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INTERNATIONAL TAX NEWSLETTER
1/2006

OVERVIEW OF THE LATEST CHANGES TO ITALY’S CORPORATE INCOME TAX

In the last three months of 2005 various provisions were enacted that amended Italy’s corporate and personal income tax in some significant respects. The most important changes concern the rules on taxation of portfolio dividends received by individuals investors and on the exemption from tax of gains from disposition of non-portfolio stock by corporate shareholders (“participation exemption”). This series of fiscal measures have been dictated mainly by budged problems and hardly fit in the corporate income tax system, in which they bring inconsistencies and uncertainty. This is a brief account of the most significant changes referred to above.

I. Participation Exemption.

1. Holding Period and Exempt Portion of Gain.

The first measures were enacted with Law Decree 203/2005 and apply to gains realized on or after October 4, 2005.

One change concerns the holding period required for the purposes of granting the tax exemption of gains from disposition of stock, which has been increased from twelve to eighteen months. However, the minimum holding period has been kept unaltered (twelve months) for the purpose of denying stock losses and interest deductions. The result of the new rule is an inconsistency between inclusion of gain and deduction of losses and interest with respect of non-portfolio stock. The prior law was based on a symmetry between exemption of gains and non deductibility of losses (and interest allocated to tax exempt stock): stock eligible for the participation exemption would generate either tax exempt gains or non deductible losses (and interest allocated to such stock were nondeductible), while stock falling beyond the scope of the participation exemption would generate only either taxable gains or deductible losses (and interest allocated to such stock was deductible). The tradeoff of the exemption of gain was the non deductibility of losses (and allocated interest), and taxation of gain corresponded to deductibility of losses (and allocated interest). Under the new law this symmetry has been broken as a consequence of the differentiated holding period, longer for the exemption of gain (18 months) and shorter for the non deductibility of losses (12 months). Therefore, with respect to stock owned for more than 12 months but less than 18 months, losses are now nondeductible while gains are fully taxable, and interest allocated to stock owned for more than twelve months but less than eighteen months under the “financial pro-rata rule” of Tax Code section 97 is nondeductible even though any gains with respect to such stock would be fully taxable.

The second change concerns the exempt portion of the gain, which was initially reduced by Law Decree 203/2005 from 100 to 95 per cent, with 5 per cent of the gain being taxable for corporate income tax purposes at a statutory rate of 33 per cent, corresponding to an effective rate of tax of 1.65 per cent (the same as the tax rate on dividends paid to corporate shareholders). Law 284/2005 that was approved on December 3, 2005, reduced the exempt portion of the gain even further, to 91 per cent (equal to an effective tax rate of 2.91 per cent) for gains realized on or after December 3, 2005 and through December 31, 2006, and to 84 per cent (equal to an effective tax rate of 5.28 per cent) for gains realized on or after January 1, 2007. Therefore, under current law, gains from disposition of non-portfolio stock for corporate income tax purposes are treated as follows:

- gains realized through October 3, 2005: fully exempt (effective tax rate zero);

- gains realized as of October 4, 2005 through December 2, 2005: 95 per cent exempt (effective tax rate 1.65 per cent);

- gains realized as of December 3, 2005 through December 31, 2006: 91 per cent exempt (effective tax rate 2.91 per cent);

- gains realized from January 1, 2007: 84 per cent exempt (effective tax rate 5.28 per cent).

Gains realized by individual shareholders engaged in a trade or business or with respect to non-portfolio stock are 60 per cent exempt and 40 per cent taxable. The law in this respect has not changed.

The new rules limiting the exempt portion of the gain stand in contrast with the general purpose of the participation exemption regime, which was that of preserving the integration of corporate and shareholder-level tax and avoiding the double taxation of corporate earnings that would arise after the elimination of the full imputation system in force under previous law. The fact is that under the pressure of budget problems and political speculation in view of the incoming general election, the participation exemption rules fell under criticism and finally the government decided to limit them in scope as a way to reject the political argument according to which the exemption of gains was designed to benefit the rich who could speculate in the stock market tax free. Such argument although clearly wrong started gaining some political appeal and the government finally decided to increase taxation of stock gains to silence it.

In the light of the new law, multinationals and group of companies should carefully plan the timing of corporate reorganization transactions or dispositions of stock that are expected to generate tax exempt capital gains. Indeed, depending on whether the relevant transaction is carried out within the end of 2006 or later on in 2007 the final tax may vary from 2.97 to 5.28 per cent.

Taxpayers should also consider the opportunity of distributing accumulated earnings as dividends before restructuring or disposing of appreciated stock, because the effective rate of tax on dividends to corporate shareholders is 1.65 per cent instead of the 2.97/5.28 tax that would apply to capital gains. In case of consolidated groups of companies, the pre-sale distribution of dividends would be even more favorable, because dividends would totally tax exempt.

More generally, it is fair to assume that the increase of tax of stock gains as a result of the extension of the holding period and the increase of the taxable portion of the gain should persuade taxpayers to change their tax planning strategies, from a preference for transactions that enjoy sale or exchange treatment and would generate capital gains now subject to higher level of tax to transactions that enjoy dividend treatment and would generate exempt (in case of tax consolidation) or low-taxed dividend income.

2. Anti-abuse Provision.

The participation exemption rules provide that portfolio stock (that is, stock purchased for short term investment purposes only and recorded as portfolio asset on shareholder’s balance sheet) is not eligible for the exemption; therefore, gains and losses from disposition of portfolio stock are fully recognized for tax purposes. In contrast, dividends distributed with respect portfolio stock are tax exempt (up to 95 per cent of their amount).

The discrepancy between dividend exemption and gain/loss recognition with respect to portfolio stock offered taxpayers easy tax avoidance opportunities. The typical transaction was the purchase of portfolio stock “cum dividend”, the collection of a tax exempt dividend (which offset the portion of the purchase price corresponding to the amount of the dividend already declared on the stock), and the immediate disposition of the stock at a loss that was fully deducted for tax purposes.

With Law 248/2005 the legislator closed this loophole by enacting an anti-abuse provision according to which losses from disposition of portfolio stock, which generally would be fully deductible, cannot be deducted up to the amount of any exempt dividends received by the transferor with respect to that stock during the thirty-six month period preceding the sale of the stock that generated the loss. Two comments are worth being made here. The first is that the new rule is very wide in scope and reaches also bona fide commercial transactions entered into by dealers in stock and securities, who are compelled to keep track of all their investments and dispositions of stock and of dividends paid with respect to the various portfolios of stock and are subject to tax on dividends even if they do not pursue tax avoidance purposes. The second is that more guidance must be provided on how the new rule should apply in case of stock acquired in different integrated transactions part of the same plan across the tainted period.

3. Stock Basis Adjustments for Previously Deducted Unrealized Losses.

Under prior law, taxpayers were able to write-down the book value of subsidiaries’ stock and deduct the loss for tax purposes. This possibility has been eliminated with the enactment of the 2004 corporate income tax reform. To avoid double benefits, the participation exemption rules provide that with respect to gains realized in 2004 and 2005, the tax basis of the stock has to be adjusted downward to the extent of any unrealized losses deducted in years 2002 and 2003, and the portion of gain attributable to such previously deducted losses is recaptured and subject to tax. Initially, the rule applied only to losses deducted in a specified period, i.e. the years 2002 and 2003. A new provision inserted in Law Decree 2/2006 extended the recapture rule to all losses previously deducted in any taxable years preceding the enactment of the participation exemption rule.

4. LIFO Method to Determine Stock Eligible for the Exemption.

If stock is acquired in separate but integrated transactions part of an overall plan, the identification of the shares sold for the purpose of calculating the minimum holding period and possible eligibility for participation exemption treatment is made by treating the shares acquired last as sold first (last in, first out rule). In its initial guidance on this matter, the Italian tax administration took the position that if shares of stock acquired in integrated transactions are booked partly as fixed financial asset and partly as portfolio asset the last in, first out rule should apply on an aggregate, pro rata basis.

This interpretation penalized those companies which both own strategic stock and portfolio stock being engaged in active trading of stock or securities. Indeed, the constant trading of portfolio stock would make it impossible for them to trace the sold stock to stock booked as financial asset and benefit from the participation exemption.

Legislative Decree 247/2005 contains an interpretative provision according to which in the above situation the last in, first out rule applies on a separate category by category basis. The provision applies retroactively starting from fiscal year 2005.

II. Classification of Financial Instruments Issued by Foreign Entities.

A change that indirectly affects the application of participation exemption rules and dividend tax regime concerns the classification of financial instruments for tax purposes. Indeed, the benefits of gain or dividend exemption apply only payments received with respect to an instrument that is classified as equity for tax purposes.

Under prior law, a financial instrument issued by a foreign entity would be classified as stock for Italian tax purposes if two requirements were met: it represented a participation to the capital of the company (i.e., it was equity for company law purposes) and (ii) its remuneration consisted entirely in a participation to the profits of the issuer (so called “double equity” requirements). This provision left room to tax arbitrage opportunities. By properly exploiting the interaction between Italian and foreign law, related taxpayers could structure an instrument in a way that it was classified as debt and therefore generated deductible interest to the issuer under foreign law, and as equity generating tax exempt dividend to the holder under Italian law, with consequent double dip (tax deduction in the state of the payor and tax exemption in the state of the recipient).

These tax arbitrage opportunities have been shut down with a new provision of Legislative Decree 247/2007 according to which an instrument issued by a foreign company is classified as equity and generates tax exempt dividend under Italian law if its remuneration is totally non deductible to the issuer under foreign law. The requirement that it is also equity for company law purposes has been withdrawn.

The new provision adopt an all or nothing as opposed to a bifurcation approach that may produce unfavorable consequences to ill advised taxpayers. An instrument whose return is partly fixed and partly determined with reference to the issuer’s profits would be classified as debt for Italian tax purposes and the whole amount of its return including the contingent portion consisting would be fully taxable to the holder in Italy.

The application of the new law revolves around the tax treatment of the payments made with respect to the instrument under foreign law. This implies an inquiry often very difficult to make.

The new provision applies to tax years beginning on or after January 1, 2006 and requires that multinationals and group of companies engaged in cross border operations review their financing structures to make sure that they maximize the tax benefits associated with cross-border intracompany financing and to avoid the potential harsh consequence of no deduction in the foreign country and full inclusion in Italy with respect to the same income.

III. Goodwill Amortization and Lease Payments Deductions.

Budget Law for 2006 increased the cost recovery period for goodwill from ten to eighteen years. The longer amortization period applies to fiscal years 2005 onwards and includes goodwill already recorded in the corporate books since that time, whose existing cost recovery period must be recomputed accordingly. The new law does not affect the depreciation of other intangible assets such as patent and trademarks, whose depreciation schedule has not been changed. It must be noted that goodwill is amortizable only in case of taxable asset deals that give the buyer a cost basis in the acquired property. In this case, in order to counter the effects of the slower cost recovery period for goodwill, taxpayers will have to try and structure the transaction in a way that allows them to allocate as much as possible of the purchase price to assets which enjoy a faster depreciation schedule. Italy does not have tax rules on allocation of purchase price in case of taxable asset purchases like the rule of US IRC §§ 338 and 1060. The matter is governed by general commercial law principles subject to anti-avoidance tests like business purpose and economic substance.

Law Decree 203/2005 extended the minimum recovery period for the purpose of deducting rents paid under contracts of lease of real property. Rents are now deductible on a pro rata basis over a period of 15 years (as opposed to 8 years as provided under prior law) regardless of the actual duration of the contract for civil law purposes.

IV. Asset Basis Step-Up.

1. Stock and Fixed Assets.

The Budget Law for 2006 provides for an election to book-up fixed assets carried in 2005 financial statement and recognize the higher basis for tax purposes accordingly. The book-up and tax basis step-up is elective. By increasing the adjusted tax basis of the asset with respect to which depreciation deductions and taxable gains are computed the taxpayers can achieve the result of generating higher depreciation deductions during the operation of the property and lower taxable gains upon its disposition. The tax basis step-up requires the payment of a tax in substitution of the general income tax (substitute tax), computed at a rate that applies on the amount of the step up and varies depending on the nature of the assets. The substitute tax rate is 12 per cent for depreciable fixed assets (tangible and intangible), 6 per cent for stock and 19 per cent for building land.

With the exception of building land (which is considered in the following paragraph), the substitute tax must paid up front (June 2006 for calendar year corporate taxpayers) while the benefits of tax basis step-up are postponed to fiscal year 2008 (and enjoyed with the tax return filed in 2009). This means that until 2008 depreciation deductions and taxable gains are computed with reference to the property’s old adjusted tax basis while from 2008 depreciation deductions and taxable gains are computed with reference to the increased tax basis inclusive of the step-up. Therefore, if booked-up property is disposed of prior to the fiscal year 2008, the benefits of the basis step-up would be entirely lost.

In case of election the amount of the tax basis step-up would be added to the asset’s old adjusted tax basis and the aggregate amount equal to the sum of the old basis and the basis step-up would be depreciated along the remaining depreciation period in course for that particular property. This means that for property with short cost recovery periods or close to the end of their cost recovery period the recovery of the stepped-up basis could be highly accelerated. In case of intellectual property (patents, know how, etc.) that has a maximum amortization rate of 33 per cent it may well happen that the basis step-up is immediately expensed in one year.

The law requires that a revaluation reserve equal to the amount of the book up (net of the substitute tax) is credited to the equity on the balance sheet. This reserve cannot be distributed. If distributed the reserve would be entirely taxable, with immediate recognition of the step up for tax purposes. The law allows the immediate release of the reserve with the payment of an additional 7 per cent substitute tax. In this case, the reserve would be immediately distributable in 2006.

Whether or not electing for tax basis step-up is beneficial to the taxpayer requires a calculation of the present value of the future benefits of the step-up (higher depreciation deductions or lower gains, postponed to 2008) and their comparison with the election’s immediate costs (substitute tax).

Most probably the tax basis step-up would be beneficial to those companies that have developed and own valuable intangible with a remaining short costs recovery period.

A favorable indirect effect of the tax basis step-up would be the immediate increase of the equity of the company as a result of the revaluation reserve to be credited to the book equity in the balance sheet, which would affect the computation of the 4:1 debt-to-equity ratio used to determine whether the thin-capitalization rules apply. By increasing the equity of the fraction the basis step up would facilitate to avoid the application of the thin-cap rules.

Before electing the basis step-up, U.S. multinationals will have to inquire into the nature of the substitute tax as a matter of Italian law, to make sure that it can be credited in the U.S. as an “in lieu of” tax for U.S. foreign tax credit purposes.

2. Building Sites.

The peculiarities of the tax basis step-up for building sites are that the substitute tax (charged at a rate of 19 per cent) can be paid in three yearly installments without interest and the basis step-up is immediately recognized for tax purpose. In this way, the owner can avoid the tax on the capital gain realized upon the sale of the building site. On the other hand, the law requires that the site be actually developed in the next five years.

V. Taxation of Dividends from Portfolio Stock.

Portfolio stock dividends paid to individual shareholders are fully taxable if the distributing company is a company organized in a low-tax jurisdiction included in the black list. Under prior law, such dividends were subject to a 12.5 per cent flat rate tax like dividends paid by any other non black-listed companies.

Similarly, gains realized by individuals with respect to portfolio stock are fully taxable in case of stock of a company organized in a black-listed jurisdiction. Previously such gains were subject to the 12.5 per cent flat rate tax that applied also to portfolio dividends.