EU & Italian International Tax Law Blog : International Tax Lawyer & Attorney : Marco Rossi Law Firm : Italy, New York, European Union, EU

The Italian parliament on March 3, 2009 enacted law n. 20 which authorizes the ratification of the new U.S.-Italy tax treaty signed in 1999.

Law n. 20 of March 3, 2009 was published on the Official Gazette on March 18, 2009 and is now into force. The U.S. had ratified the treaty on December 28, 1999.

The new treaty will enter into force at the time of the exchange of the instruments of ratification. It will apply and take effect for taxable periods beginning on or after January 1, 2010 and for withholding taxes on payments made or accrued on or after the first day of the second month following the date of entry into force. A grandfathering provision allows a taxpayer to elect for the application of the old treaty for a period of 12 months following the entry into force of the new treaty, should the old treaty result in a better treatment.

The new treaty reduces the withholding tax rates on dividends, interest and royalties; authorizes the collection of a dividend equivalent tax on the repatriated profits of a branch, includes a provision limiting the benefits of the treaty to certain qualified residents of the other contracting state, addresses the creditability in the U.S. of the Italian regional tax on production activities, and provides that the competent authorities of the two contracting states may agree to refer a case to special arbitration procedure if they fail to reach an agreement within two years of the date on which the case was referred to one of them. 

Background

The current U.S.-Italy tax treaty entered into force on December 30, 1985. On August 25, 1999 Italy and the U.S. signed a new treaty and protocol (the "1999 Treaty"). On November 5, 1999 the U.S. Senate consented to the ratification of the 1999 Treaty, subject to a reservation and understanding.

The reservation required the elimination of following language which appears as the final paragraph of the withholding tax provisions of articles 10 (Dividends), 11 (Interest), 12 (Royalties) and 22 (Other Income):

"The provisions of this Article shall not apply if it was the main purpose or one of the main purposes of any person concerned with the creation of assignment of the" (respectively, shares or other rights; debt claim, rights, and rights) "in respect of which the" (respectively, dividend, interest, royalties and income) "is" (are) "paid is to take advantage of this Article by means of that creation or assignment".

That language established the so-called main purpose tests aimed at tackling possible abuses of the treaty or treaty shopping arrangements.

The understanding concerned the exchange of information provision of Article 26, which, according to the U.S. Senate, should grant to the competent authorities of the two contracting states the authority to obtain or provide information held by financial institutions, nominees, or persons acting in an agent or fiduciary capacity, or respecting interests in a person.

President Clinton signed the U.S. instrument of ratification on December 28, 1999, subject to the above mentioned reservation and understanding. The reservation required approval from the Italian government, which held the ratification process in stand by.

The 2006-2007 Exchange of Diplomatic Notes

By way of diplomatic note n. 291 of April 10, 2006, the Embassy of the United States of America reiterated the above-mentioned conditions to the ratification of the 1999 Treaty.

The Italian Minister of Foreign Affairs issued a note on February 27, 2007 by means of which it formally agreed with the reservation requiring the deletion of the main purpose tests and the understanding on exchange of information.

That step eventually paved the way to the final ratification of the new treaty.

The Italian Law Authorizing the Ratification of the Treaty

Eventually, the Italian Parliament enacted law n. 20 of March 3, 2009 which authorizes the Italian Minister of Foreign Affairs to exchange the instrument of ratification of the new treaty.

Effective Dates and Grandfathering Provision

The 1999 Treaty enters into force on the date on which the instruments of ratification are exchanged.

In general, the 1999 Treaty shall apply to taxable years beginning on or after the the first day of the year in which it entered into force. Therefore, if the instruments of ratification are exchanged in 2009, the Treaty shall take effect for taxable years beginning on or after January 1, 2010.

In the case of withholding taxes at source, the 1999 Treaty shall apply to payments made or accrued on or after the first day of the second month following its entry into force. Therefore, if instruments of ratification are exchanged on March 24, 2009 the Treaty shall apply to withholding taxes due on or after May 1, 2009.

A grandfathering provision allows a taxpayer, for a period of 12 months following the entry into force of the 1999 Treaty, to elect for the application of the 1985 Treaty should it provide a more favorable tax treatment.

Highlights of the New Treaty

Under the 1999 Treaty, the withholding rates on dividends are 5 percent for inter-company dividends (that is, dividends paid to a person owning at least 25 percent of voting shares of the payer for at least 12 months as of the time of the declaration of the dividends) and 15 percent for portfolio dividends. Dividends paid by a US RIC are subject to 15 percent withholding. Dividends paid by a US REIT may be subject to 15 percent withholding only if specific requirements are met.

The withholding rate on interest is reduced to 10 percent.

Royalties for patents and software are subject to a 5 percent withholding and all other royalties are subject to 8 percent withholding rate.

The 1999 Treaty authorizes the application of a branch profits tax. Italy does not have a branch profits tax. However, all Italian companies operating in the U.S. through a branch shall be subject to the U.S. branch profits tax.

Article 23 of the 1999 Treaty (Elimination of Double Taxation) contains specific provisions for the computation of the amount of the foreign tax credit in the U.S. for Italian regional tax on production activities (IRAP) paid to Italy.    

Article 2, paragraphs 1-5  of the Protocol to the 1999 Treaty contains the new limitation of benefits provisions of the treaty.

A Memorandum of Understanding signed with respect to article 25 of the 1999 Treaty (Mutual Agreement Procedure) provides that the competent authorities may agree to invoke arbitration in a specific case, if they fail to reach and agreement within two years of the date on which a case was submitted to one of them. The Memorandum of Understanding sets forth the main aspects of the arbitration procedure and refers to the EU Convention on Arbitration Proceeding in transfer pricing matters and the US tax treaty with Germany.  

The 1999 Treaty also contains specific provisions on application of treaty benefits to income derived or paid by partnerships or other fiscally transparent entities.

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The Italian Supreme Court issued an important decision concerning the application of tax treaty benefits to partnerships.

The judgment (n. 4600 of 2009) will be deposited soon and we will publish it with additional comments as soon as it is available.

Under the facts of the case, a US Limited partnership received the payment of a dividend from an Italian company. A Japanese fund, member of the US limited  partnership, claimed the reduction of the Italian withholding tax on the dividend pursuant to the Italy-Japan tax treaty. The Italian dividend withholding tax rate is 27 percent. The Italy-Japan treaty reduces it to 10 percent for inter-company dividends (paid to shareholders owning at least 25 percent of voting shares of the payer) and to 15 percent for portfolio dividends.

Italy's tax administration rejected the treaty claim on the ground that the Japanese fund is not the legal recipient of the dividend. The treaty grants the benefits if "the recipient" of the dividend is a company that qualifies to treaty benefits.

In the case at hand, the US LP, which was the recipient of the dividend, was transparent and did not qualify for treaty benefits under the US-Italy treaty, while the Japanese fund was the final economic owner but not the legal recipient of the dividend.

The Court accepted the position of the tax administration and observed that other Italian treaties, granting treaty benefits to a treaty partner who is the beneficial owner of the dividend, would command a different result. 

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With ruling n. 54/E of March 3, 2009 the Italian Tax Administration clarified the treatment applicable to debt instruments issued by Italian limited liability companies. According to the ruling, the instruments can be characterized as debt obligations and enjoy the same tax treatment of debt obligations issued by joint stock companies, namely a reduced 12.5 percent tax on interest and complete exemption for certain foreign investors, if the requirements established in the code for this purpose are met.  

Article 2483 of Italian Civil Code (as amended with law n. of January 17, 2003) provides that limited liability companies (SRLs) can issue debt instruments to finance their operations of investments, subject to certain limitations. Previously, only joint stock companies (SPAs) could issue debt instruments.

Debt instruments issued by SRLs cannot be offered to the general public and can be subscribed only by professional investors (banks, insurances and financial institutions). If sold to private investors in the secondary market, the seller is liable in the event the buyer fails to make the payments required under the instrument. Seller's secondary liability can be eliminated by way of an agreement between seller and buyer.

The entity's articles or organization or certificate of formation must expressly provide for the possibility that the entity issues debt instruments and confer the power to issue debt instruments either upon the members or the managers, as well as establish the terms of the issuance including the number and amount of the instruments, issuance procedures and voting requirements.

The tax administration in ruling n. 54 clarified that, for tax purposes, debt instruments issued by SRLs are characterized as debt obligations if they satisfy the definition of debt obligation contained in article 44, paragraph 2, letter (c)(2) of the tax code, according to which three tests must be met:

- the instrument is part of a series of transferable instruments issued under same or similar terms pursuant to a single economic transaction;

- the instrument provides for the unconditional reimbursement of an amount that is at least equal to its issue price or face value, with or without payment of interest or other remuneration, and

- the instrument does not confer to the holder any power to control or participate in the management of the issuing enterprise or the transaction pursuant to which it has been issued.

If the three tests are met, the debt instrument is a classified as a debt obligation.

Interest paid under a debt obligation is subject to 12.5 percent withholding tax, provided that the maturity date of the instrument is at least 18 months or longer and the interest rate does not exceed the official discount rate increased by 2/3rd (or 200% is the instruments is regularly traded in a regulated securities market). In all other cases, the withholding tax rate is 27 per cent.

For interest paid to private individuals or foreign investors who hold the instruments outside of a trade or business that is part of an Italian permanent establishment, the 12.5 per cent is a final tax. 

However, for debt obligations held by non resident investors who are resident or organized in certain approved jurisdictions (white-listed countries), interest is totally exempt from tax.

Interest on debt instruments that fail to qualify as debt obligation is subject to the ordinary 27 percent tax rate and is not eligible for the foreign investors exemption.

In the light of the above, for foreign investors the characterization of the instrument as debt obligation is particularly important in order to qualify for the exemption.      

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On March 4, 2009 the EU Court of First Instance issued a judgment in Italy v. Commission (T-424/04), in which it ruled that Italy's favorable tax treatment for special investment funds violates state aid rule of the EC Treaty.  

Article 12 of Law Decree 269 of 2003 (converted into Law n. 326 of November 24, 2003) provides that collective investments funds which invest primarily in shares of  small and mid-capitalized companies are subject to tax at the rate of 5 instead of 12.5 per cent. The reduced tax applies on the increase of the fund's net asset value at the end of each tax year.

For the favorable tax treatment to apply, the following requirements must be met:

- the regulation of the fund must provide that at least two thirds of the fund's assets are invested in shares of small and mid-cap companies regularly traded in EU securities market;

- the fair market value of the qualified shares owned by the fund must be equal to at least two thirds of the value of fund's asset for more than one sixth of non consecutive days in each calendar year.

Small and mid-cap companies are defined as companies whose market value computed on the basis of the average share price on the last day of each quarter has not exceeded 800 million euro.

The European Commission on September 6, 2005 ruled that such favorable tax treatment violated the state aid provisions of article 87 of the EC Treaty and ordered the Italian government to collect the balance of the tax (7.5 percent) from the funds. The Italian government appealed the decision of the European Commission and the EU Court of First Instance rule in favor of the Commission and rejected the appeal.

The Italian government now can appeal the judgment to the Eurpean Court of Justice or accept the decision of the First Instance Court.

The small and mid-cap investment funds are not really common in the market; however, in the present situation the market capitalization of many companies has dropped as a result of the crisis, and such type of special investments funds could become more popular due to the favorable tax treatment now in question.        

A similar judgment was issued on the same issues on the same date in the case Associazione italiana del risparmio gestito and Fineco Asset Management v. Commission (T-445/05).

Foreign investors resident or organized in qualifying jurisdictions are entitled to a refund equal to the tax charged upon the fund. If a higher tax is eventually collected from the fund, they would be entitled to a higher refund from the fund.   

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With Circular 1E of January 26, 2009 (Cir. 1 of Jan 26, 2009.pdf) Italy's tax administration explained that taxpayers must provide a clear evidence of the specific economic interest of a transaction, in order to deduct the costs, losses or expenses arising from transactions with foreign enterprises domiciled in tax haven ("black-listed") jurisdictions. 

Tax Code article 110 provided that "no deductions are allowed for costs and other negative items of income deriving from transactions entered into between a resident enterprise and enterprises with their fiscal domicile in countries or territories not belonging to the European Union, having a privileged tax regime. They are deemed to be privileged the tax regimes of those countries and territories identified with a decree of the Ministry of the Economy and finance to be published on the Official Gazette, in consideration of their level of taxation significantly lower than the level of taxation applied in Italy, or of a lack of exchange of information, or other equivalent criteria".

With the budget law for 2008, the above provisions have been amended and now the non-deductibility rule applies to transactions entered into with enterprises domiciled in countries that are not included in a list of approved countries ("white list"), selected primarily on the basis of the lack of exchange of information with Italy. The "white-list" has still to be approved by the Ministry of Finance.

The non-deduction rule applies also to costs for professional services performed by firms organized in low-tax jurisdictions.  

Deduction is allowed if costs, losses or expenses are separately stated on the tax return and either of two requirements are met: the foreign enterprise primarily carries out a real commercial activity (active trade or business) in its country of domicile, or the transactions fulfills a real economic interest (economic substance) and has been actually executed. The burden of proof is upon the taxpayer, who can apply for an advance ruling that certifies the applicability of either exemption.

The real commercial activity exception requires that the foreign enterprises uses an adequate organization (office, staff) for its trade or business in its country or organization.

With circular 1E, the tax administration clarified that the real economic interest exemption requires a specific evidence of the fact that the particular transaction actually and directly serves the economic interest and purposes of the resident enterprises and is directly related to the enterprise's trade or business.

Proof of general economic substance based on a general connection between a transaction and the enterprise's business, as reflected and confirmed in information, data and experience generally applicable to enterprises in the same line of business is no longer allowed, and ruling n. 127 of June 6, 2003 is revoked.

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