Italy’s Supreme Court rules French holding company has sufficient substance for tax purposes

by Davide Anghileri

In a recent decision (Cassazione Civile, sez. V, 27 December 2016, n. 27113) the Italian Supreme Court clarified the concept of the “beneficial ownership” condition in the dividends article (Article 10) of the France-Italy tax treaty.

The decision is important because it addresses level of substance that a holding company must have to ensure that it is respected in Italy for purposes of obtaining a reduced rate of withholding tax under a tax treaty or for the application of the EU parent-subsidiary directive or interest and royalties directive.

The France-Italy tax treaty, like the OECD model tax convention, does not define the concept of “beneficial ownership.” This gave rise to a series of different interpretations of the concept in Italy, as well as significant uncertainty.

In essence, the Supreme Court concluded that, for Italian tax purposes, to be considered beneficial owner, a holding company does not need the level of substance (people and activities) required for an operating company, but it must instead have sufficient activities and people to manage its portfolio of assets, including the stock of its various subsidiaries.

French holding/Italian operating

In the instant case, an operating company, resident in Italy, distributed a dividend to its parent company, resident in France. The French company was a holding company managing all operations in Europe and was owned by a US parent company.

The French holding company sought the reduced 5 percent withholding tax under paragraph 2(a) of article 10 of the treaty and the partial refund of the Italian dividend imputation credit on corporate distributions issued by the Italian operating company under the Italy-France treaty, claiming it was beneficial owner of the Italian company.

In fact, under paragraph 4 (b) of article 10 of the treaty, if a French company considered a beneficial owner receives from an Italian company dividends that would be granted a tax credit if they were received by a resident of Italy, the French company shall be entitled to a payment from the Italian Treasury of an amount equal to half of such tax credit, less the treaty-rate withholding tax of 5 percent of the gross amount of the dividends.

It should be noted that the partial refund of the Italian dividend imputation credit was abolished in 2003, and the facts in this case occurred before the abolition of the dividend imputation.

It should also be noted that the US-Italy tax treaty did not provide for similar tax credit relief.

Lack of substance

The Italian tax administration did not authorize the French holding company’s claim, arguing that the company should not be considered as the beneficial owner of the dividends because of its lack of substance.

In fact, the French company had no employees, no significant business premises, no operations, no significant investment or service activities, and no assets, other than shares. Because of lack of business substance, the French company did not have its place of effective management in France, the tax administration argued.

Hence, the tax administration said that the French sub-holding should be regarded as a conduit company, interposed only to benefit from the France-Italy tax treaty to pass the distribution of dividends to the US parent company, and therefore tax treaty benefits should be denied.

The French company, on the other hand, argued that, for a holding company to be considered as a beneficial owner, the only substance needed is that which is required to undertake its peculiar business activity (i.e., owning and managing shareholding activities).

The holding company did not need to have the substance of an operating company that, by definition, undertakes other activities, the firm argued.

Supreme Court decision

In its decision, the Supreme Court sided with the French firm, concluding that the French entity had a sufficient substance for a pure holding company and should be considered the legal owner of the dividends.

Thus, the Court held that the French holding company was the “beneficial owner” of the dividends under Article 10 of the France-Italy tax treaty and treaty relief should be granted.

According to the Court, the tax authorities did not correctly evaluate all the relevant facts and had an erroneous understanding of the concept of beneficial owner and place of effective management.

The Court said that the purpose of the beneficial ownership clause is to guarantee that only those companies that have full juridical and economic ownership of the dividends, because they are the final recipient of the dividends (i.e. owner, dominus), can claim (and be entitled to) a treaty relief.

Therefore, the beneficial ownership clause is an anti-abuse provision based on the substance over form approach that allows for the denial of tax treaty benefits to a company that has no substance and is created only for tax reasons, the Court said.

According to the Court, though, the specific nature of activities of the holding company must be taken in account in determining beneficial owner status. Thus, the level of substance of an operating company cannot be used to assess the substance of a pure holding company, the Court said.

In particular, the Court said that to be treated as a beneficial owner, a pure holding company must demonstrate that it is the legal owner of the dividends and must control the use of the dividend receipts.

A pure holding company which has an organisational structure that would allow it to co-ordinate and control its subsidiaries, attend shareholders’ meetings, receive and collect dividends, should be considered to have a sufficient level of substance, the Court said.

The Court concluded that the French company had such qualities and was thus the beneficial owner of the dividend paid by its Italian subsidiary.

Conclusions

This decision clarifies that beneficial ownership conditions for a pure holding company should be tested only on the actual capability of taking autonomous decision on the dividends received by the holding as opposed to having the obligation to repay them to another entity.

Therefore, the presence of a significant organizational structure is not decisive.

Moreover, the place of effective management of a pure holding company should be considered the one where the main management and administrative decisions as well as the ones concerning the coordination of the participations are made.

The Supreme Court’s decision represents an important step in clarifying whether a non-resident holding company is the beneficial owner of income and the meaning of beneficial ownership in the context of tax treaties.

In its decision, the Court does not make any reference to the OECD Commentary on beneficial ownership, even though the OECD guidance is in line with the Court’s principles. The two most important paragraphs regarding the topic were added by the OECD after the entry into force of the 1992 France-Italy double tax treaty at issue.

Paragraph 12.3, included in the OECD Commentary in 2003, states that “a conduit company cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties.”

While, paragraph 12.4, inserted into the Commentary in 2014, provides that in case “the recipient of a dividend does have the right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass on the payment received to another person, the recipient is the ‘beneficial owner’ of that dividend….”

The Court also pointed out that a treaty benefit cannot be given to a company that does not have substance, due to Article 31 of the Vienna Convention, which requires that a treaty shall be interpreted in good faith and in accordance with the ordinary meaning to be given to its terms.

In fact, the interposition of a conduit company only for tax purposes is against the function of a double tax treaty (treaty abuse).

Finally, even though it is not explicitly said, we can infer from the decision that a pure letter box company, that is, one that is merely formed by a corporate formation agent and in which nothing happens, would not qualify as a holding company that is the beneficial owner of dividends distributed to it.