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ISSUE 5/2007


On September 28-29, 2007 the Italian government released the draft 2008 Budget Law, which will be submitted to the Parliament for discussion, review and approval (subject to amendments). The draft Budget Law includes a series of tax measures that would implement significant changes to the corporate income tax (IRES) and regional tax on production activities (IRAP) affecting inbound investments. The following are some highlights of the proposed tax measures.

Reduction of Corporate Tax and IRAP Rates

IRES rate would be reduced from current 33 per cent to 27.5 per cent from fiscal year 2008. IRAP rate would be reduced to 3.9 per cent.

Increase of Participation Exemption For Stock Gains

The exempt portion of the gain would increase from current 84 per cent to 95 per cent (as for dividends). That would reduce the effective corporate tax rate on capital gains from sale of stock from current 5.28 per cent (33 per cent of 16 per cent of gain) down to 1.375 per cent (33 per cent of 5 per cent of gain). The other requirements for the exemption would remain the same. The stock would still have to be booked as a long-term investment asset and held for at least 18 consecutive months, and the participated company would have to be engaged in the active conduct of a trade or business and resident of a non-black listed jurisdiction. Foreign investors will be eligible for participation exemption if they hold their stock of Italian operating companies through an Italian holding company or branch. In all other cases they are taxed unless treaty protection is available. Gains from sale of nonqualified publicly traded stock are foreign-source and not subject to tax.

New General Limitation on Interest Deductions

Current limitations on interest deductions, including thin-capitalization rules limiting the deduction of interest on loans granted or guaranteed by qualified shareholders or related party if exceeding a 4:1 debt-equity ratio and equity pro-rata rule limiting deductions of interest apportioned to stock that qualifies for participation exemption, would be repealed. Under the proposed rules, a general limitation would apply disallowing deduction of net interest expenses (equal to the excess of interest expenses over interest income) in excess of 30 per cent of gross book profit, subject to a ten-year carry-forward for the excess interest expenses incurred in the first three fiscal years after the enactment of the new rules, and five-year carry-forward for excess interest expenses incurred thereafter. In case of mergers, the excess interest expenses carry-forward would be limited under the same rules that apply to net operating losses transferred to the acquiring company. Excess interest expenses would be freely transferable to affiliated companies of a consolidated tax group, subject to the 30 per cent limitation that would apply on a per company basis.

Corporate Reorganizations Tax Basis Step Up

In case of tax-free mergers, divisions or transfers of assets, the taxpayer could to elect to increase the acquired assets’ tax basis to fair market value and pay an 18 per cent tax in lieu of the corporate income tax on the amount of the step -up. The step-up would apply to transactions carried out from fiscal year 2008. However, a transitory provision would allow the step-up also for any tax/book differences still shown in 2007 financial statements and tax returns.

Reduction of Outbound Dividends Withholding Tax

Current rules subject outbound dividends to a 27 per cent statutory withholding tax (subject to 4/9 refund that brings it down to 15 per cent if foreign shareholders prove that the dividend was subject to tax in home country). This compares to a 12.5 per cent withholding tax on domestic portfolio dividends, 60 per cent exemption of domestic non-portfolio dividends to individual shareholders or dividends paid on stock held in connection with a trade or business, and 95 per cent exemption of dividends to corporate shareholders (equal to an effective tax rate of 1.65 per cent, to be reduced to 1.375 per cent). Dividends paid to Italian branches of foreign companies benefit from the 95 per cent exemption. Withholding tax on dividends to EU parent companies is eliminated under the EU parent-subsidiary directive. Finally, dividends to residents in treaty partners are subject to treaty reduced withholding taxes (usually 15-5 per cent). Under the proposal, outbound dividends paid to a corporate shareholder that is resident in a EU or EEA member state and subject to tax in its home country would be subject to a 1.375 per cent withholding tax (equal to the effective tax rate on domestic dividends). The reduced withholding tax would apply to dividends paid out of post 2007 profits to EU or EEA companies included in a white list (see below).

Tax Consolidation

Total exemption of intra-group dividends and non-recognition of gains from transfer of assets within the tax group would be repealed. Instead, dividends would be 95 per-cent exempt (like those paid outside a tax-consolidated group), and transfer of appreciated assets within the group would trigger taxable gain. Affiliated companies could step up the tax basis of shares previously booked down under the pre-2004 tax regime by paying a 7 per cent substituted tax.

Tax Free Incorporation of Italian Branches and Liquidation of Italian Companies

Non-recognition transfer of assets with carryover/transferred basis would be extended to Italian branches of foreign companies, both in case of incorporation of an Italian branch into a domestic company or liquidation of a foreign-owned domestic company resulting in an Italian branch owned directly by foreign shareholders.

New White List for Cross-Border Transactions and Foreign Entities

Under current Italian international tax rules, several adverse tax consequences occur when a transaction is carried out with or through foreign entities established in low tax jurisdictions included in a special list (black listed countries). Deductions of costs incurred in transactions entered into with companies in black listed countries are subject to special limitations. Profits of controlled or related foreign companies in black listed countries are taxed currently to the Italian shareholders. Dividends and gains from sale of stock of companies in black listed countries are fully taxable. Interest to entities in black listed countries is increased to 27 per cent. Finally, portfolio income exemption is denied to entities in black listed countries. Under the proposal, the black lists would be entirely revisited and replaced with white lists based only on whether the foreign country allows exchange of information with Italy. The level of tax in the foreign country would be irrelevant. The new measure is aimed at increasing the competitiveness of Italian companies that operate in foreign markets, by subjecting them to local taxes and no residual Italian tax.

Off-Balance Sheet Tax Deductions

Costs and expenses would be deductible for tax purposes only if and to the extent that they are recognized for book purposes on company’s financial statement/P&L account.

Depreciation Deductions

Accelerated depreciations would be repealed. Depreciation would be allowed on a straight-line method only. The tax proposal included in the draft Budget Law is subject to changes during the approval process in the Parliament. We will continue to monitor the developments and issue updates. Taxpayers should pay attention to the proposed tax reforms and their impact on their tax position relating to Italian investments in order to plan effectively and in time for the next fiscal years.

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