On October 9, 2023, the last Ministerial Decree required for the final implementation of Italy’s Register of Trusts was published, and the Register of Trusts is now in effect. The initial filing deadline is December 11, 2023. The filing in the Register is required for domestic trusts, private foundations, and similar legal arrangements, defined as trusts established or resident in Italy and foreign trusts with Italian source income. The place of establishment or residence of the trust and the source of the trust’s income are the key tests applied to determine whether a trust is subject to reporting on the Register. The Ministerial Decree n. 55 of March 11, 2022 setting forth the regulation governing the filing onto the Register of Trusts. Decree n. 55 generally refers to trusts that “produce relevant legal effects for tax purposes.” The concept requires further clarifications and would seem to include a trust with Italian resident settlors or beneficiaries, wherever it may be established and managed, when and to the extent that the trust changes or affects the way in which a settlor or beneficiary is taxed with respect to the assets placed in trust and income arising therefrom. The scope of the reporting includes information on the trust’s settlor, beneficiaries, beneficial owners, and other individuals with substantial powers over the trust, as they are all within the definition of ‘beneficial owner’ outlined in the anti-money laundering legislation, as well as the date and place of establishment of the trust and reference to the trust deed establishing the trust. Taxpayers should carefully review their trust planning structure to determine whether they fall within the scope of the filing on the Register and act accordingly, considering the imminent filing deadline.
On October 16, the Council of Ministers approved a legislative proposal that will repeal the special tax regime for new resident workers, entrepreneurs, and professionals with effect from January 1, 2024.
The special regime, enacted in its final form in 2020, allows Italian and foreign nationals who establish their tax residence in Italy while not being Italian tax residents in the preceding two years to exclude up to 70 percent of their qualifying income from tax. If the tax residence is established in one of the regions of the southern part of the country or one of the islands (Sicily and Sardinia), the exclusion goes up to 90 percent.
A new regime will replace the existing regime with much stricter eligibility requirements and a much narrower scope: it will be limited to Italian or EU nationals, apply for five years with no extension, grant a 50 percent maximum exemption, require a three-year non-tax residence period, and provide for a retroactive loss of the tax benefits if the taxpayer moves her tax residence outside of Italy before the completion of the full five year period or her business outside of Italy before the completion of ten full years of residence. Also, the new regime will apply only to those who moved to Italy to start new employment, profession, or business and meet the new high qualifications or skills requirement (which includes holding a graduate degree in economics, entrepreneurship, or qualified professions).
The final legislation will set forth specific provisions for those who moved to Italy under the existing regime and are there once that is repealed and the new one will take its place.
Taxpayers currently in Italy under the special regime should carefully follow the developments and review their tax planning strategies to address the issues that may arise form the final enactment of the legislation under consideration.
Those who plan to move to Italy after the new regime is in place should consider other planning strategies, such as specifically designed trusts aimed at minimizing their income taxes there, even when they operate outside the special regime itself.
In its ruling n. 370 issued on July 4, 2023, the Italian Tax Agency concluded that in a case of a change of tax residency during the year, the treaty provision according to which the change of tax residence takes effect on the day of the transfer out of Italy to the foreign country is consistent with the clarifications provided at paragraph 10 of the OECD commentary to tax treaty article 4 and prevails over domestic tax law.
As a consequence, the taxpayer will file a part-year resident tax return in Italy, reporting her worldwide taxable income earned during the first part of the year through the last day of residence and reporting solely Italian source income, if any, earned from the last day of residence through the end of the year.
The case submitted in the ruling arises under the tax treaty between Italy and Switzerland and involves an Italian national who moved to Switzerland and took on new employment there during the course of the year. The taxpayer registered on the list of Italian nationals living abroad held at the Italian consulate in Switzerland and established her domicile there. The taxpayer will keep a permanent home in Italy, but her vital connections would be in Switzerland, where she will live with her family and carry on her employment. The transfer to Switzerland occurred on May 31. The issue is whether the taxpayer will file a full-year tax resident income tax return, as required under Ityaly’s internal tax law, or a part-year tax resident return through the date of the relocation (May 31), pursuant to the treaty.
For the purpose of the ruling, it is assumed that the taxpayer will have her center of vital interest in Switzerland, within the meaning of article, 4 paragraph 2 of the Italy-Switzerland tax treaty.
Under Italy’s domestic tax law, there is no split tax year tax residence. Instead, a taxpayer is treated as a tax resident of Italy for the entire year if she moves to a foreign country during the first half of the year (i.e., on or before July 2). Conversely, a taxpayer is treated as a nonresident for the entire year if she leaves Italy in the second half of the year (i.e., on or after July 3).
Paragraph 4 of Article 4 of the tax treaty between Italy and Switzerland provides that “The individual who permanently transfers her residence from one contracting State to another contracting State ceases to be subject to taxes in the first contracting State for which domicile is relevant, immediately after the day of transferring the domicile. The tax liability for which domicile is relevant begins in the other State from the same date”.
The Tax Agency referred to article 4, paragraph 4 of the Switzerland treaty, while also pointing out that the treaty provision is in accordance and consistent with the “recommendations” set forth in paragraph 10 of the Commentary to the tax treaty article 4. Consequently, the Tax Agency ruled that, under the facts submitted by the taxpayer and summarized above, the treaty prevails over domestic tax law, and the taxpayer’s Italian tax residency terminates on the date of the transfer.
The Commentary to treaty article 4, at paragraph 10, clarifies the following:
“The facts to which the special rules will apply are those existing during the period when the residence of the taxpayer affects tax liability, which may be less than an entire taxable period. For example, in one calendar year, an individual is a resident of State A under that State’s tax laws from 1 January to 31 March, then moves to State B. Because the individual resides in State B for more than 183 days, the individual is treated by the tax laws of State B as a State B resident for the entire year. Applying the special rules to the period 1 January to 31 March, the individual was a resident of State A. Therefore, both State A and State B should treat the individual as a State A resident for that period and as a State B resident from 1 April to 31 December”.
Ruling 370 raises an interesting issue: should the interpretative language of the OECD commentary to article 4 determine the interpretation of Italian tax treaties in general, and should the split tax year resident rule also apply to situations that arise under other tax treaties that do not contain a specific provision such as that of the Switzerland treaty?
The Italian Tax Agency’s Ruling n. 309 of April 28, 2023 (Risposta-n.-309_2023-1.pdf) deals with the issue of taxation to Italian beneficiaries of income distributions from a U.S. trust.
Under Italy’s tax law, trusts with identified income beneficiaries are treated as fiscally transparent, and the beneficiaries are taxed on their share of the income of the trust when accrued and regardless of its distribution to the beneficiaries of the trust. “identified” income beneficiaries are defined as specific persons or a class of persons who, under the terms of the trust agreement, have the right to receive distributions of income from the trust. Trusts with mandatory distribution schemes in the trust agreement are classified as fiscally transparent. Irrespective of the terms of the trust agreement, a trust may be classified as fiscally transparent if there is a pattern of regular distributions that, as a practical matter, is equivalent to a mandatory distribution scheme. Fiscally non-transparent trusts are treated as separate taxable entities, with the consequence that the trust income is taxable to the trust (at a rate of 24 percent) and can be distributed to trust beneficiaries with no additional income tax on the distributions. Income distributions from foreign, fiscally-non transparent trusts are not taxed to Italian tax resident trust beneficiaries. However, under a special anti-abuse rule enacted in 2021, income distributions from foreign trusts established in a low-tax jurisdiction are taxable to the Italian beneficiaries of the trust on the assumption that the trust income has not been subject to a minimum level of taxation in the jurisdiction where the trust is established. The income distribution is part of the annual general taxable income, and the Italian income tax is assessed at progressive rates. The minimum tax test is met whenever a foreign trust is subject to a nominal level of taxation in the jurisdiction where it is established that is equal to at least 50 percent of the Italian corresponding income tax rate (12 percent, based on the Italian nominal tax rate of 24 percent for taxation of trusts). The nominal rate test applies at the level of the trust, and the nominal rate is determined by referencing the type of income “predominantly” earned by the trust. Any generally applicable exemptions, exclusions, or deductions not specifically linked to a trust’s particular class, type, or status are disregarded. The country of which the trust is a tax resident is deemed to be the “jurisdiction where the trust is established”. In the absence of a proper accounting of the principal and income of the trust, under Italy’s tax accounting principle, the full amount of the distribution is deemed to be income taxable to the beneficiaries upon receipt.
Under the facts submitted by the taxpayer and discussed in the ruling, the trust was initially set up under the laws of the Bahamas and was governed by the laws of the State of New York since 2019 and at the time of the ruling request. Two individuals who are residents of and domiciled in the United States serve as trustees, with the power to amend the terms or change the governing law of the trust ) with the consent of the guardian), revoke, appoint and replace a trustee or trustees, increase the number of guardians, or appoint successor guardian when no one i serving in such capacity. At their sole and absolute discretion, the trustees can make distributions of principal or income of the trust to any member of a class of discretionary beneficiaries described in the trust. The trustees are not related or subservient to the trustees, with whom they have no ongoing professional relationships. The trustees approved the annual distributions made to trust beneficiaries in 2020 and 2021 by way of written resolutions included as part of the trust records. The trust owns a financial portfolio that is managed by a financial firm based in the U.S. appointed and serving as the trust’s investment advisor. For federal income tax purposes, the trust is treated as a separate taxpayer and is liable to tax on its income at a rate of up to 23.8% for dividends and capital gains and 37% on other (ordinary) income.
In its ruling, the Tax Administration agreed with the taxpayer and held that, based on the facts submitted by the taxpayer, the trust is classified as a fiscally nontransparent trust established in the United States, and the distributions of income from the trust the Italian beneficiaries were not taxable in Italy. It also ruled that future distributions will not be taxable, as long as the taxpayer can rely on sufficient evidence that the trust is taxed on its income at a nominal rate of at least 50% of the applicable Italian rate, as in effect at the time the income is earned or produced by the trust.
The ruling concerns a rather straightforward case and does not clarify certain more challenging issues that may arise in certain situations where the terms of the trust agreement provide for more flexible criteria or standards pursuant to which the trust beneficiaries may receive distributions from the trust or a foreign country’s taxation of the income of the trust may change depending on the classification of the trust or the tax treatment of the distributions in that country. However, the ruling is useful in offering an overview of the opportunities and potential traps involved in the tax planning through cross border trusts under Italy’s tax law.
In its ruling no. 267, dated March 27, 2023 (Risposta-n.-267_2023.pdf), the Italian Tax Agency addressed a case involving a trust where the Settlor reserved the power to revoke and replace the Guardian and retained certain powers related to the shares of a company he transferred to the trust, including the power to appoint the majority of the company’s directors and the company’s auditors. The Guardian, in turn, held significant powers to advise the trustee, direct some of the trustee’s decisions regarding the administration of the trust, and the power to amend and terminate the trust. In a 2015 ruling, the Tax Agency determined that such a trust would be considered interposed and disregarded for all tax purposes.
In Italy, a trust is considered interposed when the Settlor directly or indirectly maintains a sufficient level of control over the administration and enjoyment of the trust’s principal and income, resulting in the Settlor still being treated as the owner of the trust’s principal and income for both income and inheritance tax purposes. The taxpayer modified the trust and submitted a new ruling request.
With the amendments to the trust agreement, the Settlor relinquished his power to change or add new beneficiaries, issue recommendations to the trustee, and vote for the election of the company’s directors and auditors. The amended trust agreement also mandates the consent of a beneficiary (or the majority of the beneficiaries in case of disagreement among them) for the Settlor’s decision to revoke and replace the Guardian. The Settlor designated his descendants as the sole beneficiaries of the trust. Notably, the power to replace the Guardian did not necessitate that the Settlor appoint a new Guardian who is independent of and not subservient to the Settlor.
In ruling no. 267, the Tax Agency determined that the amended trust should still be considered interposed and consequently disregarded for all tax purposes. According to the Tax Agency, a trust where the trustee acts upon the direction of the Guardian, and the Settlor possesses the unconditional and unlimited power to replace the Guardian, subject only to the consent of a beneficiary, remains under the substantial, albeit indirect, control of the Settlor. As a result, the trust assets are part of the Settlor’s estate and subject to inheritance tax, and the income generated from the trust property is directly taxed to the Settlor.
In light of this ruling, taxpayers should reevaluate their trust planning structures and ensure that the combination of provisions governing the powers of trustees, trust advisors, trust protectors, guardians, and other individuals or entities involved in the administration of the trust, distribution of trust principal and income, and changes to or termination of the trust, are appropriately drafted and coordinated to avoid the risk of the Settlor ultimately being considered the dominus of the trust, causing the trust to fail in achieving its objectives.
The Italian Tax Agency recently issued a ruling (n. 251 of March 16, 2023) that provides guidance on the Italian tax classification of Family Trusts and Testamentary Trusts and the taxation of Italian beneficiaries on the trusts’ income.
The settlor, an Australian national, established the trusts while he was a resident of Australia. He later moved to Italy, where he passed away. The trusts owned rental real estate and other financial investments located in Australia.
When he was alive, the settlor treated the trusts as fiscally interposed and reported the property and income of the trusts on his Italian personal income tax return. The settlor was also one of the beneficiaries of the trusts and the owner and manager of an Australian company that acted as the trustee of the trusts.
After the settlor’s death, his children were appointed as executors of his will, trustees, and beneficiaries of the trusts. One of the children filed a ruling request with the Tax Agency, asking for clarification on the trusts’ tax classification and the taxation of the trusts’ income.
Tax Classification of the Trusts
The Tax Agency ruled that both trusts should be considered fiscally interposed with respect to the beneficiaries, who had retained the function of trustees of the trusts after the death of the settlor. In that regard, the fact that the petitioner had waived his appointment as executor of the will and had not performed any function with respect to the administration of the trusts was considered irrelevant.
Taxation of Trust Income
The Tax Agency ruled that the real estate income should be computed with reference to the gross rents without any deduction. The Italian beneficiaries would be entitled to deduct a foreign tax credit for a portion of the income taxes paid in the foreign country on that income, in proportion to the amount of income they have declared in Italy.
This ruling provides important guidance on the tax treatment of Family Trusts and Testamentary Trusts in Italy. It clarifies the tax classification of trusts and the taxation of trust income for Italian beneficiaries. This ruling will be of interest to individuals and businesses with cross-border investments and trusts in Italy.
The Italian Tax Agency recently issued Ruling n. 237 of March 2, 2023 (Risposta-n.-237_2023.pdf), which clarifies foreign trusts’ tax treatment concerning Italian tax resident beneficiaries.
Under the ruling, when the trustee of a foreign trust is required to make an annual distribution to beneficiaries based on a predetermined percentage of the fair market value of the trust, calculated at a fixed date, the trust must be considered fiscally transparent. In this case, beneficiaries are taxed in Italy on the income of the trust proportional to their interests in the trust, as specified in the trust agreement, on a fiscally transparent basis. This applies regardless of the actual distribution of income to the beneficiaries during the tax year.
The ruling considers a case in which a foreign national created a trust for her husband and three children. Her husband was entitled to a 25% share, and the three children were entitled to equal shares of the remaining 75% (or 100% if the husband predeceased her). Upon their death, their shares were held in separate trusts to benefit each child or their descendants. The trust was governed by US law and administered by an institutional trust organized in the US. The trustee was required to make an annual distribution of as much income or property of the trust that represents 4.5% of the total fair market value of the trust as of the last day of the third year preceding the year of the distribution.
The taxpayer who filed the ruling request took the position that (1) she was not required to file any inheritance income tax return with respect to her share of the assets of the trust she received in trust upon her father’s death, (2) she was not required to report the value of her trust on her Italian income tax return, and (3) the annual distribution she was entitled to should be reported as income from capital, for an amount equal to the value (in cash or other property) that is actually distributed by the trustee to the beneficiary during the year and is taxed by way of the substituted tax at the fixed rate of 26%.
The Tax Agency ruled that the assets that were distributed upon the death of the primary beneficiary to the secondary beneficiaries were not part of the decedent’s estate and were not subject to inheritance tax in Italy. The Tax Agency ruled that the petitioner is required to disclose the value of the trust and her interest in the trust in her Italian income tax return, considering that she is a mandatory beneficiary with the right to receive the distribution of at least 4.5% of the value of the trust annually.
On the issue of whether the annual distribution should be reported as income from capital, the Tax Agency ruled that the entire trust should be classified as fiscally transparent. This means that the taxpayer would be subject to tax in Italy on her share of the trust’s income, which is attributed and taxed to the taxpayer on a look-through basis, regardless of its distribution. The trust income is part of the taxpayer’s general taxable income and is taxed at progressive rates. The amount of distribution that the taxpayer receives each year from the trust is ignored for Italian income tax purposes.
It’s important to note that the ruling on the third issue is questionable and may be affected by how carefully the taxpayer presented her case. Under Italian tax law, a trust is partially fiscally transparent and partially fiscally opaque when the trust agreement does not provide that a beneficiary has the right to the distribution of the trust income as such, but instead provides that a certain percentage of the value of the trust must be distributed to the beneficiary. In that case, the trust is fiscally transparent regarding a portion of the trust income not exceeding the share of the trust.
With its Ruling n. 237 of March 2, 2023 (Risposta n. 237-2023), the Italian Tax Agency ruled that when the trustee of a foreign trust is required to make an annual distribution to the beneficiaries of the trust of cash or other property of the trust that represent a predetermined percentage of the fair market value of the trust calculated at a fixed date, that trust must be considered fiscally transparent, and the beneficiaries are taxed in Italy on the income of the trust which is proportional to their interests in the trust, as specified in the trust agreement, on a fiscally transparent basis and regardless of the actual distribution of income to the beneficiaries during the tax year. The case considered in the ruling concerns a trust constituted by a foreign (non-Italian) national in favor of her husband for a share of 25% and her three children in equal shares, for the remaining 75% (or 100% if her husband predeceased her), and upon their death, to their descendants. The children’s or their descendants’ shares will be held in a separate trust to benefit each of them. The trust is governed by the laws of the State of the United States and is administered by an institutional trust organized in the United States. The trust agreement provides that until a beneficiary reaches the age of 35, the trustee is authorized to distribute to that beneficiary all or part of the income of his or her trust as required for the beneficiary’s health, education, maintenance, and support and when a beneficiary reaches the age of 35, the trustee is required to distribute currently to that beneficiary the annual income of his or her trust for life. Upon the grantor’s death, the trust was divided into two trusts to the benefit of the settlor’s children. Upon the death of one of the children, his trust was divided into two equal shares held in trust in favor of the decedent beneficiary’s children. Upon the trustee’s petition, the Court in the U.S. with jurisdiction over the trust issued an order amending the terms of the trust and requiring that the trustee makes an annual distribution of as much income or property of the trust that represents 4.5% of the total fair market value of the trust as of the last day of the third year preceding the year of the distribution. The taxpayer who filed the ruling request took the position that (1) she was not required to file any inheritance income tax return with respect to her share of the assets of the trust she received in trust upon her father’s death, (2) she was not required to report the value of her trust on her Italian income tax return, and (3) the annual distribution she was entitled to should be reported as income from capital, for an amount equal to the value (in cash or other property) that is actually distributed by the trustee to the beneficiary during the year and is taxed by way of the substituted tax at the fixed rate of 26%. On the first issue, the Tax Agency ruled that the assets that were distributed upon the death of the primary beneficiary (the grantor’s child) to the secondary beneficiary (the decedent beneficiary’s children) were not part of the decedent’s estate and were not subject to inheritance tax in Italy. The Tax Agency does not elaborate, but the conclusion on that issue is likely predicated upon the facts that the grantor was not an Italian domiciliary at the time of the creation and initial funding of the trust, and the trust assets were not located in Italy at the time of the primary beneficiary’s death. On the second, the Tax Agency ruled that the petitioner is required to disclose the value of the trust and her interest in the trust in her Italian income tax return, considering that she is a mandatory beneficiary with the right to receive the distribution of at least 4.5% of the value of the trust annually. Tax Agency ruled that the trust should be classified as fiscally transparent on the third issue. Consequently, the taxpayer would be subject to income in Italy on her share of the trust’s income, which is attributed and taxed to the taxpayer on a look-through basis, regardless of its distribution. The trust income is part of the taxpayer’s general taxable income and is taxed at progressive rates. The amount of distribution that the taxpayer receives each year from the trust is ignored for Italian income tax purposes. The ruling on the third issue is questionable and may be affected by how carefully the taxpayer presented her case. Under Italian tax law, a trust is partially fiscally transparent and partially fiscally transparent when the trust agreement does not provide that a beneficiary has the right to the distribution of the trust income as such, but, rather, it provides that a certain percentage of the value of the trust must be distributed to the beneficiary. In that case, the trust is fiscally transparent regarding a portion of the trust income not exceeding the share of the trust value that must be distributed to the beneficiary. The ruling, on its face, seems to conclude that the entire trust is fiscally transparent, and the beneficiary is taxed on her share of 25% of the entire income of the trust. Under the partially fiscally transparent-partially fiscally opaque trust, she would be subject to tax on a share of the income of the trust not exceeding 4.5%.
The Italian tax administration, in its Circular n. 34 of October 20, 2022, provided some new guidance on the international tax reporting obligations for assets held in foreign trusts. Domestic trusts report foreign assets held under the name of the trust on their own income tax return. In the case of foreign trusts, the reporting duty falls upon the beneficial owner of the trust. The term “beneficial owner” is defined in the anti-money laundering statute and includes the trust’s settlor, trustee, and beneficiaries. Still, it must be adapted when used in the income tax reporting context, considering the underlying purpose of the international reporting rules, which is that of disclosing the beneficiary of the income deriving from the assets of the trust that might be subject to income tax in Italy.
Therefore, by way of background, Circular 34 clarifies that the beneficial owner liable for the reporting must be identified by considering the following:
- the provisions contained in article 1, paragraph 2, letter pp), in article 20, and in art. 22, paragraph 5, of Legislative Decree no. 231 of 2007 (anti-money laundering legislation);
- the provisions adopted internationally within the Common Reporting Standard, according to which the information relating to the beneficiaries is subject to communication in all the periods in which the trust exists, regardless of whether it is a mandatory beneficiary or a discretionary beneficiary (for the former, the value of the proceeds received in the tax period and the total value of the account held by the trust are reported, while for the latter only the first data is disclosed);
- the clarifications already provided in circular no. 38/E of 2013, according to which only those with the right to claim the assignment of income or assets from the trustee are considered beneficial owners of a trust and, therefore, required to fulfill the tax reporting obligations.
Then, Circular 34 draws a distinction between mandatory beneficiaries and discretionary beneficiaries.
Circular no. 38/E of 2013 limited the reporting obligation to mandatory beneficiaries, defined as those individuals who hold the right to claim the distribution of the trust’s income from the trustee. Under Circular 34, mandatory beneficiaries report “the value of the investments held abroad by the entity and of the foreign assets of a financial nature in its name, as well as the percentage of interest in the entity itself”.
With respect to discretionary beneficiaries, Circular 34 clarifies that “The beneficiaries of discretionary trusts, on the basis of the information available, such as, for example, the case in which the trustee communicates his decision to assign him the income and/or capital of the trust fund, are required to indicate in the RW part [of the return] the value of the related credit owed by the trustee, together with the investments and financial assets held abroad.” Therefore, the information required to be reported is two folds: the value of the discretionary distributions made to the beneficiary during the year (which is reported as a credit or receivable from the trustee) and the beneficiary’s interest in the investments and assets owned by the trust. Reporting the second piece of information, however, is problematic, considering that a discretionary beneficiary does not hax any right to any fixed percentage of the income or principal of the trust. The reference to the rules on the automatic exchange of information under the Common Reporting Standards, which for discretionary beneficiaries requires solely the information about the proceeds received during the tax year, and to Circular n. 38/E of 2013 limiting the tax reporting to mandatory beneficiaries supports an approach under which discretionary beneficiaries of a trust only report the distributions received from the trust during the year.
Finally, Circular 34 deals with the case of secondary beneficiaries or “subsequent interest holders” with respect to whom it clarifies the following: “With reference to ‘subsequent interest holders’, i.e., those who would become beneficiaries only when the first beneficiaries cease to exist, taking over from the latter, it is believed that they cannot be classified as ‘beneficial owners’ for the purposes of tax monitoring, provided that there are no statutory provisions or other clauses in the instruments of the trust such that they may be recipients of income or patrimonial attributions despite the presence of ‘antecedent interest holders’. With respect to these persons, any attribution arranged in their favor at the trustee’s discretion takes on relevance in the above terms”. Therefore, secondary beneficiaries only report the value of discretionary distributions that were made to them during the year as allowed under the governing law or instrument of the trust.
On September 1, 2022, the Italian Supreme Court issued a ruling (n. 25698) in a case concerning a distribution from a U.S. partnership treated as a taxable dividend in Italy. The dividend was taxed by way of a substituted tax, and Italian tax law did not allow a credit for the income tax paid the taxpayer in the U.S. on the partnership’s underlying profits. At the time of the facts of case, the Italian substituted tax was assessed at the rate of 12.5 percent. The current substituted tax rate is 26 percent. The Court held that the taxpayer was entitled to receive a foreign tax credit for the income tax paid in the U.S. on his share of the partnership’s income taxable in the U.S. pursuant to the provision of Article 23, paragraph 3 of the Tax Treaty between Italy and the U.S., which prevails on Italy’s domestic tax law.
Many commentators saluted the decision with hurrahs, welcoming it as a big victory for taxpayers. Instead, we believe the decision requires more careful consideration, leaves many important details out, and may be open to a big misunderstanding (and potentially constitute a minefield for the ill-advised).
The Italian substituted tax is a final tax on certain types of income (generally, financial income in form of dividends, interest, and capital gain), when received directly by the taxpayer. The income subject to the tax is separately stated on the Italian income tax return, and the substituted tax is self-assessed on the return and paid directly by the taxpayer. When the same income is collected through an Italian financial intermediary, the intermediary applies a withholding tax at the same rate and pays it to the Italian treasury.
The separately stated income subject to the substituted tax does not enter the computation of the general taxable income. Foreign-source income does not enter the numerator and denominator of the formula for the calculation of the amount of foreign tax credit. Therefore, no foreign tax credit is allowed on the return for any foreign income tax paid in respect of the income taxed in Italy by way of the substituted tax, potentially resulting into double taxation.
As usual, the ruling lacks a proper, comprehensive, and organized explanation of the facts of the case. Under the limited facts set forth in the ruling, we understand that the taxpayer had self-assessed on its Italian personal income tax return a substituted tax computed at the rate of 12.5%, in effect at the time, for euro 137,849, which would correspond to an income of euro 1,102,792 (the exact amount of taxable income is not mentioned in the ruling).
The ruling explains that the taxpayer had provided substantial documentation evidencing that a tax of euro 299,820 had been paid in the U.S. on the taxpayer’s share of the partnership’s underlying profits.
The ruling does not provide any information about the amount of income taxed in the U.S., compared to the amount of income taxed in Italy. The U.S. tax applies on the partner’s share of the partnership‘s underlying profits, when earned by the partnership and regardless of their distribution, while the Italian tax applies upon the partnership’s profits distributed to the partner, at the time of the distribution. The two amounts do not necessarily concide.
The taxpayer refrained from paying the amount of the Italian substituted tax he declared on his income tax returns, taking the position that he was entitled to a tax credit for the income tax paid in the U.S., which would entirely offset the Italian substituted tax due.
The Italian Tax Agency issued a notice of collection of the Italian substituted tax as self-assessed by the taxpayer on his Italian income tax return. The taxpayer filed a petition to the Tax Court (in Milan) and won the case. The Tax Agency lost on appeal (in the Regional Court of Lombardy) and filed a petition to the Supreme Court, setting forth a singled defense in support of its tax collection notice: under the provisions of the Italian income tax code, no foreign tax credit is due for a foreign income tax paid in respect of income subject to a substituted tax in Italy.
The Supreme Court rejected the final appeal and held that the provision of Article 23, paragraph 3 of the tax treaty between Italy and the U.S., which prevails over Italy’s domestic tax law, requires that a foreign tax credit is allowed, except in a case in which the substituted tax applies at the taxpayer’s request. Under the Italian income tax code, the substituted tax is mandatory, and the taxpayer cannot elect that the income be subject the general income tax and claim a tax credit reducing the amount of Italian tax due.
The ruling’s holding is set forth as follows:
“For foreign-source capital income, directly received by the taxpayer, a natural person, holder of a non-qualified shareholding in a partnership governed by international law (in this case, US law), if the subjection to taxation by withholding tax – as in the case referred to in art. 27, paragraph 4, of the Presidential Decree no. 600 of 1973, or by means of a substitute tax, completely superimposable on the first due to the identity of the function, pursuant to art. 18, paragraph 1, of the Presidential Decree no. 917 of 1986 – does not take place “at the request of the beneficiary of [the] income”, but compulsorily, since the taxpayer cannot request ordinary taxation, the income tax paid in a foreign country (in the case, the United States of America) must be considered deductible as a credit”.
The ruling stops there and does not elaborate further. Importantly, nothing in the ruling is mentioned about the way in which the income should be taxed under the facts of the case. The logical implication of Article 23, paragraph 3 of the Treaty is that a foreign tax credit is allowed when (and provided tat) the income is taxed as ordinary income under the general income tax computed at graduated rates.
When we read the ruling, we have the impression that the taxpayer wanted to have his cake, and eat it too: self-assessing the Italian income tax at the reduced substituted tax rate (which is the tax the applies on separately income not part of the ordinary income), and, at the same time, claim a tax credit for the income tax paid in the foreign country, and use it to offset directly substituted tax itself.
That would clearly be a wrong result.
If the rationale of Article 23, paragraph 3 is that the foreign tax credit applies unless the taxpayer requests that the income is taxed by way of the reduced substituted tax, then a foreign tax credit can be allowed solely when the income is reported as ordinary income and taxed under the general income tax at graduated rates.
In other terms, there are two possible tax regimes, one under the Italian income tax code and one under the code as modified by the Treaty: taxation by way of the substituted tax without foreign tax credit, or taxation under the general income tax at graduated rates with a foreign tax credit that reduces the amount of Italian tax due.
Using the numbers mentioned in the ruling, the two alternative tax regimes would work as follows:
- First scenario (Italian income tax code): taxable income euro 1,102,792, final 12.5% substituted tax euro 137,849, no foreign tax credit, total tax (in Italy and the US) euro 437,669,
- Second scenario (Italian income tax code and article 23, paragraph 3 of the treaty): taxable income euro 1,102,792, Italian regular tax before credit euro 474,200.56 (using a 43% marginal tax rate), foreign tax credit euro 299,820, Italian tax after the credit euro 174,380.56, total tax in Italy and the US euro 474,200.56.
In the case decided in the ruling, the substituted tax with no foreign tax credit still appears to be more favorable option.
With the substituted tax calculated at the current rate of 26%, the result would be the following:
- First scenario (Italian income tax code): taxable income euro 1,102,792, final 26% substituted tax of euro 286,725.92, no foreign tax credit, total tax in Italy and the US euro 586,545.92,
- Second scenario (Italian income tax code and article 23, paragraph 3 of the treaty): Italian regular tax (before credit) of euro 474,200.56 (using a 43% marginal tax rate), foreign tax credit euro 299,820, Italian tax after the credit euro 174,380.56, total tax in Italy and the US euro 474,200.56.
In the latter case, the regular income tax with the foreign tax credit appears to be substantially more favorable than the substituted tax regime with no foreign tax credit.
Taxpayers should carefully consider their options, but should not reasonably expect to be able to simultaneously assess the Italian tax at the substituted tax rate and get a full tax credit for the foreign income tax directly deductible from the substituted tax