Italy’s tax administration issued circular n. 26/E of May 21, 2009 (Circ_26E/2009.pdf), which provides clarifications on the application of the reduced withholding tax on EU dividends.

EU dividends are dividends paid to companies that are resident in a EU Member State or in a State that belongs to the European Economic Area and is included in a special list of approved countries (white list). EU dividends distributed out of earnings and profits accumulated in tax years which began on or after January 1, 2008 are subject to the reduced 1.375 percent withholding tax.

Circular 26/E clarifies that the provision which allocates dividends in reverse chronological order beginning first with profits accumulated in older tax years does not apply. Therefore, the distributing company is free to allocate the distribution to profits accumulated in tax years which began on or after 1.1.2008 and apply the reduced withholding tax.

Also, circular 26/E clarifies that the recipient of the dividend qualifies for the reduced withholding tax if it organized as a company subject to a corporate tax under the laws of its State of residence, even though it does not actually pay any tax as a result of a  exemption that is compatible with EU law or is granted in connection with the particular nature of the entity’s income (e.g., passive income earned by investment companies).  

Therefore, investment funds organized as companies in their state of residence, but not subject to tax on their invstment income (such as certain Luxembourgh or Irish investment funds), could qualify for the reduced EU dividend withholding tax rate.

Overview of Italian withholding taxes on dividends.

Italian-source dividends paid to non-resident persons (other than those attributable to a permanent establishment of the non resident person in Italy) are subject to 27 percent withholding tax. The tax applies both to portfolio and inter-company dividends paid to companies or individual shareholders. The tax rate is reduced to 12.5 per cent for dividends paid on on a special class of non-voting stock (saving shares).

If the recipient of the dividend is a resident of a treaty country, the withholding tax is reduced typically to 15 percent, for portfolio dividends, and 5 percent, for inter-company dividends, under tax treaty.

The recipient of the dividend can apply for a refund of the tax paid in its own State of residence on the dividend received, for an amount not exceeding 4/9 of the Italian withholding tax (or 12 percent of the 27 percent withholding tax). Proof of payment of the foreign tax can be provided by means of a certificate issued by the foreign tax authority.

Dividends paid by an Italian subsidiary to a EU parent company that qualifies for  the benefits of the Parent-Subsidiary Directive are free from withholding tax. For the directive withholding exemption to apply, the recipient company must be a company resident in a EU member state subject to corporate income tax in its own state of residence and must directly own at least 10 percent of the stock of the distributing company for 12 consecutive months at the time of the payment of the dividend (for the text of the EU Parent-Subsidiary directive, see DIR CE 1990_435.pdf).

Dividends paid to an Italian company are not subject to withholding tax. The recipient company is taxed on 5 percent on the amount of the dividend at the ordinary corporate income tax rate of 27.5 percent. The result is an effective tax rate on dividends equal to 1.375 percent.

The reduced EU dividend withholding tax.

The European Court of Justice in its judgments issued on December 14, 2006 in the case C-170/05 (Denkavit Internationaal) and on November 8, 2007 in the case C-379/05 (Amurta), and the EFTA Court in its judgment issued on November 23, 2004 in the case E-1/04 (Focus Bank ASA) ruled that EU Member State’s national laws which subject outbound dividends to a less favorable tax treatment than the treatment applicable to domestic dividends violate the freedom of establishment clause of the EC Treaty.

This was the case of Italy, which subjected outbound dividends to 27 percent withholding tax (reduced to not less than 5 per cent under tax treaties), compared to the 1.375 percent effective tax applicable to domestic dividends.

In order to eliminate that discrimination and bring Italian law in compliance with the EC Treaty, Italy with the budget law for 2008 enacted new provisions (now included in article 27-ter of the Presidential Decree n. 600 of 1973) according to which dividends paid to a company that is resident of the EU Member State or a state that is part of the EEA and is included in the white list are subject to withholding tax at the reduced rate of 1.375 percent. This equalizes the treatment of EU outbound dividends and domestic dividends.

The reduced rate applies to dividends on shares of stock, or payments under financial instruments or other contractual arrangements that are constituted entirely of profits of the issuer or contracting party and are characterized as dividends for tax purposes.

Requirements for the reduced rate.

The reduced withholding tax rate applies to profits distributed to companies and other entities subject to a corporate income tax. Individual shareholders, partnerships and other fiscally transparent entities do not qualify.

Furthermore, the recipient of the dividend must be resident of a EU Member State or of a State that is part of the European Economic Area and is included in the white list. At the moment, the only Member State of the EEA that is also included in the white list is Norway. Iceland and Liechtenstein, which are part of the EEA, are not included in the white list.

Therefore, in order to qualify for the reduced rate two requirements need to be satisfied: the residency requirement and the subject to tax requirement. The residency requirements is tested under the tax laws of the State of the recipient.

Subject to tax requirement.

With reference to subject to tax requirement, circular 26/E clarifies that the test is satisfied every time the recipient is a separate entity for tax purposes and is generally liable for a corporate (entity level) tax under the laws of its own State of residence, even though it in fact does not pay any corporate tax as a result of an exemption that is compatible with EU law.

Circular 26/E makes reference to paragraph 2.2. of circular n. 47 of November 2, 2005 (Circ_ 47E of 2_11_2005.pdf), which provides a similar clarification with respect to the same requirement that applies for the purposes of exempting from withholding tax the interest and royalties paid by a EU affiliate to to a EU parent company pursuant to the interest and royalties directive 2003/49/CE (2003_49_EC of 3 June 2003 (ENG).pdf.

Circular 26/E further clarifies that the subject to tax test is met even though the recipient entity does not pay any corporate income tax on its income in its own State of residence, due to an exemption that is granted in connection with the nature of its income (like, for instance, in the case of exempt passive income of investment companies), or in connection with the source of the income (like, for instance, in the case of companies that are exempt from tax on earnings derived through foreign branches).

Procedural aspects. 

For the reduced withholding tax to apply, the payee must provide to the payer a certificate issued by the tax administration of the recipient’s EU Member State of residence, certifying that the recipient is resident of that state and is liable for a corporate income tax under the laws of its State.of residence.

The payee can obtain the certificate of payment of the dividends from the payer in order to claim a tax credit for the Italian withholding tax in its own state of residence.

Entry into force.

The reduced withholding rate applies to dividends paid out of profits accumulated in tax years beginning after the tax year that is in course as of December 31, 2007. Therefore, for calendar year taxpayers, the reduced withholding tax applies to dividends distributed out of profits accumulated in the year 2008 and thereafter.

For the above purposes, the provision that allocates the dividends to profits reserves accumulated to older tax years in reverse chronological order does not apply.

The payer shall notify the payee the tax year to which the distributed profits is allocated, and whether and to what extent the distribution is made out of profits of 2008 or following years, and subject to a reduced rate, or our of profits of 2007 and prior years, and subject to the ordinary tax rates.

The payer shall also keep separate profits accounts for the allocation of the dividends in order to determine the appropriate tax rate.