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INTERNATIONAL TAX NEWSLETTER

Issue # 9 - August 9, 2005
ITALY

CARRYOVER OR TRANSFER OF EXCESS TAX PAYMENTS IN CASE OF TAX CONSOLIDATION

In case of election of tax consolidation, taxable income and losses of the affiliated companies of the group are aggregated and offset at the level of the parent company, which must report the total taxable income of the group and is liable for the tax due thereon. The election takes effect as of the first day of the taxable year in which it is made. However, for the purpose of the provisional tax payments to be made by the companies of the group during the first fiscal year of tax consolidation, the election has no effect, in a sense that each affiliated company of the group must make a provisional payment on account of corporate income tax for an amount equal to the income tax it paid for the immediately preceding taxable year prior to the election of tax consolidation or to the tax due on a reasonable estimate of its taxable income for the current taxable year, computed as if no tax consolidation election were in place and according to the general rule. The provisional tax payments made by the affiliated companies of the group are aggregated at the level of the parent company and can be used to offset the tax it owes on the taxable income of the group. Typically, the taxable income of the group for the first year of tax consolidation is lower than the sum of the taxable income of the companies of the group since it is offset with losses of other companies of the group (or the parent). Therefore, frequently an excess tax payment remains at the level of the parent company as a result of the election of tax consolidation.

Circular 35/E of July 18, 2005 clarified that the parent company can carryover the excess tax payment to future years and use it to offset any tax liability for those years or it can transfer the excess tax payment to third parties in alternative to carrying it over to offset its tax lability for future years. Potential assignees are related parties, even though they have not elected tax consolidation and are not members of the same tax consolidated group. For this purpose, related parties are companies more than 50 per cent of whose stock is directly or indirectly owned by the parent company since the first day of the taxable year immediately preceding the year in which the excess payment were transferred to the parent. The transfer can be made for the entire amount or just part of the amount of the credit and is to be finalized in accordance with the general rules on transfer of tax credits.

This clarification removes a potential obstacle to the election of tax consolidation.

ITALY IMPLEMENTED THE EC INTEREST AND ROYALTIES DIRECTIVE

With Legislative Decree 143 of May 30, 2005 published in the Official Gazette ("Gazzetta Ufficiale") on July 26, 2005 Italy implemented the EC interest and royalties directive (2003/49/EC). The legislation implementing the directive provides that interest and royalty payments made between associated companies that are resident in a EU member state according to the domestic tax laws of that state (but not resident of a non-EU member state under the tie-breaker rules of any tax treaty between such state and their state of residence) and subject to corporate income tax in their state of residence, are exempt from withholding tax in the state of source. The exemption applies also to payments made by or to permanent establishments of eligible companies located in different EU member state. For purposes of the exemption the payer and the payee must be parent-subsidiary or brother-sister companies organized in one of the legal forms provided form in an attachment to the directive and connected through a minimum 25 percent direct stock ownership (by voting power) held uninterruptedly for at least one year.

The exemption applies when an eligible company (or its permanent establishment located in another member state) is the beneficial owner of the payment, and the interest of royalty payment is subject to tax in the beneficial owner’s residence state. Beneficial owner is defined as the person who receives the payment in its capacity as final beneficiary of the same and not as an intermediary, such as an agent, authorized recipient or trustee, for another person. A permanent establishment is a beneficial owner of the payment if the loan or right with respect to which the payment is made is effectively connected with the PE and the PE is subject to tax on such payment in the state in which it is located. Legislative Decree 143 implementing the directive translates in domestic tax law the key terms and definitions and operative rules of the directive in accordance with the meaning that they have in the directive itself. We would like to briefly comment few provisions that deserve specific attention. First, the definition of interest does not include interest re-characterized as dividends under Italy’s thin capitalization rules, payments on debt-instruments whose remuneration is constituted in all or in part in a participation in the profits of the issuer, another company of the same group or the transaction with respect to which the instruments have been issued (including the portion of the remuneration that is independent from those profits), payments on debt-instruments that entitle the holder to exchange her right to interest for a right to participate in the issuer’s profits, and payments on debt-instruments that contain no provisions for repayment of the principal or where repayment of the principal is due more than 50 years after the issue date. Second, interest or royalties whose deduction is denied to the payor under the Italian transfer pricing principles, since exceeding the arm’s length interest or royalty, is also excluded from the scope of the exemption. Third, a tax avoidance rule applies when the beneficial owner of the payment is an entity directly or indirectly controlled by a person resident in a non-EU state. According to this rule, the exemption may be disallowed if it is demonstrated that that the sole or principal purpose for organizing the company in a member state was that of benefiting from the exemption.

The exemption is retroactive and applies to interest and royalties accrued since January 1, 2004.

NON RECOGNITION TREATMENT OF SPINOFF TRANSACTION PART OF A “D-TYPE” REORGANIZATION DENIED WITHOUT PROOF OF VALID BUSINESS PURPOSE

In Private Letter Ruling n. 13 of July 20, 2005 the Tax Committee on application of anti-avoidance provisions examined a transaction in which, as part of a reorganization of a multinational group with business operations in Italy aimed at achieving a more efficient and cost-effective effective management of different businesses of the group, an Italian subsidiary of a Dutch parent would transfer its real estate assets to a newly formed Italian company solely in exchange for stock of this company and would then distribute such stock to its Dutch parent. At a later stage, the Dutch parent would transfer this stock to another foreign holding company of the group. As a matter of Italian tax law, in the underlying "D-type" reorganization the Italian transferring subsidiary would take a substituted basis in the stock of the newly formed Italian company and the Italian transferee company would take a carryover basis in the transferred assets.

If the distribution were respected as a good spinoff transaction (part of a good “D-type” reorganization), the Italian distributing subsidiary would recognize no gain on the distribution of the Italian company’s stock to its Dutch parent and the Dutch parent would take an adjusted tax basis in the distributed stock equal to the distributing company’s substituted basis in such stock. The Dutch parent’s gain realized on the subsequent transfer of the distributed stock would be nontaxable under the Netherlands-Italy tax treaty.

The Committee denied non recognition treatment to the spinoff transaction in the absence of a valid business purpose duly explained by the taxpayer to be tested on the basis of the economic substance of the transaction and in the light of the declared pre-existing plan of transferring the stock of the spun-off company as part of the overall transaction. The Committee held that the sole or principal purpose of the transaction appears to be that of avoiding recognition of taxable gain on the transfer of the appreciated assets or stock under the general rules, and therefore the nonrecognition treatment is denied under the anti-tax avoidance provisions of article 37 bis of Presidential Decree n. 600 of 1973.

FOREIGN SHAREHOLDERS AND ELECTION OF FISCAL TRANSPARENCY

For a general overview of the Italian "check-the-box" rule on the election of fiscal transparency for Italian companies classified as corporations for Italian tax law purposes we refer to the Issue # 7 of July 5, 2005 of our International Tax Newsletter. Here we would like to comment further on the provision according to which, when there are foreign shareholders, the election of fiscal transparency can be made if no withholding tax applies to dividends distributed by the Italian company to its foreign shareholders or, if any withholding tax applies, it is entirely refundable. As a matter of fact, this condition is satified only in two specific situations: when the foreign shareholder is a company resident in a EU member state exempt from dividend withholding tax under the EC parent-subsidiary directive, or when the dividend is paid with respect to stock effectively connected with a permanent establishment of the foreign shareholder in Italy. With respect to the first of those two situations, the Italian tax administration with Resolution n. 109/E of July 29, 2005 clarified that it is sufficient that the non-dividend-withholding tax condition is satisfied within the end of the first taxable period for which the fiscal transparency election is made. This may happen when the one-year minimum holding period requirement for the dividend withholding exemption is completed, during the course of the fiscal year, after the dividend is declared but before the dividend is paid. This clarification confirms the general position taken on this issue with Circular 49/E containing the general guidelines on the "check-the-box" rules. For all other purposes, Resolution 109/E confirms that the one-year minimum holding period requirement for the exemption from the dividend withholding tax must have completely run when the dividend is paid.