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With its judgment no. 17206/06 of January 26, 2006, published on July 28, 2006, the Italian Supreme Court affirmed the holding of its previous decision in Ministry of Finance (Tax Office) vs. Philip Morris (GmbH), No. 7682/05, May 25, 2002 (the Philip Morris case) and re-characterized an Italian company as the permanent establishment (PE) of its foreign (Panamanian) affiliate, as a result of the fact that the Italian company participated in contract negotiations. The Court held that such activity was in direct furtherance of its foreign affiliate’s business and exceeded a mere auxiliary or preparatory activities, which would not be enough to constitute the existence of a permanent establishment. As a result of the re-characterization the foreign affiliate was held liable for failing to file value added tax (VAT) return and pay the tax on sales of goods to Italian customers deemed made through its permanent establishment in Italy.


The facts and the history of the litigation before the case reached the Supreme Court (as they appear from the Supreme Court’s judgment) are summarized here below.

It is appropriate to note that the case stemmed from a criminal investigation conducted against two Italian individuals, who were shareholders and directors of both the Panamanian and the Italian company, on charges of money laundering by the sale of jewelry and gold products in Central American (Columbia).

The VAT local agency of Arezzo (Tuscany, Italy) issued a notice to a Panamanian company for failing to file VAT return and pay VAT for the year 1993, on the assumption that the Panamanian company had made VAT taxable sales of goods (jewelry) in Italy through an Italian affiliated company, which conducted business activities to the benefits of the foreign affiliate and therefore should be re-characterized as permanent establishment of the foreign affiliate in Italy for Italian tax purposes.

The Panamanian company filed an appeal to the Provincial Tax Commission (local tax court) arguing that the Italian company had carried out only contractual negotiation activities for the Panamanian affiliate and could not be treated as a permanent establishment of its foreign affiliate. The court upheld the appeal and concluded that, regardless of the actual existence of a permanent establishment, there was no evidence of sales of goods in Italy that could give rise to VAT liability in Italy upon the Panamanian company.

The VAT office appealed the decision to the Regional Tax Commission of Tuscany, which ruled in favor of the office on February 10, 2001. The Regional Commission based its decision on the fact that foreign affiliate’s representatives (who were also shareholders and representatives of the Italian company) worked at the premises of the Italian company; the foreign affiliate maintained bank accounts in Italy on which it received remittances (presumably for sales of goods to Italian customers), and the Panamanian company’s books and records were maintained by the Italian company at its premises.

The taxpayer filed its final appeal to the Supreme Court, based on the following defenses:

- the two Italian individuals acted as shareholders and directors of the Italian company, as opposed to their capacity as shareholders and directors (also) of the Panamanian company, and no employees of the Panamanian company ever worked at the premises of the Italian company;

- the Panamanian company’ accounts and records contain no evidence of sales of goods in Italy that may give rise to VAT liability;

- the presumption according to which payments received by a company on Italian bank accounts are deemed to be for VAT taxable sales of goods in Italy (set forth in article 51 of VAT Act n. 633 of 1972) does not apply;

- as a general proposition, a company cannot be treated as a permanent establishment of another company, because it is a separate and independent legal and taxpaying entity;

- none of the situations listed in article 5 of OECD model income tax treaty that give rise to a permanent establishment exist in the case.


The Court preliminarily stated that, in the absence of a definition of permanent establishment in domestic tax law[1], reference has to be made to the provisions of article 5 of the OECD model income tax treaty, as interpreted by the national courts, and to the provisions of EU Sixth Directive on VAT setting forth the analogous concept of center or permanent activity for VAT purposes, as interpreted by the European Court of Justice[2].

The Court expressly referred to its 2002 decisions in the Philip Morris case[3] as precedents for the interpretation of the provisions of article 5 of the OECD model treaty.

The Court then reiterated the principles established in the above referenced precedents according to which a separate taxable entity can be re-characterized as permanent establishment of a foreign entity if it carries our managerial or business activities (like contract negotiations) in pursuance of a foreign affiliated entity’s business, whose scope and nature exceeds that of mere auxiliary or preparatory activities. It also reiterated that the inquiry on the existence of a permanent establishment as a result of such activities must be conducted on the basis of the substance and not the legal form or appearance of the transaction, and the fact that the local business presence is a separate legal entity is not determinative of the issue.

As evidence of managerial or business activities exceeding auxiliary or preparatory activities and, more generally, of factors allowing the re-characterization of the Italian company as permanent establishment of its Panamanian affiliate, the Court referred to the following circumstances:

- the identity of Italian company’s and its foreign affiliate’s directors and shareholders;

- the Italian company’s participation in negotiations for the conclusion of contracts relating to its foreign affiliate’s business, regardless of the fact that the Italian company did not have the authority to, nor did it ever conclude, contracts on behalf of its foreign affiliate;

- the Italian company’s maintenance of its foreign affiliate’s books and records at its premises in Italy.

The Supreme Court acknowledged that its interpretation could be in contrast with the official interpretation followed at the OECD level and elaborated upon in the new commentary to article 5 of the OECD model treaty adopted after its decisions in the Philip Morris case[4]. However, it refused to formally acquiesce to that official interpretation.

Rather, it stated that the commentary represents a mere recommendation to the OECD member states, and pointed out that Italy has issued an observation to the new commentary making clear that it is willing to follow the jurisprudence of its own national courts on the subject matter[5].


The latest Supreme Court’s decision on matter of re-characterization of an Italian company as permanent establishment of a foreign parent or affiliate seems to take Italian courts’ precedents in this area of law one step further and stands for the principle that, if an Italian company carries on activities that are in furtherance of its foreign parent’s or affiliate’s business and exceed the limits of mere preparatory or auxiliary activities, it can be re-characterized as permanent establishment of its foreign parent or affiliate for Italian tax purposes.

As a consequence of that decision, foreign taxpayers operating a business activity in Italy through Italian subsidiaries or affiliates should exercise extra care in making sure that the local entity’s activities are carried out in furtherance of its own business purposes, which should be duly and clearly stated in the local entity’s organizational documents, and conducted pursuant to clear carefully drafted contractual arrangements, and more general that such activities are well documented with respect to all their stages and manifestations, so that the proper evidence can be provided if any inquiry or audit is initiated by the tax administration or any litigation goes to court.

[1] At the time of the facts of the case, Italian tax law in not contain a definition of permanent establishment for income tax purposes. Following the tax reforms of 2004, specific rules providing such definition are now set forth at article 162 of Italy’s Income Tax Code (Presidential Decree no. 917 of 1986). The use of OECD model treaty provisions on the definition of permanent establishment to fill in the gap in domestic law was a settled principle under Italian case law (Corte di Cassazione, judgment No. 8815 of November 27, 1987).

[2] The Court expressly referred to ECJ decision of July 17, 1999 in case C-195/95 (Air Lease).

[3] Corte di Cassazione, judgments No. 3367 and No. 3368 of March 7, 2002, and judgment No. 7682 of May 25, 2002.

[4] See Commentary to article 5(5) of OECD model tax convention, paragraph 33, and to article 5(7), paragraphs 40-42.

[5] See Commentary on article 5 of OECD model tax convention, paragraph 45.10: “Italy wishes to clarify that, with respect to paragraphs 33, 41, 41.1 and 42, its jurisprudence is not to be ignored in the interpretation of cases falling in the above paragraphs”.