The Italian tax reform was enacted with Legislative Decree No 344 of December 12 2003 (the decree), which abrogated the previous Italian corporate income tax (so called IRPEG) and introduced the new corporate income tax IRES, effective January 1 2004. The new tax rate is now a flat rate of 33%.
Additionally, the decree repealed the DIT (dual income tax) and it is expected that the regional tax IRAP (currently at the rate of 4.25% levied, in general, on the net profit plus labour cost and interest expenses) will be abrogated in a few years.
The new participation exemption
The decree introduces a tax exemption for capital gains arising from the transfer of a company's participation's in entities (with or without legal status), resident or non-resident in Italy, with the exclusion of companies resident in countries which are considered to be tax havens. The tax exemption for capital gains is subject to the following conditions:
the holding must be reported in the balance sheet as a financial fixed asset; in this respect anti-avoidance rules are applicable;
the holding must be owned for a continuous period of at least one year; and
the participated company must carry out a commercial activity.
Additionally, the new Italian participation exemption does not provide for minimum participation requirements.
The following is a comparison between the previous tax regime and the new one:
A. Previous taxation (until December 31 2003)
Assuming a capital gain of €1000 ($1,220) from a stock sale, according to the previous rules there were two options:
ordinary taxation (rate 34% for 2003): €1000 x 34% = €340
substitutive taxation (rate 19%), in case of participations reported in the balance sheet as financial assets for at least three financial years: €1000 x 19% = €190.
B. New taxation (effective January 1 2004)
According to the rules contained in the tax reform, no taxation is levied upon participation transfers, if the above conditions are met. Correspondingly, the new rules provide that capital losses and devaluations of participations are not tax deductible.
Taxation of dividends received by Italian corporations
The Italian tax reform abolished the system of tax credit for dividends earned from business activity and provides for the application of a 95% tax exemption on dividends paid by companies either resident or non-tax resident in Italy, with the exclusion of companies which are resident in tax havens.
The new legislation does not require a minimum level of participation in the share capital or minimum percentage of ownership.
Additionally, a 100% tax exemption is granted with respect to dividends paid by companies that:
are included either in the domestic or in the international tax group relief; or
have elected flow through taxation.
Diagram 1 |
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Tax deduction of interest expenses and thin capitalization rules
The tax reform provides two limitations on the deductibility of interest expenses:
the thin capitalization rules;
the no-deduction pro rata method.
The new provisions concerning thin capitalization state that there will be a deduction limit for financial charges relating to loans granted or guaranteed by:
a shareholder who, directly or indirectly, controls or owns at least 25% of the debtor's share capital; or
an affiliate of a shareholder identified in the previous bullet point.
According to the thin capitalization rules, the debtor must compare (a) the debt towards the parent company or an affiliate multiplied by a factor (of five for 2004 and four starting from 2005) with (b) its own net equity (reduced by the value of the shareholdings in controlled and joined companies) attributable to the parent company. If (a) is higher than (b), the interest referable to the excess is deemed to be a dividend and consequently is not deductible for tax purposes. However, evidence may be introduced to rebut the presumption of the interest being a "dividend": in fact, in the event that the ratio between loans and net worth is exceeded, the company can demonstrate that the exceeding loans result from its capacity of credit and not from the shareholder. Failure to introduce evidence to rebut the presumption will result in the financial charges being considered and treated as dividends and, as consequence, no deduction will be allowed.
Additionally, the tax reform introduced the so called "no-deduction pro rata method", thus disallowing the deduction of interest expenses relating to the loans raised for the purpose of purchasing participations. The new no-deduction pro rata method is introduced for financial charges of companies which own participations classified in the financial statements as financial fixed assets. In such way, the new legislation aims to discourage the purchase of participations that benefit from the participation exemption treatment, through debit capital only.
The new law assumes that the ownership of participations is financed with the corporate net worth; only the hypothetical surplus of the value in the participation book in relation to the corporate net worth involves the no-deduction pro rata of debit interest. The non- deductible amount of interest expenses is calculated by applying the following ratio on the total amount of interest expenses (remaining after the application of the thin capitalization rules described above) reduced by the interest revenues in any:
The no-deduction pro rata does not apply if the numerator of the fraction is negative. Additionally, the following participations do not fall within the no-deduction pro rata method rules:
participations in companies which are included either in the domestic or in the international tax group relief;
participations in companies which have elected flow-through taxation.
M&A transactions
The tax reform repealed the substitute tax (levied at the rate of 19%) on the capital gains arising from:
transfer and contribution of businesses; and
transfer of participations.
Therefore, capital gains arising from sale of businesses and participations (not falling within the participation exemptions rules) are subject to ordinary taxation at the flat rate of 33%. Following the reform:
where the transferor owns the company for at least three years, corporate income tax at the rate of 33% is levied, with the option of splitting the capital gain in equal amounts payable over up to five fiscal years; and
where the transferor owns the company for less than three years, corporate income tax at the rate of 33% will be levied.
In addition, the decree confirmed the tax neutrality of the following transactions:
contributions of businesses held for at least three years;
transactions listed in the Council Directive 90/434/EEC of July 23 1990 on the common system of taxation applicable to mergers, divisions, transfers of assets and exchanges of shares concerning companies of different member states; and
domestic mergers and de-mergers.
In addition, it repealed the possibility to obtain the tax relevance of the merger and de-merger differences.
The option for flow through taxation
The tax reform allows Italian corporations to elect flow-through taxation, previously available only to partnerships, where they are controlled by other corporations. Particularly, where corporations elect flow-through taxation, their income (or loss) is taxed (or deducted) at the level of their shareholders, regardless of the actual profits' distribution. In particular:
this election is available to corporations only; and
this election can only be exercised if all the partners are corporations, tax resident in Italy, with a participation of at least 10%, but not exceeding 50%.
In addition, the above option can also be elected by non-tax resident corporations, who are not subject to withholding taxes on payable profits.
The option of flow-through taxation can also be elected by limited liability companies which are controlled solely by individuals, subject to the application of the widening of the tax survey (so called Studi di settore).
Finally, the decree introduces a total tax exemption for dividends distributed among companies which opted for flow-through taxation, as opposed to the ordinary tax treatment which grants a 95% tax exemption of the gross dividend.
Domestic tax group relief
The tax reform introduced the concept of domestic tax group relief in to the Italian system, thus allowing the taxation of the group of companies by the algebraic addition of each taxable base. The consolidation procedure chosen by the Italian legislature consists of a simple consolidation of the taxable bases.
Diagram 2: Flow-through taxation |
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According to the new tax system, each member company may choose to be taxed on the grounds of its group. This election is irrevocable for three years.
Particularly, the decree states that to benefit from group-wide taxation:
the parent company has to be resident or has to have a permanent establishment in Italy;
the option for the group taxation can be exercised only by the Italian-controlled companies; the exercise of the option must be submitted to the Italian IRS through the proper procedure; and
all the companies must have the same fiscal year.
With regard to the "control requirement" the new law points out that controlled companies are those in which the parent company owns, directly or indirectly, the majority of the shares entitled to vote during the ordinary general meeting of shareholders.
The taxable base of the group is calculated by the addition of the taxable bases of each group company. The consolidation will be calculated on the total taxable base of the controlled company, even if this company is not totally controlled. Therefore, the domestic tax consolidation will not be proportional to the parent company's participation. In such way, the parent company will pay taxes on the total taxable base of the group.
In other words, the above system allows the compensation or set-off of the profits and losses of all the companies participating in the group relief. As a consequence, the company of the group, which transfers losses, is penalized because it cannot make any compensation between using these profits and losses of the following years. Therefore, for avoiding this penalization, the new legislation introduces the "off-setting payment system", according to which the companies of the group indemnify the companies that transfer losses. Such indemnifications are tax neutral.
The election of the tax consolidation option cannot be revoked for three years, where control is maintained. In fact, the revocation of the option could create several problems relating to the assignment of hypothetical losses of the group not yet offset. Therefore, the new law provides for specific regulation of the assignment of the remaining losses in the case of the partial or total winding-up of the group. In addition, to avoid any evasive conduct, the new legislation fixes a limit for carrying forward losses achieved by the company before joining the group.
Diagram 3: Domestic tax group relief |
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The decree introduces an optional neutral tax treatment of certain transfers of assets among the companies of the group. In addition, in case of a company leaving the group, the new legislation provides for tax value adjustment, with a consequent taxation of the capital gains earned due to the application of the above neutral tax regime.
In the case of previous deductions of participation devaluations by the parent company, whether the tax value of the participation in the controlled company is lower than the net worth's quota, the parent company will have to adjust the above values.
Finally, the decree introduces the total tax exemption for dividends distributed among the companies of the group, as opposed to the ordinary tax treatment, which states the 95% tax exemption of gross dividend.
International tax group relief
The tax consolidation of multinational groups is different to the domestic tax consolidation, as for international tax group relief purposes all the non-resident controlled companies must be included too (that is, all in, all out). The election of the option for international tax group relief is irrevocable for five years.
The decree states that to benefit from international tax group relief, the Italian parent company must be either listed or controlled by the republic of Italy, public entities or Italian individuals who do not control any other company.
Under the international tax consolidation, the controlled foreign company's taxable income is determined according to the Italian ordinary tax rules with few exceptions.
With regard to the calculation method of the taxable base of the multinational group, it has to be pointed out that it is different from the calculation method applicable to the taxable base of a domestic group. In fact, the international tax consolidation is proportional to the parent company's participation. In such way, the parent company will not pay taxes on the total taxable base of the group, but only on the portion of its actual participation.
Even though the controlled foreign company's taxable income is taxed in Italy, it remains subject to taxation in the foreign country, where it will pay corporate taxes according to the ordinary national tax system. Therefore, to avoid double taxation, the decree introduced a tax credit system for the taxes paid abroad.
Diagram 4: International tax group relief |
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Controlled foreign companies rules
The tax reform extended the application of the current rules relating to controlled foreign companies (CFC) resident in tax havens to CFCs related to Italian tax residents. The Italian CFC legislation states that the profits gained in a tax haven are subject to taxation in Italy, independently from their actual distribution as dividends.
The new legislation also introduces the application of the CFC legislation to the foreign related companies, stating the taxation of the highest value between:
the operating income; and
the income calculated in a lump sum, by the application of income ratios to the net assets.
Foreign tax credit
The decree introduced several changes to the foreign tax credit, to reduce the effects of double taxation on the same taxable income. The problem of reducing double taxation arises where the taxable income of the resident taxpayer includes its worldwide income upon which the taxpayer is taxed also by the foreign state where part or the whole taxable income is derived. Therefore, the tax credit is a way to reduce the taxation of the taxpayer.
In brief, the new provisions aim to achieve the following targets:
the calculation of the taxable income for each CFC and for each permanent establishment, or alternatively but only for the permanent establishment; and
the possibility to take carry forward and back the tax credit not used for eight fiscal years.
Biography |
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Luca Dezzani is the head of the Milan office of his firm. He specializes in national and international tax law, in particular relating to capital and loan markets (initial public offerings, asset-backed securities, asset-backed commercial paper, bonds and derivatives) and M&A transactions such as international and domestic group structuring. He also assists major multinational corporations, investment banks and private equity funds with tax issues relating to transactions in Italy, financial products and structured finance transactions. Luca Dezzani is author of more than 100 articles, comments and essays published in major publications, including Il fisco, Italia oggi, Il nuovo diritto delle società , Diritto e pratica tributaria, Fiscalità internazionale, Impresa commerciale industriale and International Tax Review. Moreover, his articles were recommended by the Italian ministry of economy and finance in the monthly Bulletin. Luca Dezzani is professor at Scuola Superiore dell'Economia e Finanze of the Italian ministry of economy and finance, he is a regular speaker in conferences and seminars organised by Le conferenze di Affari e Finanza di Repubblica, Information Management Network (IMN), Italia oggi and Learning Resources Associates (LRA) and he lectures at Infor Training College for the postgraduate masters in tax law. He was ranked as a leading European tax adviser by International Tax Review in 2003. Additionally, he was ranked by World Tax 2004 among the leading individuals in capital markets and financial products, being referred to as "very highly regarded for his capital markets experience".Global Counsel 3000, ninth edition, ranked Luca Dezzani among the "recommended" individuals advising in Italy on tax law. He was educated cum laude both at the University of Economics in Turin (doctor in economics) and the University of Law in Parma (JD). He was admitted as a dottore commercialista (chartered accountant admitted to practice before tax courts) in 1995. He speaks Italian, English and he has a fair knowledge of French. |
