By Luca Tortorella, Senior Associate, Gatti Pavesi Bianchi Ludovici, Milan
The year 2021 was prolific for the Italian Revenue Agency, which published several documents aimed at providing taxpayers and, in general, the business arena with its interpretation of domestic and international tax issues. Transfer pricing aspects were no exception. The last resolution of the year (dated December 31) was dedicated to the link between year-end transfer pricing adjustments and reportable obligations under DAC6.
The DAC6 framework
DAC6 obligations were transposed into the Italian legislative system in August 2020, when the related legislative decree was published in the Official Gazette. The text of the Italian law and the list of hallmarks do not deviate from the wording of the directive. Subsequently, in November 2020 the Ministry of Economy and Finance published a ministerial decree providing additional rules, including the conditions related to the achievement of “tax advantage” and the definition of the “main benefit test.”
Given the complexity of the matter, on February 10, 2021, the revenue agency included in a comprehensive circular letter its first clarification on the interpretation and application of the Italian DAC6 rules, following a public consultation process.
In general terms, based on the interpretation of the legislative and ministerial decrees, and as the circular letter confirmed, the identification of a reportable cross-border arrangement must follow a specific path by adopting a system of selective criteria. Specifically: the arrangement must be cross-border, i.e., it must concern Italy and one, or more than one, foreign jurisdictions (the Italian law provides a definition of cross-border arrangement aligned with the one included in BEPS Action 12, i.e., “a scheme, an agreement or a plan”); the cross-border arrangement must contain at least one hallmark; for certain hallmarks, the cross-border arrangement must entail a (potential) reduction of the taxes due in another EU member state or in a third country with which a dedicated agreement for DAC6 purposes is signed; and under specific circumstances, the main benefit test also must be satisfied.
The directive and the Italian law dedicated a specific hallmark to transfer pricing. Indeed, a cross-border arrangement occurring among associated entities resident in Italy and in one or more foreign jurisdictions qualify as reportable when it meets one of the following hallmarks: E.1 related to the use of unilateral safe harbor rules; E.2 related to the transfer of hard-to-value intangibles; or E.3 related to the intragroup transfer of functions and/or risks and/or assets.
The cross-border arrangement also qualifies as reportable when it entails a tax savings in the EU or in another state that signed a mandatory disclosure agreement with Italy.
The main benefit test is not requested. Hallmark E does not encompass all transfer pricing aspects, however. Hallmark C.1, in fact, indirectly addresses transfer pricing arrangements, as it involves mechanisms based on deductible cross-border payments between associated enterprises if: the recipient is not resident for tax purposes in any jurisdiction; although the recipient is resident for tax purposes in a jurisdiction, that jurisdiction either: does not impose any corporate income tax or imposes a corporate income tax at the rate of zero or almost zero (according to the Italian Revenue Agency, “almost zero” means less than 1%) or (ii) is included in a list of non-cooperative jurisdictions; the payment benefits from a full exemption from tax in the jurisdiction where the recipient is resident for tax purposes; or the payment benefits from a preferential tax regime in the jurisdiction where the recipient is resident for tax purposes.
As opposed to hallmark E (except for E.2), under hallmark C.1 the term “associated enterprises” deviates from the one provided under transfer pricing Italian rules, being wider and including cases where the participation in the capital, voting rights, or profits of another enterprise exceeds 25%, versus the 50% threshold generally set for transfer pricing rules.
The December 31 resolution
As for the resolution in question, certain Italian taxpayers requested the revenue agency determine whether the performance of year-end transfer pricing adjustments should be treated as a reportable cross-border arrangement under hallmark C.1.b(i) or C.1.b(ii) when the related counterparties are located in non-cooperative jurisdictions or in jurisdictions in which the corporate income tax rate is almost zero. According to the interpretation proposed by the taxpayers, year-end transfer pricing adjustments cannot qualify as “deductible cross-border payments” because such adjustments are made to allow the controlled entities to reach an arm’s length return, in line with functions performed, risks assumed, and assets employed. Therefore, they should not be relevant for reporting purposes.
The revenue agency rejected the taxpayers’ interpretation: Year-end transfer pricing adjustments qualify as cross-border arrangements and are actual “deductible cross-border payments”, the authorities said. In fact, following the “path” described by the legislative and the ministerial decree, according to the authorities: a group transfer pricing policy (and consequently year-end transfer pricing adjustments) is a legally binding arrangement and, by definition, it is cross-border because it concerns companies of the same multinational group located in different jurisdictions. The existence or otherwise of written agreements is irrelevant to characterize the transfer pricing policy as a cross-border arrangement. In the case at stake, year-end transfer pricing adjustments imply a “deductible cross-border payment” to counterparties located in non-cooperative jurisdictions or in jurisdictions in which the corporate income tax rate is almost zero. Therefore, hallmark C.1 is met. Whether the mentioned year-end adjustments entail a tax savings (and when payments are made to entities located in countries that impose less than a 1% corporate income tax rate, the main benefit test is satisfied), they are subject to the mandatory disclosure rules.
It is worth analyzing the revenue agency’s answer because this position might have impacts on other aspects not immediately apparent.
The resolution confirmed that multinationals operating in Italy are allowed to execute year-end transfer pricing adjustments. Although in practice, it is now uncommon that officers challenge this kind of transaction (in past years we have seen cases where tax inspectors denied their deductibility), year-end adjustments often have been characterized by a grey area. Such uncertainty increased after the publication of the OECD Italian transfer pricing country profile (dated December 2021) where the answer to a question on the possibility of executing year-end adjustments had left the door open to various interpretations.
The resolution also confirmed that the concept of a cross-border arrangement given by the law has to be read in an extensive manner and, when it refers to an agreement, it should originate from a legally binding circumstance, no matter if in writing or in oral form.
In addition, the resolution clarified the controversial interpretation of the term “payment” for hallmark C.1: Year-end transfer pricing adjustments cannot be considered notional payments for tax purposes, but “actual payments.” While certain foreign authorities already provided guidance on how to read the term “payment,” before the resolution at stake the Italian revenue agency only clarified that a payment is generically a “deductible negative item of income.” Thus, year-end transfer pricing adjustments cannot be treated separately from the whole intercompany transaction flow and must be reported (under conditions of hallmark C.1), even if they are aimed at complying with the arm’s length principle for tax purposes and do not involve “the creation of any new economic rights between the parties” (see para. 28 and the definition of payment in Recommendation 12 of BEPS Action 2).
Given that the questions the Italian taxpayers raised focused on hallmark C.1.b(i) and C.1.b(ii), in their resolution the revenue agency limited the answer to such issues only. However, it is reasonable to expect that the interpretation of the authorities might extend to the entire hallmark C.1, i.e. to all the intercompany payments (and year-end transfer pricing adjustments), which benefit from certain exemptions. In principle, the approach is understandable given the purpose of DAC6 to communicate a potentially harmful situation. However, when the transaction is purely business-driven and when transfer pricing adjustments are made to observe the arm’s length principle, taxpayers may incur an excessive administrative burden that might be overwhelming for small- and medium-sized enterprises.
In almost all circumstances of hallmark C.1, Italian taxpayers would be required to identify the main benefit test, calculating the weight of the tax advantage on the overall benefits deriving from the transaction. In all circumstances of hallmark C.1, taxpayers are requested to calculate the tax savings, comparing the actual taxes levied with the cross-border arrangement with those that would have been levied in its absence.
Such an approach deviates from the ultimate goal of the mandatory disclosure rules, which is to immediately report potentially aggressive cross-border tax-planning arrangements to create an environment of fair taxation, not to impose indiscriminate tax obligations on taxpayers.
The definition of the transfer pricing policy (and year-end transfer pricing adjustments) as a cross-border arrangement implies that any amendments to the policy might trigger the reporting obligations under hallmark C.1. However, reading the 2021 circular letter, only significant amendments to the cross-border arrangements are subject to communication. It should however be kept in mind that, even if the arm’s length nature of the cross-border arrangement is under negotiation with the tax authorities through an advance pricing agreement (APA), taxpayers are in any case subject to report it, thus duplicating de facto the information to be provided to the revenue agency.
Finally, as far as timing is concerned, the law provides that the mandatory disclosure rule applies for arrangements implemented from June 25, 2018. All transfer pricing policies implemented before that date should be excluded from the reporting obligations, even if taxpayers continue to make year-end transfer pricing adjustments to comply with that policy. However, if the transfer pricing policy has been implemented (or significantly amended) after that date, the arrangement becomes reportable. On this, the resolution clarified that the first communication must be done within 30 days from the implementation, while subsequent communications must be submitted within 30 days from the date of approval of the financial statements of the entity making the adjustments.
DAC6 introduced complicated features, which should be properly managed. Unfortunately, the resolution seemed to add further obligations, requesting taxpayers (and intermediaries) report pure business-driven transactions without any abusive purpose.
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Luca Tortorella is an international tax and transfer pricing senior associate at Gatti Pavesi Bianchi Ludovici in Milan.
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