On September 1, 2022, the Italian Supreme Court issued a ruling (n. 25698) in a case concerning a distribution from a U.S. partnership treated as a taxable dividend in Italy. The dividend was taxed by way of a substituted tax, and Italian tax law did not allow a credit for the income tax paid the taxpayer in the U.S. on the partnership’s underlying profits. At the time of the facts of case, the Italian substituted tax was assessed at the rate of 12.5 percent. The current substituted tax rate is 26 percent. The Court held that the taxpayer was entitled to receive a foreign tax credit for the income tax paid in the U.S. on his share of the partnership’s income taxable in the U.S. pursuant to the provision of Article 23, paragraph 3 of the Tax Treaty between Italy and the U.S., which prevails on Italy’s domestic tax law.
Many commentators saluted the decision with hurrahs, welcoming it as a big victory for taxpayers. Instead, we believe the decision requires more careful consideration, leaves many important details out, and may be open to a big misunderstanding (and potentially constitute a minefield for the ill-advised).
The Italian substituted tax is a final tax on certain types of income (generally, financial income in form of dividends, interest, and capital gain), when received directly by the taxpayer. The income subject to the tax is separately stated on the Italian income tax return, and the substituted tax is self-assessed on the return and paid directly by the taxpayer. When the same income is collected through an Italian financial intermediary, the intermediary applies a withholding tax at the same rate and pays it to the Italian treasury.
The separately stated income subject to the substituted tax does not enter the computation of the general taxable income. Foreign-source income does not enter the numerator and denominator of the formula for the calculation of the amount of foreign tax credit. Therefore, no foreign tax credit is allowed on the return for any foreign income tax paid in respect of the income taxed in Italy by way of the substituted tax, potentially resulting into double taxation.
As usual, the ruling lacks a proper, comprehensive, and organized explanation of the facts of the case. Under the limited facts set forth in the ruling, we understand that the taxpayer had self-assessed on its Italian personal income tax return a substituted tax computed at the rate of 12.5%, in effect at the time, for euro 137,849, which would correspond to an income of euro 1,102,792 (the exact amount of taxable income is not mentioned in the ruling).
The ruling explains that the taxpayer had provided substantial documentation evidencing that a tax of euro 299,820 had been paid in the U.S. on the taxpayer’s share of the partnership’s underlying profits.
The ruling does not provide any information about the amount of income taxed in the U.S., compared to the amount of income taxed in Italy. The U.S. tax applies on the partner’s share of the partnership‘s underlying profits, when earned by the partnership and regardless of their distribution, while the Italian tax applies upon the partnership’s profits distributed to the partner, at the time of the distribution. The two amounts do not necessarily concide.
The taxpayer refrained from paying the amount of the Italian substituted tax he declared on his income tax returns, taking the position that he was entitled to a tax credit for the income tax paid in the U.S., which would entirely offset the Italian substituted tax due.
The Italian Tax Agency issued a notice of collection of the Italian substituted tax as self-assessed by the taxpayer on his Italian income tax return. The taxpayer filed a petition to the Tax Court (in Milan) and won the case. The Tax Agency lost on appeal (in the Regional Court of Lombardy) and filed a petition to the Supreme Court, setting forth a singled defense in support of its tax collection notice: under the provisions of the Italian income tax code, no foreign tax credit is due for a foreign income tax paid in respect of income subject to a substituted tax in Italy.
The Supreme Court rejected the final appeal and held that the provision of Article 23, paragraph 3 of the tax treaty between Italy and the U.S., which prevails over Italy’s domestic tax law, requires that a foreign tax credit is allowed, except in a case in which the substituted tax applies at the taxpayer’s request. Under the Italian income tax code, the substituted tax is mandatory, and the taxpayer cannot elect that the income be subject the general income tax and claim a tax credit reducing the amount of Italian tax due.
The ruling’s holding is set forth as follows:
“For foreign-source capital income, directly received by the taxpayer, a natural person, holder of a non-qualified shareholding in a partnership governed by international law (in this case, US law), if the subjection to taxation by withholding tax – as in the case referred to in art. 27, paragraph 4, of the Presidential Decree no. 600 of 1973, or by means of a substitute tax, completely superimposable on the first due to the identity of the function, pursuant to art. 18, paragraph 1, of the Presidential Decree no. 917 of 1986 – does not take place “at the request of the beneficiary of [the] income”, but compulsorily, since the taxpayer cannot request ordinary taxation, the income tax paid in a foreign country (in the case, the United States of America) must be considered deductible as a credit”.
The ruling stops there and does not elaborate further. Importantly, nothing in the ruling is mentioned about the way in which the income should be taxed under the facts of the case. The logical implication of Article 23, paragraph 3 of the Treaty is that a foreign tax credit is allowed when (and provided tat) the income is taxed as ordinary income under the general income tax computed at graduated rates.
When we read the ruling, we have the impression that the taxpayer wanted to have his cake, and eat it too: self-assessing the Italian income tax at the reduced substituted tax rate (which is the tax the applies on separately income not part of the ordinary income), and, at the same time, claim a tax credit for the income tax paid in the foreign country, and use it to offset directly substituted tax itself.
That would clearly be a wrong result.
If the rationale of Article 23, paragraph 3 is that the foreign tax credit applies unless the taxpayer requests that the income is taxed by way of the reduced substituted tax, then a foreign tax credit can be allowed solely when the income is reported as ordinary income and taxed under the general income tax at graduated rates.
In other terms, there are two possible tax regimes, one under the Italian income tax code and one under the code as modified by the Treaty: taxation by way of the substituted tax without foreign tax credit, or taxation under the general income tax at graduated rates with a foreign tax credit that reduces the amount of Italian tax due.
Using the numbers mentioned in the ruling, the two alternative tax regimes would work as follows:
- First scenario (Italian income tax code): taxable income euro 1,102,792, final 12.5% substituted tax euro 137,849, no foreign tax credit, total tax (in Italy and the US) euro 437,669,
- Second scenario (Italian income tax code and article 23, paragraph 3 of the treaty): taxable income euro 1,102,792, Italian regular tax before credit euro 474,200.56 (using a 43% marginal tax rate), foreign tax credit euro 299,820, Italian tax after the credit euro 174,380.56, total tax in Italy and the US euro 474,200.56.
In the case decided in the ruling, the substituted tax with no foreign tax credit still appears to be more favorable option.
With the substituted tax calculated at the current rate of 26%, the result would be the following:
- First scenario (Italian income tax code): taxable income euro 1,102,792, final 26% substituted tax of euro 286,725.92, no foreign tax credit, total tax in Italy and the US euro 586,545.92,
- Second scenario (Italian income tax code and article 23, paragraph 3 of the treaty): Italian regular tax (before credit) of euro 474,200.56 (using a 43% marginal tax rate), foreign tax credit euro 299,820, Italian tax after the credit euro 174,380.56, total tax in Italy and the US euro 474,200.56.
In the latter case, the regular income tax with the foreign tax credit appears to be substantially more favorable than the substituted tax regime with no foreign tax credit.
Taxpayers should carefully consider their options, but should not reasonably expect to be able to simultaneously assess the Italian tax at the substituted tax rate and get a full tax credit for the foreign income tax directly deductible from the substituted tax