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.