Italy draft guidance clarifies transfer pricing documentation requirements

By Giuliana Polacco, Annarita De Carne, Francesco Drago and Camilla Cominelli, Studio Legale Bird & Bird, Milan

On 20 September, the Italian revenue agency published a draft version of the long-awaited circular letter on transfer pricing, focused on the appropriate documentation necessary to verify the correct application of the arm’s length principle. The publication is coupled with the launch of a public consultation aimed at obtaining views and recommendations from the tax community, including business associations.

The approach of the revenue agency, i.e., asking the tax community to provide their comments in advance of official publication, is now frequently adopted (especially for significant topics). It is the clear sign of the willingness to build an open dialogue with taxpayers and the tax community to understand their positions and practical issues, thus preventing conflicts at a later stage.

The tax community is now called on to provide comments by October 12. As a result, it is expected that certain aspects that are still unclear or burdensome may be removed or simplified.

The scope of the draft circular letter is to provide clarifications and explanation on the new regulations on transfer pricing documentation which were issued on November 23, 2020 (Regulations n. 360494). The release comes close to the tax return filing deadline, which is November 30 for companies closing the fiscal year on December 31.

Compliance with transfer pricing documentation and procedural rules is key to avoiding penalty application. In fact, compliance with the regulations shall allow taxpayers to benefit from the non-application of penalties for the unfaithful filing of a tax return in the event of a tax audit focused on transfer pricing issues (so-called penalty protection), which may range from 90 to 180 percent of the tax adjustment.

Moreover, the presence of adequate transfer pricing documentation will protect taxpayers also in case of challenges deriving from the adjustments to royalties and interest expense exceeding the alleged normal value, when the Italian revenue agency does not recognize the reduced tax rates provided by the tax treaties against double taxation or the EU Royalty Interest Directive (Article 1, paragraph 6 and Article 2, paragraph 4-ter, of Legislative Decree no. 471 of 18 December 1997).

The draft circular letter reiterates the main purpose on which the transfer pricing documentation is grounded, i.e., the detailed explanation of the transfer pricing policy applied within the group, ensuring that the transactions are concluded at arm’s length, in line with the indications provided by paragraph 5.5. of the OECD guidelines. As a result, the transfer pricing documentation is seen as an instrument to establish a cooperative and transparent approach with the revenue agency.

Among the various improvements on the transfer pricing side, the regulations specified that the transfer pricing documentation is considered adequate when both the master file (i.e., the document focused on the multinational group in general, the value chain, intangible assets owned by the group, intra-group financial assets, etc.) and the local file (which, as in the past, is more focused on the Italian entity) are drafted. This requirement is mandatory irrespective of whether the Italian entity is a holding or sub-holding.

The draft circular letter specifies that the format of the master file and local file shall have to be followed and may not be modified. In case of doubts with respect to the interpretation of the content of the relevant documents, reference may be made to the OECD guidelines.

With respect to the master file, the draft circular letter clarifies that the document drafted at the global level could be modified for Italian purposes, if the information included is not complete or does not cover all the topics expected by the Italian revenue agency.

In the case of different business lines inside the group, it can be acceptable to have more than one master file inside the group. This may happen for example in the case of multinational groups with a decentralized organizational, legal or operational structure, i.e., made up of divisions with lines of business that operate largely independently. The draft circular letter clarifies that in this case, it would be possible for the Italian subsidiary to submit the master file relating to the specific division in which it operates.

However, the draft circular letter raises concerns with respect to the description of the information to be included in the master file, since a very comprehensive and detailed description shall have to be made. This includes all the structures of the group, the location of all the companies (including all the branches), the flow of the transactions, the consolidated financial statements, and all the advance pricing arrangements (APAs) signed by the groups with revenue agencies at the global level (even if not involving the Italian entity).

As to the local file, a new development of the regulations is that the taxpayer may decide not to include all the intragroup transactions to which it is part. The relief from penalty shall be granted only with regard to those transactions duly analyzed and tested in the transfer pricing documents.

The draft circular letter clarified when a transaction is material for purposes of the local file, stating that a transaction should be considered as such if it amounts to more than 5% of the income or cost component disclosed in the “transfer pricing” worksheet in the tax return. The taxpayer may decide to exclude from transfer pricing analysis transactions that are not considered material.

A cause for concern is that the circular letter requires the company to include in the local file the organizational structure, including the reporting lines of employees both from a functional and hierarchical perspective, which could be quite burdensome for groups with a significant international structure and number of employees in Italy.

Finally, with respect to APAs, it is important to include in the local file a copy of any unilateral or bilateral APAs to which the Italian company may not be a part but is connected to the business carried out by the Italian entity. However, in the case of the presence of a confidentiality clause, it would be possible to draft a chart with the main information on the APA. 

 The draft circular letter provides indications also with respect to the transfer pricing documentation to be prepared by permanent establishments, i.e., both Italian permanent establishment of foreign entities or foreign permanent establishments of an Italian entity (and in this latter case also if the option for the branch exemption is exercised). 

Small and medium enterprises (i.e., those with a turnover lower than EUR 50 million) have always been subject to a simplified approach, since the benchmark analysis could be updated on a three-year basis. The draft circular letter provides some indications as to the methodology to be used to calculate the thresholds, specifying that the EUR 50 million threshold applies to the higher of the turnover or the revenues generated in a certain year. From 2020, however, based on the regulations, medium and small enterprises could not be qualified as such if they control or are controlled by a company exceeding the threshold.

With regard to the low-value added services, the regulations provided precise indications on the set of documents that the taxpayer shall have to prepare if the simplified approach is adopted (i.e., application of 5% mark-up, without performing a specific benchmark analysis).

The draft circular letter clarified that if the taxpayer is rendering or receiving only low value-added services, the description of such services should be included in the same local file and described in line with the indications in the regulations. This includes a description of the services, explanation of the reasons for their inclusion in the category of low value-added services, the beneficiaries, the criteria for their pricing, the benefits expected or obtained, the allocation keys used to re-charge the aggregate costs, together with the relative underlying reasons for their selection. Moreover, the draft circular letter clarified that the master file and local file shall have to be set even though the low-value-added service represents the sole intercompany transactions carried out by the entity.  

The revenue agency has made a significant effort to clarify the timing and procedural aspects of the formalities to be complied with to obtain penalty protection, taking into account all the problems raised in the past, which the regulations were not able to clarify.

The draft circular letter confirms that the master file or the attachments could be written in English or in Italian. Any other language requires a translation into English or Italian, which needs to be provided together with the original document. They have to be signed by the legal representative of the taxpayer or by a delegated person through electronic signature and time stamp within the deadline for the filing of the corporate income tax return. This new obligation has been introduced to ensure that transfer pricing requirements are met before the filing of the tax return, to ensure that transfer pricing documentation is contemporaneous.

In the event of a tax audit, the transfer pricing documentation shall have to be provided to the tax authorities within twenty days. Additional information requested by the tax authorities during audits could be provided by the taxpayer within seven days or a longer term agreed with the taxpayer.

The availability of the transfer pricing documentation has to be communicated to the revenue agency by flagging the specific box in the tax return. While this formality existed also in the past, the circular letter provides that if no communication is done at the time of the filing of the tax return, the taxpayer may cure the mistake by filing for the first time or an amended tax return within 90 days from the initial deadline (November 30 for taxpayers having fiscal years coinciding with the calendar year). The master file and the local file shall have to be signed with electronic signature and time stamp within the date of the filing of the belated tax return.

Moreover, the revenue agency confirmed also the possibility of taxpayers to cure the omitted communication in the tax return within the deadline to file the tax return related to the following fiscal year (so called, “remissione in bonis”), by paying related penalties ranging from EUR 250 to EUR 2,000 and to the extent that no audit activities have been already started.

Such clarifications are very important and represent a long-awaited development, considering that, in the past, tax inspectors have generally adopted a very rigid and formalistic approach as to the application of penalties when no communication was timely performed in the tax return. Indeed, in the absence of advanced communication in the tax return, even when the transfer pricing document was voluntarily provided in the course of a tax investigation, the relief from penalty was rarely granted.

Clarifications in the draft circular letter were provided also with respect to the possibility to amend or integrate the transfer pricing documentation if a lower taxable basis or taxes are detected by the taxpayer at a later stage with respect to the filing of the tax return. In this regard, when amendments of the taxable basis or the tax are brought in the tax return through an integrative tax return, the taxpayer would be generally entitled to amend accordingly the transfer pricing documents.

Finally, another important clarification of the draft circular letter relates to the confidentiality of the information. Indeed, the revenue agency confirms that the information included in the transfer pricing documentation, i.e., manufacturing processes, patents, formula or industrial secrets will not be communicated, but used only for the scope of the tax audits.

To conclude, although there are still open points to be clarified and significant efforts are requested by taxpayers for the draft of the transfer pricing documentation within strict deadlines, the revenue agency has certainly made a significant effort to meet taxpayers’ requests and seems to adopt a positive and cooperative approach to prevent strong confrontation with taxpayers.

The comments that the tax community will provide on the draft circular letter would certainly improve the quality of the final document and eliminate grey areas still present.

• Giuliana Polacco is Senior Counsel, Studio Legale Bird & Bird, Milan.

• Annarita De Carne is Senior Associate, Studio Legale Bird & Bird, Milan.  

• Francesco Drago is Senior Associate, Studio Legale Bird & Bird, Milan.  

• Camilla Cominelli is Senior Associate, Studio Legale Bird & Bird, Milan.