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

Italian law.

Italy implemented the EU mergers directive by way of legislative decree n. 544 of 1992. Recently, the EU mergers directive was amended and extended by Council Directive 2005/19/CE, implemented in Italy by way of Legislative Decree n. 199 of 2007.

In case of cross-border transfer of shares, Italy's tax administration with resolution n. 190 of December 13, 2000 took the position that shareholders of the target could achieve tax free treatment on their transfer of shares of the target for shares of the acquiring company at the condition that they took a substituted basis in the shares of the acquiring company and the acquiring took a carryover basis in the shares of the target received in the transaction.

Subsequently, with resolution n. 159 of July 25, 2007 the tax administration revoked its previous ruling and eliminated the double carryover basis requirement.

Consequently, Italian law is in line with the EU mergers directive and EC Treaty on this particular issue.

Italian Law on Domestic Mergers.

Under Tax Code section 172, a merger can be carried out with nonrecognition of gain by either the target company or its shareholders, if the target shareholders receive only stock of the acquiring company in exchange for their stock of the target. The target shareholders take a substituted  basis in the stock received in the transaction, and the acquiring company takes a carryover basis in the assets and liabilities acquired in the merger. The tax deferral treatment applies only to mergers between domestic companies.

EU Mergers Directive.

EU directive 90/434/ECC provides for non recognition treatment of mergers between EU companies.The conditions to be met are the following:

- the companies involved in the merger are resident in two or more EU member states;

- the companies involved in the merger are taxable entities subject to corporate income tax in their state of residence;

- the transaction qualifies as a merger under the definition of the directive, i.e., one or more companies transfer all of their assets and liabilities to an existing or newly formed company, on being dissolved without going into liquidation, with the shareholders of the merged companies receiving solely stock of the surviving company in exchange of their stock of the merged companies and, if applicable, a cash payment not exceeding 10 per cent of the nominal value or the accounting par value of their stock in the merged companies.

If the assets transferred in the merger include a permanent establishment of the merged company situated in another EU member state, both the member state of the merged company and the member state of the permanent establishment renounce their right to tax the gain on the assets of the permanent establishment, and the acquiring company receives takes a carryover basis in the assets of the permanent establishment.    

The mergers directive was amended by way of the EU directive n. 2005/19/CE.

Italy implemented both directives with provisions that are now contained in Tax Code sections 178 to 181. As a result, a merger of a company resident in Italy and a company resident in another EU member state, or of two companies resident in two different EU member states with a permanent establishment in Italy, are governed by the directive and can be carried out with non recognition of gain if the conditions for the tax free treatment are met.    

The Facts of the Ruling.

The ruling deal with the merger of two banks resident in Germany with permanent establishments in Italy.

The transaction qualifies as a merger under both domestic law and the EU mergers directive. However, since it is a merger between two companies that are resident in the same EU member state (Germany), technically the mergers directive cannot apply.

The Opinion of the Italian Tax Authority.

According to the Italian tax administration, the general nonrecognition treatment of domestic mergers can apply also to the merger in question.

The tax administration refers to the provisions of Tax Code article 176 on the contributions of assets to a company in exchange for stock of the company (equivalent to the section 351 transactions under US Internal revenue Code), as amended with the Budget Law for 2007, which expressly apply also to the case in which the transferring or the transferee companies are non resident in Italy, whether or not they are resident in a EU or non-EU country, and grant non recognition treatment with respect to the business assets of the transferring company located in Italy.

The tax administration observes that the Italian legislator deemed it appropriate to extend the tax free treatment in the above case also to transactions carried out between companies resident outside of Italy and the EU. As a result, it seems appropriate to extend the tax free treatment also to mergers carried out between foreign companies, which do not fall within the scope of the mergers directive, when all other conditions for the non recognition treatment are respected and the Italian assets are transferred to the acquiring company with a carry over basis that preserve Italy's right to tax the gain on those assets.

Conclusion.

The ruling is very important because it clarifies the Italian legal background in case of cross border reorganization. The Italian legal system is very favorable, because under its international private law it recognizes mergers carried out pursuant to foreign law, and grants non recognition treatment to foreign cross border mergers involving Italian companies or assets located in Italy. The same nonrecognition treatment can apply also in case of transfer of Italian assets or stock in a contribution transaction between two foreign companies.   

French law at Issue

Section 223 A of the French Tax Code provides for an elective group tax regime that allows French companies to file a consolidated tax return with their at least 95-per-cent owned direct or indirect subsidiaries. Profits and losses of group members are combined and intra group transactions are ignored. Only French parent and French affiliates directly or indirectly owned by other French companies (or foreign companies taxable in France) can be members of the tax group. A foreign company not subject to tax in France, and a French parent owning stock in French subsidiaries through a foreign holding not subject to tax in France, cannot be part of the group.       

Facts of the case

A French parent company had set up a consolidated tax group including several French companies which it indirectly held through a Dutch wholly owned intermediate holding company. The Dutch company, an NV, was not subject to tax in France, having no French permanent establishment, so it could not be included in the consolidated group. Because the NV was not French, the consolidated group had to exclude also the NV's French parent.As a result, the French parent's income was recalculated, and the French parent was subject to tax on its own profits, with no offset with the losses of other French subsidiaries in the integrated group.    

The French parent company disputed the tax assessment by arguing in Court that the restriction in section 223 A of the French Tax Code was incompatible with the EU freedom of establishment. The lower court and the Court of Appeal of Paris rejected the claim, and the parent company appealed the judgment to the Conseil d'Etat (French Supreme Court).

The Conseil d'Etat referred the case to the ECJ for a preliminary ruling on two questions of EU law: (1) was the freedom of establishment of at least one member of the group (the French parent) restricted by the tax consequences of the parent company's decision to hold its French subsidiaries through a EU holding company, rather than a French company, that being the inability for the French parent to be part of a tax group with its French subsidiaries and offset its profits with the losses of the other members of the group and reduce its tax liability; (2) may the restriction be justified by the need to preserve the coherence of the tax system or avoid tax evasion.

Ruling of the Court.

On the first issue, the Court noted that the tax integration regime reduces the tax liability of the parent company, by allowing it to combine its profits with the profits and and losses of all the companies in the fiscally integrated group. As a consequence, the tax integration regime constitutes a favorable tax treatment, because the offsetting allows the group to deduct the losses of certain of its members immediately thereby reducing the combined tax liability of the group.    

Under French law, a parent company can benefit from the integration regime only if it holds its subsidiaries directly or through another company that is liable to tax in France and is itself member of the integrated group, that is, a French company or a foreign company that does business in France through a French permanent establishment and is subject to tax in France. If the parent holds the stock in the subsidiaries indirectly through a EU company that is not taxable in France, it cannot benefit from the tax integration regime. 

The ECJ found the different treatment, which puts a Community situation at a disadvantage compared to  purely domestic situation, while the two situations are otherwise similar, discriminatory and in violation of the freedom of establishment.

On the second issue, the Court refused to apply the tax evasion justification and distinguished the case from Marks & Spencer on the ground that, unlike Marks & Spencer, the problem is not the risk that the same losses are used twice (by the French subsidiary and the foreign holding company), but the ability of the French parent to offset its profits with the  losses and profits of its French subsidiaries in the tax group.

With regard to the coherence of the tax system argument, the Court recognized that in case of consolidation of French taxable entities, all profits and losses of the entities are combined within the group and all intra-group transactions are neutralized, which avoids the possibility to use the same losses twice at the level of the resident companies falling under the tax consolidation regime.

Instead, in case of an intermediate holding which is not taxable in France and is not member of the tax group, the losses recorded by the French sub-subsidiary may be taken into account twice, first in form of direct losses by the sub-subsidiary, and then in the form of a write down recognized by the French parent company for the depreciation of its holding in the intermediate holding, and the losses of the sub-subsidiary and the write down of the parent would not be neutralized internal transaction would not be neutralized because the intermediate holding is not subject to the tax integration regime.

In such circumstances, a resident parent would achieve the benefits of the tax consolidation regime, by immediately taking into account the losses of the companies subject to the tax integration, without the losses of the sub-subsidiary and the write-down of the parent in the stock of the foreign holding being neutralized.

As a consequence, the restriction might be justified with the need to preserve the coherence of the tax system.

However, according to the Court, the restriction goes beyond what is necessary and fails to meet the proportionality test. According to the Court, it is not always possible to identify the origin of a write down and trace it to the losses of a subsidiary, and the risk of double use of losses can be addressed with the recourse to the exchange of information system granted under the Council Directive 77/799/EEC  and by asking the proper documentation and information to the resident parent.

As a result, the ECJ struck down the French rules as incompatible with the EC Treaty.  

Implications under Italian Law

Under Italian worldwide consolidation rules, foreign subsidiaries can be consolidated, but under stricter rules and standards than those that applies to domestic consolidation, and taxpayers cannot benefit from the use of foreign losses to the same extent as they can use domestic losses in the domestic consolidation regime.

The main differences from domestic consolidation are as follows:

• Only the ultimate Italian parent company can consolidate foreign subsidiaries. Ultimate Italian  parent company means the domestic resident company at the top of the group, whose stock is publicly traded or owned by Italian resident individuals who do not control other resident or nonresident companies. The permanent establishment  in Italy of a foreign company, and the Italian intermediate holding company of a foreign group, cannot consolidate foreign affiliates owned by the Italian holding company for Italian tax purposes.
• The election for consolidation is binding for five years.
• The requirement for consolidating is more than 50 percent of stock (by value), voting power, and profits share.
• All foreign affiliates must be included in the consolidation ("all in all out" rule, which contrasts to the "pick and choose" rules that applies to domestic consolidation).
• Only a proportionate share of the foreign affiliates’ profits and losses is combined in the
  computation of the consolidated income or loss (as opposed to the entire amount of profits and losses that are offset in domestic consolidation).
• Independent auditors must audit the financial statements of foreign affiliates.
• An advance ruling that certifies that all requirements are met is required to be able to
  elect for worldwide consolidation.

In light of the above, from the perspective of foreign taxpayers investing in Italy, consolidation of
lower-tier foreign subsidiaries controlled by a foreign-owned Italian company is not permitted.

From the perspective of Italian investors, although consolidation of foreign subsidiaries (through the
ultimate Italian parent) is permitted, it is subject to stricter limitations compared with domestic consolidation, which makes it less advantageous in many respects.

To the extent that the foreign subsidiaries are based in a EU member states, the restrictions to worldwide consolidation might be in contracts with the freedom of establishment and non discrimination principles of the EC Treaty.

Indeed, pursuant to the ECJ ruling in Société Papillon, any restrictions to the access to the tax consolidation regime in cross-border EU situations are illegal.

The restriction may be justified under the need to combat tax evasion, but only if they are narrowly tailored to target excusively tax abusive situations (see Cadbury Schweppes), or to avoid double dipping, provided that there is any real risk or possibility that the losses are usable also in the foreign country (see Marks & Spencer), or to preserve the coherence of the tax system, but only if they do not exceed what is strictly necessary for this purpose.  

Taxpayers who can benefit from tax consolidation of foreign subsidiaries in the EU but do not meet any of the standards required for this purpose should test the validity of the law under EU law principles and assess any chances of challenging them before the ECJ.