On 4 July 2006 the Italian Government issued Law Decree no. 223 (the "Decree"), which was converted into law, with substantial amendments, on 4 August 2006 (Law 4 August 2006, no. 248). The Decree provides, inter alia, for a substantial reform of the Italian indirect tax regime applicable to transfers and leases of real estate properties.

The main goals of the reform were twofold: on the one hand, to increase the tax revenues deriving from real estate transactions; on the other hand, to limit tax frauds mainly connected to the mechanism of deduction of input VAT. Said goals were achieved through the broadening of the range of real estate transactions exempt form VAT and through the enlargement of the scope of application of other indirect transfer taxes. Moreover, the Decree also introduced new rules relating to the determination of the tax bases and to penalties related to VAT violations.

The new provisions have a significant impact on the business decisions relating to the purchase, holding and sale of real estate properties and on the structuring of real estate transactions.

The previous regime

Prior to the enactment of the Decree, the following regime was applicable to transfers of real estate properties:

(i) transfers of residential properties were generally VAT exempt, but subject to registration tax (usually applied at a rate of 7% on the sale price) and to mortgage tax and cadastral tax (usually applied at a rate of 2% and 1%, respectively, on the sale price). The only transfers of residential properties subject to VAT (at the ordinary 20% rate or at the reduced 10% rate, depending on the nature of the property and on the status of the purchaser) were those executed by one of the following entities: (i) the developer of the building, (ii) the entity that carried out certain restoration activities set forth by the law, or (iii) an entity whose prevailing or exclusive activity was trading in such properties. In such cases, registration, mortgage and cadastral taxes were applicable at the flat rate of €168 each;

(ii) on the contrary, transfers of commercial properties were usually subject to VAT (at the ordinary 20% rate); in such case, registration, mortgage and cadastral taxes were applicable at the flat rate of €168 each.

With respect to lease transactions, rentals deriving from residential properties were generally VAT exempt and subject to registration tax (applicable at the rate of 2% on the rentals due for the entire duration of the lease agreement), while rentals from the leasing of commercial building were subject to VAT at the ordinary 20% rate, and to registration tax at the flat rate of €168.�

The new regime for transfers of real estate assets

As mentioned above, under the previous regime a clear distinction was made between the indirect tax treatment applicable to residential properties and commercial properties. While the first version of the Decree provided for a general VAT exemption regime applicable to all real estate transactions - irrespective of the nature of the underlying asset - the final version that was converted into law still provides for a different regime in respect of residential and commercial properties. For the purpose of the application of indirect taxes on transfer and leases, the distinction between residential and commercial properties shall be based exclusively on the cadastral classification of the property, irrespective of its actual use.

Transfers of residential properties are generally exempt from VAT, while registration, mortgage and cadastral taxes apply at proportional rates, as follows:

(i) the standard regime for individuals and companies provides for the application of registration tax at a rate of 7% and of mortgage and cadastral taxes at a rate of 2% and 1%, respectively, to be applied on the sale price;

(ii) individual may benefit from a special regime ("prima casa") in respect of residential properties to be used as principal residence; in such case, registration tax is reduced to 3% and mortgage and cadastral taxes apply at the flat rate of €168 each;

(iii) real estate trading companies (i.e. those companies whose main or exclusive activity is trading in real estate assets) may benefit from a reduced 1% registration tax, provided that in the transfer deed the purchaser undertakes to sell the property within three years.

In respect of residential properties, the ordinary VAT regime only remains applicable to transfers where the seller is the enterprise that developed or restored the property, provided that the sale occurs within four years from completion of the construction or renovation.

As a general rule, pursuant to the new provisions introduced by the Decree also transfers of commercial properties are VAT exempt. However, said transfers still remain subject to VAT (at ordinary rates) in the following cases:

(i) when the seller is the enterprise that developed or renovated the property, provided that the transfer occurs within four years from completion of the construction or renovation;

(ii) when the purchaser has a pro-rata of deductibility of input VAT equal or lower than 25% (i.e. it may not deduct more than 25% of input VAT paid on purchases of goods and services); this is typical for entities that mainly perform VAT exempt activities, such as banks and other financial companies;

(iii) when the purchaser is not acting in the context of a commercial or professional activity (for instance, in case of individuals or non-commercial entities), and therefore it would not be entitled to recover VAT paid; or

(iv) if the seller makes an express election in the relevant deed to apply the ordinary VAT regime to the transfer.

Irrespective of whether the transfer is subject to VAT or exempt, the following additional taxes apply to all transfers of commercial properties: (a) registration tax at the flat rate of €168; and (b) mortgage tax and cadastral tax, at the rate of 3% and 1%, respectively, to be applied on the sale price.

A special regime is provided for those transfer where one of the parties to the transfer is a real estate fund, a bank or another financial intermediary, such as a leasing company; in such cases, mortgage and cadastral tax are reduced by half, and therefore apply at an aggregate rate of 2% (1,5% mortgage tax and 0,5% cadastral tax).

In particular, this is one of the most significant changes introduced by the Decree. Indeed, while in the previous regime transfers of commercial properties were generally "neutral" for indirect tax purposes, due to ability of the purchaser to deduct input VAT paid, the new regime provides for an additional transfer tax – at the aggregate rate of 4% (or 2%) - on any transfer of commercial properties, even if subject to VAT.

In general, transfers of assets into REFs by way of contribution (i.e., in exchange for newly issued units of the REF) are subject to the same tax regime applicable to the sale of assets described in paragraph 3.1 and 3.2 above. However, as mentioned above, those transactions having a REF as a party may benefit from the reduced 2% mortgage and cadastral tax, instead of the ordinary 4% aggregate rate.

It is worth noting that he Decree did not affect a special provision applicable to REFs, according to which the contribution into a REF of a plurality of assets mainly rented shall be treated as a contribution of a business going concern; accordingly, no VAT would be due while registration, mortgage and cadastral taxes would apply at the flat rate of €168.

It shall also be noted that contributions and purchases of assets made by REFs from the State, regions, municipalities and similar public entities are subject to registration, mortgage and cadastral taxes at the flat rate of € 516,46.

The new regime for leases of real estate properties

Rentals deriving from the lease of residential properties are always exempt from VAT, irrespective of the status of the lessor. Registration tax applies on residential lease agreements, at the rate of 2% on the rentals due for the entire duration of the agreement.

Rentals deriving from the lease of commercial properties are generally VAT exempt. However, commercial leases may be subject to VAT (at the ordinary 20% rate) in the following cases:

(i) when the lessee has a pro-rata of deductibility of input VAT equal or lower than 25%;

(ii) when the lessee is not acting in the context of a commercial or professional activity, and therefore it would not be entitled to recover VAT paid; or

(iii) if the lessor makes an express election in the relevant lease agreement to apply the ordinary VAT regime.

Irrespective of whether the lease is subject to VAT or exempt, commercial lease agreements are subject to registration tax at the rate of 1%, to be applied on the rentals due for the entire duration of the agreement.

As discussed above, in the previous regime commercial lease agreements were subject to VAT and, as such, the registration of said agreements was not required. Therefore, for those lease agreements already in effect at the time in which the new provisions came into force, the Decree provides that the parties shall file with the registration tax office a declaration stating the amount of rentals still due under the agreement until its term, on which the 1% registration tax applies; the same declaration may be used to make the election for the VAT regime mentioned under point (iii) above. The procedural aspects relating to such filing, which shall occur by November 30, 2006, are disciplined by a decree issued by the Ministry of Finance on September 15, 2006.

A special provision applies in respect of financial leasing of commercial properties. In particular, in order to avoid a double taxation, the lessee is entitled to deduct the 1% registration tax due on the rentals from the mortgage and cadastral taxes due on the purchase price due upon redemption of the leased asset.

Finally, it is worth noting that in order to prevent possible tax avoidance schemes, the Decree provides that the tax regime applicable to the lease of real estate properties shall also apply to the lease of businesses, when both the following conditions are met:

a) the fair market value of real estate properties amounts to more than 50 per cent of the value of the entire business; and

b) the application of the ordinary regime for the lease of businesses would allow the taxpayer to obtain a tax benefit, if compared to the regime applicable to the lease of real estate assets.

This actual scope of this provision is quite unclear, since it does not specify whether - in the event the two conditions are met - the new VAT regime would only apply to real estate properties included in the leased business or rather also to the other assets (including movable assets and intangibles) that are part of the leased business.

Impact of the new regime on VAT deduction

In general, VAT taxable persons are entitled to deduct input VAT paid on purchases of goods and services, to the extent that goods and services purchased are used for the purpose of transactions ordinarily subject to VAT. In particular, where taxpayers carry out both transactions subject to VAT and VAT exempt transactions, the VAT deduction is only allowed in proportion to those transactions which are subject to VAT (s.c. pro-rata).

As mentioned above, pursuant to the new provisions introduced by the Decree the range of real estate transactions which qualify as VAT exempt has significantly increased. As a consequence, companies holding, trading and managing real estate assets will be more often faced by the inability to entirely deduct input VAT paid.

Moreover, according to Art. 19 bis2 of the Italian VAT Code (which implemented Art. 20 of EC Directive no. 77/388/EEC of 17 May 17,1977, the "VAT Directive"), the initial VAT deduction made by the taxpayer upon purchase of a given asset shall be adjusted when, inter alia, a change to the VAT regime applicable to the relevant asset occurs (for instance, when the sale of said asset become VAT exempt). In particular, the adjustment must be made in proportion to holding period of the asset, over a standard period of ten years (starting from 1998, when said provisions were firstly enacted); for instance, in respect of an asset owned since four years at the time in which the change in law occurs, 6/10 of the amount of VAT originally deducted shall be "recaptured".

Pursuant to the first version of the Decree, the straight application of the VAT "recapture" regime provided by art. 19 bis2 would have led to signifcant detrimental consequences for taxpayers owning real estate assets. Indeed, as a consequence of the introduction of a general VAT exemption regime applicable to real estate assets, they would have been required to adjust the VAT deductions made since 1998 in respect of input VAT paid on the purchase of real estate assets.

In order to mitigate the impact of the new rules and to protect the legitimate expectations of taxpayers, the final version of the Decree contemplates certain exceptions to the applicability of the VAT "recapture" mechanism set forth by art. 19 bis2. In particular, the Decree provides that input VAT paid and deducted on the purchase of residential assets already owned by the taxpayer at the date of enactment of the Decree shall not be recaptured. In respect of commercial assets, the VAT deduction adjustment shall only apply for those assets in respect of which it is not exercised the election for the VAT regime in the first deed executed following the enactment of the Decree.

The above mentioned limitations to the VAT adjustment mechanism, provided for by the final version of the Decree, seem to be in line with the principles set forth by the VAT Directive and aimed to protect the legitimate expectations of taxpayers and to grant them legal certainty. The matter has been recently examined by the European Court of Justice (ECJ) with reference to a similar case. In particular, with decision of 29 April 2004 (joined cases C-487/01 and C-7/02), the ECJ stated that the VAT Directive does not prevent the right of a Member State to adopt changes to the taxation of real estate transactions which may result in the adjustment of deductions previously made with reference to such asset; however, in the actual implementation of such changes the Member State must take into account the legitimate expectations of taxpayers.

Limitations to VAT deduction for "dormant �companies"

Pursuant to art. 30 of Law no. 724/1994, a company qualifies as "dormant" when its ordinary income is not consistent with the value of its assets, based on certain parameters set forth by the law; for instance, a company is deemed as dormant if its revenue is lower than 6% of the book value of real estate properties booked as fixed assets.

The main consequence of being qualified as a dormant company relate to income taxes; indeed, in such case a minimum deemed taxable income shall be reported, to be determined as a percentage of the book value of the assets qualified as "fixed assets" in the balance sheet.

However, also certain limitations to the ability to transfer or claim for refund VAT credits apply to dormant companies, which limitations have been tightened by the Decree. In particular, in case the company does not carry out for 3 consecutive tax years any sale of goods or services subject to VAT, than the company cannot anymore carry forward such VAT credits. The Decree also provides that in case of extraordinary non-recurring events which may prove the inability to met the "activity" parameters the company can obtain a ruling from the tax authority to avoid the application of the above mentioned restrictions.

Changes to assessment rules and penalties

As mentioned above, the new provisions introduced by the Decree are also aimed at couteracting VAT tax frauds related to real estate transactions. In line with this ratio legis, the Decree also provides for more efficient assessment powers in favour of tax authorities and for new criminal sanctions in connection with VAT violations.

Pursuant to the Decree, tax authorities are now entitled to assess the taxable base for VAT purposes on the basis of the fair market value of the assets transferred, regardless of the actual purchase price agreed by the parties in the deed of transfer. In general, the burden of proving that the actual price does not reflect the fair market value lies with the tax authorities. However, the Decree also introduced a specific presumption according to which the fair market value of real estate assets cannot be lower than the amounts borrowed by the buyer in connection with the purchase of the asset.

Moreover, new criminal sanctions has been introduced. In particular, according to paragraphs 10-ter and 10-quater of art. 10 of Legislative Decree no. 74 of 10 March 2000, as modified by the Decree, (i) the failure to pay VAT due as resulting from annual VAT return, and (ii) the use of undue VAT deductions - in both cases for amounts exceeding €50.000 - are now punishable with imprisonment from six months to two years.

Biographies

Paolo Giacometti Chiomenti Studio legale Via Verdi 2 20121 Milan Italy Tel: +39 02 721 571 Fax: +39 02 7215 7224 Website: www.chiomenti.net Paolo Giacometti is a partner in the Tax Department of Chiomenti Studio Legale, based in the Milan and London offices. His practice focuses on a broad range of domestic and international tax issues connected to corporate restructurings, mergers and acquisitions, capital markets and structured finance transactions. He is a frequent lecturer at tax seminars and a contributor to various domestic and international tax publications. Massimo Antonini Chiomenti Studio legale Via Verdi 2 20121 Milan Italy Tel: +39 02 721 571 Fax: +39 02 7215 7224 Website: www.chiomenti.net Massimo Antonini is a senior associate in the Milan office of Chiomenti Studio Legale. He advises on all areas of tax law, with particular emphasis on international taxation, tax litigation, trusts and estate tax planning. He frequently lectures at post graduated masters and seminars, both in Italy and abroad. He has also written extensively on international taxation matters, with particular focus on permanent establishment, tax residence, transfer pricing and EC tax law. He is a member of the International Fiscal Association and has been Italian national reporter for the IFA Congress 2006.