Italy’s Supreme Court’s ruling n. 26965 of November 26, 2020 provides a clear example of how things can quickly turn for the worse, for an ill-advised taxpayer who fails to report a foreign financial account on his Italian income tax return, and then fails to properly handle the following tax inquiry and audit stemming from it.

According to the facts reported in the ruling, the Italian Tax Agency, pursuant to the provisions of the Directive of the Council of the European Union n.77/799/CEE of 19/12/1977 concerning the mutual tax assistance between the competent authorities of the member states (and article 27 of the Convention against double taxation between Italy and the United Kingdom of 5 November 1990 and article 26 of the Convention against double taxation between Italy and Australia of 18 November 1984), was able to obtain foreign documentation evidencing that the taxpayer was the only beneficiary of the “Massago Etablissement fund”, established in Vaduz (Liechtenstein), the value of which, as of 31/12/2000, amounted to € 2,381,015.00.

The Italian tax office assessed an additional income tax on the amount of the increase in the value of the account in the years 1999 and 2000, treating it as residual category of capital income which is classified as ordinary income taxable at graduate rates. Usually, income from capital in the form dividends, interest or capital gains is subject to substituted tax charged at the flat rate fo 26 percent.

The taxpayer appealed the regional tax court’s decision – which ruled in favor of the tax agency’s determination – to the Supreme Court, with no luck.

The Supreme Court ruled that, in the case of financial assets not declared on part RW of taxpayer’s Italian income tax return, the tax office can legitimately assume that the entire increase in value of the financial assets held on a foreign financial account represents taxable income. In particular, the increases of the value of the assets on the account, withdrawn and/or deposited abroad, are not considered capital income from foreign sources to be subjected to substitute tax (at 26 percent flat rate), but “interest and other income relating to the use of capital” pursuant to article 44, paragraph 1 letter. h) of the Tuir, which is subject to ordinary income tax at graduate rates.

On the procedural issue, the Supreme Court ruled that the national tax agency can rely on the documentation collected from a foreign tax authority pursuant to international statutory provisions on international cooperation and exchange of information for tax purposes, which, in the absence of meaningful and substantiated challenges from the taxpayer, deserves the highest degree of deference and constitutes sufficient evidence for the assessment of the additional tax.

The lesson for taxpayers is two fold: the duty to report foreign accounts is to be taken seriously, and, more importantly, taxpayers have to be careful in preparing for a possibile tax audit, during which they are expected to provide solid explanations on the nature and sources of funds and sources of income arising from their foreign accounts, in order to avoid extremely hateful tax assessments base don a presumption of evidentiary value of any information in the hands of the tax administration.

With Circular n. 33 of December 28, 2020, Italy’s Tax Agency provided administrative guidance on the special tax regime for new resident workers, professionals and entrepreneurs.

The special tax regime, amended and extended in 2019, provides a 70 percent exemption from tax for income earned by individuals who establish their tax residence in Italy.

Eligible taxpayers include Italian and foreign nationals who (1) were not Italian tax residents in the two preceding tax years, (2) moved their tax residence in Italy in the current tax year, (3) undertake to maintain their tax residence in Italy for at least two years, and (4) during the tax year, carry out the activities which give rise to the exempt income primarily in Italy. The exemption applies for a period of five years, and, when certain conditions are met, can be extended for additional five years for a total period of up to ten years.

Circular 33 clarifies that the the 70 percent taxable income exemption applies to taxpayers who moved their tax residence in Italy on or after April 30, 2019 and became tax residents for the year 2019. Initially, the 70 perched exemption was limited to those who moved to Italy on or after July 3, 2019 and would apply starting from the tax year 2020, while a lower 50 percent exemption would apply to new residents in 2019.

Circular 33 clarifies that the first requirement (non-Italian tax residency during the preceding two years) is met, for taxpayers who are treated as Italian tax residents under Italian internal law, but as residents of a foreign country under the provisions of any applicable income tax treaty. The rule applies to Italian nationals who failed to register abroad and remained registered as Italian resident individuals at the time of their transfer to a foreign country, as well as to foreign nationals who at any had time registered themselves in Italy or maintained a place of habitual abode there, but had at all time their permanent home or center of vital interests in a foreign treaty country and should be treated as residents of that country under article 4 of a treaty between Italy and that country.

Circular 33 does not clarify the requirement that the activities giving rise to income eligible for the exemption be carried out primarily in Italy during the tax year.

Some possible interpretations are that the taxpayer:

– spends more than half of the calendar days in Italy,
– spends more than half of her working days in Italy,
– performs the majority of the activities giving rise to the income eligible for the exemption in Italy, regardless of the number of days she spent in Italy during the year.

The 70 percent tax exemption applies to the following categories of income:

1) employment income,
2) other categories of income taxable as employment income,
3) income from independent professional services,
4) business income.

The exemption applies solely to Italian source income.

Circular 33 clarifies that only business income earned by the taxpayer directly (as a sole proprietor) is eligible for the exemption. Income earned though a partnership or other entity treated as fiscally transparent, and flowing through to the taxpayer under Italy’s partnership rules, does not qualify for the exemption. Indeed, under Italy’s partnership rules, foreign source business income earned through an Italian partnership is re-characterized as Italian source partnership income, based on the partnership’s place of organization.

On the other hand, all foreign entities – including U.S. partnerships, limited liability companies treated as partnerships and corporations treated as S-corporations – are classified as separate taxable entities, for Italian income proposes (regardless of their legal form and tax classification in their foreign country of organization). As a result, in the case of a U.S. national who is a member of an LLC taxed as partnership, or shareholder of an S-corporation, the income which flows through the entity and is taxed upon her under U.S. income tax law is not eligible for the exemption. When that income is distributed to the member or shareholder, it is classified as a dividend and taxed with the 26 percent dividend tax rate in Italy.

Eligible income may derive from business or professional activities already under way at the time of the transfer of taxpayer’s tax residence to Italy, or new business or professional activities commenced at any time thereafter (within the five or ten year eligibility period).

There is no requirement that the employment or professional activities giving rise to the eligible income be performed for an Italian-based employer or resident entity. As a result, income received by foreign nationals who have become Italian residents and continue working in Italy for their foreign employer is eligible for the exemption. In the event the foreign employer is treated as having a permanent establishment in Italy as a result of its employee being based and working in Italy, any income attributable to the employer’s Italian permanent establishment would be taxable to the foreign employer under the regular Italian income tax rules.

Royalties received for the license of self-developed intangibles, copyrights or image rights are treated as income taxable as employment income. If paid by an Italian based entity or individual, they would be Italian source income eligible for the exemption.

Circular 33 provides some important clarifications on the application of the exemption to income earned before but received after the transfer of taxpayer’s residency to Italy. When the income is paid with respect to past employment carried out outside of Italy, when the taxpayer was a nonresident individual, for Italian income tax purposes, that income is not eligible for the exemption. The rule applies to incentive compensation schemes such as stock options or bonuses, and to severance or lump-sum payments, accrued with respect to foreign employment, but paid to a new resident taxpayer during the eligibility period.

Conversely, a bonus, severance or lump-sum compensation accrued with respect to Italian employment or services carried out in Italy during the eligibility period, but received after the end of the eligibility period, when the taxpayer has already moved her residence out of Italy, are also not eligible for the exemption and are taxable as Italian source income of a nonresident under the regular Italian income tax rules.

The eligibility period is five years. It can be extended by five years (going from a total of five to a total of ten years) for taxpayers with one dependent minor child (either at the time of the transfer, or at any time thereafter within the initial five year period), or who purchased a house in Italy during the twelve month period preceding the transfer, or at any time during the eligibility period. For taxpayers with three or more dependent minor children, the amount of exemption is increased from 70 percent to 90 percent.

Failing to maintain Italian tax residency for the minimum two-year period results in the retroactive loss of the exemption.

In general, the special tax regime for new resident workers, professionals and entrepreneurs offers tremendous opportunities to foreign companies with existing or new business in Italy, which plan to move personnel from heir home office to their Italian subsidiaries, foreign nationals who plan to pursue employment opportunities with Italian companies, and foreign professionals and entrepreneurs who plan to move to Italy and continue or start new business or professionals activities while there.

With proper planning, an exemption of as much as 90 percent of eligible taxable income in effect for a period as long as ten years is available to new tax residents under the special regime.

On November 20, 2020 Italy’s Minister of Economy and Finance published its ministerial decree dated November 17, 2020, which contains specific provisions on the meaning and enforcement of the main benefit test of COUNCIL DIRECTIVE (EU) 2018/822 of 25 May 2018 on mandatory reporting of cross border arrangements (commonly referred to as “DAC6”).

Following the ministerial decree, on December 28, 2020 Italy’s Tax Agency published on its website a draft tax circular which provides administrative guidance on the interpretation and application of the Italian legislation that implements DAC6. Taxpayers and their advisors can provide comments on the draft circular until January 15, 2021.

Under DAC6, certain cross border agreements must be reported whenever they contain certain generic or specific “hallmarks” (meaning, a characteristic or feature that presents an indication of a potential risk of tax avoidance) and, simultaneously, meet the “main benefit test” (meaning, the main benefit or one of the main benefits of the arrangement is the obtaining of a tax advantage).

Generic hallmarks linked to the main benefit test include the following:

1. An arrangement where the relevant taxpayer or a participant in the arrangement undertakes to comply with a condition of confidentiality which may require them not to disclose how the arrangement could secure a tax advantage vis-à-vis other intermediaries or the tax authorities;
2. An arrangement where the intermediary is entitled to receive a fee (or interest, remuneration for finance costs and other charges) for the arrangement and that fee is fixed by reference to:
(a) the amount of the tax advantage derived from the arrangement; or
(b) whether or not a tax advantage is actually derived from the arrangement. This would include an obligation on the intermediary to partially or fully refund the fees where the intended tax advantage derived from the arrangement was not partially or fully achieved;
3. An arrangement that has substantially standardized documentation and/or structure and is available to more than one relevant taxpayer without a need to be substantially customized for implementation. 

Specific hallmarks linked to the main benefit test include the following:

1. An arrangement whereby a participant in the arrangement takes contrived steps which consist in acquiring a loss-making company, discontinuing the main activity of such company and using its losses in order to reduce its tax liability, including through a transfer of those losses to another jurisdiction or by the acceleration of the use of those losses;
2. An arrangement that has the effect of converting income into capital, gifts or other categories of revenue which are taxed at a lower level or exempt from tax;
3. An arrangement which includes circular transactions resulting in the round-tripping of funds, namely through involving interposed entities without other primary commercial function or transactions that offset or cancel each other or that have other similar features;
4. An arrangement that involves deductible cross-border payments made between two or more associated enterprises where the jurisdiction of which the recipient is a resident either does not impose any corporate tax or imposes corporate tax at the rate of zero or almost zero;
5. The payment benefits from a full exemption from tax in the jurisdiction where the recipient is resident for tax purposes;
6. The payment benefits from a preferential tax regime in the jurisdiction where the recipient is resident for tax purposes;
 
For a more detailed discussion of the provisions of DAC6, we refer to our presentation (NYU ITP Tax Presentation 11-7-2020) at the NYU’s International Tax Program of November 7, 2020.

The ministerial decree’s provisions on the main benefit test (“MBT”) are set forth at articles 6, 7 and 8, while the draft circular provides guidance on the application of the MBT at sections 3.3 and 3.4. Based on the decree and draft circular, the MBT is met when two conditions occur:

– there is a tax benefit from a cross-border arrangement,

– the economic value of the tax benefit exceeds the other economic (non-tax) benefits of the arrangement.

The ministerial decree provides that a tax benefit is determined with reference to the difference between the taxes due on the basis of one or more cross-border arrangements and the taxes which would be due in the absence of such arrangement or arrangements.

The draft circular clarifies that a tax benefit can derive from a cross-border arrangement which, compared to a transaction in which that cross-border arrangement is not employed, allows the taxpayer to:

– obtain reduction of the taxable base,
– obtain (or increase the amount of) a foreign tax credit or similar relief from international double taxation,
– obtain (or increase the amount of) a tax refund,
– defer the payment – or accelerating the refund – of a tax,
– eliminate or reduce a withholding tax.

The ministerial decree provides that the MBT is met whenever the economic value of a tax benefit represents more than 50 percent of the total tax and non-tax economic benefits of the transaction. The ministerial decree makes it clear that the tax benefit must be the principal benefit, and not just one of the benefit, of the arrangement.

The draft circular clarifies that the actual existence (and the measure of the value) of a tax benefit, is determined with reference to the the overall tax treatment of a transaction, by taking into consideration the income taxes due in Italy and in any other foreign jurisdictions in respect of that transaction. When the total amount of income taxes due is lower that the amount of taxes which would be due in the absence of that particular cross- border arrangement, the tax benefit test is met. Also, the draft circular clarifies that the tax benefit is an objective test, which does not requires any inquiry into the taxpayer’s subjective motives or intentions.

In order to determine whether the tax benefit is the principal benefit of the transaction, a fraction must be sued, at the numerator of which there is the amount of the reduction in income taxes which is achieved through the use of the cross-border arrangement, and, at the denominator, there is the sum of the amount of the tax reduction and all other economic or monetary non-tax benefits of the transition. Whenever the result of the fraction is more than 50 percent, the MBT is met. Th formula can be represented as follows:

Amount of Tax Benefit
_______________________________= more than 50%
Amount of Tax Benefit +
other non-tax economic benefits

The draft circular clarifies that the non-tax economic benefits of the transaction, which go into the formula, may consist in cost savings or revenue increase, but must be measurable objectively, on the basis of specific documentation that the taxpayer should be able to make available and rely upon.

In conclusion, the MBT is an objective test, requires that the tax benefit is determined by taking into consideration the overall tax treatment of the cross-border arrangement and the income taxes due in all jurisdictions involved, and is met whenever the tax benefit is the principal benefit of the transaction, namely, prevailing over the total of other non-tax economic benefit of the transaction.

The ministerial decree and draft circular confirm that the administration and enforcement of the MBT will require a potentially very complicated analysis of the tax treatment of a cross-border arrangement in different jurisdictions, difficult calculations of the income taxes due in relation to a cross-border arrangement compared to the income taxes that would be due in relation to a comparable transaction carried out pursuant to a different legal scheme, and challenging computations of the monetary value of non-tax benefits of the arrangement to include in the measurement formula.

Not surprisingly, taxpayers are going to face significant challenges when trying to assess whiter a cross-border arrangement is reportable under the MBT.

By now, Italian tax practitioners and tax scholars have had the opportunity to report on Italian Supreme Court’s ruling n. 14756 of July 10, 2020 (Cass.14756-20), which ruled that interest paid by an Italian operating subsidiary to its Luxembourg direct holding company is eligible for the withholding tax exemption granted under article 26-quater of Presidential Decree n. 600 of September 29, 1973, which implemented the provisions of the E.U. Directive n. 2003/49/EC of June 3, 2003 on payments of intra-European Union interest and royalties.

We would like to add below some additional comments and our final take on it.

Outbound interest is subject to a 26 percent withholding tax under article 26 of Presidential decree n. 600 of 1973. However, interest paid by an Italian company to a company organized a E.U. Member State, in the form of corporation liable to tax in the State, and holding at least 25 percent of the stock of the interest-paying company, is exempt from withholding tax, in accordance with the E.U. Directive n. 2003/49/EC.

One requirement for the withholding tax exemption is that the recipient qualifies as beneficial owner of the interest.

According to article 26-quater of Presidential Decree n. 600 of 1973, the recipient is a beneficial owner of the interest, when it receives the interest as final beneficiary, as opposed to an intermediary such as an agent, fiduciary or person acting in a similar capacity.

Under the facts of the case, after a leverage buy-out transaction leading to the acquisition of an Italian industrial company, the Italian target carried a loan held by its Luxembourg holding company, and made payments of interest to the Luxembourg holding company under that loan for an amount of approximately 18 million euro, without applying any withholding tax.

The Luxembourg holding’s loan was part of a series of back-to-back loan arrangements extending along the ownership chain all the way up to the non-EU parent of the group. The terms of the Luxembourg holding’s loan mirrored those of the back-to-back loans outstanding along the ownership chain of the group.

The rates and timing of the payment of the interest owed under the various loans did not exactly coincide, in a sense that the Luxembourg holding maintained control of the interest it received from the Italian subsidiary, albeit for a short period of time, and it ultimately earned a net profit margin of 0.125%.

The Luxembourg holding company did not operate any active business in Luxembourg, and maintained no offices, employees or other organizational structure on the ground there. Rather, it was a “pure” holding company, which performed financing and treasury functions for various subsidiaries of the group. In that capacity, it received various funds from its parent or other affiliates and extended various loans to subsidiaries of the group in Europe, receiving and paying interest on those loans and reporting net income in Luxembourg on its financial returns.

The parties in the case stipulated that the Luxembourg holding company satisfied all other statutory requirements for the interest withholding tax exemption, and the only issues was whether it qualified as beneficial owner of the interest for the purpose of the exemption.

The Italian Tax Agency took the position that the Luxembourg holding company was a “passive” holding company, namely, an entity not engaged in any business activity in its country of organization, devoid of any organizational structure or “substance” in Luxembourg, which just held legal title to shares of stock in subsidiaries. As such, according to the Tax Agency, it had to be be regarded as operating solely as an intermediary or agent for the collection of the interest from the Italian borrower and and the repayment of it to the ultimate lender of the group. As a result, the Tax Agency assessed a withholding tax on the interest paid to the Luxembourg holding company, for an amount of approximately 4.7 million euro.

The tax assessment was challenged in the tax courts, and the Italian Supreme Court confirmed the appellate court’s decision, ruling against the Tax Agency and in favor of the taxpayer.

In support of its ruling, the Italian Supreme Court relied on the interpretation and meaning of the term beneficial owner as it applies in the context and for the purpose of international tax treaties. The Court referred to the Commentary of the OECD Model of Income Tax Treaty, according to which beneficial ownership requires that the recipient hold the full right to use and enjoy the income, unconstrained by a contractual or legal obligation to pass the payment it receives up to any other person not eligible fort the benefits of a treaty.

The Court also referred to the decisions of the European Court of Justice in the so called Danish cases, according to which a withholding tax exemption granted under a E.U. Directive does not apply whenever the recipient is a conduit, whose sole activity is the collection and repayment of the income to another person that is not eligible for the exemption.

Against that background, the fundamental holdings of Supreme Court’s ruling n. 14756 can be summarized as follows.

First, according to the Court, the fact that a holding company operates as a “pure” or “passive” holding company, namely, it is not engaged in any active business, and does not employee people, own or rent offices or establish and maintain any other physical footprint in its country of organization, in an on itself, is not dispositive of its status as beneficial owner of the income it receives from controlled entities.

Rather, according to the Court, focus must be placed upon whether or not the holding company enjoys sufficient independence in adopting decisions which concern its own governance, the direction, supervision, management and control of its shareholdings in subsidiaries and controlled entities, and the receipt, use and enjoyment of its income.

By making reference to its own jurisprudence in dividend withholding cases, the Court expressly pointed out that it had already held that a pure holding company can be the beneficial owner of the dividend, whenever it properly books the dividend in its financial statement, is the legal owner of the dividend, and the dividend income can legally be attached by its creditors.

Second, according to the Court, in determining the holding company’s status as beneficial owner, reference must be made to the activities and all items of income of the holding company, as a whole, rather than focusing only on the specific item of income in respect of which the status of beneficial is called in question.

Based on the above principles, the Court ruled that the Luxembourg holding company had to be regarded as beneficial owner of the interest, considering that it carried various loans on its books, with respect to which it collected and reported substantial income in Luxembourg, retained some non insubstantial profit, performed active financing and treasury functions to the benefit of the parent and other affiliated companies of the group, and took on an active role in various acquisition transactions carried out by the group.

Also, according to the Court, the Luxembourg holding company retained a sufficient level of control over the interest and made a sufficient net profit out of the loan to its Italian subsidiary.

Finally the Court found no evidence that, under the facts of the case as summarized here above, the Luxembourg holding company operated solely as a conduit for the collection and repayment of the interest.

We believe ruling n. 14756 is of particularly significance, in the part in which the Court focuses on the nature and scope of the legal arrangements involving the holding company, its governance structure, and its legal operation and activities, while it dismisses other factors such as employees, offices, or organization of the holding company in its country of organization (so called “substance”), which have a meaning with respect to traditional industrial or commercial companies, but not equal meaning with respect to holding companies.

With some years now on record after the enactment of Italy’s tax rules on special tax regime for high net worth individuals, we attach and article (Italy’s Special Tax Regime for High Net Worth Individuals, Three Years In) recently published on the topic.

The distinctive features of the Italian special tax regime are the following:

– a low fixed amount tax in lieu of the Italian regular income tax (100,000 euro, with an increase of 20,000 euro for each family member who decides to join the main applicant);

– complete exemption from regular income tax for all foreign-source income (as defined under Italian internal tax law sourcing rules);

– complete exemption from Italian estate and gift tax on foreign-located assets;

– complete exemption from Italian asset value-based taxes on foreign real estate assets (so called IVIE) and financial investments (so called IVAFE);

– complete exemption from International tax reporting of foreign investments and financial accounts on sector RW of Italian income tax return;

– ability to use the network of Italian tax treaties to eliminate or reduce foreign taxes on foreign source income subject to the special tax regime in Italy;

– ability to entirely opt out of the regime at any time, by simply transferring the tax residency outside of Italy;

– ability to selectively opt out of the regime for income derived from specific foreign-countries, in order to be able to claim a foreign tax credit in Italy for foreign taxes charged on that income under a tax treaty between Italy and selected foreign countries.

Italy does not require that foreign-source income falling within the scope of the special tax regime be kept offshore and not be repatriated in order to benefit of the forfait tax.

Also, a taxpayer does not lose the benefits of the Italian forfeit tax if he or she is employed or engaged in a trade or business in Italy (but Italian source employment or business income is subject to Italian regular income tax).

To be eligible for the regime, a taxpayer must not have been a resident of Italy for Italian income tax purposes for more than one year in the last ten years prior to the special tax regime election.

Taxpayers who intend to benefit from the special tax regime can apply for an advance tax ruling, both on the tax residency issue and on any issue concerning the proper characterization and sourcing of their expected items of income falling within the scope of the forfait tax.

The ruling is binding upon the Italian tax administration and stands until any material fact submitted in the ruling application changes.

Alternatively, they can elect for the special tax regime with the filing of their first Italian income tax return after establishing their tax residency in Italy.

A taxpayer who is an Italian tax resident and is subject to the special tax regime in Italy should still be able to claim the benefits of Italian tax treaties with any foreign treaty country.

On December 23, 2019, the Italian Ministry of the Economy and Finance published on its web site a draft of the Ministerial Decree setting forth the provisions for the establishment and operation of the Register of Beneficial Owners of business entities, non-commercial entities and trusts. The establishment of the Register of Beneficial Owners is required by article 21 of the Legislative Decree n. 231 of November 21, 2007, which contains the domestic legislation implementing the European Union Anti Money Laundering Directives into Italian law. The draft Decree is open to public discussion, and comments and observations can be submitted through the Ministry’s web site until February 28, 2020. The final decree will be published and enter into force within July 3, 2020

In an article published on Tax Notes International on January 20, 2020 (Preparing for Italy’s Beneficial Ownership Register, Tax Notes International, January 20, 2020) we provide and analysis of the proposed rules.

The new beneficial owners’ filing obligations will apply to commercial entities, private non commercial organizations, trusts, foundations and other fiduciary arrangements. They will require disclosure of information on directors, managers, trustees, administrators and entity’s ultimate owners.

Members of the public can have access to the information filed with the register provided that they have standing, meaning, upon showing that they have a direct, present and ascertainable legal interest, right or claim the pursuance of which requires access to the information.

Individuals classified as beneficials owners and subject to the disclosure can preemptively object to the filing of their personal information on the ground that disclosure would expose them to an excess risk of threat, kidnapping, blackmailing, and similar dangers.

The new filing obligations will pose significant challenges and require specific attention on part of entities and individuals falling within the scope of the rules.

News broke out that Italian tax auditors have issued a proposed tax assessment for Euro 1.4 billion ($1.6 billion) as additional corporate income tax due from Fiat Chrysler Automobiles N.V. (“FCA”), in connection with the merger between FCA and FIAT S.p.A. (“FIAT) carried out in 2014, after FIAT had completed its acquisition of US automaker Chrysler.

FCA was incorporated in the Netherlands, and established its tax domicile in the UK, to carry out the reorganization of the Italian automotive group FIAT following the acquisition of U.S. car manufacturer Chrysler in January 2014. In the merger, FIAT merged into FCA and its shareholders exchanged their shares of FIAT for shares of FCA in a stock for stock deal.

Under Sections 178 and 179 of the Italian Corporate Tax Act, as enacted to implement the EU Directive 90/434/EEC of July 23 1990 (further codified in the Directive 2009/133/CE) on cross-border mergers within the E.U., the merger of an Italian tax resident company into a E.U. company qualifies as a nonrecognition transaction, provided that any cash consideration paid to the shareholders of the target does not exceed 10% of the value of the shares of the acquiring corporation the target’s shareholders receive in the exchange. The acquiring corporation takes a carryover basis in the target’s assets, and the target’s shareholders take a transferred basis in the shares of the acquiring corporation they receive in the transaction.

Under paragraph 6 of Section 179, as in effect at the time of the merger, the “components of the business or line of business” that are transferred in the merger, and are not attributed to a permanent establishment of the acquiring corporation which is located in Italy, after the merger, are “deemed realized at normal value”. The resulting gains are taxable to the target, at the corporate income tax rate.

Italian tax authority claims that FIAT S.p.A. unreported or underestimated the fair market value of the U.S. assets which were not attributed to FCA’s Italian P.E. after the merger, for an amount of Euro 5.185 billion, which would result in the assessment of an additional tax of Euro 1.4 billion at the 27 percent corporate tax rate in effect at the time of the merger.

In its merger report filed at the time the transaction FIAT acknowledged that the merger would be tax neutral with respect to FIAT S.p.A.’s assets that would remain connected with FCA’s Italian P.E. after the merger, while the merger would trigger the recognition of taxable gains or losses embedded in FIAT S.p.A.’s assets that would not be connected with the Italian P.E. FIAT also noted that such gains would be offset by tax loss carryovers available to FIAT’s tax consolidated group in Italy.

The retroactive use of FIAT’s tax loss carryovers existing at the time of the merger to offset any additional taxable income which may be assessed by the Italian tax authority could face some hurdles.

According to section 181 of the Italian CTA, the tax loss carryovers of the target which exist at the time of the merger are allocated as follows:

– first, to any taxable income of the target in the year of the merger,

– second, to any taxable gains recognized by the target in the merger,

– third, to the Italian P.E., in proportion of the fair value of the assets attributed to the Italian P.E. compared to the total value of the assets transferred in the merger.

– forth, to the remainder of the corporation (in proportion of the value of the non P.E. assets compared to the total value of the assets transferred in the merger).

The losses allocated to the Italian P.E. can be carried forward and used by the Italian P.E. to offset the taxable income of the P.E. in Italy in the tax years following the merger

The losses allocated to the remainder of the corporation will no longer usable in Italy.

The P.E. established in Italy after the merger is a new taxable entity, separate and different from the target.

The ability of FIAT to claw back and use the tax losses that were allocated to the Italian P.E. of FCA after the merger would seem to require that FCA’s Italian P.E. files corporate amended tax returns by which it relinquishes those tax losses and makes them available again to FIAT. That may result in additional taxable income for the Italian P.E. for the tax years following the merger.

Also, FIAT would need to file its own amended return for the year of the merger, recomputing and reallocating the tax losses that existed at the time of the merger after taking into account the assessment of additional taxable gains pursued by the tax agency.

As a result of an increased value of the U.S. business, more losses would be allocated away from the post merger Italian P.E. and could no longer be used to offset post merger income subject to tax in Italy.

The Italian tax authority can issue the tax assessment after 60 days from the filing of the proposed assessment, unless a settlement is reached with the taxpayer. FIAT would then have 60 days to challenge the tax assessment in court.

By way of ruling n. 25490 issued on October 10, 2019 (Supreme Court Ruling 25490 of 10-10-2019), Italy’s Supreme Court upheld the appellate court’s ruling which denied both the dividend withholding tax exemption of the EU Parent Subsidiary Directive n. 435/90/CEE of the Council dated July 23, 1990 (the “Directive”), and the dividend withholding tax rate reduction granted under article 10 of Italy-Luxembourg tax treaty (the “Treaty”), for dividends paid by an Italian subsidiary to a Luxemburg holding company, on the grounds that the recipient of the dividend did not have a place of effective management and control in Luxembourg (with the consequence that the recipient could not be regarded as a resident of Luxembourg, for the purpose of either the Directive or the Treaty), and had not been subject to actual taxation on the dividends in Luxembourg, where it benefited from a participation exemption regime exempting dividends and capital gains from corporate income tax (and, therefore, it could not be regarded as the beneficial owner of the dividends).

The decision is important and confirms the Court’s latest course on the issue of the application of Directive’s dividend withholding exemption, or treaty reduced dividend withholding tax rate, which may be denied unless strict requirements concerning the recipient’s economic substance, actual place of establishment, and beneficial ownership of dividends are met.

The facts of the case can be summarized as follows.

Macquarie Airports (Luxembourg) S.A. (“MALSA”) in Luxembourg, ultimately owned or controlled by Australia’s multinational independent investment bank and financial services company Macquarie Group Limited, was organized for the purpose of acquiring a share of 44.74 percent of the Italian company Aeroporti di Roma S.p.A. (“ADR”), which operates Roma’s airports. The acquisition was carried out in March 2003 and, later in that year, ADR distributed to MALSA a dividend of Euros 14,476,462.

ADR charged a withholding tax on the dividend at the reduced rate of 15 parent pursuant to the tax treaty between Italy and Luxembourg. MALSA filed a petition for refund of the withholding tax claiming the dividend withholding exemption of the EU Parent Subsidiary Directive. Italy’s Tax Agency rejected the request of refund and assessed the full 27 percent withholding tax rate provided for under Italy’s tax code. MALSA filed a petition to the Provincial tax Commission (trial tax court), which upheld the assessment of the additional withholding tax. The Regional Tax Commission (appellate tax court) rejected the appeal and MALSA filed a final appeal to the Supreme Court.

The Regional Tax Court, whose judgement was challenged in the appeal to the Supreme Court, held that neither the withholding tax exemption of the Directive, nor the withholding tax reduction of the Treaty, could apply, for various independent reasons.

First, the Regional Tax Court held that, in order to qualify as a resident of Luxemburg, for purposes of the Directive or the Treaty, MALSA’s place of effective management needed to be located in Luxemburg. Since MALSA was managed out of Australia, where its parent company was established, MALSA did not qualify as a resident of Luxemburg for the purpose of either the Directive or the Treaty.

With regard to the aforementioned argument, one of the requirements for the application of the Directive is that the recipient of the dividend is a company organized in a EU Member State, which, according to the tax laws of that State, is considered to be resident in that State for tax purposes and, under the terms of a double taxation agreement concluded with a third State, is not considered to be resident for tax purposes outside the Community.

From the Supreme Court’s ruling, there appears to be no discussion as to whether MALSA was actually treated as a resident of a third State under a tax treaty between Luxembourg and a non-EU country. Notably, Australia and Luxembourg started the negotiations for a tax treaty only in 2016, and have never had any tax treaty in force to date.

On the other end, under the typical provision of article 4, paragraph 3 of tax treaties modeled after the 2010 OECD Model Income Tax Convention, or earlier models, when a company is a resident of both Contracting States under the internal tax laws of those States, by reasons of the provisions of paragraph 1, then it shall be deemed to be a resident only of the State in which its place of effective management is situated. Again, the Court does not discuss whether MALSA was actually treated as a resident or a third State under a tax treaty between Luxembourg and a non-EU country.

The Supreme Court seems to be content to interpret the provisions of the Directive as requiring that the recipient of the dividend be actually established and effectively managed in its EU country of organization, for it to be considered a genuine arrangement duly eligible for the withholding tax exemption. Indeed, the Court refers to the special anti abuse provision of paragraph 5 of article 27-bis of the Italian Presidential decree n. 600 of 1973, according to which, whenever the EU recipient of the dividend is a company owned or controlled by a company established in a third State, the dividend withholding exemption of the Directive applies solely when the taxpayer proves that the EU company has not been organized for the sole or main purpose of obtaining the Directive’s withholding tax exemption.

The Supreme Court also states that article 10 of the OECD model tax treaty must be interpreted in a narrow way, to avoid a possible abuse of the treaty, and should apply solely when the recipient of the dividend is a genuine arrangement resulting in an actual establishment in the other treaty country.

Next, the Regional Tax Court held that MALSA, lacking a place of effective management in Luxembourg, had to be regarded as a wholly artificial arrangement not eligible for the benefits of either the Directive or the Treaty. The Supreme Court upheld this argument, pointing out that, although a holding company cannot be required to have the same level of economic substance as an industrial or commercial company, whenever it lacks any meaningful connection to the country in which it is legally organized, such as a place of effective management there, and operates as a mere legal conduit for the purpose of the collection and transfer of the dividends to its ultimate owners, it is not eligible for the benefits of the Directive or a tax treaty. According to the Supreme Court, the freedom of establishment and free movement of capital of the EU Treaty do not apply, whenever a company constitutes a wholly artificial legal arrangement, as opposed to an actual genuine establishment in a EU Member State.

Finally, the Regional Tax Court held that, in the absence of actual taxation of the dividend in Luxembourg, the recipient of the dividend does not meet the liable to tax requirement of the Directive, and cannot be treated as the beneficial owner of the dividend under article 10 of the Treaty. MALSA had not paid any tax on the dividends in Luxembourg, under Luxembourg’s participation exemption regime. The Supreme Court upheld also this argument.

In respect of the Directive’s issue, the Supreme Court referred to the provision of the Directive according to which, for the dividend withholding exemption to apply, the recipient of the dividend must be subject to a corporate income tax (which in case of Luxembourg, is the impôt sur le revenu des collectivités in Luxembourg), without the possibility of an option or of being exempt. Generally, that provision has been interpreted as requiring that a company be liable to tax, meaning that it is organized as a separate taxpaying entity falling within the scope of application of a corporate income tax. The fact that a specific item of income might be exempt from tax, as is the case for dividends and capital gains, under a typical participation exemption regime, had never been considered as an obstacle to the application of the Directive. Instead, the Italian Supreme Court, following a new course established in some of its most recent rulings, issued in similar cases, argued that the dividend withholding exemption is granted to avoid the double taxation of the dividend, which does occur, whenever the dividend is exempt from tax in the recipient’s Member State.

In respect of the Treaty issue, the Court held that the Regional Tax Court’s finding that the dividend recipient is not the beneficial owner of the dividend constitutes a finding of fact which cannot be reviewed by court in the absence of a clear error.

On a side issue, the Supreme Court held that a certificate issued by the tax authority of the recipient’s country of organization stating that the recipient of the dividend maintains a place of effective management in that country and is the beneficial owner of the dividend, is not binding, because it concerns factual situations which the taxing authority cannot directly evaluate and assess.

Ruling n. 25490n is consistent with some recent rulings of the Supreme Court’s on the same issues, which attracted significant attention and are commented on this Blog.

As general consideration from ruling n. 25490, it seems clear that EU holding company structures are under significant challenges, and taxpayers should review their specific situations and consider the idea of waiving the opportunity to claim the Directive altogether, ignoring any intermediate holding company which does not meet the new substance requirements that are strictly enforced in the host countries where the operating subsidiaries are located, and directly claim treaty benefits on behalf of the ultimate parent company, for the purpose of obtaining at least the treaty reduced withholding tax rate.

That approach has it now hurdles, but deserves specific attention and is worth the effort, since the risk otherwise is that of potentially owning the much higher domestic withholding tax rate.

Law Decree n. 124 of October 26th, 2019 (which is immediately effective, but needs to be converted into law within 60 days to become final) includes, at article 13, new provisions on taxation of certain distributions from foreign trusts to Italian resident beneficiaries (individuals and non-business entities).

By way of background, Italy does not have its on law on trust, but it recognizes and gives effects to trusts established under foreign law, pursuant to the Hague Convention of 1 July 1985 On The Law Applicable To Trusts and Their Recognition, which Italy ratified by Law n. 364 of October 13th, 1989.

Italy classifies a trust as domestic, or resident, for Italian tax purposes, whenever the place of administration of the trust is located in Italy. If the trustee is an Italian resident individual or entity, the trust is presumed to be a domestic or resident trust, unless the taxpayer can prove that the place of actual administration of the trust is located abroad. Conversely, a trust is treated a foreign, or non-resident, for Italian tax purposes, whenever the trust’s place of administration is located outside of Italy. If the trustee is a non resident individual or foreign entity, the trust is presumed to be a foreign (non resident) trust.

For income tax purposes, Italy treats non discretionary trust, which requires that the income be distributed to named beneficiaries, as fiscally transparent, and taxes that income directly upon the beneficiaries, regardless of when it is actually distributed. The rule applies to both domestic and foreign fiscally transparent trusts. The income is classified as income from trusts, regardless of the character of the income when earned by the trust, and as Italian source or foreign source income, depending on the whether the trust is a resident trust or non resident trust, and regardless of the source of income in the hands of the trust.

Instead, discretionary trusts, whose income can be distributed, at trustee’s discretion, but with no named beneficiaries holding a fixed right to receive the distribution of the income from the trust, are treated as fiscally opaque, which means that the income is treated as taxable income of the trust and, when distributed to the beneficiaries, it is not taxed a second time. Italian fiscally opaque trusts are taxed on all of their income, from whatever sources, on a worldwide basis, while foreign opaque trust are taxed solely on their Italian source income.

Article 13 of Law Decree n. 124 provides that income distributed to Italian resident beneficiaries by foreign fiscally opaque trusts established in countries and territories which, with respect to the tax treatment of the income generated through the trust, are considered tax preferential regimes, in accordance with article 47-bis of the Unified Income Tax Code (Presidential Decree n. 917 of December 22, 1986), is taxed in the hands of the Italian resident beneficiaries.

For this purpose, a country or territory should be considered a tax preferential regime whenever the income of the trust is subject to a nominal tax rate that is lower than 50 percent of the Italian applicable tax rate. Italy taxes trust’s beneficiaries on income from trusts at a fixed rate of 26 percent. Opaque trusts are subject to tax at the corporate income tax rate of 24 percent.

Trust distributions are presumed to come from the income of the trust, unless – and to the extent that – the taxpayer is able to prove that they should be allocated to the principal of the trust (in which case they are non-taxable).

It is reasonable to expect additional administrative guidance on the interpretation and application of the new provisions of article 13 of Law Decree n. 124.

In the meantime, however, the new provisions are very important in establishing that:

– income distributions made by foreign fiscally opaque trusts, which are not established in a preferential tax regime country, are not subject to tax, in the hands of the Italian resident beneficiaries,

– income of a foreign fiscally opaque trust, which are established in a preferential tax regime country, is not taxable, unless it is actually distributed to its Italian resident beneficiaries.

Taxpayers should adjust their tax planning, taking into account the new Italian provisions on taxation of distributions from foreign trusts.

In particular, foreign trusts which are established in low tax jurisdictions, should migrate to or be re-established in a non-low tax country, to avoid taxation in italy of income distributions to their Italian beneficiaries.

By way of thirteen decisions issued in June and July (numbers 15451, 15453, 15455, 15456 of June 7, 2019, numbers 16699, 16700, 16701, 16702, 16703, 16704, 16705 of June 21, 2019, no. 19167 of July 17, 2019 and no. 19319 of July 18, 2019), the Italian Supreme Court ruled that the Italian gift tax does not apply to the transfer of property to a trust, at which time the gift is to be regarded as not complete yet.

According to the Court, the gift tax should apply only when trust property is distributed out of the trust to the beneficiary, and the gift is final and complete.

The position taken by the Supreme Court, which is stated in more general and comprehensive terms in one of the above mentioned decisions, namely Ruling n. 16699 of June 212, 2019 (Ruling 16699 of June 21 2019) potentially turns Italian trust tax planning upside down, and creates fresh issues and new challenges for taxpayers and their tax advisors, particularly in a cross border context.

Foreign individuals who moved to Italy with trusts in place that had been set up and funded before the move, and have become Italian resident taxpayers, should review their trust planning and be aware of its new Italian tax implications. Those who plan to move but have not made the move yet, should review their trust plain in advance.

Similarly, foreign individuals who set up trusts abroad with trust beneficiaries who live in Italy, or owing Italian assets, should make sure of new potential tax exposure in Italy.

On the other side of the spectrum, Italian residents who plan to move abroad may find new opportunities to create trusts holding Italian assets with no immediate tax consequences in Italy, and then have the assets of the trust distributed outside of the trust to beneficiaries in such a way to avoid any Italian gift and estate tax altogether.

Background.

Italy operates a gift tax which applies to an outright, complete transfer of property to a person for no consideration, as a result of which the recipient receives the legal title to and immediate economic enjoyment of the property. The underlying constitutional ground for the tax is that the recipient or, donee, by having immediate access to and enjoyment of the property is enriched by the gift and the the tax is justified in light of the constitutional principle of ability to pay.

The donee is the party liable for the tax.

In case of a resident donor, the gift tax applies on a worldwide basis, namely, also to gift of property located outside of Italy. In case of a nonresident donor, the gift tax applies solely to gifts of property located within Italy. residency for gift tax purposes is defined in the same way as residency for general income tax purposes.

Article 2, n. 47 of Law Decree n. 262 of October 3, 2006 (L.D. n. 262) included within the scope of the gift tax any legal arrangement (referred to as “destination or use constrain arrangements”) as a result of which a property is transferred outside of the estate of the transferor, for it to be administered and disposed of for the specific purposes indicated therein.

The provision of Article 2 n. 47 of L.D. 262 covers the transfer of property or right to a trust, which is a fiduciary arrangement pursuant to which a person, the settlor, departs from the legal ownership and economic enjoyment of a property, and another person, the trustee, is entrusted with the duty to administer the property in a fiduciary capacity in the interest of another person or persons indicated as beneficiaries, and ultimately dispose of the property and deliver it to the beneficiaries in accordance with the terms of the agreement of trust.

Tax Agency’s Position.

Two conflicting positions regarding the interpretation and application of Article 2, n. 47 of L.D. n. 262 soon emerged.

According to one position, taken by the Italian Tax Agency, the new provision extended the tax beyond the traditional concept of a “gift”, to any fiduciary arrangement which creates a limitation or constraint over the use and enjoyment of a property, and requires that it be used for or destined to a specified and limited purpose.

In the context of a transfer of property to a trust, the Tax Agency held that the gift tax is due, by the trustee, at the time of the transfer of the property to the trust. No gift or estate tax is then due at the time of the final distribution of the trust property to the trust’s beneficiaries.

The gift tax rates (ranging from 4 percent for transfer to spouses, ascendants and descendants, to 6 percent for transfer to siblings, to 8 percent for transfers to all other persons) and tax exemptions (ranging from one million euro for spouses, ascendants and descendants, to one hundred thousand euros for siblings, to zero for all other individuals) should be determined on the basis of the relationship between the settlor, and the beneficiaries named in the trust. In case of trust with undefined beneficiaries, the 8 percent rate and zero exemption should apply.

The position of the Italian Tax Agency is reflect in administrative guidance provided by way of Circular 3 of January 22, 2008 (Circular 3-E 2008)

Taxpayers’ Position.

According to another position, advocated by taxpayers and Italian notaries involved in the drafting and execution of deeds of trust in Italy, the new provision did not extend the scope of the original gift tax, nor did it create a new tax, and the gift tax should always apply exclusively to the final distribution of a property from the trust to its beneficiary, or whenever the beneficiary of a trust has direct access to and full enjoyment of the trust property from the outset. Until there is a final transfer of title and enjoyment of the property, the intended recipient is not enriched, and the legal ground for the gift tax does not occur. The tax rates and exemption are determined with reference to the relation between the settlor and the final recipient of the property.

Italian Supreme Court’s Case Law And Latest Rulings.

The Italian Supreme Court issued rulings that oscillated between three positions: 1) the gift tax applies to any arrangement pursuant to which a property is transferred outside of the estate of the transferor and subjected to a specific use or destination, which includes the transfer of property into any kind of trust, 2) the gift tax applies solely to straight gifts, which, in case of trust, only occurs at the time of the final distribution of the trust property to a specific beneficiary, 3) the gift tax applies also to indirect gifts, which occur in case of a transfer of property into a trust with sufficiently identified future beneficiaries, who have the reasonable expectation to receive the property sometimes in the future, based on the terms of the trust.

The rulings issued in June and July are aimed at resolving the conflict and establish a uniform interpretation of the statute, according to which, regardless of the type of trust or other fiduciary arrangement, the gift tax should only apply at the time that there is a definitive distribution of a property to an identified beneficiary of the trust, who receives full and unconstrained legal title to and economic enjoyment of it.

Ruling n. 16699 of June 21, 2019 (Ruling 16699 of June 21 2019), in particular, clarifies the general principles which should guide the application of Article 2, n. 47 of L.D. 262, and clearly states that even in the case of “fiscally transparent” trusts, in which the beneficiaries of the income of the trust are immediately identified in the trust agreement, and the income is attributed to and taxed directly upon the beneficiaries regardless of its actual distribution, no gift tax should apply until the trust corpus is distributed to the beneficiaries outside of the trust.

The Court goes on by saying that the same conclusion is true in case of “fiscally opaque” trusts, that is, trusts with no identified beneficiaries who hold the immediate right to the distribution of the income of the trust.

According to the Court’s interpretation, a gift is complete only at the time of the final and unconditional distribution of the property to the beneficiary, and the gift tax becomes payable only at that time.

Consequences and Cross Border Issues.

The position taken by the Supreme Court potentially turn Italian trust tax planning upside down. Previously, taxpayers were able to transfer property to a trust, pay the gift tax on the value of the property at the time of the transfer to the trust, and let the property appreciate within the trust, to the ultimate benefit of the trust beneficiaries, estate and gift tax free. The Supreme Court’s latest rulings requiring that the gift tax apply upon the full appreciated value of the property at the time of its final distribution out of the trust to the beneficiaries trumps that tax planning opportunity. The benefit of deferring the gift tax is greatly offset by the potentially significant increase of the taxable base subject to the gift tax at a later time.

In a cross border context, it raises significant challenges and completely novel issues.

One concerns the application of the tax in case of change of tax residence by the settlor, between the time of transfer of property to a trust, and the time of distribution of trust property from the trust to the beneficiaries.

In the case of a settlor who was a nonresident individual, for Italian tax purposes, when he or she transferred property located outside of Italy, into a trust, and later on, he or she moves to Italy, becoming an Italian tax resident individual when the property is distributed to the beneficiary of the trust, the question arising is whether the Italian gift tax should apply, based on the settlor’s newly acquired and existing Italian tax residency, at the time of the distribution of the property from the trust to the beneficiary.

Conversely, an individual who is an Italian resident settlor, at the time of the transfer of a non-Italian property to a trust, and moves outside of Italy and becomes a non-Italian resident, at the time of the transfer of the property to the beneficiaries of the trust, could take the position that no gift tax is due in Italy, based on the fact that the settlor is a nonresident individuals and and the property is located outside of Italy, when the gift is completed with the distribution of the property from the trust to the beneficiary.

Foreign taxpayers who moved to Italy with their trusts already in place at the time of the move, and are Italian tax residents at the time of distributions of trust properties to trust beneficiaries, should review their plan for those who plan to move to the country make the proper adjustments to make sure they will avoid adverse and unintended Italian tax consequences.

Conversely, Italian individuals who plan to ove out of Italy, have the opportunity to use trusts without immediate Italian gift tax and plan a distribution of their assets with on Italian tax altogether.

Another issue arises whenever the type and location of the trust property changes, between the time of transfer of property to a trust, and the time of transfer of trust property to trust beneficiaries. The question is whether Italian property transferred to a trust without immediate Italian gift tax, and then converted into non-Italian property before being distributed out of a trust, will till avoid Italian gift tax at the time of its final distribution to the trust beneficiaries.

The Italian Tax Agency has not reviewed its position yet, in the light of the Supreme Court’s latest rulings. If it does so, it shall have have to provide completely new guidance which should properly reflect the new approach on Italian taxation of transfer of properties to a trust.

Taxpayers should stay tuned, monitor all the developments and constantly review their trust planning to make sure it remains tax effective.