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New Legislation on Tax Residency and Overseas Dividends - International Law Office

International Law Office

Corporate Tax - Italy

New Legislation on Tax Residency and Overseas Dividends

November 17 2006

Tax Residency of Foreign Holding Companies
Dormant Companies
Dividends from Tax Havens
Stock Options


Newly issued legislation introduces a number of new provisions relating to Italian tax law.(1) As the government is in the process of finalizing the Finance Bill 2007, which is due to be approved by Parliament before the end of 2006, changes to the new provisions are expected.

Tax Residency of Foreign Holding Companies

One of the most significant measures concerns the tax residency of foreign companies (or similar entities) which have a link to the Italian territory that is presumed to be relevant under the terms of the new law.

Articles 35(13) and (14) of Law 248/2006 state that the place of effective management - and therefore the place of residency for tax purposes - of a foreign, non-resident company or entity (FNRC) which owns and directly controls participations in Italian resident companies or trading entities is presumed to be in Italy, provided that the FNRC is in turn controlled (even indirectly) by Italian residents or, alternatively, managed by a board of directors (or an equivalent management body) of which the majority of the members are resident in Italy. This provision constitutes a rebuttable presumption at the hands of the FNRC.(2)

The presumption is aimed at all FNRCs (regardless of whether they are resident in tax havens) which hold at least one direct controlling participation in an Italian resident company; for the purposes of the control test, a company is presumed to be in the hands of an FNRC if the latter holds the majority of the voting rights at the ordinary shareholders' meeting.

In the case of chains of companies, a second-tier holding (ie, a structure in which an FNRC controls another FNRC, which in turn holds a controlling participation in an Italian resident company) falls within the scope of application of the law to the extent that the FNRC which directly controls the Italian resident company is deemed to be resident in Italy according to the presumption.

In order for an FNRC to qualify as an Italian resident entity, a further (alternative) requirement is imposed in addition to the criterion relating to the controlling participation in an Italian resident company. The rule applies only if the FNRC is in turn controlled (even indirectly) or managed by a board of directors of which the majority of the members are Italian residents. If the resident in question is an individual, the voting rights of his or her relatives must also be taken into account. Both requirements must be met on the final day of the non-resident company's fiscal year.

It remains unclear how the rule works if a member of the board of directors of the FNRC is not an individual but, for example, a trust company which is not resident in Italy, but whose managers, trustees or shareholders are nonetheless Italian residents.

If an FNRC cannot rebut the presumption, it is deemed to be resident in Italy for tax purposes and will be required to comply with provisions relating to, among other things:

  • the taxation of capital gains derived from the sale of participations under the Italian participation exemption;

  • the retention of withholding tax on interest, royalty and dividend payments to non-resident persons;

  • controlled foreign company (CFC) rules in the case of a subsidiary which is resident in a tax haven; and

  • the obligation to file income tax and value added tax (VAT) returns.

However, Italian residency may have the advantage of allowing an FNRC to benefit from the consolidation tax regime, the consortium relief regime and/or Italian thin capitalization rules.

The tax authorities have yet to provide examples of facts, situations or actions which would be sufficient to demonstrate that the actual place of effective management of an FNRC is not in Italy. Expert opinion generally accepts the need to distinguish between trade companies (ie, FNRCs which actively conduct business) and holding companies (ie, FNRCs which manage their participations). The place where business is carried out is generally the same as the place of management, particularly in the case of holding companies. Therefore, when applying the rule on residency to holding companies, it will be relevant to identify the place where strategic, operational and executive decisions are taken.

A large number of cases of dual residency are expected to arise as a result of the new provision; reciprocal tax treaties and similar arrangements may be helpful in clarifying the law, but procedures under such rules usually take too long to be of use in business contexts. Given the implications of these changes, a reaction from foreign governments - not least Italy's EU partners - is expected soon.

Dormant Companies

Article 30 of Law 724/1994 states that companies will be deemed to be dormant if they fail to accrue a minimum amount of revenue in a fiscal year, in which case they are presumed to be liable to tax on the basis of a minimum taxable income proportionate to their assets. Articles 35(15) and (16) of Law 248/2006 extend the basis on which the minimum amount of revenue is identified and the minimum taxable income is calculated.

The calculations are to be based on average revenue over three fiscal years; calculations for 2006 will therefore take into account income for 2004 and 2005, when the new parameters did not apply. This will have the undesirable effect that the parameters for both revenue and taxable income for 2006 will be above the levels required by law: the minimum amount of revenue is equal to 6% of the real property held by the dormant company, compared with 4% for 2004 and 2005, and an effective minimum amount of revenue of 10% will be required for 2006 in order to escape the dormant company classification.

The dormant companies regime has also been extended to VAT. Dormant companies are excluded from reimbursement of VAT input and VAT input set-off. If a dormant company fails to carry out VAT transactions in line with the minimum taxable input parameters, the VAT input is lost, and whereas in the past the dormant company regime could be avoided automatically in exceptional circumstances, an official ruling by the tax authorities is now required.

Dividends from Tax Havens

Articles 36(3), (4) and (4)(2) bring fully within the scope of Italian taxation all profits(3) deriving from legal entities which are resident in countries identified as tax havens on a list issued by the tax authorities in relation to the CFC rules.(4) The main rationale is to exclude dividends from tax havens from the participation exemption, which applies at 60% of the gross dividend if paid to Italian resident individuals and partnerships and at 95% if paid to Italian resident corporations.

The new provisions change the previous wording, which stated that dividends could be taxed in full if they were "directly paid by tax haven resident companies".(5) The main change is the addition of the words "profits deriving from" in the provisions relating to dividends paid in favour of individuals and enterprises. However, some grey areas still exist. In particular, the revised provisions for individuals and partnerships(6) exclude from the participation exemption "profits deriving from companies resident in countries [identified as tax havens]", stating that the same regime applies to Italian individuals receiving proceeds as a result of silent partnership agreements in which the silent partner is resident in a tax haven. On the other hand, the revised provision for corporations in Article 89(3) confirms that the participation exemption applies to:

    "profits deriving from persons included in Article 73(d) (ie, non-resident companies and entities) and proceeds deriving from agreements mentioned in Article 109(9)(b) (ie, silent partnership agreements) stipulated with the said persons, provided that they are not resident [in tax havens]."

In the case of dividends and proceeds from a silent partnership, it could be argued that the new rules have a wider scope of application if the payee is a corporation.

The new rules will operate in conjunction with the CFC rules, for which the scope of application was also broadened in 2006 in relation not only to companies which are resident in tax havens and controlled by Italian resident persons, but also to associated enterprises in which an Italian taxpayer's holding is equal to at least 20% of the company's profits.

CFC rules, where applicable, will prevail over the new rules on dividends. If CFC rules do not apply because the tax haven company has given evidence to the tax authorities that it does not enjoy a privileged tax regime, which is the first condition for disapplying the rules, dividends paid by the company will fall within the participation exemption; however, if CFC rules do not apply because the tax haven company has given evidence that it carries out an effective trade and business (ie, the second, alternative condition), the new rules on dividends (and consequent full taxation) apply and the participation exemption does not apply.

The authorities have made clear that the new provision is aimed at fully taxing dividends deriving from tax havens, even if such dividends are received through chains of companies resident in non-tax haven countries.(7) This approach may lead the government to breach EU regulations if the intermediate company between the tax haven company and the Italian parent company is covered by the EU Parent-Subsidiary Directive - the European Commission has already started proceedings against Italy (on other grounds) in relation to the enforcement of the directive. The approach may also contravene certain bilateral tax treaties, in particular those agreed with Germany and Brazil, which provide for 0% taxation on dividends received by Italian parent companies.

In all cases involving an intermediate company which is not resident in a tax haven, an additional issue may be raised in relation to the proportion of a dividend that is deemed to derive from a company in a tax haven. No clear guidance is given on how the taxpayer and/or the authorities are to establish the proportions of (for example) EU dividends which are not eligible for the participation exemption because they are considered to derive from a tax haven.

Dividends paid by companies which are not resident in tax havens will continue to benefit from the participation exemption if the paying company has received the income from a tax-haven subsidiary in the form of income other than a dividend; this reading of the measures is confirmed by the tax authorities' statement that the rule plays:

    "a key role in the tax system against triangular dividend schemes which allow the shareholder to receive profits deriving from tax havens through intermediate companies which are substantially interposed."(8)

Stock Options

The new legislation introduces fundamental changes to the tax treatment of stock options granted to employees. The former provisions in Article 51(2)(g)(2) of the Corporation Tax Act provided that the difference between the arm's-length value of the underlying shares at the exercise date and the price paid by the employee did not represent employment income if: (i) the price paid by the employee on exercising the options was at least equal to the arm's-length value of shares when they were granted; and (ii) the shares and rights owned by the employee did not exceed 10% of the voting rights in the ordinary shareholders' meeting or a participation of 10% in the company's capital. Accordingly, in the event of the subsequent disposal of the shares, the employee was liable to capital gains tax at 12.5%.(9) The tax benefit of these rules - if the two conditions were met - was to differentiate the arm's-length value of the shares received by the employee from his or her employment income and allow it to be treated as a capital gain, but only in the event of disposal, not on an accrual basis.

Pursuant to the recent changes, the employment income exemption is subject to three further requirements:

  • The option shall be exercisable (on vesting) only if the shares were granted at least three years previously;

  • The shares must be listed on a stock exchange when the option becomes exercisable; and

  • For at least five years from the date on which the options are exercised, the employee must maintain an investment in the same shares which amounts to no less than the difference between the arm's-length value of the shares on exercise and the price paid by the employee. If the investment is settled, disposed of or set under guarantee before the five-year period expires, liability for income tax is triggered in the relevant fiscal year.


For further information on this topic please contact Marco Abramo Lanza or Francesco Nobili at Studio Legale Tributario Biscozzi Nobili by telephone (+39 02 763 6931) or by fax (+39 02 780 146) or by email (marco.lanza@slta.it or francesco.nobili@slta.it).


Endnotes

(1) Law 248/2006 converts into law the provisions of Decree-Law 223/2006, partially amended by Decree-Law 262/2006.

(2) Regulation 28/E, issued on August 4 2006.

(3) The term 'dividend', as used in the legislation, includes dividends paid out of the profits of companies and entities, proceeds from financial instruments and hybrid loans which qualify as dividends under Italian law and interest which is non-deductible due to thin capitalization payments.

(4) The blacklist was included in a ministerial decree issued on November 21 2001.

(5) Regulation 4/E, issued on January 18 2006.

(6) Articles 47(4) and 59 of the Corporation Tax Act respectively.

(7) Regulation 28/E.

(8) Id.

(9) Previously, when an individual disposed of qualifying shares, 40% tax was payable on the capital gain at progressive rates. Shares qualified if the participation in the company's capital was greater than 20% of the voting rights or greater than 25% of the company's capital (these percentages were stepped down to 2% and 5% if the shares were held in listed companies). Therefore, as a 10% cap applied to shares and rights owned by employees, 40% tax at progressive rates applied only in the case of listed companies.



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