03 Nov International taxation
The pursuit of an economic activity abroad by an economic Italian operator can be carried out through the opening of a permanent formal establishment (in the practice defined by the English term branch) or through the formation of an entirely or partially locally owned company, by the Italian parent company.
In certain cases, local law does not permit the establishment by a foreign fully controlled economic company operated by the latter, but requires the presence in the social structure of a local member who in some cases must hold a majority stake (at least formally) in the share capital of the incorporating company.
A branch does not constitute an autonomous legal entity in relation to the parent company, although it is subject to taxation in the foreign country where the economic activity is carried out.
Article 5 of the OECD Model, which was transposed into Italian in Article 162 of the Italian Tax Code, identifies a branch as “a fixed place of business through which the non-resident enterprise is wholly or partially carried out in the country”.
With reference to a permanent establishment of an Italian enterprise abroad, we note that (in the absence of legal autonomy of the branch) the costs, revenue and any inventories become an integral part of the permanent establishment of the Italian company’s financial statements and contribute to the formation of its taxable income.
From an accounting point of view, there is an obligation (under Article 14 of Italian Presidential Decree 600 dated 1973) to detect management performance relating to the financial year of the permanent establishment, with separate determination of the operating results attributable to it.
In Italy a tax credit is recognised for taxes that have been definitively paid abroad on income produced by the permanent establishment (Article 165 of the Italian Tax Code).
Since the permanent establishment is not a legally distinct entity in relation to the parent company, withholding tax on profits (net) that are assigned by the permanent establishment to its parent company generally does not apply. This application on the other hand is expected – but in some cases mitigated or eliminated by virtue of specific agreed clauses – in the case of distribution of dividends by a foreign subsidiary to the Italian investee.
Given the lack of legal subjectivity of the permanent establishment, against recognised profit generated by it, as the – positive – difference – between revenue and costs, it should be mentioned that in situations where the permanent establishment is making a loss (negative difference between revenue and costs), there will be direct relevance in the accounts of the Italian parent company.
Among the advantages of the permanent establishment, there is the opportunity provided in Article 12 of Italian Legislative Decree 446/1997, to deduct from the taxable income of the parent company’s share of income attributable to the permanent establishment located abroad. This, of course, is a result of the direct recording of positive and negative income components of the permanent establishment in the accounts of the parent company.
A further aspect of significant importance is provided by the eventual sale to third parties of the business activities carried out abroad through the permanent establishment.
In this case, as it does not have legal and patrimonial autonomy, the possible sale would be fully charged to the taxation of the Italian parent company as the difference between the tax values admitted in the financial statements (inventories, any tangible and intangible assets attributable to the permanent establishment) and the sale price.
If, however, you were to decide to operate abroad through a subsidiary company, it should be noted that the subsidiary has full legal and tax autonomy, such that the income produced by it is subject to taxation only in the foreign country of residence.
Except where the company is resident or domiciled in a country with low-taxation, the dividend may be distributed by the foreign subsidiary to the Italian investee company within the limit of 5% of its amount thereof, with an IRES rate of 27.5%.. Dividends do not form part of the IRAP tax base.
This results, for all intents and purposes, in an imposition equal to 1.375% (27.5%*5%).
Even the gain arising from the sale of the investment is subject to tax, if the conditions lay down in Article 87 of the Italian Tax Code are within the limits of 5%, generating effective taxation of 1.375%.
The aforementioned rules do not apply when the subsidiary is resident or domiciled in a so- called “black listed” country.
In this case, the regulations in Articles 167 and 168 of the Italian Tax Code (the provisions on controlled foreign companies and provisions on associated foreign companies, respectively) provide for transparency of taxation of income generated by subsidiaries residing there, regardless of the actual distribution of profits. Obviously, at the time of actual distribution, they will be subject to taxation once more.
To avoid profits being directly attributed to the investee company, in accordance with the so-called principle of fiscal transparency, a specific request for non-application must be accepted, suitable to demonstrate that “the non-resident company or other entity effectively performs industrial or trade activity, as its main activity in the market of the country or territory of settlement”.
It is therefore necessary, as confirmed by the circular from the Italian Inland Revenue Office that the company is effectively “rooted” in the economic fabric of the country in which it operates.
As an alternative to demonstrating the actual activities carried out in the country, it is possible for the taxpayer to show that the location of the subsidiary does not follow the localisation of income in a low-tax country. This, of course, is relevant only in cases where the subsidiary is resident in countries that have not been “black listed”.
But this is not enough. In fact, it is not possible to use all the exemptions referred to in paragraph 1 of Article 167, if the subsidiary company achieves more than 50% of their income “from the administration, holding or investment in shares, holdings, loans or other financial assets, from the sale or the granting of the right to use intellectual property rights related to industrial, literary or artistic work, as well as the provision of services to persons who directly or indirectly control the company or the non-resident entity, companies controlling it or controlled by the same company that controls the non-resident company or entity, including financial services.
The specific rules on transfer pricing (transfer pricing – Article 110, paragraph 7 of the Italian Tax Code), shall apply to the regulations referred to in the preceding paragraphs, according to which the price at which goods and services are exchanged between subsidiaries and parent companies must be assessed according to the normal value, in other words on the basis of the price that would be applied between third party businesses and independent parties. This aspect is particularly important as it is a condition to which the investigation and control bodies attribute greater importance. The framework is particularly complex and requires, in most cases, a thorough study of the goods and services exchanged, the reference markets, any market competitors and other factors specific to the market sector.
In general, for companies operating in different markets through their subsidiaries, the preparation of a master file and National Documentation for each individual subsidiary is required. In light of the above, it is apparent that the choice between operating in a given country through a branch or a subsidiary depends on various factors. However, it can be said that the better choice is to operate through a subsidiary company, as this allows for the deferral of the imposition of taxation in Italy on profits earned at the time of their actual distribution, thus benefiting from limited taxation (1.375 %).
However, in situations where the activity must be carried out in a country with low-tax, it is necessary, through specific application, to be able to prove eligibility for exemptions provided by Article 167 of the Italian Tax code which has been repeatedly mentioned.
Finally for the purposes of completeness, it should be noted, that any dividend distributed by a company resident in an offshore country to its Italian investee is subject, in accordance with the provisions of the agreements against Double Taxation concluded between Italy and the country – reference market, to withholding tax equal to:
- 5% where the company’s holding is at least 25% of the capital of the company paying the dividends or
- 15% in other cases.
There is however, no provision, for tax withholding or levy on any interest paid by a subsidiary company to a investee company (and vice versa) except in cases where the amount of interest has not been determined according to the rules that would have applied in the event that a participatory relationship between creditor and debtor subject existed.
It should be highlighted that with particular reference to the possibility of obtaining an affirmative answer to the specific request for non-application of transfer pricing, the matter is particularly delicate and complex and therefore requires a specific test case.
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