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INTERNATIONAL TAX NEWSLETTER
7/06

ITALIAN TAX COURT OF APPEAL RE-CHARACTERIZES DEPENDENT SUBSIDIARY AS PERMANENT ESTABLISHMENT OF THE FOREIGN PARENT

With judgment n. 17/14/06 issued on March 30, 2006 and deposited on April 20, 2006 the Italy’s Regional Tax Commission of Veneto[1] rendered an important decision on a very sensitive tax issue concerning under what circumstances a local subsidiary might constitute a permanent establishment of its foreign parent according to the provisions of article 5 of OECD Model Income Tax Treaty[2].

In this ruling, the Regional Tax Commission held that the Italian wholly owned subsidiary of a German company qualifies as permanent establishment of its German parent under the provisions of article 5 of the Germany-Italy income tax treaty as a result of the fact that, pursuant to certain terms and conditions of the licensing and distributing agreement between the subsidiary and its foreign parent, the subsidiary operates in a subordinate position and as instrument of the foreign parent with no real independent authority to conduct its business.

The ruling expressly refers to Italy’s Supreme Court’s decision in the Philip Morris case issued in 2002[3] but relies on a different rationale and represents a step further in the aggressive position taken by Italian courts on this particular matter.

The facts of the case can be summarized as follows. A German multinational group operated in six different lines of business. Each line of business was operated through a German intermediate holding company that owned the entire stock of operating subsidiaries located in various foreign jurisdictions and was controlled by the ultimate German parent company of the group. A line of business consisted in the manufacturing and sale of equipment for the production of paper and was carried out also in Italy, through a fully owned Italian subsidiary. The Italian subsidiary held a nonexclusive, nontransferable license from its German parent for the manufacturing and distribution of the equipment in the Italian market. As a consideration for the license the Italian subsidiary paid to its German parent a royalty equal to 5 per cent of the gross sale price of the products sold to its Italian customers. As a matter of fact, the Italian subsidiary purchased spare parts and components from various affiliated companies of the group, projected the equipments, contributed to the manufacturing of the equipment through the assembly of such components and sold the equipment to Italian customers. In addition, it also performed post sale assistance services to Italian customers. The license and distribution agreement included certain terms that granted to the German parent company extensive authority and control over its Italian subsidiary, including the power to determine the prices and the standards of quality of the products sold in the Italian market and a covenant not to compete. In addition, some executives of the German parent company worked at times at the premises of the Italian subsidiary, periodically revised the Italian subsidiary’s records and accounts and supervised and directed the Italian subsidiary’s activity in two general meetings held each year in Germany. The Italian subsidiary’s activities for its German parent under the license and distribution agreement accounted for about 98 per cent of the subsidiary's total business activity.

Against the background of those facts, the Italian revenue agency took the position that the Italian subsidiary was in a subordinate position vis a vis its German parent, and as a result of its legal and economic dependence on the foreign parent it should be treated as a permanent establishment in Italy of the German parent for Italian tax purposes. As a consequence, the revenue agency denied the deduction of the royalty payments made by the Italian subsidiary to its German parent under the license agreement and of the VAT charged by the German parent to the Italian subsidiary with respect to the transfer of certain goods or services to the Italian subsidiary and assessed additional corporate income tax and regional tax (IRAP), for an amount of 1,306,190.30 euros, and VAT for an amount of about 140,000 euros upon the Italian subsidiary. The Italian subsidiary challenged the assessment before the local tax court, which held for the taxpayer with ruling no. 265 and no. 266 deposited on October 4, 2004. The revenue agency appealed the tax court’s rulings before the Regional Tax Commission of Veneto.

The issue before the Regional Tax Commission was whether a dependent subsidiary, that is, a subsidiary economically and legally dependent on its parent and subject to total or strict control and authority of the parent as to the conduct and management of its business, should be respected as a separate taxpaying entity or rather treated as a branch or permanent establishment of the foreign parent company for tax purposes. The Regional Tax Commission examined the issue mainly on the face of the provisions of article 5 of the OECD model income tax treaty as reflected in article 5 of the Germany-Italy tax treaty of 1989[4]. It also referred to the Sixth Directive on VAT (no. 77/288/CEE), which uses the concept of center of permanent activity that, according to Italian tax courts, has to be interpreted consistently with the meaning of the PE concept used in tax treaties and in the area of income taxes.

The Tax Commission emphasized that the analysis should be conducted not on the basis of formal criteria, but having due regard to the economic substance of the overall business relationship between the parent and the subsidiary (and the other members of the group), and referred to the Supreme Court’s decision in the Philip Morris case as the authority in support of this approach. It also reiterated the principle, equally stemming from the Philip Morris Supreme Court decision, according to which a subsidiary can constitute a PE of multiple foreign affiliated companies belonging to the same group and the analysis of the issue should be conducted by examining the activities of the subsidiary in the context of the activities of the whole group.

The Commission stated that circumstance that the parent controls the subsidiary, together with other consistent and serious circumstances showing legal and economic substantial dependence of the subsidiary, can work as evidence of the fact that the subsidiary acted as instrument of the parent and therefore should be re-characterized as a PE. On the basis of the above principles of law, the Regional Tax Commission examined the facts of the case, and focused on certain terms of the licensing agreement between the German parent and the Italian subsidiary that indicated a substantial dependence of the Italian subsidiary on its foreign parent. Those terms in particular included the obligation to discuss and agree with the parent on the terms of the sale of the equipment in Italy; the prohibition to make changes to equipment sold without parent’s prior approval; a covenant not to compete; the obligation to comply with the quality standards imposed by the parent; the obligation to discuss and agree with the parent all possible improvements to equipment goods and the duty to transfer any improvements, discovery or new technology to the parent free of charge, even if procured by the subsidiary during the licensing contract at its own cost; the prohibition to make any change to the terms of the license, and the obligation to refer any dispute arising from the licensing agreement to the decision of the president of the ultimate German holding company and the manager of the parent company with no recourse to ordinary courts or tribunals. Similar licensing agreements containing similar terms were also in place with other affiliated companies of the group.

The Commission also noted that the Italian subsidiary employed 25 employees for the projecting work and 5 employees for the assembly and manufacturing work (which was carried out mainly outside of Italy), and it concluded that the projecting services to the benefits of the other companies of the groups were the real and dominant part of the Italian subsidiary’s business.

After a thorough analysis of the license agreement and the way in which the Italian subsidiary conducted its business in cooperation with the parent and other members of the group, the Regional Tax Commission concluded that the Italian subsidiary was to be re-characterized as the PE in Italy of its German parent as a result of its substantial dependence from the parent, the parent’s extensive powers to control and direct the subsidiary’s business activity and the subsidiary’s lack of independent authority and own resources. With regard to the consequences of the re-characterization, the Regional Tax Commission employed a single-taxpayer approach, and denied the deductions for payments made to the parent and VAT charged in the parent’s invoices and assessed additional taxes upon the subsidiary-PE, which it treated as taxpayer for this purposes.

This case substantially differs from the Supreme Court’s decision in thePhilip Morris case with respect to the rationale used to reach the conclusion that an Italian subsidiary constitutes a PE of its foreign parent. In the Philip Morris case, this conclusion was reached on the basis of the fact that the subsidiary had participated in contractual negotiations for the parent (regardless of the fact that it had not authority to nor did it conclude any contracts on behalf of the parent) and had carried out supervision and managerial activities for the parent in Italy. Instead, in this case, although the judges used a similar substance-over-form type of analysis the holding is based on the different concept and turns around the subsidiary’s legal and economic dependence and its status as servant or instrument of the parent lacking any independent authority or ability to conduct its business on the basis of its own judgment and to its own direct profit.

Therefore, a new concept would seem to emerge from this decision, that is the concept of dependent subsidiary qualifying as a PE of the controlling parent, which may be placed mid way between the concepts of fixed place of business PE and dependent agent PE expressly addressed in tax treaties. This new concept is not directly dealt with in the OECD commentary to article 5 of the model treaty. The decision appears to be a new precedent under Italian case law and require a separate and additional level of planning by foreign investors who wish to establish subsidiary operations in Italy that are respected as such and run no risk of being re-characterized as PEs of the foreign parent or the group.

As a result of this decision, foreign taxpayers will have to pay specific attention to the contractual terms of the arrangements between their Italian subsidiaries and the foreign parent (or other foreign affiliated companies of the group) and use additional planning and legal advice to make sure that these terms strike a reasonable balance between sufficient control vs. complete economic and legal dependence of the Italian subsidiary, which may lead to a PE re-characterization.

Of course, the Regional Tax Commission’s ruling is not binding on other courts under Italian law and subject to appeal to the Supreme Court. However, it should be taken in due consideration by foreign taxpayers planning to establish business operations in subsidiary form in Italy.

[1] The Regional Tax Commission is equivalent to the Circuit Court of Appeals in the U.S.
[2] The issue is still attracting a lot of attention in the international tax community, and is far from settled despite the revision of OECD commentary on article 5 issued in response to Italy’s Supreme Court’s decision in the Philip Morris case. As an example of the most recent debate on this issue, we would like to refer to the David R. Tillinghast Lecture titled “Can a Subsidiary be the Permanent Establishment of its Foreign Parent”, delivered by Professor Jean-Pierre Le Gall at NYU Law School on September 26, 2006, and a panel discussion at the recent ABA Tax Section’s meeting which took place in Denver on October 20, 2006 titled “The Shadow Presence in he United States”.
[3]Ministry of Finance (Tax Office) vs. Philip Morris (GmbH), Corte Suprema di Cassazione, No. 7682/05 (May 25, 2002).
[4] Signed on October 18, 1989, ratified with Law Novembre 24, 1992 n. 459 and entered into force on december 26, 1992.