Italian Authorities Update Consolidated Taxation Guidelines
By Andrea Rittatore Vonwiller and Paolo Baruffi (MWE, Milan)
One of the new tax rules that will be introduced in the 2004 Italian tax reform is unquestionably the taxation of group of companies, so-called “consolidated taxation.” According to the consolidated taxation, groups are taxed by adding the taxable bases of all group companies. The rules on Italian consolidated taxation are included in Section II Chapter II (art. 118–art. 131) of the Draft Legislative Decree concerning the new legislation on taxes.
Companies Eligible for Consolidated Taxation
The following types of companies are eligible for consolidated taxation: joint stock companies (S.p.A.), limited partnerships with a share capital (S.a.p.a), limited liability companies (S.r.l.) and public and private entities whose main or sole purpose is the exercise of commercial activities on the condition that a parent-subsidiary relationship exists among the companies involved in the consolidation.
Non-resident companies, such as parent companies, may also take part in consolidated taxation, provided they exercise a commercial activity in Italy through a permanent establishment. Parent companies residing in countries that have not entered into a double tax treaty with Italy are, in any case, excluded from consolidated taxation.
As to the requirement of a parent-subsidiary relationship, according to Article 121, the definition of controlled companies includes corporations in which the parent company or entity holds, directly or indirectly, more than 50 percent of the capital. In determining this percentage, a reduction effect generated by the corporate control chain has to be taken into account.
For instance, if Company A represents the parent company at 80 percent, and Company B is 70 percent, then Company C is eligible for consolidated taxation because A has a 56 percent (80 percent *70 percent) shareholding in Company C. Shares without voting rights at general shareholders’ meetings are not computed when determining control percentages. The parent-subsidiary relationship needs to have been exercised since the beginning of the fiscal year in which the parent or controlled company opts for consolidated taxation.
Companies eligible for the consolidated taxation may opt to determine a single aggregate income for their group. The option is irrevocable and remains in effect for three years. It is conditional upon the fulfillment of the following requirements:
the fiscal years of the subsidiaries and of the parent company must coincide
every subsidiary and the parent company must all exercise the option jointly and at the same time
subsidiaries must elect domicile at the offices of the parent company
the companies must inform the tax authorities of the joint exercise of the option
Consolidated taxation involves the determination of a single aggregate income consisting in the algebraic sum of the full amount of each subsidiary’s taxable income, regardless of the percentage of the parent company’s shareholding. The parent company is responsible for carrying forward losses, if any, resulting from the algebraic sum of taxable bases, for liquidating the single tax liability payable or the single tax credit that the company may claim for refund or carry forward and for the obligations to make partial payments and payments in settlement of any tax liability.
Advantages and Disadvantages of Consolidated Taxation
One of the major advantages of consolidated taxation is the opportunity to offset positive taxable income against negative taxable bases of group companies. The group is entitled to include only the tax losses of the year for which it exercised the consolidated taxation option in the consolidation. Any tax losses accrued in years prior to the group taxation may be used only by the companies that suffered such losses.
If tax losses of controlled companies are included in the consolidated taxable basis, the parent company will benefit from a tax saving and could recognize a consideration to the controlled company for the saving. In this case, the law expressly states that any amounts received and paid among consolidated companies as consideration for the tax benefits received or granted are not included in the calculation of the taxable income.
An additional advantage of consolidated taxation is the exclusion of dividends distributed by consolidated companies from the consolidated taxable base. Accordingly, the parent company will reduce the taxable base by an amount corresponding to the taxable portion of the distributed dividends, even if they originate from profits taxed in years prior to the beginning of the option.
Finally, consolidated taxation neutralizes provisions that make the part of financial charges relating to the loan obtained to finance the acquisition of shareholdings not deductible. It also allows for the adoption of a neutral tax regime for inter-company transactions involving assets other than the ones that generate revenue, including transfers and contributions of lines of business.
Article 8 of the decree law passed on September 29, 2003, establishes the basic principles of the international rulinga mechanism addressed only to business trading at an international level. The term “ruling” means procedures that may be exercised by taxpayers before the tax liability arises and aims to settle in advance any issues that could potentially give rise to disputes with the tax authorities on the correct amount of tax to be paid.
International ruling entitles companies with international businesses to start a procedure that allows issues related to the taxation of transfer prices, interest, dividends and royalties to be settled. The application for a ruling has to be submitted to the appropriate revenue office in Milan or Rome by following the procedure that will be established with a measure that the director of the revenue office will issue in the near future.
The international ruling is completed with the execution of an agreement between the competent revenue office and the taxpayer. The agreement is binding for the tax period in which it is executed and in the following two tax periods, unless material changes in fact or in law occur. In such tax periods, the tax authorities cannot exercise their powers of assessment on matters covered by the agreement.
The Italian tax authorities are responsible for providing a copy of the agreement on the tax authorities’ jurisdiction in the countries where the companies with which taxpayers make the relevant transactions are resident. Article 8 states that this rule is applicable starting from the tax period after the one in progress on the date the decree law was enacted. Accordingly, companies with a tax period that coincides with the calendar year may start applying the provisions on January 1, 2004.
Thin capitalization is one of the most important rules introduced by the draft tax law reform. It limits the allowed deduction of financial charges connected with financial facilities granted or secured by a shareholder or related party. The rule is currently contained in Article 99 of the draft legislative decree dated September 12, 2003.
The rationale underlying the rule is the need to limit the excessive undercapitalization of Italian companies in order to prevent shareholders from financing the partially owned company, thus encumbering it with interest payable, rather than contributing sufficient endowment funds.
To apply these provisions, two conditions need to be fulfilled. According to Article 99, the thin capitalization rule applies to interest payable accrued on financing facilities granted or secured, directly or indirectly, by a qualified shareholder (meaning one that directly or indirectly holds a participating interest of at least 10 percent in the capital of the entity receiving the financing facility) and parties related to the qualified shareholder, meaning companies controlled by the latter pursuant to Article 2359 of the Italian Civil Code.
Pursuant to Article 2359 of the Italian Civil Code, controlled companies are companies in which another company holds the majority of voting rights exercised in ordinary shareholders’ meetings (so-called “direct control”); companies in which another company holds sufficient voting rights to exercise a significant influence in ordinary shareholders’ meetings (so-called “de facto control”); and companies that are under the significant influence of another company pursuant to particular contractual provisions entered into with the latter.
The expression financing facilities in the provision includes loans, money deposits and any other relation of a financial nature. It also may include cash pooling arrangements. Security means any real or personal guarantee given by the qualified shareholder and/or its related parties, including through conducts and actions that, although legally not defined as guarantees, have the same financial effect.
Under Article 99, interests on financing facilities fulfilling the above conditions cannot be deducted where they exceed, at any time during the tax period, the threshold of 4:1 with reference to the book value of net equity attributable to such shareholder and relevant related parties. Based on the rule, the indebtedness or net equity ratio must always be complied with during the entire fiscal year.
To compute the 4:1 ratio, it is essential to understand how to determine the amount of the financing facility (numerator) and of the book value of the net equity (denominator). The amount of the financing facility reference is made to the aggregate amount of financing facilities granted or secured by the qualified shareholder plus the financing facilities granted or secured by any related parties. The book value of the net equity reference is made solely to the share of the qualified shareholder and its related parties. The book value of the net equity is the value stated in the balance sheet for the previous fiscal year inclusive of retained profits for the year, decreased to account for uncalled capital; the book value of own shares; losses where they have not been covered by the date of approval of the balance sheet for the second tax period following the period in which such losses arose; the lower of the book value of the shareholding in the company; and the corresponding book value of the net equity of subsidiaries and associated companies.
Any capital contribution made by the same shareholder pursuant to joint venture agreements need to be added to the book value of the net equity. This rule does not apply to companies with revenues that are less than € 5,164,569.
Non-Deductible Interest Payable Treated as Dividends
An additional new aspect introduced by the tax law reform is that the part of interest payable that cannot be deducted on account of the application of the thin capitalization rule is treated as dividends. This provision is included in Article 90 of the draft tax law reform.
In particular, Article 90 expressly states that only 5 percent of the distributed profits, irrespective of how they are distributed and how they are called, are taken into account when computing the company’s taxable income for the year when distributed profits have been received. The same exclusion applies to interest on financing facilities in excess, as referred to in Article 99 directly granted by the shareholder and its related parties. Based on Article 90, it is advisable to discriminate between financing facilities granted directly or secured.
The amount of interest payable that cannot be deducted by the subsidiary that benefited from the financing facility is treated as dividends when determining the taxable income of the shareholder (or related parties). The shareholder granting the financing facility will be taxed on the interest collected at a 5 percent rate. If the financing facility is granted by a third party and it is merely secured by the shareholder, then the interest is not treated as dividends. Any interest payable by the borrower is, in any case, not deductible if the thin capitalization rule applies.
The New Tax Regime Applicable to Dividends
On January 1, 2004, the delegated law on the reform of the state tax system (Law No. 80, April 7, 2003,) will come into force. The reform introduces the new Italian corporate income tax (IRES) and significantly affects the taxation of dividends.
One of the major aspects of the reform is the abolition of the mechanism of the tax credit on dividends. During the application of the present provisions, this mechanism has protected the recipient from double taxation. Indeed, with this mechanism the income of companies has been taxed at a company and at a shareholder level, but a tax credit is granted to the shareholders in an amount equal to the taxes already paid by the company.
The discontinuance of the mechanism ensues from the European Commission’s communication COM (2001) 582 that states, with reference to the process of harmonization of national legislation on the taxation of dividends, this mechanism grants particular credits to national shareholders only, and, as such, is a barrier to investments at a EU level.
To compensate for the abolishment of the dividend tax credit and with a view to ensuring the avoidance of double taxation on dividends, the decree law mentioned above introduces a number of mechanisms: First is the extension of the “exemption model” to resident companies, albeit with different exemption thresholds depending on the nature of the recipient. This includes companies and entities treated as companies or persons liable to IRES (corporate income tax); individuals that are not a business persons and non-commercial entities-persons liable to IRE (general income tax); and individuals that are business persons - person liable to IRE. The thresholds also depend on the nature of the interest that generated the dividends, including qualified interest or non qualified interest and an extension of the “transparency model” to companies that meet specific requisites. Based on this model, income is taxed directly at shareholder level. The introduction of the “domestic consolidated taxation” that grants full exemption of the dividends remain within a corporate group.
Rules on Dividends Received by Corporations (Liable to IRES)
The new legislation provides that 95 percent of profits distributed by companies with a legal personality, whether resident or non-resident in Italy, are excluded from computation when determining the taxable income.
Dividends paid by partnerships resident in Italy continue to be taxed according to the tax transparency basis: the dividends are and will be charged to partners, regardless of the amount of the payment, proportionally to their profit-sharing percentage.
In the case of dividends paid by commercial companies and entities, 95 percent of the dividends are not computed when determining the taxable income of the recipient. There is no minimum or maximum threshold of participation that applies in order to benefit from these provisions. The exemption regime also applies to profits distributed if the shareholder leaves the company, if the excess capital is reduced and if the company is wound upeven for insolvency. The residual 5 percent is taxed as a positive income component of the taxable business income. The exclusion from computation of the taxable income also applies to joint venture and profit sharing agreements under article 2554 of the Italian Civil Code, where the agreement provides for a contribution other than of works or services as well as financing facilities granted directly by the shareholder or related companies, in the amount exceeding the debt/equity ratio referred to in Article 99 of the draft new Italian income tax consolidated text (TUIR).
For dividends paid by non-resident commercial entities and companies, the new (95 percent) exemption provisions apply to profits distributed by non-resident companies and entities but only where certain conditions are met. Amounts are tax exempt only if they have the nature of dividends or of results proportional to financial results (but not interest).
The new tax regime of profits will be applicable on all dividends collected in tax periods starting from January 1, 2004, even if originating from resolutions approving distributions that were adopted in prior tax periods. Consequently, the new regime will also apply to profits achieved by partially owned companies in the fiscal year 2003, taxed according to the current provisions and distributed with the balance sheet approved in 2004.
The taxation of dividends received by an individual that is not a businessperson, liable to IRE, is effective January 1, 2004. Dividends received by individuals will be taken into account when computing the taxable basis to an extent equal to 40 percent of their amount, where referring to qualified interests and will be taxed by applying a substitute 12.5 percent tax, where referring to nonqualified interests.
The new taxation regime of profits will be applicable to tax periods starting from January 1, 2004. Accordingly, dividends received up to December 31, 2003, are taxed according to the provisions currently in force (tax credit). Effective January 1, 2004, the exemption regime as described above is applicable.
Effective January 1, 2004, dividends received by individuals in carrying out their businesses will be computed when determining their taxable income up to an amount equal to 40 percent.
Interest and Royal Ties Between Associated Companies in EU Countries
Directive 2003/49/EC of June 3, 2003, published in the Official Bulletin of the European Union dated June 26, 2003, No. 157/L should come into force by January 1, 2004. It establishes an important principle: interest and royalty payments made between associated companies resident in two different EU countries must be free from taxation in the “source [s]tate.”
This directive aims at removing distortions connected to the application of source withholding taxes on interest and royalty payments and at treating this kind of payments made between associated companies of different member states or their permanent establishments as the ones made between residents of the same state. Consequently, the directive provides for the abolition of taxes on interest and royalty payments in the “source [s]tate” to ensure precisely that local and cross-border transactions are granted the same tax treatment.
The enactment of the directive will entail a more convenient management of intra-EU transaction that are typically completed by corporate groups (for instance, loans granted by the holding company to operating companies or licenses of software, patents, technology and know-how or even rights to exploit intellectual works).
Companies Affected by the Directive
Only companies may benefit from this rule, on the condition that the associated company, or the permanent establishment, is the beneficial owner of the of the payments and does not receive the monies as an intermediary, a agent, a delegate or a fiduciary agent of third parties. Pursuant to the directive, two companies are “associated” when one of the two companies has a direct minimum holding of 25 percent in the capital of the other, or if a third company has a direct minimum holding of 25 percent in both companies.
The exemption applies only to interest or royalty payments, as defined in article 2 of the directive. “Interest” means income from debt-claims of every kind, whether or not secured by mortgage carrying a right to participate in the debtor’s profits and, more specifically, income from securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment are not included in the definition of interest. “Royalties” means payments of any kind received as consideration for the use of, the right to use any copyright of literary, artistic or scientific work (including cinematographic films and software), any patent, trademark, design or model, plan, secret formula or process or for information concerning industrial, commercial or scientific experience. Royalties also include payments for the use of, or right to use, industrial, commercial or scientific equipment.
However, the source state may deny the benefits granted by the directive where payments carry the right for the beneficiary to participate in the debtors’ profits.
Conditions for the Directive’s Application
In enacting the directive, each source state may require that the condition of the holding percentage be maintained for at least two years uninterrupted, and the fulfillments of the requirements be proven by an attestation at the time of the interest and royalty payment. If the attestation is not submitted, it is entitled to deduct the tax at source, make the exemption conditional on the issue of a decision granting the exemption following an attestation certifying fulfillment of the requirements and request the legal justification of the payments made pursuant to contracts.