Questions raised on Italy’s penalty protection regime

Following Italy’s new transfer pricing (TP) requirements¹ introduced on 23 November 2020, there has been much discussion as to whether the taxpayer may benefit from penalty protection that also covers additional withholding tax otherwise due when the Italian tax authorities (ITA) perform adjustments that recharacterise the nature of a transaction.  A Circular² letter was then issued by the ITA In November 2021 which provides clarifications on the TP requirements introduced.

In order for multinational groups to benefit from penalty protection³ from the fiscal year 2020, they must comply with the new TP documentation requirements that replace the provisions introduced in 2010.

It should be noted that the filing of TP documentation is not compulsory under Italian law. However, if it is available in time and is compliant with Italian TP regulations, taxpayers will benefit from penalty protection which may range from 90% to 180% of the tax adjustments.

TP documentation protects against challenges

The presence of adequate TP documentation will also protect taxpayers in the case of challenges deriving from adjustments to royalties and interest expenses. In particular, for outbound interest or royalties on which there is no withholding rate based on the EU Interest and Royalties Directive or a reduced withholding rate applied based on double taxation treaties, However, if the amount paid in excess of the arm’s-length value were challenged, it would be subject to the ordinary withholding rate provided by national legislation.

Where TP documentation is considered compliant, for example when it follows the structure of the new TP requirements and provides a complete description of the facts and circumstances that enable the tax auditors to perform their analysis, the penalty protection also applies for withholding tax purposes.

Different opinions on treatment of challenges to transactions

It is undisputed that the taxpayer benefits from the penalty protection regime on withholding tax when the amount of the transaction is challenged by the ITA.  An example might include an Italian taxpayer paying a royalty for access to intangible property (IP) owned by an overseas-related party and the tax auditors consider the royalty is not in line with the arm’s length principle. This is expressly provided for by the Italian TP legislation, as highlighted above.

However, this differs when the tax auditors challenge the TP model underpinning the intercompany transaction. Such a situation might arise when an Italian taxpayer receives a payment from a related party for the provision of services and the tax auditors consider that such payments are not for services, but rather to remunerate the IP shared by that related party.

The question is whether by recharacterising the service charge the taxpayer should also benefit from the penalty protection regime on the applicable withholding tax when the nature of the transaction is challenged by the tax auditors.

There are different opinions. One of which sustains that, according to the concept of systematic consistency within the Italian tax legislation, the taxpayer should benefit from the penalty protection even when the nature of the transaction is challenged and there are withholding tax implications.

This is because where the taxpayer is not granted penalty protection it would result in disparity and inconsistency with respect to the penalty protection regime; protection which the taxpayer would be eligible for anyway on direct taxes, including corporate and regional taxes, IRES, and IRAP respectively.

Clarification on new TP requirements

Others argue that the taxpayer should not be eligible for the penalty protection regime when the nature of the transaction is challenged and there are withholding tax implications. This position is based on a Circular letter issued by the ITA, which provides clarifications on the new TP requirements introduced. This clarification expressly mentions that the taxpayer would benefit from penalty protection on withholding tax for those transactions related to the payment of royalties or interest that are described in the TP documentation. However, there is no clarification on treatment when the nature of the transaction is challenged.

The above position would introduce a qualitative element regarding not only the opinion on the TP documentation, but also regarding the TP model underpinning the intercompany transactions.

In fact, the taxpayer would be eligible for the penalty protection regime for withholding tax only when the TP model underpinning the intercompany transactions has not been challenged and not when the challenge implies a revision of the nature of the transactions and the relevant financial flows.

In this regard, it is important to highlight that based on the new TP requirements and the Circular published by the ITA, the taxpayer should be eligible for the penalty protection regime when the TP documentation follows the formal structure and includes a complete and truthful set of information related to the intercompany transactions carried out by the taxpayer^[1]. This would enable the tax auditors to collect all the relevant information to perform a complete and detailed analysis of transfer prices applied in the intercompany transactions.

Therefore, it can be argued that the correct representation of the facts and circumstances that allow the tax auditors to perform their analysis should be enough to grant the taxpayer eligibility for the penalty protection regime.

Further clarification required

Based on the above, the ITA should provide clarification regarding this matter and whether a qualitative element should also be introduced.

From our experience and considering the formalistic approach by the ITA, we are of the opinion that it is very likely that the tax auditors will follow a conservative approach, applying penalties on the withholding tax when the nature of the transaction is challenged.

However, there are elements to support the position that the penalty protection should cover the taxpayer tout court when the documentation provides a complete description of the facts and circumstances that enable the tax auditors to perform their analysis. This should apply even when the analysis involves revising the nature of the transactions with withholding tax implications.

^[1]1. Measure no. 360494

2. Circular letter n. 15/E

3. Please note that there are also other eligibility requirements for the penalty protection regime,e.g., the documentation must be electronically signed by the legal representative or by a delegate, and a time stamp must be affixed to the documentation by the date of the submission of the annual tax return, etc.