The application of tax treaties to fiscally transparent entities is controversial. Two requirements for the application of the benefits of a tax treaty (that is, the elimination or reduction of the source country tax on payments made by a person resident in one Contracting State, to a person resident in the other Contracting Sate) are that the person receiving the payment is a "resident" of the other contracting state, and the "beneficial owner" of the payment.

Residence is usually defined in tax treaties (typically, under article 4, paragraph 1), as requiring that a person be "liable to tax" in the other Contracting States, by reason of his residence, domicile, place of management, place of incorporation or other criterion of a similar nature (article 4, paragraph 1).

According to the OECD, whenever an entity is treated as fiscally transparent in a State, the entity is not "liable to tax" in that State, within the meaning of article 4, paragraph 1, and so it cannot be a resident thereof for purposes of a treaty. In such case, the entity’s partners or owners should be entitled to the benefits of the treaty entered into by the State of which they are residents, with respect to their share of the income of the entity, to the extent that the entity’s income is allocated to them under the tax laws of their State of residence (see OECD Commentary to the Model Tax Convention, on Article 1, paragraph 5).

The current Tax Treaty between Italy and the United States adopts a slightly different approach and assigns tax residency to a an entity that is treated as fiscally transparent entity in the United States, for the purposes of the treaty, to the extent that the entity’s income is taxed in the U.S in the hands of its parents or beneficiaries. In fact, Article 4, paragraph 1, letter b) of the Convention, with reference to partnerships, estates and trusts, provides that in the case of income derived or paid by a partnership, estate of trust, this term applies only to the extent that the income derived by such partnership, estate or trust is subject to tax in that State, either in its hands or in the hands of its partners or beneficiaries”. Article 1, paragraph 5, letter d) of the Protocol extends the same provision to fiscally transparent entities, by providing that d) The provisions of subparagraph 1(b) of Article 4 (Resident) of the Convention shall apply to determine the residence of an entity that is treated as fiscally transparent under the laws of either Contracting State.

Under the provisions referred to here above, a U.S. entity that is treated as fiscally transparent under US tax laws, receiving dividends from an Italian subsidiary, should be entitled to the 5% withholding tax on inter company dividends, provided that it satisfies the other requirement (minimum 25% ownership for a period of at least 12 months at the time of the payment of the dividends). For that purpose, the documentation provided to the Italian subsidiary must include tax certificates for both the entity and it shareholders or beneficiaries, providing that the shareholders or beneficiaries US residents and are taxed on the entity’s income in the United States.    

As for the second requirement, the term "beneficial owner" is generally not defined in tax treaties. However, the 2014 Update to the OECD Model Tax Convention issued by OECD the Committee on Fiscal Affairs on June 26, 2014 clarifies the meaning of beneficial owner as requiring that a person have "the right to use and enjoy" the income, "unconstrained by a contractual or legal obligation to pass on the payment received to another person". Sometimes, the term is interpreted as meaning that the beneficial owner is the person to whom the income is attributed for tax purposes under the tax laws of a Contracting State. 

The EU Directive 2003/49/EC of June 3, 2003 provides a definition of the term “beneficial owner” for the purposes of the withholding tax exemption of interest and royalties paid to a EU parent or affiliate corporation, according to which “A company of a Member State shall be treated as the “beneficial owner” of interest or royalties only if it receives those payments for its own benefit and not as an intermediary, such as an agent, trustee or authorized signatory, for some other person”. Circular 47/E of November 2, 2005, which at paragraph 2.3.2 clarifies that in order for a company to be considered the beneficial owner of the interest or royalties, “it is necessary that the company receives the payment as the ultimate beneficiary, not as an intermediary such as an agent, a fiduciary, or collector of the payment for another person, … and that the company receiving the interest or royalties derives a direct personal economic benefit from the income from the transaction”.

Clearly, the tax treatment of an entity in its country of organization is key to determine whether the entity, or its shareholders, partners or members, are entitled to the benefits of a treaty with respect to a parent made by a resident of the other Contracting State. The residence and beneficial owner requirements, whose meaning is not entirely free from doubt, and depends on the facts and circumstances of the particular case, call for extensive analysis of the tax classification and treatment of the entity and its owners, under the laws of their country or organization or asserted residence, as well as the organizational structure, role and functions of the entity receiving the payment. Under that scenario, the payer of the income bearing withholding agent obligations is usually under pressure, and must make sure that the documentation provided by the payee establishes with sufficient certainty the payee’s eligibility for treaty benefit.               

 

 

 

  

   

The pending 1999 U.S.-Italy Tax Treaty entered into force on December 16, 2009, when Italy and the United States exchanged the instruments of ratification.

The new U.S.-Italy Tax Treaty (PDF) is effective from February 1, 2009, for income subject to withholding tax and from January 1 2010, for all other provisions of the treaty.

The 1999 U.S.-Italy Tax Treaty remained pending for ten years due to certain general anti abuse provisions for the application of the reduced withholding tax rates on dividends interest and royalties, and some other issues concerning the exchange of information provision of the treaty and the arbitration procedure to resolve treaty disputes. Italy waived the anti abuse provisions by means of the exchange of diplomatic notes in April 2006 and February 2007 and ratified the treaty in April 2009.   

The new treaty includes provision on the creditability in the United States of the Italian Regional Tax on Production Activities (IRAP), the application of the US branch profits tax and new withholding tax rates on dividends, interest and royalties, plus a limitation of benefits provision in the protocol. 

The new withholding tax rates are 5 percent for inter-company dividends (namely, dividends paid to a company which owned at least 25 percent of the stock of the distributing company for more than twelve months), 10 percent on interest and zero percent on royalties from copyrights.

 

             

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.