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INTERNATIONAL TAX NEWSLETTER

Issue # 3/2006

ITALY’S INTERNATIONAL TAX RULING

1. Introduction.

Multinational enterprises doing business in Italy (and domestic enterprises doing business abroad) have new opportunities to achieve certainty on the tax treatment in Italy of income derived from cross-border transactions. thanks to a new procedure available under Italian law and referred to as international tax ruling. Despite its name, Italy’s international tax ruling is a special procedure that leads to an agreement with Italy’s tax administration regarding the tax treatment in Italy of items of income arising from cross-border transactions. Therefore, it can be considered an analogous of the various advance pricing agreement programs that are common practice in many jurisdictions around the world. Its peculiarity is that it is not confined to transfer pricing issues, but it extends to all international tax issues arising from cross-border investments and business operations. Italy’s international tax ruling is reasonably fast and wide-in-scope and should be considered with attention by foreign multinationals that desire to avoid surprises or unpredictable results and the cost of audits or potentially painful court litigation. Since, to the best of our knowledge, it has received little attention internationally so far and scarce (if any) application in practice, we believe it may be useful to describe its essential features, in particular from the perspective of a foreign taxpayer investing in Italy.

2. Taxpayers Eligible for the Ruling.

The international tax ruling was implemented with article 8 of Law Decree n. 269 of September 30, 2003, converted into law n. 326 of November 24, 2003 (Law 326). The tax administration issued specific guidance for the application of the international tax ruling procedure with Notice dated July 23, 2004 (the Notice). Taxpayers eligible for the ruling are “resident enterprises engaged in international transactions”. The general definition is clarified in the Notice. The term “enterprise” includes a sole proprietorship, partnership, company or any other unincorporated business entity. The term “resident (enterprise)” means a permanent establishment located in Italy or a partnership, company or other business entity resident in Italy for tax purposes. The term “engaged in international transactions” is defined as follows:

a) a resident enterprise (defined as above) subject to Italy’s transfer pricing rules of Tax Code Section 110, paragraph 7. This occurs in the case of:
- permanent establishments in Italy owned by a nonresident, with respect to transfer of goods and services between the permanent establishment and its home office or other related foreign entities [1];
- resident entities, with respect to transactions entered into with foreign related parties (that is, foreign entities controlling the resident entity, controlled by the resident entity, or controlled by the same foreign entity that controls the resident entity);

b) all or part of the assets, equity or fund of a resident enterprise are owned by a nonresident (this includes a nonresident taxpayer’s permanent establishment in Italy or foreign-owned Italian entities), or a resident enterprise owns all or part of the assets, equity or fund of a foreign person (this includes a resident taxpayer’s permanent establishment in a foreign country or Italian-owned foreign entities) [2];

c) a resident enterprise pays to or receives from a foreign person (related or unrelated) dividends, interest or royalties;

d) a foreign person is engaged in a trade or business in Italy through a permanent establishment.

A foreign taxpayer has direct access to the ruling procedure if it is engaged in business activities in Italy through a permanent establishment. In all other cases, it can have access to the ruling indirectly, through the Italian entity that it owns or which with it does business and which is involved in the transaction that is the subject matter of the ruling.

3. Scope of the Ruling.

When defining the matters that can be covered by the ruling, the statute expressly refers to transfer pricing, dividends, interest and royalties (both inbound and outbound). However, it is clear the the ruling extends also to issues concerning permanent establishment (existence of and attribution of profits to a nonresident’s permanent establishment in Italy or a resident’s permanent establishment in a foreign country). In all cases the ruling extends to the treatment of a specific transaction under domestic law (and EU tax law if relevant) and any applicable treaty. Therefore, the ruling covers all possible international tax issues that may arise from a foreign taxpayer’s investment or business operation in Italy or from a transaction with an Italian counterpart (related and, in case of interest and royalties, also unrelated) and which may generate Italian-source income subject to tax in Italy. These issues are examined with reference to both Italy’s domestic tax laws and any applicable tax treaty between Italy and the foreign country involved. In more detail, the ruling procedure can be used:

- to address permanent establishment issues such as whether a foreign taxpayer’s presence in Italy amounts to a permanent establishment; the amount of income attributable to such permanent establishment; the consequence of restructuring, liquidating or transferring a permanent establishment, and the tax treatment of transfer of goods or services between the permanent establishment and its head office or other entities of the group [3];

- to determine the arm’s length price of controlled transactions entered into between an Italian subsidiary and its foreign parent or another foreign related entity (such as a low-taxed manufacturing or distributing subsidiary of the group);

- to determine the withholding tax applicable to dividends paid by an Italian entity to its foreign owner (including eligibility for tax treaty benefits or for the exemption from withholding tax under the EU parent-subsidiary directive);

- to determine the tax treatment of interest paid by an Italian entity to its foreign parent, a related foreign financing entity or an unrelated foreign entity (including possible reduction or elimination of withholding tax under any applicable tax treaties or the EU interest and royalties directive, disallowance of deduction under domestic thin-capitalization rules, debt-equity re-characterization rules or other domestic rules on limitation of interest-deduction, and similar issues);

- to determine the tax treatment of royalties paid by an Italian entity to its foreign parent, a foreign related licensing entity or a third party (including possible reduction or elimination of withholding tax under any applicable tax treaties or the EU interest and royalties directive) [4].

The ruling does not apply to CFC issues since income inclusion under CFC rules does not involve a payment. The ruling procedure can be used for the purposes of clarifying the tax issues arising from a single transaction or a series of transactions that are part of the same investment or business operation. The transaction submitted with the ruling application may have already been entered into or in place. Indeed, the agreement reached at the end of the ruling procedure apply retroactively from the beginning of the tax year is which the agreement is reached.

From the perspective of nonresident taxpayers engaged in investments or business transactions in Italy, it is important to point out that the the ruling can be used to address in advance any issues concerning the proper application of Italy’s tax treaties by Italy as the source country. This, of course, would include problems concerning the eligibility for treaty benefits in the first place. Treaty benefits (low withholding rates on portfolio income, exemptions, nondiscrimination protections and permanent establishment provisions) may be denied for several reasons. With respect to portfolio or investment income, they can be denied on the basis that the taxpayer claiming the benefits is not a resident of the other contracting state under the general definition of residency for treaty purposes contained in article 4 of the OECD Model Treaty, or that it does not satisfy the specific requirements a treaty’s limitation-on-benefits article (if any). Second, they can be denied under domestic anti-conduit provisions or judicial doctrines [5]. Third, they can be denied pursuant to other treaty rules like, for instance, on the basis that the immediate recipient of the income is not the “beneficial owner” of the income for treaty purposes [6]. Finally, specific problems may arise in the context of payments made to or by fiscally transparent or hybrid entities [7]. With respect to business income, major problems may arise with respect to the application of the treaty permanent establishment threshold to protect a nonresident taxpayer from taxation of its business income earned in the host country [8]. All these issues can be part of the international tax ruling procedure and can be addressed and agreed upon in advance between the taxpayer and the tax administration.

4. Ruling Procedure.

The ruling procedure begins with a taxpayer’s application [9], which must provide all information about the taxpayer and the transaction(s) submitted with it, so that the tax administration is a position to determine, as a preliminary matter whether the request falls within the scope of the ruling. If the application concerns transfer pricing matters, the taxpayer must also submit information about the transfer pricing methods and calculations used to determine the prices applied to the transaction.

Within 30 days from the receipt of taxpayer’s application, the tax administration must notify the taxpayer if it thinks that the application is not feasible (because the taxpayer is not eligible for the ruling or the matters submitted with the application fall outside the scope of the ruling), or it needs additional documentation to determine the admissibility of the application. If the application is admissible, the applicant and the tax administration meet to discuss the matters concerning the ruling. During the negotiations, the tax administration can require additional documentation or can agree with the taxpayer as to how and when it can directly collect additional evidence or information and peruse additional documentation at the taxpayer’s place of business. Law 326 and the Notice do no clarify the scope of the tax administration’s powers in that regards, and much room and discretion is left to the negotiations between the parties. The procedure must be concluded within 180 days from the day the application was filed. The deadline is extended when the tax administration seeks information from tax authorities of foreign countries under cooperation or exchange of information agreements, and for as long as it is necessary to obtain such information.

5.The Agreement.

At the end of the negotiations and within the deadline set out above, the tax administration and the taxpayer reach an agreement on the matters of the ruling. The agreement must set forth the transfer pricing methods, calculations and results, or the tax treatment of the specific matters submitted with the ruling application in all other non-transfer pricing cases (under Italy’s domestic law as modified by any applicable tax treaties and taking into account also the impact of EU tax law provisions), as agreed between the taxpayer and the tax administration. The agreement is binding for both the taxpayer and the tax administration for a period of three years (including the year in which the agreement is reached if the transaction was already in place at the time of the application). The agreement is notified to the tax administrations of the other countries involved [10].

6. Anticipated Termination of the Agreement.

After reaching the agreement, the tax administration has the power to check that the facts and circumstances (and the law) on the basis of which the agreement had been reached have not changed. For this purpose, it is provided that the taxpayer must (i) furnish to the tax administration the relevant information or documentation, periodically or upon specific request, and (ii) allow the tax administration’s officials to collect or review relevant information and documentation at the taxpayer’s place of business [11]. If the tax administration believes that the facts have changed it notifies the taxpayer who has thirty days to submit its comments. If no comments are provided or those provided are considered insufficient, and no new agreement is reached between the parties that takes into account the change in circumstances, the tax administration can terminate the agreement [12]. The anticipated termination takes effect from the day on which the relevant facts changed or, if this day cannot be determined with reasonable accuracy, from the day the agreement was entered into.

7. Renewal of the Agreement.

The agreement can be renewed not later than 90 days before the expiration. The tax administration must notify its acceptance or rejection of the request of renewal not later than 15 days prior to the expiration of the agreement [13].

8. Conclusions.

The advantages or Italy’s international tax ruling are the reasonable speed of the process (which may be limited to 180 days), the wide scope of the ruling (which can embrace all international tax issues arising from nonresidents’ investments and business operations in Italy, including issues arising under tax treaties and EU tax law as well as outbound issues concerning Italian companies owned by foreign investors), and the possibility to achieve certainty on these issues over a reasonable period of time by means of an advance binding agreement with the tax authority h.aving a duration of at least three years and renewable for the same period of time prior to its expiration (and from time to time thereafter).

The disadvantages are the lack of details in the law as to the tax administration’s exact powers to inspect taxpayer’s books and records and ask for additional information and documentation, both within the ruling process, before the agreement is reached and after the agreement has been reached, for the purpose of ascertaining whether any change in the facts and circumstances or the applicable law occurred that may trigger an early termination of the agreement.

The unilateral nature of the agreement is not necessarily a major disadvantage because outside of transfer pricing cases, when the problem at issue is the tax treatment of a certain transaction by Italy as the country of source, settling such issue with the country of source may be all the taxpayer really needs to achieve. Overall, we believe that in various circumstances foreign investors may have an interest in considering carefully the opportunity to apply for an international tax ruling with respect to certain transactions they are involved in, in order to avoid unanticipated outcomes and harsher consequences as a result of unilateral audits carried out by the tax administration, which cannot always be satisfactorily sorted out at the administrative level or successfully defended in court [14].

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[1] Italy adopts a separate entity approach and test the transfer of goods and services between a PE in Italy and its home office abroad under the arm’s length standard. Controlled transactions between a PE and other entities of the same group are also subject to transfer pricing rules.
[2] The ownership size does not matter for the purpose of eligibility for the ruling under this category.
[3] Italy follows the separate entity approach (like the approach taken in article 7.2 of the OECD Model Income Tax Treaty) and transfer pricing standards apply to transfer of goods or services between an Italian PE and its foreign head office.
[4] The applies equally to payments received by an Italian entity from a foreign subsidiary. Therefore, foreign multinationals owning Italian companies which own foreign companies can use the ruling across the board. However, since the ruling is a unilateral agreement with Italy’s tax administration concerning only the tax treatment of a certain item of income or transaction under Italian law, the application of the ruling to inbound payments subject to withholding tax in the foreign country is of no use to determine the application of the withholding tax in the foreign country of source. it is useful to resolve transfer pricing issue with respect to income received by the Italian subsidiary (by avoiding the risk that Italy assess a higher price increasing the income in the hands of the Italian recipient).
[5] From the US perspective, reference can be made to IRC Section 7701(l) and the regulations issued thereunder, and to the Tax Court decision in Aiken Indus., Inc. v. Comm’r, 56 T.C. 925 (1971). Italy does not have specific anti-conduit statutory or regulatory provisions. However, it does have anti-conduit general statutory rules (Tax Code article 2, and article 37(3) of Presidential Decree n. 600 of September 29, 1973), and the Supreme Court in two recent decisions crafted and applied a general anti-abuse or anti-conduit doctrine to deny tax effects to what was perceived as a abusive transaction.
[6] The recent judgment of the UK Court of Appeal in the Indofood International Finance Ltd. case is an example of how the beneficial ownership clause can be used to deny the application of treaty benefits.
[7] These problems are rarely addressed in tax treaties. The OECD Model Income tax Treaty does not contain any specific provisions on application of treaty benefits to hybrid entities. However, the OECD has issued a report on this matter (published in 1999 and titled “The Application of the OECD Model Tax Convention to Partnerships”) and the Commentary contains several paragraphs that reflect the conclusions reached in that report. The 1996 U.S. Model Income Tax Treaty contains specific provisions on application of treaties to fiscally transparent entities at article 4(1)(d), and detailed rules have been enacted at US domestic level with regulations issued under IRC Section 894(c).
[8] These problems are far from settled. Italy’s Supreme Court decision in the Philip Morris case is an example of the detriment that the taxpayer may suffer as a result of lack of proper planning and unpredictable outcomes at court level.
[9] The application must be directed to the International Tax Ruling Office of the Agency of Revenues, based in Milan for taxpayers located in northern and some of the central regions, and based in Rome for taxpayers located in Southern and other central regions.
[10] This notification has the only purposes of putting the authorities of the other countries on notice, but does not mean that the other countries’ tax administration are involved in or anyhow party to the agreement. The agreement reached as a result of Italy’s international ruling procedure remains an unilateral agreement between the taxpayer and Italy’s tax administration.
[11] Neither Law 326 nor the Notice clarify what kind of information or documentation that tax administration is entitled to request and the taxpayer is obliged to provide. It would seem reasonable to say that it must be information and documentation directly related to the matters covered by the agreement and strictly necessary to ascertain whether there has been any relevant change of facts and circumstances that may lead to an anticipated termination.
[12] This decision is not automatically binding upon the taxpayer, who can maintain that the agreement is still in force and dispute the termination or any assessment of taxes made by the tax administration by disregarding the agreement as terminated.
[13] The Notice does not clarify what remedies the taxpayer may have in case of unreasonable refusal to renew the agreement, even though all the relevant circumstances have not changed. Therefore, the conclusion is that the tax administration is free to refrain from renewing the agreement at the expiration of the tree year period at its absolute discretion.
[14] The Philip Morris case recently decided by Italy’s Supreme Court, in an way that was largely perceived as incorrect by the international tax community (and forced the OECD to move and refines the concepts applied by Italy’s court to avoid similar odd results), as apparently in contrast with the general international tax principles applicable in the matter of taxation of non residents’ permanent establishment in the host country, is a good example of how any downside that may be seen in the international tax ruling process can be counterbalanced by even worser results at the administration and litigation level.