NEWSLETTER


Issue # 1 - April 4, 2005

With this issue we begin our newsletter service after a long-prepared and significant step forward in the development of our practice, which is represented by the opening of our office in New York City. We are proud to maintain an exclusive specialist expertise in international taxation and believe that through our fixed presence in New York, the financial capital of the world, we now join local knowledge and a real international profile, can better serve our international clients and can stay at the forefront in the field. Our biweekly International Tax Newsletter is intended to provide a flash update on some of the latest developments in the area of international tax, with particular focus on Italy, the European Union and the United States. We are excited at the challenging work ahead and committed to do our best. Your are strongly encouraged to provide your feedback, suggestion and criticism, to enable us to always improve our service.


Thank you


Marco Rossi


Marco Q. Rossi & Associati, International Tax Practice


Italy-New York
ITALY


ITALIAN TAX ADMINISTRATION ISSUES GUIDANCE ON NEW ANTI-THIN CAPITALIZATION RULES

With Circular n. 11/E issued on March 17, 2005 the Italian tax administration provided long-awaited guidance on the anti-thin capitalization rules of Income Tax Code (“ITC”) section 98, enacted in 2004. According to these rules, interest on related parties financing is nondeductible by the borrower if the debt-equity ratio at the borrower level exceeds a certain limit. In particular, if the ratio of the average amount of loans and other extensions of credit made or guaranteed by a qualified shareholder or any of its their related parties, during the taxable year ("disqualified debt"), and the share of borrower's net equity (at book value and reduced by certain items) pertaining to such qualified shareholder and its related parties, as of the beginning of the taxable year, exceeds 4 to 1 ("the permitted ratio"), interest paid or accrued on the part of the disqualified debt exceeding the ratio ("excess debt") is non deductible by the borrower. For purposes of determining the applicability of the rules, the debt-equity ratio computation is made both on an aggregate basis, taking into account all qualified shareholders and related parties (general debt-equity ratio), and then on an individual basis, with respect to each qualified shareholder and related party lender (specif debt-equity ratio). A "qualified shareholder" is any person that controls the borrower, within the meaning of section 2359 of the Civil Code (i.e., directly or indirectly owns more than 50% of the borrower’s voting power, or directly or indirectly owns sufficient voting power to exercise a dominant influence on the borrower, or can exercise a dominant influence on the borrower pursuant to specific contractual relationships), and any shareholder owning at least 25 per cent of the stock of the borrower, by value, computed including also the stock owned by the shareholder's related parties. A "related party" is a company that is controlled by a qualified shareholder within the meaning of section 2359 of the Civil Code (as referred to above). In case of multiple loans made or guaranteed by a qualified shareholders or its related parties, the average interest rate is computed by dividing the total remuneration paid or accrued on the total amount of disqualified debt by the total amount of disqualified debt, and then the nondeductible interest is computed by applying the average interest rate so obtained to the excess debt pertaining to each qualified shareholder and related party lender. Nondeductible interest directly paid to or accrued in favor of a qualified shareholder or related party lender is re-characterized as dividend for all tax purposes. In case of multiple loans made by a qualified shareholder and its related parties, the amount of non deductible interest re-characterized as dividend is also computed on a pro rata basis, as described above (i.e., by applying the average interest rate so obtained to the aggregate amount of the excess debt, and then by allocating to the qualified shareholder and related party lender a share of the total nondeductible interest so computed, in proportion to the loaned amount of each of them). The anti-capitalization rules apply also to permanent establishments in Italy of foreign entities (corporations, partnerships and trusts). For this purpose, a loan is attributed to the PE by way of direct allocation or, if tracing is not possible, by apportionment on the basis of the ratio of gross profits of the PE to total profits of the entity of which the PE is part. As a general exception, the rules do not apply if the taxpayer is able to prove that the disqualified debt is supported by its own borrowing power and that similar credit would have been extended also by third parties relying exclusively on taxpayer's net assets. The anti-capitalization rules and the related guidance released by the tax administration are numerous and complex, and any detailed analysis goes beyond the limited scope of this newsletter. A separate report on this subject is being prepared and will be published soon.


ITALIAN TAX ADMINISTRATION CLARIFIES TAX TREATMENT OF SRL INTERESTS ISSUED IN EXCHANGE FOR SERVICES


Italian company law permits contribution of services to limited liability companies (SRLs) (section 2464 civil code), but not to joint stock companies (SPAs) (section 2342 civil code). In resolution n. 35/E issued on March 16, 2005, the tax administration discussed the tax treatment of the grant of an interest in an SRL in exchange for services. On the face of the facts given in the resolution, the interest is a capital interest which would vest as and when the services are actually performed. The Italian tax administration illustrated the issue by clarifying that at the end of each taxable year the company takes a deduction, and the service provider recognizes income, for an amount equal to the value of the services performed during the year, and the company books down the value of the services reported on the asset side of its balance sheet for an equal amount. The Italian tax administration rejected the taxpayer’s view that the transaction is a nontaxable event, in a sense that the service provider would take a zero tax basis in the capital interest and would be taxed if and when she disposes of the interest in a taxable transaction, on the amount realized from such taxable disposition. The resolution does not expressly address the tax treatment of a vested capital interest. In that regard, it would seem fair to conclude that income is recognized and deduction taken at the time of the exchange, for an amount equal to the fair market value of the interest, and the service member takes a tax cost basis in that interest equal to that amount. In some earlier occasions, the Italian tax administration had clarified that the receipt of a mere profits interest in exchange for services is a nontaxable event, and that the provider recognizes dividend income on accrual or receipt of profits, with no deduction allowed to the issuing company.


DEDUCTION OF LEASE PAYMENTS IN CASE OF SALE AND LEASE-BACK OF INTANGIBLE PROPERTY

Under Italian tax law, in the absence of clear abuse, a lease contract is respected for tax purposes. The lessor includes in income the lease payments received and takes depreciation deductions for the leased property, while the lessee is entitled to a deduction for the lease payments. Since a lease could be used to accelerate the cost recovery process by providing for larger lease payments over a shorter period of time, than the cost recovery periods and deductions provided for under general tax depreciation rules, Italian Income Tax Code (ITC) section 102, paragraph 7 limits the lessee’s ability to take a deduction for lease payments by providing that a deduction is allowed only if the lease has a duration of not less than 8 years, in case of real property, and at least half of the normal cost recovery period, in case of tangible property. Notably, the statute makes no reference to intangible property. In resolution n. 27/E issued on February 25, 2005, the tax administration took the position that the statute applies by way of analogy also to leases of intangible property (in that case, a trademark). Since intangible property is depreciated on a straight-line basis over a period of 10 years (ITC, section 103), a lease of intangible property must have a duration of at least 5 years for the lessee to be allowed to take a deduction for lease payments made under the lease.


TRANSFER PRICING RULES APPLY TO TRANSACTIONS BETWEEN EGEI AND ITS MEMBERS

In resolution n. 18/E issued on February 15, 2005 the Italian tax administration considered the following facts: a US manufacturing company distributes its products in the European market through distributing subsidiaries based in the Netherlands and the UK, and provides technical assistance and marketing services associated with the distribution of such products through a European Group of Economic Interest (EGEI), based in London. The EGEI operates in the EU through branches located in the various EU Member States. The members of the EGEI (likely, the European marketing subsidiaries, although the facts are non clear on this point) transfers funds to the Italian branch of the EGEI to cover its operational costs. On the face of these facts the Italian tax administration characterized the transfers as payments made by the EGEI’s members in exchange for services performed by the EGEI’s Italian branch to the distributors and third party buyers in the interest of EGEI’s members, and concluded that such payments should be tested under the arm’s length standard of Italian transfer pricing rules (ITC, section 110, paragraph 7). The specific issue of law addressed in the resolution is whether the EGEI is a “controlled” entity for transfer pricing purposes. The tax agency reached concluded affirmatively, on the ground that the notion of “control” for transfer pricing purposes is broad and includes legal as well as economic control, and that as a matter of law an EGEI is under the direction of its members, who have managerial and decisional powers over the activities of the EGEI. The tax administration did not give any indication as to the best method which should be used to establish the correct transfer price under the circumstances.


DENIAL OF DEDUCTION FOR COSTS INCURRED BY A "COMMISSIONAIRE" IN TRANSACTIONS WITH ITS PRINCIPAL


In resolution n. 12/E issued on February 1, 2005, the Italian tax administration stated that ITC article 110, par. 10, which denies deduction for costs incurred in transactions entered into with (related or unrelated) taxpayers who are residents in a black-listed jurisdiction, applies also to a “commissionaire”, to disallow deduction of costs of goods purchased from its principal (under the facts, a Swiss company) and sold to final purchasers. In civil law, a commissionaire is an entity that buys and sells in its own name for the account of another. It enters into contracts with customers, usually with set prices or pricing guidelines, and such contracts, since typically concluded by the commissionaire in its own name, although for account and in the ultimate interest of the principal, are legally binding upon the commissionaire and not directly enforceable upon the principal in the first place. The commissionaire arrangement is commonly used to avoid to create a dependent agent PE in the host country. Indeed, the provision of article 5, par. 5 of OECD Model Tax Treaty appears to require that the dependent agent conclude contracts on behalf, i.e. in the name of, its principal, for the agent to constitute a PE in the source country, aand the commissionaire arrangement seems to fall beyond the literal scope of this provision. Under Italian tax law, this arrangement may actually work for the purpose of getting around a tax treaty dependent agent PE rule; however, a potential downside is represented by potential complete disallowance of deduction for costs incurred by the commissionaire in transactions with its principal, if the principal is established in a low-tax jurisdiction included in the black-list. International tax planners should pay specific attention to this issue, when advising non-Italian clients on how to structure a transaction to avoid taxation of business income in Italy.
EUROPEAN UNION


IRAP VIOLATES EU LAW, ACCORDING TO THE ECJ'S ADVOCATE GENERAL

In his opinion issued on March 17, 2005 in the Banca Popolare di Cremona vs. Agenzia Entrate Ufficio Cremona case (C-475/03), the ECJ’s advocate general took the position that Italy’s Regional Tax on Production Activities (“IRAP”) violates EC law and should be declared invalid. He also argued that the Court should consider the opportunity to limit the temporal effects of its decision by setting an appropriate date for this purpose. If the ECJ upholds the advocate general’s position and strikes down IRAP as in contrast with EC law, and depending also on how it will rule on the temporal effects of its decisions, taxpayers may be entitled to claim refund of IRAP that they paid over the taxable period for which the statute of limitation as provided for under general Italian domestic tax law has not run. This period is 48 months running from the date of the payment(s) of the tax and is safeguarded by the filing of the refund claim in the for of a registered letter addressed to the tax administration. We refer you to our latest Client Alert for more information on this subject and will keep you updated with the developments. If you have not received the Client Alert, contact us.
 
UNITED STATES


IRS EXTENDED PRE-FILING AGREEMENT PROGRAM (PFA)

By Revenue Procedure 2005-12 issued on December 22, 2004, the Internal Revenue Service significantly expanded the pre-filing agreement program (the PFA program), which was launched as a pilot program in 2000 and in its revised version may provide significant benefits to multinational and foreign enterprises with business operations in the United States. The program falls within the province of the Large and Midsize Business Division of the IRS, as opposed to the chief counsel who is in charge with the advance pricing agreement (APA) program, but the concurrence of the associate chief counsel (international) is required if international tax issues are submitted by taxpayers. The objective of the program is to enable taxpayers and the IRS to resolve or eliminate tax controversy on technical issues relating to tax returns before the pertinent tax return is actually filed, by executing an agreement that identify the relevant factual issues, and the settled legal principles that apply to those facts, in a cooperative environment, avoiding the costs, burdens and delays frequently incident to post-filing examinations and disputes. Among the international tax matters that can be submitted with the PFA application, there is the issue of whether the taxpayer has a permanent establishment in the United States for purpose of a bilateral income tax treaty and, if so, what profits are attributable to that permanent establishment. Rev. Proc. 2005-12 provides guidance on the procedural and substantive aspects of the program. Multinational enterprises have an additional tool to proactively address critical international tax issues relating to their investments and operations in the US.