Italy: new circular outlines tax deductibility of blacklist costs

by Davide Anghileri

Italy’s tax authorities on September 26 issued Circular No. 39/E, clarifying new rules on the deductibility of costs associated with transactions between Italian resident individuals or entities and businesses operating in blacklisted tax haven countries (blacklist costs).

The circular details separate rules applicable to tax years beginning in 2015 and those applicable to tax years beginning in 2016 and thereafter, implementing amendments introduced by Legislative Decree Promoting Growth and Internationalization (No. 147 of 14 September 2015) and the Stability Law (No. 208 of 28 December 2015).

Beginning in 2015, the tax regime has changed from one which provided for a total non-deductibility of blacklist costs (rebuttable through an active business test) to one where costs incurred in blacklisted countries are typically deductible up to fair market value. Beginning in 2016, the rules related to the deducibility of costs in tax havens are abolished.

The circular also clarifies that, beginning in 2015, the identification of tax havens is based solely on whether a country has ineffective exchange of information, taking in account bilateral and multilateral agreements signed in this respect. Thus, after 2015, a jurisdiction’s tax rate is not taken into consideration.

2015 tax year

With effect from tax year 2015, taxpayers do not need to demonstrate the existence of an exemption to deduct blacklist costs originated in tax heavens.

Deductions are allowed up to the amount of the corresponding fair market value of the goods or services purchased (which the taxpayer must prove), provided that the transaction with which the expenditure in question is associated with has been executed. In addition, if the taxpayer proves that the operations carried out have an actual economic effect, deduction of the blacklist costs will be allowed in full.

The new approach to deductibility introduced by the legislature is based on quantitative criterion, namely, fair market value. In fact, if the cost incurred is less than or equal to the fair market value of the goods or services provided, the latter will be deductible for the full value. Conversely, if the cost incurred is greater, the deduction will be limited to fair market value.

Any surplus may be deducted from business income of the resident entity only if it is demonstrated that the transaction with which the expenditure is associated with has been put into place and has an actual economic effect.

The circular clarifies that taxpayers must prove the fair market value of blacklist costs, taking in account all the elements and circumstances of the particular case, and also establish that the amount deducted is equal to the fair market value of the purchased goods or services received from operators located in the tax haven.

In fact, the legislator did not accept the principle that the costs incurred are to be considered to be fair market value, unless proven otherwise.

OECD model treaty, CFC rules

The circular takes the position that this anti-tax-haven rule does not conflict with article 24, paragraph 4, of the OECD model tax treaty regarding tax treaty non-discrimination.

The tax authority notes that paragraph 75 of the commentary to article 24 states that “paragraph 4 does not prohibit additional information requirements with respect to payments made to non-residents since these requirements are intended to ensure similar levels of compliance and verification in the case of payments to residents and non-residents.” The risk of abuse in a transaction in a tax haven is higher than in a purely domestic transaction, the circular states.

Further, the circular refers to paragraph 9.5 of the commentary to article 1 of the OECD model, which provides that “the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions.”

The circular also clarifies that controlled foreign company (CFC) rules will apply before the regime on the deductibility of blacklist costs.

2016 tax years and beyond

The changes introduced by the Stability Law have led to a radical change in the regime of blacklist costs.

With effect from tax year 2016, the anti-tax-haven rules have been repealed.

In fact, the new regime provides for:

• The full deductibility of the blacklist costs (subject to compliance with the ordinary deductibility requirements provided for by law).

• The elimination of the obligation, previously required, to report separately blacklist costs on the tax return, and abolition of the related sanctions.

• The elimination of exhaustive government lists of states or territories with privileged tax regimes.

Because of the changes introduced by the Stability Law, after December 31, 2015, blacklist costs are fully deductible subject only to ordinary deductibility rules as similar costs incurred in respect of any supplier.

Transfer pricing

The circular explains also that the transfer pricing legislation will apply to costs incurred in respect of a foreign operator that is resident in a country considered blacklist-based in the previous legislation, and belonging to the same group of the person resident in Italy.

Under current rules, the transfer pricing laws are only applicable to controlled transactions between associated enterprises. No express definition of the term “associated enterprises” is given under Italian tax law, and reference is merely made to the concept of “control.” The concept of “control” has been characterized by the tax authorities as “all instances of potential or effective economic influence” (de facto control), without any specific threshold.

Finally, the circular states that the general principle of favor rei (which means that the tax authorities must apply the most favourable law to the accused) is not applicable to penalties for violations with reference to tax yeas prior to 2016, meaning that fines for unfaithful declaration and for the omitted separate declaration of the blacklist costs in the tax return will be applicable.