With its Ruling n. 4091 of June 12, 2017, the Eighth Department of Tax Commission (District Tax Court) of Milan, Italy ruled that upon the cancellation of an inter company loan from a Dutch parent company to its Italian subsidiary, the interest accrued on the loan and deducted by the Italian subsidiary on an accrual basis, during the course of the loan, is deemed “constructively received” by the foreign parent, and is potentially subject to the Italian interest withholding tax (at the rate of 20 percent, pursuant to article 26, paragraph 5 of Presidential Decree n. 600 of 1973, recently increased to 26 percent).
However, the Tax Court also ruled that the Dutch parent company qualified as “beneficial owner” of the interest, and was eligible for the withholding tax exemption granted under article 26-quater of Presidential Decree n. 600 of 1973, which implemented the EU Directive n. 2003/49/CE (so called interest and royalties directive).
Under the facts of the case, a Dutch company extended a loan to its Italian subsidiary, after taking a loan from a Dutch subsidiary, which in turned had obtained a loan from a third party bank. After a number of years, the Dutch parent decided to unilaterally cancel the loan to its Italian subsidiary. Under Italian law, the cancellation of a shareholder’s loan does not give rise to taxable income in the hands of the borrower; rather, it is treated as a contribution to the capital of the borrower, thereby increasing the adjusted tax basis of the shareholder in its stock of the borrowing company.
The Italian Tax Agency took the position that, upon the cancellation of the loan, the interest from the loan, which had accrued and had been deducted by the Italian subsidiary during the course of the loan, was constructively received by Dutch parent and reinvested into the subsidiary, with the consequence that it was subject to the Italian interest withholding tax.
The theory of the constructive receipt of the interest, in the hands of the lender, upon cancellation of a shareholder loan, is based on a circular of the Ministry of Finance issued on May 27, 1994 with number 73/E.
Furthermore, the Tax Agency denied the benefit of the exemption from the withholding tax for interest paid between affiliated companies established in a EU jurisdiction, granted under the EU interest and royalties directive (Directive 2003/49/CE), as implemented in Italy by way of article 26-quater of Presidential Decree n. 600 of 1973. According to the Tax Agency, the strict interconnection and similarity of the terms of the back-to-back loans from the Dutch subsidiary to its Dutch parent and from the Dutch parent to its Italian subsidiary, and the lack of organizational structure at the level of the Dutch parent, excluded that the Dutch parent could qualify as beneficial owner of the interest for the purpose of the exemption.
The Tax Court sided with the Italian Tax Agency on the first issue, concerning the application of the withholding tax, and ruled that the interest was “constructively received” by the Dutch parent at the time of the cancellation of the loan, and thereby it was subject to the Italian withholding tax. The rational of the ruling is that the deduction of the interest in the hands of the Italian subsidiary, at the time of the accrual of the interest during the life of the inter company loan, must necessarily correspond to the actual receipt of the interest, in the hands of the shareholder-lender, either at the time of the actual payment of the interest, or at the time of the cancellation of the loan, whichever is earlier. Otherwise, there would be “loss” of tax along way, with the benefit of the deduction of the interest reducing the Italian tax on the subsidiary, upon accrual of the interest, on one side, without the Italian withholding tax on the interest at the time of the cancellation of the loan, on the other side.
It is worth noting that the new paragraph 4-bis of article 88 of the Italian Tax Code, enacted by way of the Legislative Decree n. n.147 of September 14, 2015, the cancellation of an inter company loan is treated as taxable income, in the hands of the borrower, to the extent that the amount of cancelled debt exceeds the adjusted tax basis of the debt (i.e. the principal amount of the loan). The result is that the borrower recognizes taxable income for the amount of of interest accrued, and not paid, under the loan. Under this new provision, the rational for the application of the outbound interest withholding tax on cancellation of an inter-company loan seems to lose value.
Instead, the Tax Court sided with the taxpayer on the issue of the Dutch parent’s eligibility for the interest withholding tax exemption under the EU interest directive. According to the Tax Court, the terms of the two back-to-back loans where sufficiently different, and the Dutch parent had the legal and economic dominion and control over the interest from the loan, thereby qualifying as beneficial owner of the interest for the purposes of the withholding tax exemption. The Tax Court noted that the interest rate under the Dutch subsidiary loan was different from the interest rate under the Italian subsidiary loan, living a margin of profits in the hands of the Dutch subsidiary, that the Italian subsidiary loan did not contain any provision requiring the Italian subsidiary to repay the loan, in the event the Dutch parent had to repay the loan to the Dutch subsidiary, and that the Dutch parent had the unconditioned right to waive its credit for the principal and interest of the loan towards the Italian subsidiary, as it actually did.
For the interpretation of the meaning of the term beneficial owner, the Tax Court referred to the OECD Commentary to the OECD Model Income Tax Treaty. Curiously, the Court did not refer to the definition of the term beneficial owner which is set forth in the EU Directive (at article 1, paragraph 4), according to which beneficial owner of the interest is the person which has the legal dominion and control over the interest and derives a direct economic benefit from it.
The decision provides some useful guidance on the tax treatment of interest arising from related party back-to-back loans, and illustrates some of the features of those loans that may be relevant in order to recognize the status of beneficial owner to the immediate recipient of the interest, to the extent that it is required to preserve certain tax benefits such as an interest withholding reduction or exemption.