Stefano Bognandi and Flavia Vespasiani of LED Taxand analyse the implementation of the DAC6 Directive in Italy focusing on the hallmarks addressing transfer pricing.
To further strengthen the means available to tax authorities of EU member states to prevent and discourage aggressive tax planning, EU Directive 2018/822 (directive) introduced a new mandatory disclosure obligation for ‘intermediaries’ and taxpayers in relation to cross-border arrangements that may cause a potential risk of tax avoidance.
Implementation status in Italy
The directive has been implemented in Italy through Legislative Decree No. 100 of July 30 2020 (decree), which establishes the rules and procedures relevant for the reporting to the Italian Tax Authorities (ITA) of relevant cross-border arrangements that meet certain ‘hallmarks.’
The decree was integrated with the publication of the Decree of the Ministry of Economy and Finance of November 20 2020 (ministerial decree) and Ruling No. 364425 of November 26 2020 (ruling), containing guidelines on the procedures for the communication of reportable cross-border arrangements (RCBA).
The domestic regulatory framework was completed by Circular Letter No. 2/E of February 10 2021 (circular), through which the ITA provided detailed guidance related to the implementation of the directive in Italy.
Hallmarks directly addressing TP
Hallmarks concerning transfer pricing (TP) are ‘hallmarks’ whose mere existence entails the obligation to report the arrangements to the ITA, regardless of the circumstances that, based on the TP analysis performed by the taxpayer, the price applicable to the arrangement is in line with the arm’s-length principle.
A cross-border arrangement qualifies as reportable if it meets one of the following ‘hallmarks’ listed under category E of Annex 1 of the decree:
- Use of unilateral safe harbour rules; or
- Transfer of hard-to-value intangibles (HTVI); or
- Intragroup transfer of functions and/or risks and/or assets.
These arrangements will trigger reporting duties only to the extent that they:
- Occur among ‘associated entities’; and
- Are related to scheme, agreement or project concerning Italy and one or more foreign jurisdictions; and
- Entail a reduction of taxes due by the taxpayer in an EU member state or in a third state that entered into a mandatory disclosure agreement with Italy (regarding this, the ITA clarifies that no agreements for the exchange of information regarding cross-border mechanisms have been currently signed).
According to the ITA, a tax saving is determined with reference to the difference between the taxes due based on one or more cross-border arrangements and the taxes which would be due in the absence of such arrangement/s.
The circular further clarifies that a tax saving can be derived from a cross-border arrangement which, compared to a transaction in which that cross-border arrangement is not employed, allows the taxpayer to:
- Obtain reduction of the taxable base;
- Obtain (or increase the amount of) a foreign tax credit or similar relief from international double taxation;
- Obtain (or increase the amount of) a tax refund;
- Defer the payment – or accelerate the refund – of a tax; and
- Eliminate or reduce a withholding tax.
Finally, in line with the directive, the ITA clarifies that hallmarks listed under category E must be disclosed regardless of the assessment of whether a tax advantage is the main benefit expected from the arrangement, i.e. the so-called ‘main benefit test’ (MBT).
Definition of ‘associated entities’
It must be noted that the definition of ‘associated entities’ in the decree is wider than the one provided under the TP domestic regulations.
Within the meaning of the decree, in addition to the concept of dominant influence, the term ‘associated enterprise’ concerns all cases where the participation in the capital, voting rights or profits of another enterprise is more than 25% (even in the absence of a dominant influence). This definition differs from the one provided under domestic legislation which is 50%.
In this respect, the ITA clarifies that considering the explicit reference to TP, a cross-border arrangement is reportable under category E provided that the transaction occurs between ‘associated entities’ as defined under domestic TP legislation.
The ITA further clarifies that the only exception is related to the hallmark concerning the transfer of hard-to-value intangibles (HTVI) for which the definition provided in the decree is relevant for the purpose of reporting obligations.
This means that, only with respect to hallmark E.2, mapping transactions through the analysis of the TP documentation brings the risk of not identifying all arrangements potentially subject to reporting obligations (e.g. cases in which there is a participation in the capital, voting rights or profits of another enterprise between 25% and 50%, and where there is no dominant influence over the management of another enterprise, based on equity or contractual constraints).
Arrangements using ‘unilateral’ safe harbour rules
In a TP regime, safe harbour is a provision that applies to a defined category of transactions and that preliminarily establishes certain rules and minimum parameters, complying to which enterprises are exempt from providing further evidence under the TP regulation or practice.
The aim of safe harbour is to reduce the administrative burden that the analysis of transactions normally requires with reference to specific inter-company transactions.
It is recognised that when safe harbours are enacted when only one state is involved in the transaction, they can be subject to misuses from both tax authorities and taxpayers, generating cases of tax avoidance.
The view is also confirmed by the Commission Services within Working Party IV – Direct Taxation – September 24 2018, where safe harbours should be regarded as ‘unilateral’ only where they depart from the international consensus expressed in the OECD TP Guidelines.
Based on the explanation in the circular, in addition to any unilateral agreement between foreign tax authorities and taxpayers, the ITA considered as ‘unilateral’ safe harbours and, therefore, subject to reporting obligations, any established practice (regardless of whether it is formalised through a regulatory act) used by a foreign tax administration to assess the arm’s-length price of an arrangement without performing a TP analysis and the accurate delineation of a transaction (i.e. cases where safe harbour rules do not comply with the OECD recommendations).
In this respect, it should be noted that, in Italy there are no safe harbour rules. The only simplification measures concern the implementation by the ITA of the OECD recommendations on low value-added intragroup services and the simplified approach provided for small and medium-sized enterprises (SMEs) – opting for TP documentation – with reference to the information provided in the country specific documentation.
From an Italian perspective, safe harbour on intra-group low-value-adding services should be excluded from the scope of application of the decree since it is a simplified approach shared at international level. In the same way, the domestic simplified approach for SMEs, as it is a simplification measure that does not directly involve the determination of arm’s-length prices.
Likewise, although not expressively excluded by the ITA, it is believed that a unilateral APA should not trigger reporting obligations provided that the determination of the TP for the transaction(s) object of the agreement is based on the arm’s-length principle.
Arrangements involving the transfer of HTVI
The domestic definition of HTVI perfectly mirrors the definition provided in the OECD TP Guidelines. In particular, the decree provides that this hallmark is applicable to cases of intra-group transfer of intangibles or rights in intangibles for which no reliable comparable exists and, at the time the transactions was entered into, the projections of future cash flows from the intangible, or the assumptions used in valuing the intangible are highly uncertain.
As such, many transfers of IP performed during the current pandemic could eventually qualify as HTVI for reporting purposes, because – in a vast number of cases – tax administrations may have grounds to argue that the assumptions used in valuing the IP are ‘highly uncertain.’
However, it is also true that, when dealing with HTVI, the OECD intends to address specific issues arising from information asymmetries between taxpayers and tax administrations when HTVI are involved.
The OECD provides tax administrations with the possibility to use ex-post results as a pointer about the arm’s-length nature of ex-ante pricing arrangements. However, these special situations do not apply to any HTVI; they are restricted to circumstances when, for example, the IP is only partially developed at the time of the transfer or the consideration for the HTVI is a lump sum payment.
In conclusion, the decision to report cross-border arrangements involving their transfer or use may not be straightforward. Regardless of reporting obligations, it is important, in transactions involving the transfer or the use of HTVI, to prepare a robust set of supporting documentation allowing to provide evidence of the information available at the time the transaction is performed and the key assumptions for the valuation.
One point worth mentioning is that, in line with the circular, the hallmark on transfers of HTVI also covers the transfer between a head office and a permanent establishment (PE).
Finally, if the HTVI is transferred as part of a more complex transaction (e.g. transfer of a business as a going concern), it is considered that this mechanism must be communicated based on the hallmark E.3.
Arrangement concerning business restructuring
The reporting obligation applies to business restructuring that has a significant impact on the transferor’s income statement. In particular, this hallmark cover arrangement involving an intra-group cross-border transfer of functions and/or risks and/or assets, if the projected annual earnings before interest and taxes (EBIT) of the transferor(s), during the three-year period after the transfer, is less than 50% of the projected annual EBIT if the transfer had not been made.
For the purposes of the definition of ‘business restructuring operation’ the circular makes explicit reference to Chapter 9 of the OECD TP Guidelines which provide the following examples:
- Conversion of full-fledged distributors into limited-risk distributors, marketers, sales agents, or commissioners for a foreign associated enterprise that may operate as a principal;
- Conversion of full-fledged manufacturers into contract manufacturers or toll manufacturers for a foreign associated enterprise that may operate as a principal;
- Transfer of intangible rights to central entity (i.e. IP company) within the group; and
- Centralisation of function related to procurement, sale support, logistic, etc.
For the arrangement to be reported, it must also be verified whether the EBIT and the tax saving requirements are met. No requirement regarding the state where the transferee is established, i.e. the hallmark applies even if it is a high-tax state.
To calculate the potential tax saving, the ITA clarifies that, it is necessary to take into consideration any compensation due related to the transfer, which shall be determined in compliance with the arm’s-length principle.
Regarding the determination of EBIT, the circular clarifies that it must be computed based on the financial projections of each of the companies involved in the transfer and that the EBIT shall be construed based on local GAAP and according to the profile of the entities involved (e.g. industrial and insurance companies, financial institutions, etc.).
The ITA further clarifies that the hallmark will balways be applicable when the transferor’s average EBIT, during the three-year period after the transfer, is negative, compared to a positive average EBIT in the absence of transfer.
Finally, the circular stated that the hallmark also covers business restructurings between the head office and its Italian PE, and vice versa.
Hallmarks indirectly addressing TP
Although the direct purpose of the following hallmarks is not to address TP, enterprise should pay attention when dealing with hallmark listed under category C.1 of Annex 1 of the decree which involves a mechanism based on deductible cross-border payments between associated enterprises, provided that one of the following conditions is met:
- a) The beneficiary is not resident for tax purpose in any jurisdiction;
b) The beneficiary is a tax resident:
1) in a jurisdiction which does not impose any CIT or imposes CIT at the rate of zero or almost zero;
2) in a non-cooperative jurisdiction;
- c) The payment is fully exempt;
d) The payment benefits from a preferential tax regime.
With specific reference to hallmarks listed under category C.1, letter b) sub-1, c) and d), further to the cross-border nature of the arrangement and the potential tax saving criteria, such arrangement must be disclosed, provided that the MBT is met (i.e. whenever the economic value of a tax benefit represents more than 50% of the total tax and non-tax economic benefits of the transaction).
There may be cases in which the arrangement also integrates at the same time a hallmark for which the MBT is not required. In such circumstances the ITA clarifies that the hallmark for which the MTB is not required shall prevail. Therefore, the arrangement will be subject to mandatory disclosure obligation regardless of whether the MBT criterion is met.
The directive introduced new burdensome compliance activities for intermediaries and taxpayers which are now required to identify intra-group arrangements at which the ITA may wish to have a closer look.
In this respect, it is important to highlight that the reporting obligation does not constitute a pre-assessment on the existence of tax avoidance behaviour that could legitimate a tax challenge made by the ITA.
However, should the RCBA be subject to a tax audit, it is important to keep documentation to provide evidence of the analysis and the valuations performed to provide the ITA with evidence of the legitimacy of the RCBA.
Click here to read the 2021 TP Special Focus Guide: www.internationaltaxreview.com