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.