Italy joins competition among tax regimes

Author: | Published: 24 May 2005
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The Italian tax system is undergoing reform that seems to be aimed at creating a direct taxation regime closer to the more efficient systems in other EU countries, thus increasing Italy's competitiveness.

Since January 1 2004, the Income Tax Consolidation Act has been substantially modified. Local taxpayers used to hate Italy's tax system. But has recent reform converted the country into a tax bright spot for foreign investors?

The evolution of corporate taxation in a number of European countries and the blacklisting of many tax havens has changed the ways that international investors and companies can legally minimize their tax liabilities.

Tax exemptions on dividends and capital gains elsewhere in Europe have induced a large number of investors, including Italian entrepreneurs, to set up holding companies in those countries. Competition among tax systems has harmed the Italian economy for a long time, given its delay in implementing tax reforms to promote inward capital flows. But this is changing. Italy has started to adopt the tax devices used in other legal systems. In particular, it is introducing tax exemptions on dividends and capital gains, which, besides being necessary for tax harmonization among European systems, aim to increase competitiveness.

It is undeniable that Italy lags behind its European counterparts on this issue. For example, Spanish tax reform in 2000, which altered the 1995 rules, grants a general exemption on dividends paid by Spanish companies or the capital gains pertaining to them. The juridical qualification of ETVE (Entitades de Tenencia de Valores Extranjeros) is available to all companies established in Spain whose articles of association allow them to invest in foreign entities. The Ministry of Finance's authorization is no longer required, and has been replaced by a simple prior notification of an activity. Other European countries, such as Austria, Belgium, Denmark, Germany, Luxembourg, and the Netherlands, have also adopted similar exemptions.

The Netherlands and Luxembourg in particular have long made opportunities for tax planning strategies available to foreign entities.

Of course, a direct comparison between different exemption regimes is not always easy because they are based on different requirements. In the Netherlands, for instance, there is no shareholding requirement for holding companies that own a minimum of 5% of the foreign company's capital. Moreover, the company in which the holding company has shares must pay tax equivalent to that which is imposed in the country where the holding company is established, and the investment must be justified by an actual financial or managerial activity.

Luxembourg's tax system provides that the exemption regime on capital gains is available if the shares sold amount to at least 10% of capital in the company concerned, which must be taxed at a rate not less than 15%, in the case of non-European countries. Moreover, Luxembourg's rules require the shares to be directly and continuously held for the 12 months before their transfer.

Italy's tax reform, and the rules concerning holding companies for the purpose of participation exemption, will turn Italy into a country worth considering in terms of international tax planning strategies. The reform could divert the flow of foreign capital aimed at non-resident companies from other jurisdictions, where more favourable provisions were already applicable, to Italy.

Regarding the criteria underlying income imputation systems, the introduction of an exemption (though partial), as opposed to a tax credit, will remove pre-existing disparities. The measures in force before the introduction of the Italian corporate tax reform (IRES) granted a tax credit to resident shareholders, as well as to non-resident shareholders with a permanent establishment, discriminating against non-resident shareholders without a permanent establishment.

The changes introduced by the Italian tax reform are based on legal rules that already apply in other European countries. These were, in turn, inspired by the American system. Since the nineties, most European systems have gradually moved away from the imputation system, which granted a tax credit to shareholders, towards the exemption method (also providing for partial exemption). Even France, traditional bulwark of the imputation system based on tax credits, proposes to abolish the so-called avoir fiscal in 2005.

In Europe, provisions basing the taxation of foreign entities on worldwide consolidated accounts were already explicitly contemplated by Denmark and France. The system outlined by the Italian law decree is based on the French system, although the tax reform in France is not due to enter into force until 2005.

The concept of flow-through taxation does not represent a breakthrough in the Italian tax system, even if, until the present reform, it had not yet found an explicit statutory sanction. However, Spain is the most representative forerunner in the introduction of this concept.

Flow-through taxation was introduced with several specific purposes: the non-deductibility of capital losses following participation exemption requires the introduction of appropriate corrections to avoid penalizing incorporated joint ventures and, more generally, agreements that require the establishment of jointly owned companies by legal entities.

In such situations, possible losses of the newly incorporated company would otherwise be non-deductible for participants in the deal, save for the possible opportunity, for one of them only, to profit from the consolidated accounts rule.

So the option of a transparency regime, similar to that applicable to partnerships, has been introduced to remove the problems arising in these situations.

This option's most obvious attraction for a foreign investor is the possibility of its partial application in the presence of non-resident shareholders. The Italian legislator provides for such a regime when foreign shareholders exist for whom a withholding tax would ordinarily apply on dividends distributed in a different country.

In this respect, the non-applicability of the withholding tax on dividends is also subject to the requirements provided for in the so-called mother-daughter directive. Moreover, the removal of withholding taxes on dividends is effective where the mother-daughter directive applies, which is in turn subject to a set of requirements.

Finally, in order to profit from the transparency option, both the foreign shareholder and the business concerned must be legal entities.

The advantage gained from the application of flow-through taxation is that the foreign shareholder's revenue is classified as business revenue rather than capital revenue. The real point of classifying these revenues as business revenues is not to avoid the withholding tax on dividends distributed in a different country, but to accrue a foreign tax credit against the taxes paid in Italy.

But the IRES Italian tax reforms do not appear enough per se to attract foreign investors, when compared to the rules already in force in other European countries. A peculiar aspect of the new Italian regimen that might provide specific tax appeal for foreign investors is the taxation of contractual joint ventures.

Although this set of rules has been modified to some extent by the IRES reform, establishing the non-deductibility of consideration in favour of partners contributing assets other than labour, there remains a clear distinction among financial instruments available to Italian companies, including holding companies, between those to which the rules pertaining to shares apply, and those to which the debenture rules apply instead.

The non-deductibility is only provided for the sums owed to the owners of the former, such sums being considered as dividends, but not for sums payable to the owners of the latter. So the favourable taxation regime applies to financing agreements entered into by Italian holding companies with third parties, including parties belonging to the same group.

Such financing agreements can be the object of a contractual, as opposed to an incorporated, joint venture, which in turn can take the form of, for example:

  • a silent partnership in the US;
  • a sleeping partnership in the UK.;
  • a Stillgesellshaft in Germany;
  • a cuenta in partecipaço in Portugal and Brazil;
  • a participaciòn a la galancia in Spain and Latin America;
  • an EEIG in all European countries;
  • an associazione in partecipazione in Italy;
  • a contratto partecipativo a patrimonio separato in Italy and several other countries.

The creation of a new independent entity, as is the case with incorporated joint ventures endowed with rights and obligations, implies a new tax liability upon the joint venture as distinct from the venturers.

The issue is more complex with regard to contractual joint ventures, where the income wholly arises from one of the parties involved and is distributed among the others. This framework is significant in terms of taxation: the issue is whether the portion of income allocated to the other parties is deductible from the total income and therefore is taxable upon the said party, or if it is to be considered allocation of income after tax.

Whenever the latter applies, it must be established whether the monies owed to the other parties are tax-free or if they contribute to the venturer's taxable income, upon the granting of a proportional tax credit. This follows from the joint venture's classification as either a trade agreement or a partnership agreement.

In both circumstances, the issue may be further complicated when the parties involved in a contractual joint venture belong to different legal systems.

For instance, assuming that a joint venture should be considered a trade and not a partnership contract, the other party's income would be deductible from the pre-tax income to which a given party to the contract is entitled. On the other hand, the deductible income might be exempt, in compliance with the rules provided for by the legal system in force in the other party's country. In this context, situations of under-taxation would arise, leading to rather obvious tax planning strategies.

This is why, even though contractual joint ventures are usually considered trade, as opposed to partnership, agreements, many legal systems have enacted a series of US-style anti-avoidance measures, providing in particular for the non-deductibility of the sums which are attributable to the other party as its profit from the joint venture. The Italian IRES reform takes this direction.

Before the reform, as far as the deductibility of the other party's income from the joint venturer's income is concerned, the rules in Italy provided for by Article 62 of DPR 917/86 applied. This arrangement tended to allow tax avoidance through income-swap transactions.

The new IRES provisions establish, under paragraph 9 of Article 109, the non-deductibility of the other venturer's profits and, more generally, the non-deductibility of any revenue arising from financial instruments and transactions involving a right to share the revenues of a given business.

On the other hand, the tax-planning strategy discussed above still applies to contractual joint ventures that imply the use of financial instruments comparable to debentures, or to other financial instruments that imply a consideration other than a share of the profits.

These situations create international opportunities to reduce tax, which can be exploited through strategies based on the analysis of every category of income and on the execution of carefully drafted transactions between independent parties that happen to be based in appropriate countries.