June 07 2013
In principle, capital gains realised by an Italian-resident company from the disposal of shares of its subsidiaries are 95% exempt from corporate income tax if the conditions required for application of the participation exemption regime are met. However, any capital loss cannot be deducted. If these conditions are not met, the capital gain realised by the Italian shareholder is generally subject to ordinary corporate income tax, while the capital loss will be deductible from the taxable income of the Italian-resident company.
Under Article 87 of the Income Tax Code (Decree 917/1986), any capital gain(1) derived by an Italian-resident company is 95% tax exempt (ie, only 5% of the gain is subject to corporate income tax), provided that the shares transferred fulfil the following participation exemption requirements:
At the time of disposal of the shares, the residence and business activity requirements must have been fulfilled continuously for at least three consecutive tax years. Since the participation exemption regime was introduced, the tax authorities have often been asked to consider specific cases involving these two requirements. As a result, on March 29 2013 the tax authorities issued Circular Letter 7/E, which further clarified such issues.
In particular, with regard to the business activity requirement, the tax authorities have affirmed that a subsidiary is deemed to carry out a business activity for participation exemption purposes when it is provided with an operating structure adequate to produce and/or commercialise goods or services that eventually generate proceeds. In other words, the business activity requirement is deemed to be met when the company is able to satisfy market demand within a reasonable period as required by the industry.
In this respect, Circular Letter 7/E has further clarified that the business activity requirement should be substantially verified, as the company's corporate purpose and formal qualifications are irrelevant. In this context, the collection of proceeds is useful, but is insufficient to verify that the subsidiary carries out an actual business activity.
Moreover, in relation to the three-year period during which the subsidiary should carry out a business activity continuously, the tax authorities have stated that a temporary interruption is irrelevant if the subsidiary maintains an operating structure which allows it to restart the business activity within a reasonable period. However, if the activity is interrupted due to the weakening of the business (eg, subsequent to the sale of relevant assets or the dismissal of personnel), it should be evaluated on a case-by-case basis whether the business activity requirement is still met.
As mentioned above, should the participation exemption requirements not be met (eg, if the subsidiary carries out a non-commercial activity), any loss of capital derived from the disposal of such shares is deductible from the overall business income of the seller in the tax year in which the loss is realised. In this respect, Circular Letter 7/E has stated that – applying the anti-avoidance principle – even in order to affirm that the subsidiary does not carry out a business activity, the taxpayer must prove that the subsidiary did not meet the business activity requirement continuously for a three-year period before disposal. This interpretation by the tax authorities is not grounded in any legal provisions; nor does it respect the aim of the legislature when it introduced the participation exemption regime. Should this interpretation be applied, the taxpayer would face a major disadvantage, as the potential capital loss realised from selling a shareholding would almost never be deductible.
Circular Letter 7/E makes some recommendations as to how to apply the business activity requirement to specific businesses, such as start-up companies, public works concessionaires, energy companies, real estate companies, companies which carry out both business and non-commercial activities, and holding companies.
In principle, as far as real estate companies are concerned, where the company assets mainly consist of real estate assets other than those built or purchased by the company itself in order to be (re)sold or used to carry out a business activity, a non-commercial activity is presumed to exist if the contrary cannot be proven. In order to verify whether the real estate assets owned by the company prevail over its other assets, reference should be made to the market value of all assets (not to their accounting value), also taking into account any liability attached to the assets that may reduce such value (eg, mortgages).
The tax authorities have now acknowledged that if a real estate company also provides significant functional and complementary services which represent active management of the real estate assets, the business activity requirement may be satisfied even by real estate companies. In any case, the income arising from the provision of services should exceed the passive income from the leasing of assets; if not, in the context of a tax audit, the taxpayer will be required to give evidence of the consistency of the services provided.
Second, as far as the disposal of shares relating to holding companies is concerned (ie, companies whose exclusive or main business activity is the holding of participations), Article 87 of the Income Tax Code provides that in order to verify whether the residence and business activity requirements are met, reference must be made to the subsidiaries of the holding company (the 'look-through' approach). The two conditions above are deemed to be fulfilled by the holding company if the taxpayer gives evidence that the most of the shareholdings held by the holding company comply with such requirements. In this respect, Circular Letter 7/E added that – for the participation exemption regime to apply – the residence requirement must be complied with not only by the indirectly controlled foreign companies, but also by the holding company itself where this latter is resident in a tax haven.(5) Should this be the case, the taxpayer controlling a holding company that is not tax resident in a White List country should pre-emptively file with the tax authorities proof that, since the beginning of the ownership, the tax residence therein never had the purpose of localising income in tax havens.
For further information on this topic please contact Franco Pozzi, Simona Zangrandi or Ludovica Lorenzetto at Studio Legale Tributario Biscozzi Nobili by telephone (+39 02 763 6931), fax (+39 02 780 146) or email (firstname.lastname@example.org, email@example.com or firstname.lastname@example.org).
(2) With regard to this condition, pursuant to Article 37bis of Decree 600/73 the tax authorities may disallow the tax advantages deriving from the participation exemption regime obtained through booking the participation as fixed financial assets in the financial statements if they deem that the participation should have been accounted for as inventory.
(4) The 'White List' under Article 168bis of the Income Tax Law includes countries that allow the exchange of information with the Italian tax authorities.
(5) In general, the notion of 'tax havens' (also known as 'Black List countries') refers to countries excluded from the White List (ie, those that do not allow for the exchange of information with the Italian tax authorities).
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