In a post on December 3, 2010 we reported on a recent ruling issued by the Italian tax court of Emilia Romagna against an Italian banking group in respect of a series of structured finance transactions aimed at obtaining abusive tax benefits (mainly, foreign tax credits under applicable tax treaties).

Based on a copy of the decision (Italian Tax Court Ruling.pdf) the transactions under dispute were structured as follows.

1) The first transaction is an interest rate swap combined with a sale and repurchase agreement on Brazilian bonds, pursuant to which the Italian bank as legal owner of the bonds claimed a tax sparing credit under the Brazil-Italy tax treaty equal to 25% of the interest paid on the bonds. According to the Italian tax administration, based on the terms of the transaction the Italian bank did not assume any risk or obtained any economic advantage from the transaction (in substance, it is as though the Italian bank made a loan to the foreign counterpart), except for the tax advantage represented by the tax sparing credit claimed under the Brazil-Italy tax treaty (which the parties shared in form or a below market rate loan from the Italian bank to the foreign counterpart). The foreign bank would not have been entitled to any credit had it owned the bonds directly.

2) The second transaction is a sale and repurchase transaction of UK stock. Economically, under the terms of the contract, the risk of losses and profits from the securities belong to the UK counterpart. UK treated the transaction as a loan. However, for Italian tax purposes the Italian bank was treated as the owner of the securities and the dividend income attached to it. As a result the Italian bank claimed a tax credit even though there was no actual UK tax on the dividends.

3) The third transaction is a sale and repurchase transaction of UK bonds. The interest on the bonds are subject to 10 percent withholding in the UK, which the Italian bank as buyer and owner of the bonds takes as a foreign tax credit in Italy. At the same time the seller receives a tax credit for the same withholding tax under the tax laws of its country of residence, which treats the seller as the economic owner of the bonds. According to the tax administration, the derivative contract eliminates any risk or profit opportunities but for the tax advantage of a double tax credit claimed in two different countries for the same withholding tax (double dip).

The tax court ruled in favor of the tax administration and denied the tax credits under the general abuse of law doctrine according to which, when a transaction is entered into a) without a valid economic reason, and b) for the sole purposes of obtaining an "abusive tax advantage", it can be ignored for tax purposes.

The tax court clarified that it applied a restrictive version of the abuse of law doctrine, which requires that the tax advantage be considered "abusive", meaning that it is obtained clearly moving against the spirit, ratio and purposes of the tax provisions from which it is derived. The mere tax advantage of a specific transaction is not sufficient for this purpose.