Critical Factors in Handling Italian Transfer Pricing Controversies
July, 17th 2015
In response to the economic downturn and the growing need for tax revenues, the Italian Tax Authorities (ITA), like authorities in many other jurisdictions, have more aggressively targeted multinationals and their tax planning strategies in recent years, resulting in more domestic and international tax controversies. Transfer pricing (TP) issues account for the lion’s share of these controversies between multinationals and the ITA.
In 2010, Italy introduced TP documentation regulations that provide penalty protection for taxpayers that comply with the documentation requirements. Considering the harsh penalties applicable in cases of TP adjustments (ranging from 100 to 200 percent of the assessed tax deficiency), Italian companies (particularly Italian affiliates of multinational groups) have generally taken the opportunity to seek protection from penalties very seriously, and have made appropriate efforts to establish compliant TP documentation. In turn, the ITA have been able to rely on more complete data sets, making it easier for them to assess TP policies within multinational groups. Contrary to previous standard tax audit practice, currently no tax audit of a multinational takes place without a thorough investigation of the group’s TP policy. Not surprisingly, the number of TP controversies has dramatically increased as a result.
When facing a TP adjustment, Italian companies have an array of available remedies, including both domestic and international procedures. At a domestic level, there are various forms of settlement with the ITA, either before or after litigation has been started. Although litigation remains a viable solution, generally neither party (taxpayer or ITA) is keen to litigate TP cases, given the technicality of the issues at stake, the length of the proceedings and the unpredictability of the tax court’s decisions.
Taxpayers also can apply for a mutual agreement procedure (MAP) with the competent authorities under the applicable Double Tax Convention (DTC), in order to avoid double taxation. If the related party involved in the intercompany transaction is a resident of another EU Member State, the taxpayer may choose to initiate an MAP pursuant to the EU Arbitration Convention, which includes a mandatory arbitration clause, instead of an MAP pursuant to the applicable bilateral DTC, which usually only entails a best effort (not an obligation) for the competent authorities to reach an agreement.
The interplay between domestic remedies (settlement, litigation) and MAPs is intricate, however, and works differently depending on which kind of MAP (pursuant to the DTC or to the EU Arbitration Convention, where applicable) is initiated. In any case, the ITA’s position is that a domestic settlement forecloses the possibility of pursuing an MAP, so that in case of settlement only a correlative adjustment unilaterally granted by the other State could avoid or reduce double taxation. This position seems to contrast with the Discussion Draft on BEPS Action 14, and taxpayers eagerly await a change in the ITA’s policy.
While an MAP theoretically is the best solution from a taxpayer’s perspective, several factors put pressure on the taxpayer to settle the controversy with the ITA, resulting in loss of access to the MAP according to the ITA’s current position. Such factors include the following:
Penalties. Tax settlement rules entail significant reductions in tax penalties, ranging from one-sixth to one-third of the applicable penalty. Such reduction may occur as a general rule when no TP documentation has been provided for the relevant fiscal year, so that the penalty protection rule is not applicable. However, reduction may also occur as a result of denial to apply the penalty protection rule—i.e., if the ITA deem that the TP documentation does not meet the statutory requirements in terms of its structure or, more likely, its accuracy and/or reliability. The ITA sometimes raise this objection, even instrumentally, in order to deny the penalty protection and put additional pressure on the taxpayer to settle the case.
Interplay with MAPs under bilateral DTCs. Generally, MAPs under bilateral DTCs require that domestic remedies not be waived, obligating the taxpayer to start a domestic litigation. Under Italian rules, starting litigation does not suspend the obligation to pay the assessed taxes; one-third of the assessed taxes and relevant interest remain due. However, the taxpayer can submit a claim of suspension to the court, which has discretionary power to grant suspension of the interim payment.
Uncertainty, timing and cost. MAPs entail uncertainty regarding the outcome for an extended period of time, and are expensive and time-consuming procedures. Moreover, as noted, most DTCs do not include an arbitration clause, so an agreement between the competent authorities is not mandatory and may not be reached.
Profit/loss impact. Management is often more sensitive to profit/loss rather than cash impacts. If an accrual is to be made pending an MAP, it is often perceived as a final impact in a short-term management approach.
Among the factors listed above, penalties, when applicable, perhaps play the most critical role, and may constitute a trade-off that can seriously discourage a taxpayer from starting an MAP. While a reduction of the TP adjustment under a domestic settlement automatically entails an ensuing mitigation of penalties, the same reduction of the TP adjustment achieved under an MAP has no effect on the corresponding penalties.
The following example shows the minimum result required for an MAP to break even—i.e., to match the final charge (tax plus penalties) obtained under a settlement.
*Assuming that the higher tax due in Italy as a result of the MAP is fully offset by the tax relief on the corresponding adjustment in the other State. This analysis is negatively affected if a lower tax rate applies in the other State.
TP adjustments also can have criminal ramifications. Under Italian law, tax adjustments above certain thresholds (which are easily reached when large companies are involved) can result in tax crimes irrespective of whether any fraudulent intent or behavior by the taxpayer exists. The ITA often submit a notice of crime to the Public Prosecutor. While most of these cases are dismissed before going to trial, particularly when the tax penalty protection rule applies, in some cases criminal proceedings have actually been started (and continued) on TP matters.
The possibility of criminal prosecution clearly can be powerful factor in a taxpayer’s decision regarding defensive strategy. Under current legislation, settlement with the ITA does not automatically imply dismissal of a criminal charge, but is generally viewed favorably by the Public Prosecutor. Sometimes the choice of settlement strategy is primarily, if not solely, driven by the opportunity to facilitate the dismissal of a criminal charge. A legislative change expected to be enacted later in 2015 provides that tax settlement will automatically trigger dismissal of any criminal charge; this change will likely further increase the pressure on taxpayers to settle.
The combination of the aforementioned factors provides many practical reasons for Italian affiliates of multinational groups to settle TP adjustments with the ITA under domestic procedures, even though such settlement forecloses access to MAPs and waives the possibility for a correlative adjustment in the other State involved (unless the latter unilaterally provides relief against double taxation). This ITA policy does not seem consistent with the spirit of the DTCs entered into by Italy and appears to be in contrast with the Discussion Draft on BEPS Action 14. As long as this policy remains unchanged, however, multinationals may be forced to choose suboptimal defensive strategies when dealing with TP adjustments.
This ITA policy also often creates disappointment in the competent authorities of the other States involved, as they sometimes feel “forced” to grant unilateral relief against double taxation that they might otherwise be unwilling to concede. A practical way to mitigate this effect is to involve the competent authorities of the other State at a very early stage of the Italian administrative, and where applicable, criminal, proceedings. Such involvement can be achieved by initiating an MAP in the other State and keeping the competent authorities of that State constantly informed of any developments occurring on the Italian side, in parallel with the developments of the MAP (if any). This continuous flow of information may give the competent authorities a better awareness of the factors pushing the taxpayer to settle the controversy with the ITA, and the fact that a settlement with the ITA may ultimately represent the most effective remedy available for the taxpayer.