Italy’s Supreme Court rules on VAT treatment of intercompany management fees

By Gian Luca Nieddu, Partner, Transfer Pricing & Tax Value Chain, Hager & Partners, Milan area

In a recent decision, Italy’s Supreme Court (Corte di Cassazione) addressed the VAT deductibility of intercompany charges accomplished by the reverse charge mechanism.

In brief, the Italian Supreme Court, in n. 3599 of 13 February, confirmed decisions issued by first and second degree tax courts, finding that the VAT paid in reverse charge is deductible only if the purchases and imports are made in the exercise of a business, an art, or a profession; in other words, only if they are relevant (i.e., inherent) to the activity carried out by the taxpayer.

Therefore, the cost must not only be accounted for, but its relevancy and economic connection to the business must be demonstrated.

In the specific case of the provision of intragroup services, for the amount paid to be deductible for direct tax purposes and for the VAT paid to be correspondingly deductible, the company must derive a benefit from the service in question and the utility must be objectively determinable and adequately documented.

The decision concerns an Italian subsidiary, which, in 2004, was charged for intercompany services rendered by related entities resident in the European Union.

On audit, the Italian tax office determined that the intercompany service charges (management fees) were not deductible for direct tax purposes and the related VAT (accomplished in reverse charge) was also deemed not deductible.

Both Italian tax office challenges were based on the deemed lack of a relationship (i.e., so called inherence) between the costs and the activities conducted by the Italian subsidiary.

On the direct tax side, the Supreme Court decision reveals that the deductibility of the management fees was challenged, not based on the arm’s length principle, but rather because there was a lack of connection with company operations.

This approach – quite usual from the Italian tax authorities when intercompany service charges are audited – has two relevant impacts: first, the taxpayer can not benefit from the penalty protection provided by appropriately prepared transfer pricing documentation following specific law provisions.

Additionally, focusing on the lack of connection instead of the arm’s length principle prevents the taxpayer from taking advantage of international procedures to solve double taxation issues, like the double tax treaty mutual agreement procedure (MAP) and the EU Arbitration Convention.

From the VAT perspective, which is the focus of the decision under review, the Supreme Court first states that the transfer pricing regulation is not applicable for VAT purposes.

Reference must be made to EU principles (Art. 73 of the Directive 112/2006/EEC) that stated that the consideration received is a key element when applying VAT, based on the principle of neutrality. This principle is violated if the tax base is calculated so that it is higher than the consideration received.

However, the Supreme Court – blessing the rationale adopted by the regional tax court – confirms that the taxpayer’s appeal has to be rejected essentially on the assumption that the latter had not demonstrated the relevancy of the costs, to which the deducted VAT was referred.

In fact, recalling some of its previous decisions, the Supreme Court underlines that, according to VAT principles, for purposes of deducting the costs, the accounting of the same costs is not sufficient, since the taxpayer must demonstrate, in its dispute with the tax administration, also their existence, connection, and economic consistency.

The Supreme Court goes even further, specifically referring to intercompany costs, i.e., where the parent company of a multinational group decides to provide services or directly takes care of the activities of common interest to the companies of the group, sharing the costs to coordinate the operational choices of the formally autonomous companies and reduce the management costs through economies of scale.

The Court said that the commonly shared view is that the burden of proof regarding the existence and relevancy of the costs incurred lies with the company that claims to have received the service.

The Court said that the commonly shared view is that the burden of proof regarding the existence and relevancy of the costs incurred lies with the company that claims to have received the service.

Consequently, for the consideration paid to the parent company to be deductible for direct taxes and the related VAT deductible for indirect tax, it is necessary that the subsidiary derives an effective benefit and that such benefit is objectively determinable and adequately documented.

The Court said its approach is not in contradiction with the principle recently expressed in other recent decisions, according to which “in terms of VAT, the principle of inherence concerning deductible costs derives from the notion of business income and expresses a correlation between costs and activities actually carried out, translating into a qualitative judgment, which does not in itself prescribe utilitarian or quantitative assessments”.

It is important to note that, in the case under review, the regional tax court did not deny that the costs formally originated from a cost-sharing agreement the Italian subsidiary had joined but considered the VAT to be non-deductible, as the Italian subsidiary had not proven its relevance to the economic activity in practice exercised.

In this regard, the Supreme Court stressed that although the taxpayer argued that the regional tax court did not analytically examine all the company documentation, it was unable to decisively prove a direct link between the services covered by the agreement and its entrepreneurial activity.

It is worth noting that the documentation provided by the taxpayer included the cost-sharing agreement, copies of related invoices received, related certifications from an auditing firm, the company’s organizational chart, a list of employees, files showing the costs pools borne by the related service providers of the group, and allocation keys used for consequent recharge to the participating entities.

Even the e-mails between the taxpayer and the group’s IT team were not decisive proof of the relationship between the costs and the activities conducted by the Italian subsidiary since they appeared to be merely informative correspondence concerning – for example – bank disservices or simple communications about temporary suspension of the team’s activities, without further specification.

In the end, the approach embraced by the Italian Supreme Court in this decision – which is aligned with other recent judgments on the same topic issued by the same Court – seems to create a bridge between direct taxation and VAT, so generating the risk of an automatic twofold assessment when the connection of intercompany service charges is challenged.

Therefore, the contemporaneous collection of robust supporting evidence (going beyond formal documents like written agreements and invoices), including transfer pricing documentation and related working papers, can become a crucial element to prove the relevancy of management fees, both for direct taxes and for VAT, many years later during a tax audit.