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.

With its tax ruling n. 88/E of October 18, 2019 (Ruling 88-2019), the Italian Tax Agency denied the interest withholding tax exemption provided for in the EU Interest and Royalties Directive, in respect of interest due by an Italian Target on a shareholder’s loan extended from its EU Parent in connection with a merger leveraged buy-out transaction carried out in Italy.

A EU-based holding company (Purchaser) set up and Italian acquisition vehicle (NewCo), which it financed through an inter company (shareholder) loan. NewCo raised additional capital by issuing notes to outside lenders, and used the proceeds from the notes and the shareholder loan to acquire an Italian operating company (Target). Purchaser entered into an assignment agreement with the bond-holders, pursuant to which it assigned to the bondholders its receivables under the shareholder loan, as a guarantee for the payment of the principal and interest due by NewCo to the bond-holders under the notes. NewCo eventually merged into Target as part of the overall acquisition transaction.

In its application for the tax ruling, the taxpayer asked the Tax Agency to confirm that the interest payable to Purchaser under the shareholder’s agreement would be exempt from withholding tax pursuant to the EU Interest and Royalties Directive n. 49 of June 3, 2003 (Council Directive 2003:49:EC of 3 June 2003), as implemented into Italian internal tax law by way of Article 26-quater of Presidential Decree n. 600 of September 29, 1973.

In the ruling, the Tax Agency refers to the terms of assignment agreement entered into between Purchaser, as assignor; the bondholders, as assignees, and NewCo as assigned debtor, which provided the following:

– the assignment of all the claims and rights of Purchaser for the amounts payable under the loan agreement, as collateral for the payment of the amounts due by NewCo to the bond-holders under the notes,

– the transfer to the assignee of all guarantees, liens and security rights pertaining to assignor’s claims arising under the shareholder loan, as provided for under Italian Civil Code Article 1263,

– the issuance by the bond-holders of a power of attorney to Purchaser, conferring upon Purchaser the authority to handle the claims and collect the amounts due and payable under the shareholder’s loan, but revocable upon the occurring of an event of default under the notes,

– the re-assignment, back to Purchaser, of the assigned claims and relating rights as arising under the shareholder loan, at the time of the final and full payment of all amounts due to the bond-holder under the notes in full discharge thereof,

– the payment to a bank account of the assignor, designated by the representative of the bondholders, of the amounts due by NewCo under the shareholder loan.

Pursuant to the EU Interest and Royalties Directive, in order to be eligible for the withholding tax exemption, the recipient of the interest must meet the following requirements:

1. it must be organized in one of the legal forms set forth in the Directive,

2. it must be resident in an EU Member State, without being considered a non resident of that State pursuant to an income tax treaty between its State of organization and a third non-EU country,

3. it must be liable to a corporate income tax on its profits, or equivalent or substitute tax, in its State of residence, without benefiting from an exemption from tax of general scope,

4. it must own directly at least 25 percent of the voting shares of the payor of the interest,

5. it must have owned the voting shares of the payor of the interest uninterruptedly for at least one year.

Two additional requirements for the withholding tax exemption require that the interest be subject to tax, upon the recipient, in its State of organization, and that the recipient be the beneficial owner of the interest.

The ruling focused on whether the Purchaser could be regarded as the beneficial owner of the interest payable by the Target under the shareholder’s loan, in light of the assignment of its rights under the shareholder’s loan to the bondholders.

The Tax Agency refers to Circular n. 47/E of November 2, 2005 (Circular 47-E of 2 November 2005) which provides guidance on the interpretation snd application of the EU Interest and Royalties Directive, and clarifies that a company qualifies as beneficial owner of an interest or royalty payment, whenever it has the legal title to, and actual control and power of enjoyment and disposition of the payment, and derives an economic benefit therefrom.

The Tax Agency refers also to its Circular 6/E of march 30, 2016 (Circular 6:E of March 30, 2016), which provides administrative guidance on certain tax issues arising from leveraged buyout transactions. Circular 6/E clarifies that, in order to be treated as the beneficial owner of interest from acquisition financing granted in connection with a leveraged buyout transaction, the EU purchasing entity must be engaged in a real and genuine economic activity, through a real connection within the EU Member State in which is legally organized, and cannot operate as a mere conduit or pass through, for the sole purpose of the collection and transfer of the interest payment to another related entity organized outside of the EU.

According Circular 6/E, an entity lacks economic substance, and therefore it is not eligible for a beneficial tax treatment such as the withholding tax exemption for interest and royalties, whenever one or more of the following circumstances are present:

– the entity operates through a “light” organizational structure, measured by reference to its personnel, premises, and equipment, it does not carry out any meaningful activities, and it does not have any real independent decisional power of its own,

– the entity acts as a financial conduit, with respect to a specific transaction, in which payments received and payments made are carried out under contractual and economic terms and conditions that mirror each other as to duration, amounts, methods of payment and periods of accrual of interest, or are designed to make sure that there is a substantial equivalence between receivables and payables with no withholding on outbound payments from the entity’s State of organization.

The Tax Agency also refers to the recent cases decided by the European Court of Justice (“ECJ”) with its judgement of February 26, 2019 in joined cases N Luxembourg 1 (C-115/16), X Denmark A/S (C-118/16), C Denmark 1 (C-119/16), Z Denmark ApS (C-299/6) (so called “Danish Cases)”. In its judgement, the ECJ held that the interest withholding tax exemption applies solely when the recipient of the interest is the actual economic owner and possess full dominion and control over the interest, with the power to determine its final enjoyment, use and destination.

According to the ECJ, there are certain indicia that the recipient of the interest may not be the beneficial owner of the interest, and, as such, may not be eligible for the withholding tax exemption, which include:

– the fact that the interest is wholly or in substantial part repaid, within a short period of time after it is received, to an entity that does not qualify for the benefit,

– the fact that a group or multi step transaction is structured in such a way that the immediate recipient of the interest is under the legal obligation to transfer the interest received to a related entity which does not qualify for the exemption,

– the fact that the interest recipient’s sole activity is limited to the collection and repayment of the interest to the actual beneficial owner or other intermediate entities,

– the presence of interconnected contractual arrangements entered into among various related entities of a group which allow the transfer of the interest within the group, with the purpose of obtaining a favorable tax treatment, and depriving the immediate recipient of the interest or other intermediate entities in the group from any actual power of enjoyment, control and disposition of the interest.

Turning to the assignment agreement entered into by the Purchaser and the bondholders, the Tax Agency noted that, according to the Italian Supreme Court’s established case law, a contract of assignment results in the full and complete legal transfer of the assigned rights and claims to the assignee, which becomes the legal owner of those right and credits (Supreme Court’s ruling n. 3797 of April 16, 1999), unless the terms of the assignment are drafted in such a way as to clearly limit the purpose of the transfer to that of authorizing the assignee to proceed with the collection of the amounts due in respect of the transferred claims (Supreme Court’s ruling n. 17162 of December 3, 2002).

According to the Italian Supreme Court, in the event of assignment of contractual rights which is entered into solely as as a guarantee for the fulfillment of a separate obligation, the assignee becomes the owner of the assigned rights and is entitled to enforce and collect its claims under the main agreement or the assigned contract, and the effect of the assignment terminates upon the full discharge of the principal obligation, at which time the rights assigned under the assignment agreement are automatically transferred back to the assignor. In other terms, the assigned claims belong to the assignee, until the guaranteed obligation is discharged (Supreme Court’s rulings n. 4796 of April 2, 2001 and n. 15677 of July 3, 2009).

According to the Tax Agency, it would seem that from the assignment agreement the Purchaser did not retain the legal right to the receivables under the shareholder’s loan, but, rather, it fully transferred them to the assignee, in order to guarantee the payment of the amounts due under the notes by the Target, and that the bondholders have become the new owner of the interest due under the shareholder’s loan and transferred pursuant to the assignment. The fact that the interest due under the shareholder loan is collected by the assignor, should be regarded as a matter of convenience only, which does prevent the assignee to become the new legal owner of the right to the interest under the shareholder loan pursuant to the assignment.

In particular, according to the Tax Agency, the assignment agreement provides that until all the secured obligations arising from the notes are duly fulfilled and discharged, the assignor collects the interest due under the shareholder loan for the benefit of the bondholders. As a result, under the terms of the assignment agreement, Purchaser would not appear to be the legal owner of the interest or to have retained full dominion and control over the interest, and, as a consequence, it cannot be considered the beneficial owner of the interest for purpose of the interest withholding tax exemption.

Interestingly, the Tax Agency in the ruling does not discuss whether the EU holding company does not have sufficient “substance” (meaning, is not engaged in a real business through its own organization), acts as financing conduit, or is not actually subject to tax on the interest income in its EU State of organization, so that it could fail to be eligible for the exemption on any of those other legal grounds.

The ruling confirms that a leveraged buyout transaction must be carefully planned and executed and still faces potentially significant tax challenges, under Italian law, when it comes to the ability of Target to take a deduction for certain payments made to its foreign shareholder, which reduce Target’s taxable income in Italy, and, at the same time, to claim the benefits of an exemption from Italian source-based withholding tax on those cross border payments.

In its Ruling N. 380 of September 11, 2019, Italy’s Tax Agency provided its guidance on certain tax implications of a corporate reorganization pursuant to which a Luxembourg holding company, which owns an Italian company, would reincorporate into Switzerland and convert into a Swiss tax resident company.

Prior to the reincorporation of the holding company in Switzerland, the dividends paid by the Italian subsidiary to its Luxembourg parent were exempt from Italian withholding tax under the EU Parent-Subsidiary Directive.

The issue in the ruling request was whether, after the reincorporation of the holding company into a Swiss tax resident company, the dividends paid by the Italian subsidiary to its (Swiss) parent company would still be exempt from Italian withholding tax.

Under the Switzerland-EU Agreement, which provides Switzerland access to benefits similar to those in the EU parent-subsidiary directive, withholding tax is reduced to 0% on cross-border payments of dividends between related companies residing in EU member states and Switzerland when the capital participation is 25% or more and certain other criteria are met.

More precisely, Article 9 of the Switzerland Tax Agreement extends the dividend withholding tax exemption of the EU Parent-Subsidiary Directive to dividends paid to EU-based companies to a parent company organized in Switzerland, provided that the Swiss holding company has been owning 25 percent or more of the shares of the Italian company distributing the dividends, for at least two consecutive years as of the date the dividends are declared.

In its ruling request, the taxpayer provided evidence that Luxembourg law allows a Luxembourg company to reincorporate abroad, as a Switzerland company, and that Swiss law, conversely, allows a foreign company to reincorporate into Switzerland, maintaining its original corporate charter now governed under Swiss law, with both laws treating the transaction as a reincorporation of a Luxembourg company into Switzerland, rather than a dissolution of the Luxembourg company followed by the incorporation of a newly organized Swiss company.

In light of the treatment of the transaction under the corporate laws of the two countries involved, according to the Italian Tax Agency, the original Luxembourg entity is not dissolved but continues as a Swiss entity; as a result, under the terms of the reorganization transaction, the minimum ownership and holding period requirements for the dividend withholding tax exemption are met and dividends paid by the Italian subsidiary would still be exempt from withholding tax.

The question is whether the same conclusion should stand whenever two EU-based companies engage into a tax-free reorganization pursuant to which the acquiring company receives the shares of a EU subsidiary from the acquired company, on a tax-free basis and without recognition of gain, and prior to the reorganization the requirements for dividend withholding tax exemption with respect to those shares were met.

In that scenario, taxpayers would argue that the minimum ownership and holding period requirements in the hands of the acquired company should be teated as carrying over to the acquiring company, and the withholding tax exemption should be maintained.

In its Private Letter Ruling n. 355 of August 30, 2019 the Italian Tax Agency considered the tax implications, for Italian gift tax purposes, of a transaction involving the early termination of an irrevocable trust by way of mutual consent of the trustee, settlor and beneficiaries of the trust, with a return of the trust’s assets to the settlor.

The Tax Agency treated the termination of the trust as a gift of the trust’s assets to the settlor, which was subject to Italian gift tax.

The trust had been set up in Italy and was governed by the laws of Jersey. The trust had a term of thirty years, and the lineal descendants of the settlor were named as beneficiaries of the trust’s assets upon the expiration of the trust. The trust agreement provided that the beneficiaries were not allowed to early terminate the trust, without the consent of all other parties (namely, the settlor and trustee).

The relevant statutory provision of the governing law of the trust provides that “Without prejudice to the powers of the court under paragraph (4) and notwithstanding the terms of the trust, where all the beneficiaries are in existence and have been ascertained and none are interdicts or minors they may require the trustee to terminate the trust and distribute the trust property among them”.

Considering the limits and restraints to a unilateral anticipated termination of the trust by the beneficiaries of the trust as set forth in the trust agreement, the parties to the trust decided to early terminate the trust by way of mutual consent among all of the parties to the trust, namely the settlor, trustee and named beneficiaries, and return the trust’s assets to the settlor.

The taxpayer took the position that a transfer of assets to a trust is not a complete gift, until the assets are distributed to the beneficiaries, and, conversely, an anticipated termination of the trust, with a return of the assets to the settlor, before they are actually distributed to the beneficiaries, would just retore the parties into their initial positions and should have no effects for Italian gift tax purposes.

The tax agency disagreed and confirmed its position according to which a transfer of assets to an irrevocable trust for no consideration constitutes a final gift and is subject to gift tax, while no further tax is due at the time of the final transfer of the trust’s assets to the beneficiaries. As a result, according to the Tax Agency, an anticipated termination of the trust by way of mutual consent of settlor, trustee and beneficiaries, with the return of the trust’s assets to the settlor, costitute a “gift” of the trust’s assets to the settlor, which, in turn, triggers the gift tax.

The ruling is important, especially in a cross border context, whenever the parties to a non Italian trust with Italian assets decide to proceed with an anticipated termination of the trust, without being fully aware of the implications that the transaction may have in Italy. Similarly, in case of an Italian trust with foreign assets, the anticipated termination of the trust with a return of the assets to the settlor could trigger a gift tax in Italy, as well as in the foreign country in which the assets are located, in the event it follows the same approach as that pursued by the Italian tax agency. That would be, indeed, the exact result in the event on an early termination of an irrevocable trust holding assets in the United States.

Italian tax residence is a very important topic for foreign nationals who travel regularly to Italy, own houses and spend significant time with their family there, while living and working abroad, as well as for those who relocate to Italy and work, do business or just retire there.

For the former, it may be surprising to know that they may have crossed the line and become Italian tax residents, under Italian tax law, even though they have spent less than 183 (or 121 on average) days a year in Italy and would never be resident should the provisions of the Internal Revenue Code apply to their case.

For the latter, it is important to understand the need to plan in advance the establishment of their Italian tax residence, to fully understand the tax treatment they will be subject to once they have become resident, and make the proper adjustments to maximize the benefits and minimize the inconvenience of being subject to tax in Italy.

Now that Italy is the most formidable tax haven in the world for foreign nationals who plan to relocate there, Italian tax residence can be an opportunity, more than it has ever been, and an interesting topic to review with a positive state of mind.

In this area of international tax law, the disconnection between Italian internal law and U.S. domestic tax law is a significant as it can be, and can give rise to opportunities, or problems, depending on the taxpayer’s approach.

While the basic Italian rules are sufficiently clear, not surprisingly, there are still open issues, which arise in particular in the context of the interactions between Italian internal law and tax treaties.

In this article we offer a refresher of the basic rules while we stop and outline the open issues in the hope of rising awareness and create a basic knowledge of the system that can help any further and more detailed investigation of specific real-life situations.

Tax Residence Tests

Italy assigns tax residency to individuals based on one of three alternative criteria:

– registration on the list of Italian resident individuals,

– residence, as defined in the civil code (i.e. place of habitual abode),

– domicile, as defined in the civil code (i.e. main center of interests).

Tax residence is triggered whenever any one of those three criteria is met for more than 183 days in a given a year.

The Registration Test

The registration on the list of Italian resident people is carried out upon an individual’s application, which sets forth the individual’s home address in Italy and the date the individual moved to and started living regularly there. The application is filed with the local municipal office of the place where the individual’s home is located.

The effective date of registration, which will ultimately dictate the tax residence starting date (see the discussion of this topic below), may be tricky. The general rule is that the application takes effect from the date it is filed. The application paper, however, requires to set forth the date of the relocation to Italy (on which the individuals filing the application moved to and started living there), which can even be an earlier date.

In many instances, foreign nationals register inadvertently, or, rather, without fully knowing the tax implications of the registration, often encouraged by local notaries or accountants at the time of the purchase of a home in Italy, as suggested in order to benefit from abatement of transfer taxes granted by Italian law in connection with the purchase of a “first home” in Italy.

The registration, together with the ownership of a home in Italy, are matters of public record, and Italian tax offices carry out regular checks on the list of residents and real estate register and, when they do not find a matching Italian income tax returns on their file, they send inquiries about the tax status of those individuals who are registered as residents and own a home but appear to have never filed an Italian income return.

The Residence Test

Residence means place of habitual abode, that is, the place where an individual regularly lives, in a non transitory manner, and with the intention of living there for an indefinite time as it may be inferred from his or her social relations, activities, personal connections and family ties to that place. Residence is a fact and circumstances test based both on physical presence (which must be regular and not sporadic or temporary) and state of mind.

No fixed or minimum number of days of presence is required to meet the residence test, and traveling away for some temporary of transitory reasons, and staying outside of Italy for a long period of time, or even working primarily outside of Italy while traveling regularly back and maintaining personal ties and family life there, does not affect the location of someone’s place of habitual abode in Italy.

The Domicile Test

Domicile means main center of interests, which can be personal or economic. For the purpose of this test, the days of presence in Italy are completely irrelevant. One can have his for her domicile in Italy event without living there at all.

Case law is inconsistent on whether personal and family interests should be given more weight than economic or professional connections, for purposes of both the residence and domicile test.

A substantial body of case law and tax ruling exists in this area, and no meaningfully conclusion can be reached, without a carefully review of the facts of each particular case against the background of the reveal case law and administrative guidance.

First and Last Day of Residence and Change Of Residence During The Year

For Italian tax residence to begin, it is required that any of the three tests described above is met for more than 183 days in any particular year.

The first day of residence is the first day of the year in which either test is satisfied. Conversely, the last day of residence is the last day of the year in which either test is satisfied.

In other words, if someone establishes his or her residence or domicile in Italy sometime on or before June 30 of a given year, his or her tax residence would begin on the first day (January 1) of that year, and if someone moves his or her residence or domicile outside of Italy sometimes on or after July 1 of a given year, his or her last day of residence would be the last day (December 31) of that year year.

Conversely, if someone establishes his or her residence or domicile in Italy sometimes on or after July 1 of a given year, and moves his or her residence or domicile outside of Italy sometimes on or before June 30 of the following year, he or she would had never been be a tax resident of Italy, either in year one or the following year.

In light of the above, as a rest of the application of the Italian rules, there may be situations on double tax nonresidence, or double tax residence, with all the implications that would have.

Tax Treaties And Change of Residence During the Year

Italian internal tax law does not contemplate a case in which an individual can be a resident – or a nonresident – for part of the year. Tax residence, whenever established during the year, either retroacts to the first day of the year (if established within the first half of the year) or is postponed to the first day of the following year (if established in the second half of the year). Under that approach, an individual is either a resident, or a non resident, for the entire year.

An open issue concerns whether the application of a tax treaty may change the outcome dictated under Italian law and make somebody a part-year resident (or part-year non resident) of Italy for the purposes of that treaty. We refer to a case in which an individual, who is resident of Italy and another country which has a tax treaty with Italy, under their respective internal tax laws, moves from Italy to the other State during the second half of the year and successfully demonstrates that his or her residence should be assigned to the other contracting State, under the provisions of article 4 of the treaty between Italy and that State, from the time he moved there.

In that case, the issue is whether, pursuant to the treaty, the last day of residence in Italy (which, under Italian law, would be the last day of the year) should be set on the the day within the year on which the treaty test assigning residence to the other treaty country is met.

The Italian tax administration (in a tax ruling dating back to 2008) seems to take the position that part-year residence applies solely when expressly provided for in the tax treaty. However, as far as we know, there is very little direct guidance and clear case law on the issue, which is open to discussion.

Effects of Tax Residence

Italian tax residence has far reaching effects that cover income tax, gifted estate tax, international tax reporting and taxation of trusts.

Notably, under Italian law, and unlike in the U.S., the tax residence tests are the same for income tax as well as gift and estate tax purposes.

Once Italian tax residence is established, under any of the tests discussed here above, a taxpayer treated as an Italian resident individual:

– is subject to income tax in Italy on all of his or her or income, from whatever source derived, in Italy or abroad,

– is subject to Italian gift and estate tax, on all of his or her assets, wherever located in the world,

– is required to report, for information purposes, on his or her Italian income tax return, all of his or her assets, located outside of Italy, in which he or she has a financial interest, legal or beneficial ownership or legal control,

– is subject to foreign assets based taxes charged on the fair market value of foreign real estate (at the rate or 0.76%) or financial assets (at the frate of 0.2%), due on top of Italian personal income taxes,

Also – and equally important – any trust of which an Italian resident individual is a trustee, is presumed to be an Italian resident trust, subject to tax in Italy on its income (as attributed to the trust under Italian tax rules), from whatever sources derived.

Tax Treaty Residence And International Tax Reporting Of Foreign Assets

Under the typical tie breaker provisions of article 4 of Italian income tax treaties, an individual who is a tax resident of both Italy and another State, under their respective internal tax laws, can be treated as a resident of the other contracting State, for the purposes of that treaty.

Generally, a tax treaty applies only to income taxes, and solely for the purpose of computing a taxpayer’s income taxes due.

An unsettled issue is whether an Italian tax resident individual, under Italian internal law, who is treated as a non resident pursuant to the provisions of article 4 of an income tax treaty and, consequently, is not liable to tax in Italy on his or her foreign (i.e, non-Italian) income, for purposes of that treaty, would also be exempt from the duty to report his or her foreign (i.e. non-Italian) assets on his or her Italian income tax return.

The technical language of the treaty limits its application to the computation of income taxes due in either of the two contracting States, while, for all the tax purposes, an individual remains a resident of the contracting State under its own internal law.

The U.S. approach is that a resident alien individual, under U.S. internal tax laws, who files as a nonresident pursuant to article 4 of an income tax treaty, is treated as resident for all other income tax purposes and is subject to the duty to file his or her international informational returns (such as form 8938, 114a, 5471, and the like) as required under U.S. tax law.

In Italy, the issue is open. There is some case law that seems to suggest that the Italian tax administration would require that an Italian income tax return be filed, with section RW duly filled out with information on foreign assets, even when there is no income tax liability because the taxpayer is treated as a nonresident under a treaty (and does not have Italian source taxable income to report). That would be consistent with a recent administrative guidance according to which the Italian tax agency requires reporting also for foreign personal assets that do not produce any income taxable in Italy.

On the other hand, Italian international tax reporting rules seems to limit the reporting by making reference to foreign assets “which are capable of producing foreign source taxable income”, which clearly is not the case when the taxpayer in a nonresident under a treaty (and is never liable to tax in Italy on foreign source income). The language of the statute would appear to justify the absence of a duty to file an Italian tax return in the situations described above.

Since reporting is for information purposes only and there is no tax attached to it (and considering the penalties for failure to file) a conservative approach would suggest filing an income tax return whenever an individual is an Italian tax resident under Italian internal law.

Tax Treaty Residence And Non-Income Taxes

Another issue is whether an individual, who is treated as a nonresident under thew provisions of article 4 of an income tax treaty, should still be treated as a resident, for all other Italian non-income tax purposes.

As noted, Italy uses the same tests to determine an individual’s tax residence for purpose of the Italian estate and gift tax.

However, income tax treaties do not apply to estate and gift taxes, and typically estate and gift tax treaties (which Italy has with several countries, including the U.S.) do not set forth provisions on residence or domicile for estate and gift tax purposes.

As a result, the answer to our question should be a clear yes.

However, some tax experts opine that, since the residence test are the same, for income tax and estate and gift tax purposes, there seems to be a unitary tax residence concept in the Italian tax system, and it would set fair that, in the event that an individuals’ tax residence is assigned to another country, under the provisions of article 4 of an income tax treaty, that individual should be treated as a nonresident for any tax purposes, and also for the purpose of the Italian estate and gift tax.

Interestingly, the same issue arises with respect to certain asset-based taxes that have to be reported on the regular income tax return. They are the tax on the fair value of foreign real estate, charged at the rate of 0.76%, and the tax on the fair value of foreign financial assets, which is charged at the rate of 0.2%.

Italian resident taxpayers are subject to those taxes, which are computed on a separate section of the regular income tax return and are paid together with the regular income tax.

The question is whether a taxpayer who is treated as a nonresident under an income tax treaty, is exempt from those taxes, and therefore not required to file an income tax return, or due to the fact that they are non-income taxes falling outside the scope of the treaty, implies that a resident taxpayer under Italian internal law regardless of the treaty is still subject to those taxes and required to file the return.

Tax Residence and Trusts

Another implication – and potentially unintended consequence – of establishing the tax residence in Italy arises with respect of trusts. Under Italian tax rules on trusts, the tax residence of a trust is deemed to be in Italy, whenever the trustee is an Italian resident individual. The taxpayer has the burden to prove that the trust is effectively managed in a foreign country.

A Italian tax resident trust is taxed in Italy on any income which is allocated to the trust under Italian tax law (which does not need to be consistent with US law), whether from Italian or foreign source. In the case of a trust with identified beneficiaries, the trust’s income flows through the trust and is allocated and taxed to the beneficiaries. However, whenever it flows through an Italian resident trust, its source and character change, in a sense that it becomes Italian source income and is classified as income from trust. As such, it is taxable to foreign beneficiaries, unless it is exempt under a treaty (presumably, the other income provision of article 12).

Tax Residence And Special Tax Regimes For Foreign Nationals

Italy enacted several special tax regimes for foreign nationals (or Italian citizens living abroad) who move to Italy.

One regime is designed for high skilled workers, professionals and independent contractors and entrepreneurs, and provides for a 70% or 90% taxable income exemption for employment income, professional income and business income, for a period of five years that can be extended to ten years under certain circumstances.

Another regime is designed for retirees and provides for a 7 percent flat income tax rate applicable on all of the income of individuals who receive some retirement income.

Another regime is designed for high net worth individuals and provides for a fixed 100,000 euro tax on all of their foreign source income.

All those special tax regimes are predicated on the requirement that the taxpayer did not have his or her tax residence in Italy for a certain period of time before, and established his or her tax residence in Italy after, electing for the special tax regime.

In this context, the analysis on a taxpayer’s residence is critical to determine his or her eligibility for the preferential tax regimes.

Recently, the Italian tax administration has clarified that, whenever a taxpayer has been a resident of Italy under the registration test, and would not be eligible for the special tax regime, but maintained his or her residence or domicile in a foreign country, he or she can claim to be treated as a nonresident under article 4 of the income tax treaty with that country also for the purpose of claiming his or her eligibility for the special tax regime. The interpretative guidance addresses the very common situation of many Italian citizens who move abroad but never terminate their registration in Italy.

Even though the Italian tax administration has not dealt with it, also the opposite should be true: an individual who has never been registered in Italy, but maintained in Italy his or her actual domicile or place of habitual abode, within the relevant period of time before the election, might have become a resident under the domicile or residence test and could therefore be considered not eligible for the special tax regime.

Considering the attractiveness and rising popularity of the special tax regimes for new residents, it is not surprising that the concept of tax residence will receive additional attention and greater scrutiny.

Conclusions

In conclusion, the concept of tax residence in Italy has pervasive ramifications in many areas of Italian tax law and gives rise to challenging issues in a cross border context.

Careful tax planning on the issue of Italian residence can provide significant tax benefits, while taxpayers who ignore it do that at their own peril and may encounter severe troubles.

Italy taxes various categories of financial income – namely dividends, interest and capital gains – earned by private investors outside the carrying on of a trade or business, by way of a substitute tax charged on the gross amount of the income at the flat rate of 26 percent.

With effect from January 1, 2018, capital gains are no longer categorized as gains realized from the sale of qualified shareholdings (i.e., shareholdings exceeding a minimum percentage of a company’s stock measured by vote or value), which were partially exempt under Italy’s participation exemption rules, and partially taxed, as ordinary income, and gains realized from the sale of portfolio shareholdings (which were subject to the substituted tax), and are all taxed at the 26 percent substituted tax rate.

In case of dividends, interest and capital gains earned through an Italian-based bank or financial intermediary, the bank or financial intermediary which collects the income on behalf of its customers applies the 26 percent substituted tax and credit the net amount of the income to the customers.

In case of dividends, interest or capital gains that are earned form investments held outside of Italy, and without the intermediation of an Italian-based bank or financial institution, the taxpayer is required to self-report the income on a separate section of his or her Italian income tax return, and compute the 26 percent substituted tax, which adds up to the ordinary income tax due on taxpayer’s general income.

One significant issue arising from Italy’s method of taxation of financial income described above is that no foreign tax credit is allowed to be computed, on the Italian income tax return, for any foreign income tax paid in respect of foreign-source financial income earned from investments held outside of Italy and reported by an Italian resident taxpayer on the Italian income tax return.

Under the general provisions of the Italian income tax code, any foreign tax credit for foreign income taxes paid on foreign-source income is limited by a fraction that bears, at the numerator, the foreign-source portion of the taxpayer’s general income, and, at the denominator, the total amount of the taxpayer’s general income.

Since the income subject to the 26 percent substituted taxed is separately stated on the return and does not fall within the taxpayer’s general income pool, and the 26 percent substituted tax is charged separately from the general income tax due on taxpayer’s general income, the result of the limitation fraction is zero.

The 26 percent substituted tax is mandatory. Neither the provisions of the tax code nor the mechanical steps for the preparation of the Italian income tax return give the taxpayer the election to report the financial income within the general income pool, compute the Italian tax on that income at graduated rates, and compute and take a credit for the foreign income taxes paid on that income to educe the Italian general income tax, even when that computation would lead to a lower tax than the tax computed by charging the 26 percent substituted tax rate.

For American taxpayers living in Italy, the issue affects the taxation of dividends and interest earned from their U.S. investments. Capital gains are generally classified as foreign source, under the U.S. Internal Revenue Code, based on the residency of the taxpayer, which would allow a foreign tax credit in the United States for the Italian substituted tax paid in Italy.

For all other Italian-resident taxpayers (Italian citizens or foreign national alike) which invest outside of Italy, the issue extends to capital gains realized from the sale of shares of or other ownership interests held in foreign entities, and which are subject to tax in the foreign country in which the entity is organized, based on the criteria of the entity’s residency or place of organization. That is particularly true for gains realized from the sale of shares in privately-held company, such as start-ups and the like.

We believe that Italy’s 26 percent substituted tax on financial income, with the denial of a foreign tax credit for foreign income taxes paid on foreign source financial income, is a potential violation of the provision of Article 23 of Italy’s tax treaties. The typical languages of a treaty’s Article 23 requires Italy to grant a foreign tax credit for foreign income taxes paid on foreign source income, and under Italy’s constitutional law system, tax tarries prevail over domestic tax law.

The language of Article 23 of Italy-U.S. income tax treaty appears to support the taxpayer’s position. In particular, the first part of paragraph 3 of Article 23 appears to clearly require that Italy grants the credit, by providing as follows:

“If a resident of Italy derives items of income which are taxable in the United States under the Convention (without regard to paragraph 2(b) of Article 1 (Personal Scope)), Italy may, in determining its income taxes specified in Article 2 of this Convention, include in the basis upon which such taxes are imposed the said items of income (unless specified provisions of this Convention otherwise provide). In such case, Italy shall deduct from the taxes so calculated the tax on income paid to the United States, but in an amount not exceeding that proportion of the aforesaid Italian tax which such items of income bear to the entire income”.

The second part of paragraph 3 of Article 23 allows Italy to deny the foreign tax credit solely in the event that a particular item of foreign income is subject to a flat rate withholding tax separately from the general tax on general income, at the request of the taxpayer:

“However, no deduction will be granted if the item of income is subjected in Italy to a final withholding tax by request of the recipient of the said income in accordance with Italian law”.

As explained above, the 26 percent substituted tax is mandatory, and the Italian income tax code does not grant the taxpayer the ability to declare the income in the general income pool and reduce his or her tax by a credit for the foreign income taxes paid on foreign-source financial income.

We are not aware of any court case, administrative guidance or tax ruling addressing the issue.

Considering the dramatic increase of the substitute tax rate on financial income, which raised from 12.5 percent to 26 percent in the last few years, the issue has clearly become substantial for many taxpayers. It is reasonable to expect that the matter will be brought to the attention for the Italian tax administration, in form a ruling request, or, more likely, the denial of the credit will be challenged and the matter will be ultimately decided by the tax courts or the Supreme Court.

With its resolution n. 53/E issued on May 29, 2019 the Italian tax agency issued some important clarifications on the exact scope of the Italian international tax reporting rules in case of foreign assets held through trusts, foundations or similar entities.

In particular, the ruling focuses upon the interpretation of the term “beneficial owner”, which applies and is used to identify the individuals subject to the duty to report.

Under Italian law (article 4, paragraph 1 of Law Decree n. 167 of 6/28/1990), resident individual taxpayers and non-commercial entities such as foundations and trusts have the duty to report, on a specific section of their Italian income tax return (so called section RW), any assets that they own outside of Italy, which are capable of producing foreign-source income taxable to Italian taxpayers in Italy.

The duty to report falls upon those individuals who are the legal owners of the foreign reportable assets, as well those individuals who indirectly own the assets through intermediaries, fiduciaries, conduits or similar legal arrangements, through which they have the dominion and control over those assets and enjoy the economic benefit of the income arising therefrom.

The term beneficial owner has been enacted to properly extend the duty to report beyond the mere holding of the legal title to foreign assets, to the actual control and enjoyment of those assets and associated income.

The tax statute does not uses its own definition of the term beneficial owner, but, rather, it incorporates by reference the definition of the term beneficial owner which is provided in the anti money laundering legislation.

As recently amended by way of Legislative Decree n. 90 of 2017, which transposed into Italian law the provisions of the EU IV Anti Money Laundering Directive (2015/849/EU), Italian anti money laundering law provides (at the new article 20 of legislative decree n. 231 of 2007) that, in case of private foundations, trusts and similar entities, beneficial owners are: the settlor, the trustee, the guardian, the beneficiaries of the trust, if identified, or the class or classes of persons for the ultimate benefit of which the assets are held in trust.

The issue addressed in the ruling was whether an Italian resident trustee of an Italian resident trust with investments outside of Italy, who falls within the definition of beneficial owner of those investments as provided in the anti money laundering statute, had the duty to report the investments on his own income tax return.

The taxpayer took the position that the meaning of the term beneficial owner as set forth in the anti money laundering legislation, and incorporated by reference into the tax statute, must be interpreted in a way that is consistent with the ratio and overall purpose of the income tax reporting rules, namely that of allowing the tax administration to monitor the existence of foreign assets owned or controlled by Italian resident taxpayers potentially generating foreign source income taxable in Italy. In that context, according to the taxpayer, the trustee should have no duty to report, on his own income tax returns, the foreign assets of the trust that he owns and administer not for his own benefit, but on behalf of the trust and in the interest of the settlor and the trust’s ultimate beneficiaries.

The Italian tax agency, in its ruling approving the position of the taxpayer, confirmed that the tax reporting rules apply in case of foreign investments legally or beneficially owned by Italian resident taxpayers, the income arising from which would be taxable to them in Italy. The objective of the tax reporting rules is to allow the tax administration to monitor those assets and associated income and make sure that such income is properly taxed in Italy, to the taxpayers who own it, whenever the income is realized and a tax becomes due. The tax administration acknowledged that the anti money laundering definition of beneficial owner should not apply literally, but should be interpreted – and narrowed down, if required – so that it is consistent with the scope and purpose of the international tax reporting rules, as previously clarified.

The clarification is very important, in principle, and is relevant also in other situations in which the same issue would arise.

One situation concerns trusts classified as fiscally nontransparent (opaque) trusts for Italian tax purposes, which own investments located outside of Italy. Opaque trusts are those trusts which do not have identified beneficiaries with an immediate right to current distributions out of the income or principal of the trust. In that case, the income arising from the investments held in trust is attributed to and treated as income of the trust, for Italian tax purpose, and it is not immediately taxed to the beneficiaries of the trust, in Italy. Following the logic set forth in ruling 53/E, under those circumstances no duty to report the trust’s foreign assets should fall upon the trust’s Italian resident beneficiaries. Indeed, the trust beneficiaries to do not own those assets, and are not taxable on the income of the trust earned out of them.

Similarly, under the same circumstances, the settlor of the trust who does not retain any right to the principal or income of the trust, should not be subject the duty to report.

It is interesting to monitor the future developments in this area of Italian tax law, in which some uncertainty still lingers with particular regard to tax reporting of foreign assets and taxation of foreign source income of foreign trusts with Italian resident settlor and beneficiaries.

We attach below a link to resolution n. 53/E of May 29, 2019:

RISOLUZIONE+N+53+2019

With its decision n. 5608 of December 10, 2018 the Italian Provincial Tax Court of Milan ruled against the (ab)use of so called “unit linked” life insurance policies for tax avoidance purposes.

The decision of the tax court refers to the latest rulings of the Supreme Court on the matter and represents a significant step towards a more decisive step towards a crack-down on a potentially abusive tax practice.

Under Italian tax law, in case of cash value life insurance policies a taxpayer is allowed to defer the payment of the tax on the increase in value of the policy until the payment of the value of the policy to the beneficiaries, upon the death of the policyholder, or to the policyholder, upon the expiration or surrender of the contract. At that time, the difference between what the taxpayer gets back and what he or she paid by way of insurance premiums is taxed as income from capital, with a fixed-rate 26 percent tax withheld directly by the issuer.

A Unit-Linked Insurance Policy is a combination of a life insurance and an investment vehicle. A portion of the premium paid by the policyholder is utilized to provide insurance coverage to the policyholder and the remaining portion is invested in equity and debt instruments. The aggregate premiums collected by the insurance company providing such insurance is pooled and invested in varying proportions of debt and equity securities in a similar manner to mutual funds. Each policyholder has the option to select a personalized investment mix based on his/her investment needs and risk appetite. Like mutual funds, each policyholder’s Unit-Linked Insurance Plan holds a certain number of fund units, each of which has a net asset value that is declared on a daily basis and varies based on market conditions and performance of the plan’s underlying investments. A portion of premium goes towards mortality charges i.e. providing life cover. The remaining portion gets invested funds of policyholder’s choice. Invested funds continue to earn market linked returns.

The Tax Court referred to the Supreme Court’s ruling n. 10333 of 2018 which upheld the decision of the Appellate Court of Milan n. 220 or 2016.

According to ruling n. 1033, in the absence of some required traits of a typical permanent life insurance policy, such as the guarantee of the payment of the principal amount of premiums upon termination of the contract and the assumption by the issuer of risk of death of the policyholder (demographic risk), the contract should be treated as an investment plan (i.e. a mutual fund) and the taxpayer should be taxed currently on the income arising from the insurance policy’s underlying investments.

Under the facts of the case, the policyholder (a well known professional soccer player) underwrote an investment plan labelled as life insurance policy and issued by a foreign company, which gave him the unlimited right to make withdrawals from or payments to the insurance plan, during the course of the contract, and the power to direct and manage the investment of the underlying assets, while the issuer’s only obligation was that of paying an amount equal to the net asset value of the underlying investments at the time of the policyholder’s death or the contractual termination of the policy.

The tax court treated the contract as a financial investment, applied the imputed rate of return provided for under article 6 of Law Decree n. 167 of 1990 (in the absence of a taxpayer’s of the actual amount of income generated by the underlying investments), and assessed a tax of euro 64,004 plus interest and a penalty in the amount of euro 76,804.80.

Italian taxpayers should consider different strategies to obtain the benefits of deferral of tax on income arising from their financial investments, such as the use of nonresident discretionary or support trusts properly planned and designed to provide adequate protection of the invested capital and desired benefits in case of death or upon retirement.

A link to the Tax Court’s decision is provided below:
CTP 10-12-2018 n. 5608)