By Giuliana Polacco and Annarita De Carne, Studio Legale Bird & Bird, Milan
On December 27, the Italian Revenue Agency issued two documents focused on the controlled foreign companies (CFC) legislation provided by article 167 of the Consolidated Income Tax Law. The current version of the CFC legislation has been amended by article 4 of Legislative Decree n. 142/2018, i.e., the so-called ATAD Decree, which was implemented in Italy ATAD Directive n. 2016/1164.
The first document is the “Provision of the Director of the Revenue Agency,” which sets out new rules establishing a simplified way to determine the effective level of taxation to be compared with the Italian “virtual” level of taxation under the CFC legislation, i.e., the methodology to verify whether the effective tax rate applicable to foreign profits is less than 50% of what the level of taxation would have been in Italy.
The second document is the long-awaited circular letter n. 18/E, which is an extensive and complex document, numbering more than 150 pages. Among the main topics, the circular letter provides clarifications on the subjective and objective requirements to apply the CFC regime, the procedure to compare the level of actual foreign taxation with the Italian “virtual” taxation, the exemption for non-application of the legislation, the taxation of the controlling entity, and the CFC regime in cases of extraordinary transactions.
The Revenue Agency published the circular letter following a public consultation launched with the business and tax community and after having collected a significant number of comments. This is the approach the Revenue Agency had already adopted in other circumstances, like for the digital service tax and transfer pricing regulations, showing the willingness of the agency to interact with tax experts and taxpayers before issuing official documents on significant topics.
CFC legislation
CFC rules are currently provided by article 167 of the Consolidated Income Tax Law, which has been modified over the years and in its current version simplified the prior regime along the lines of the ATAD Decree.
Under the CFC legislation, foreign profits of companies resident in Italy may become subject to tax in Italy through a transparency mechanism when such profits are generated by CFCs that meet two conditions. First, the CFC is located in a country where the effective tax rate is less than 50% of the virtual taxation that would have applied in Italy. Second, at least one-third of the CFC’s total revenues consists of certain categories of income (passive income), without carrying out an effective economic activity.
The consequence of the CFC legislation is, therefore, to tax at the level of the Italian parent company, in proportion to the respective share of profits, all the proceeds accrued by the controlled entity, regardless of the actual receipt of the same in the form of dividends. The main novelty brought by the ATAD Decree to the CFC legislation is that of having introduced conditions to verify whether a company would be subject to the anti-abuse mechanism applicable to all controlled entities, irrespective of their location, while in the past a differentiation was made between controlled companies located in “black list” countries and those located in “white list” countries, i.e., the so-called dual system.
Moreover, there were additional relevant changes to the previous legislation. Among these, the CFC legislation has been extended to permanent establishments in Italy of non-resident subjects with respect to the foreign entities controlled through the permanent establishment, as well as to the permanent establishments abroad of Italian resident subjects which opted for the branch exemption regime.
In addition, the notion of control, direct and indirect, is applied also when participation in the profits is higher than 50%, and the threshold for the quantification of the passive income to be included in the CFC legislation has been reduced from 50% to one third.
Furthermore, the list of passive income has been extended to include also financial and insurance activities, as well as proceeds from trading goods with and supplying services to associated enterprises, adding no or little economic value (specific reference is also made to a decree issued by the Minister of Economics and Finance in 2018 on low-value-added services).
The changes also add exemption rules, i.e., the foreign entity shall not be considered a controlled foreign entity to the extent that it carries on a substantive economic activity supported by staff, equipment, assets, and premises.
However, while awaiting a new CFC Decree, the one issued in 2001 is still applicable, as also confirmed by the circular letter.
Circular Letter n. 18/E of December 27, 2021
The circular letter attempts to resolve all doubts and requests for clarifications that were brought to the Revenue Agency’s attention, as well as to coordinate official interpretations of the law provided in the past by the Revenue Agency with the new wording of the CFC legislation, explicitly mentioning those that are out of date.
The circular letter, after providing explanations regarding the purpose and regulatory context of the legislation, focuses on the requirements for its application, making a distinction between subjective and objective requirements. Specific instructions have been provided for “Undertakings for the Collective Investment in Transferable Securities,” i.e., UCITS, which also fall within the special CFC rules. A specific chapter also addresses extraordinary transactions.
The notion of control exercised by the Italian resident entity (including individuals and partnerships) with respect to the foreign-controlled company is reviewed in detail.
Ample space is dedicated to one of the most relevant topics, which is the identification of the level of taxation of the foreign-controlled entity and the calculation of the virtual tax applied in Italy, spending a lot of attention on the presence of a permanent establishment located either in Italy or abroad.
A key point which has been an object of debate within the tax community is that of the exemption condition, which has been subject to significant amendments, as well as concerns with respect to holding and financial companies, which ordinarily have a limited management structure and might not be considered in line with the current requirement of substantive economic activity.
All the procedural aspects related to the filing of the tax return and related communication, as well as the possibility to obtain the exemption from the CFC legislation, are deeply analyzed.
Some of the most relevant clarifications are summarized below.
How the CFC legislation applies
The circular letter clarifies that if the conditions to conclude that a company falls within the CFC legislation are met, i.e., the level of taxation and the percentage of passive income, then all the profits generated by the foreign entity are to be taxed in the hands of the Italian resident controlling entity. This is the outcome of the approach adopted by the Italian Revenue Agency, which decided to apportion to the Italian controlling entity not only the profits deriving from passive income but the entire amount of the same generated by the controlled entity.
Method for determining the effective level of taxation
The CFC legislation has tried to simplify the approach for calculating the effective level of taxation of the foreign-controlled entity (including the permanent establishment).
For this reason, the circular letter has not only provided clarification on the topic but a specific Provision of the Director of the Revenue Agency has been issued, replacing the prior one dated September 16, 2016, no. 143239. It has been emphasized that the behaviors adopted by taxpayers before the issuance of the new provision that are not in line with the new rules will not be subject to penalties.
For this purpose, relevance shall have to be given only to taxes paid definitively which are not refundable, even by virtue of the application of any relevant convention against double taxation in force between the state of location of the controlled foreign entity and the state of the source. Moreover, non-permanent adjustments of the taxable base are irrelevant.
For the purpose of calculating the effective taxation rate, it would be necessary to identify all taxes paid by the controlled foreign entities. This includes income taxes actually due in the country of location, net of tax credits for income generated in countries different from those produced in the country of location. It also includes taxes due on the income of the same foreign entity in other jurisdictions (for example, withholding taxes levied in the states of the source of the income other than the state of location) and the taxes due from the foreign entity in relation to the income attributable to the activity carried out through a permanent establishment under the tax credit regime located in another jurisdiction (including, in both cases, Italy among the other jurisdictions).
Effective tax rate tests will be made on a separate basis in the case of CFC cascade effects (i.e., when an Italian entity controls a CFC which in turn controls another CFC).
Moreover, both the circular letter and the Provision of the Director of the Revenue Agency confirmed that temporary upwards or downwards adjustments shall have to be excluded in the computation of the foreign effective tax rate, in case the final reversal is certain and already determined. The same exclusion applies for the substitute taxes paid in one year to step up the fiscal values of certain items (becoming relevant only when fiscal and accounting values are aligned).
Virtual domestic taxation
The virtual taxation of the Italian controlling entity is calculated taking into account only the corporate income tax (IRES), with the consequence that the local income tax or other taxes shall not have to be computed (differently from the past). Moreover, taxes have to be taken in the gross amount, i.e., without considering any tax credits which would have to be granted in the case of residence in Italy.
The calculation must be carried out starting with the data from the financial statements or the accounts of the controlled company, drafted according to the rules of the country in which it is located.
More precisely, if the financial statements and accounts are drafted in compliance with the international accounting standards, the resident controlling company is required to calculate the income of the subsidiary in accordance with the provisions specifically provided for parties adopting these international accounting standards. The computation of the income to be attributed to the Italian controlling company shall have to exclude the notional interest deduction, as recently clarified. Accordingly, the notional interest deduction will not be relevant in performing the effective tax rate test.
Moreover, in line with the clarifications provided for the computation of the effective level of foreign taxation, temporary upwards and downwards adjustment shall have to be duly considered.
The exemption conditions
The CFC legislation may not apply if the controlled entity is able to give evidence to the Italian tax authority that the controlled entity (or permanent establishment) carries out an effective economic activity in its state of residence (or establishment), through the use of personnel, equipment, assets, and premises. The provision is consistent with the ATAD directive, which meant to avoid any breach of the principle of free establishment. Indeed, the prior version of the legislation requested different types of proof depending on whether the controlled entity (or establishment) was located in a black list or white list country.
As a result, the possibility to obtain the exemption from the application of the controlled foreign legislation is now broader, since it may apply also to companies that earn mainly passive income (such as holding companies). Moreover, the notion of “activity” to be exercised is no longer limited to industrial and commercial activities as before. Finally, the condition that the company would have to carry out an activity in the country of residence has been removed.
The more difficult part has been acknowledged to be collecting the information and documentation giving evidence that the controlled entity exercises an effective economic activity. The circular letter tries to give indications to taxpayers, making a distinction between commercial companies and companies qualified as “not properly commercial” (i.e., holding companies or companies that manage fixed assets) and listing recommendations on information and documentation to be provided in annexes 4 and 5.
Procedural aspects
As to the procedural aspects, the Italian resident company may decide to demonstrate the existence of the exemption in advance by filing a ruling request to the extent that the two conditions, i.e., the percentage of passive income and the effective tax rate, are met unless the company is admitted to a cooperative compliance program. In this case, although the ruling is preventive, the relevant request must be presented only after the mentioned conditions have been verified and, therefore, before the presentation of the Italian tax return with the specific SC Form. It should be remembered that this is a possibility, not an obligation.
In all other cases, the documentation will have to be prepared in advance and provided to the tax auditors (in case of audit), bearing in mind that the burden of proof always remains on the taxpayer. The proof would be, however, particularly difficult with respect to non-commercial entities, where the presence of an effective economic activity through personnel, equipment, assets, and premises would not be so straightforward.
In any event, in the case of a tax audit, the Revenue Agency is obliged to notify the taxpayer through an advance notice, asking to be provided with, within 90 days, evidence for the non-application of the CFC legislation.
Conclusion
The set of CFC rules is complex. Despite the clarifications provided and the attempt of the Revenue Agency to simplify and illustrate the rules through several examples, it is expected that taxpayers will bring several questions and issues to the attention of the Central Directorate through ruling requests.
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