Italy tax agency issues circular on transfer pricing documentation rules

By Luca Tortorella and Michele Targa, Gatti Pavesi Bianchi Ludovici, Milan

On 26 November, the Italian revenue agency finally issued the Circular (Circular No. 15/E) aimed at providing clarifications and increasing the level of certainty on the interpretation of new instructions relating to amended transfer pricing documentation requirements issued last year.

Under regulations issued 23 November 2020, the Italian transfer pricing documentation requirements for penalty protection purposes changed significantly, increasing the administrative burden for Italian taxpayers. The revenue agency last year also issued operational instructions regarding the new appropriate set of documentation that Italian multinationals and Italian permanent establishments of foreign entities are allowed to prepare to demonstrate the correct application of the arm’s length principle.

The new Circular clarifying the instructions follows the draft version published on 20 September for a public consultation procedure, which lasted until 12 October and was aimed at obtaining views and suggestions from the tax business community (corporations, professionals, business associations, etc.).

The final version of the Circular, issued a few days before the 30 November deadline for declaring the possession of the transfer pricing documentation, confirmed most of the aspects already included in the draft, with recommendations of business operators only partially transposed in the final version.

Penalty protection

Before entering into details of the Circular’s clarifications with respect to the contents of the local file and the master file, it is worth mentioning some formalistic aspects that the Circular specified must be applied by Italian taxpayers for relief from administrative penalties.

In general, the Circular confirmed what was included in the operational instructions. That is, the transfer pricing documentation is considered compliant when both the master file and the local file are properly drafted – irrespective of whether the Italian entity is a holding entity (e.g., parent company) or a controlled one – and their possession is timely declared.

In case of a tax assessment, penalty protection applies if certain conditions are met. The transfer pricing documentation must include all the information allowing the tax inspectors to perform an independent transfer pricing analysis (with specific reference to the accurate delineation of transactions and the comparability analysis). The local file, master file, and related attachments must be digitally signed by the legal representative with a digital time stamp affixed before the filing of the yearly tax return. If the master file has already been signed by the legal representative of the entity that prepared it (e.g., the parent company), this must be signed in any case also by the legal representative of the Italian entity. Finally, the possession of the documentation must be communicated by ticking a dedicated box in the yearly tax return.

The Circular flagged that a late digital signature and/or digital time stamp implies the loss of the penalty protection. However, taxpayers are allowed to communicate the possession of the proper transfer pricing documentation at a later stage, but no later than 90 days from the original deadline to file the tax return.

The Circular clarified a controversial aspect regarding late preparation of the transfer pricing documentation, unfortunately denying the possibility for Italian entities to prepare the reports after the 90-day extended term but within the term for filing the succeeding annual tax return and before the start of any tax audit (so-called remissione in bonis). This interpretation, apparently unsupported by any particular reason, prevents taxpayers who have not been able to prepare the transfer pricing documentation within the deadline from benefiting from the penalty protection, even if in a spirit of cooperation and good faith they intend to prepare the documentation later in the year and in any case before tax audits.

The Circular specified that the remissione in bonis applies only when the transfer pricing documentation has actually been timely prepared and digitally signed with the time stamp, but the taxpayer has only failed to flag its possession in the related tax return, thus significantly limiting the practical implementation of such remedy.

Regarding the suitability of the transfer pricing documentation for penalty protection, the Circular expressly mentioned that penalty protection must be tested against every single transaction and not “as a whole.” This is an important innovation compared to the previous regime, where penalty protection applied to the entire documentation.

With the new interpretation given by the revenue agency, in the case of a tax assessment and if the tax office deems that a transaction has not been properly described, penalties might apply to that transaction only, while other documented transactions, even if not considered aligned with the arm’s length principle, might still be protected against administrative penalties.

Master file

With reference to the contents of the master file and local file, the Circular mainly reflected what was already reported in the draft version and specified some minor additional information that, even if not indicated in the operational instructions, needs to be included.

For the master file, the Circular confirmed that Italian entities can rely on the master file prepared by the direct or indirect controlling entity if such document contains the minimum level of information requested by the Italian discipline (which is mostly aligned with annex I to chapter V of the OECD guidelines). The Italian entity will be allowed to prepare an appendix to the master file to integrate, where needed, the information not covered by the report prepared centrally. In this sense, it is worth mentioning that in the financial activity section, Italian taxpayers are requested to provide additional details regarding the financial arrangements the group has in place with third parties, such as type of agreement, lender, beneficiary, date of stipulation, duration, amount, currency, conditions, interest rate applied, as well as any guarantees given.

The Circular addressed also the case when the end of the fiscal year of the controlling entity which prepares the master file differs from the fiscal year of the Italian entity. In such a case, the Italian entity can present the master file referring to the fiscal year whose closing date precedes the one for which the Italian entity is preparing the transfer pricing documentation.

Local file

As far as the local file content is concerned, the Circular makes several clarifications.

Regarding organizational structure, the Circular clarifies that the number of human resources assigned to each company function, as well as the description of the role of individuals in charge of local management functions and their reports (in Italy and abroad), must be included.

With respect to royalties and interest expenses, in a change from the draft version, the final Circular incorporated suggestions received during the public consultation and provides that amounts must be reported according to the accrual principle. Amount of payments under the cash principle must be provided only in the case of a specific request by the tax authorities during an audit.

The Circular also provides clarifications on the reconciliation of financial data, confirming that financial indicators of the tested party used in applying the transfer pricing method can be reconciled with the official financial statements on an aggregate basis.

In addition, relating to internal dealings for permanent establishments, in a change from the draft version, the final Circular confirmed that the transfer pricing documentation applies only to Italian permanent establishments of foreign entities that opted for the branch exemption regime, thus excluding – only a few days before the deadline – a large number of permanent establishments that relied on the draft version of the Circular and prepared (and in some cases declared the possession of) the transfer pricing documentation.

Finally, a specific mention is needed regarding marginal transactions. The Circular underlined that intercompany transactions which do not exceed the threshold of 5% of the total value of intercompany transactions (i.e., considering the sum of intercompany costs and revenues) can be considered as marginal and can be not fully documented. However, if such transactions are not analyzed, penalty protection would not apply in the event of a tax adjustment. The approach does not appear aligned with what is provided by the OECD guidelines, which in chapter 5 affirm “Tax administrations have an interest in seeing the most important information while at the same time they also have an interest in seeing that MNEs are not so overwhelmed with compliance demands that they fail to consider and document the most important items”. However, in this sense, a prudent approach seems to be listing also marginal transactions in the local file, specifying for such transactions the amount, their nature, and the counterparties (including if such transactions occur also with third parties).

• Luca Tortorella is a senior associate at Gatti Pavesi Bianchi Ludovici, Milan.

• Michele Targa is a senior associate at Gatti Pavesi Bianchi Ludovici, Milan.