Monday, 23 January 2017

Italy's tax court decisions cast doubt on compatibility of participation exemption regime with EU law

Nonresident companies that recently have sold (or are considering selling) a participation in an Italian company should be aware of two 2015 Italian tax court decisions that address the compatibility of Italy’s domestic participation exemption regime for capital gains with EU law. In the decisions, tax courts at the provincial and regional levels (i.e. the first and second-tier tax courts) concluded that the regime is incompatible with the Treaty on the Functioning of
the European Union (TFEU) because it treats gains realized by Italian companies on the sale of an Italian participation more favorably than those realized by foreign companies. The courts found this treatment to be an unjustifiable restriction of the free movement of capital and/or establishment.
Under Italian tax law, capital gains realized by Italian companies on the sale of participations in Italian subsidiaries are 95% exempt from corporate tax if certain conditions are satisfied, which – given the current corporate income tax rate of 27.5% – results in a final tax rate of 1.375%. In contrast, capital gains on the sale of Italian participations realized by a foreign entity without a permanent establishment in Italy are taxed as follows:
  • Sales of qualified participations (i.e. holdings of more than 20% of the voting rights or 25% of the share capital of private companies, or more than 2% of the voting rights or 5% of the share capital of public companies) are subject to a 13.67% final withholding tax (i.e. 49.72% of the gains is taxed at a 27.5% rate).
  • Sales of nonqualified participations are subject to a flat 26% final withholding tax. However, sales of nonqualified participations in Italian public companies are tax exempt if the seller is resident in a “white-listed country” that allows an effective exchange of information with Italy (an updated version of the white list recently was issued by the Italian government).

The higher tax burden on capital gains realized by nonresident companies raises the question of whether the Italian participation exemption regime is in breach of the fundamental freedoms guaranteed by the TFEU. In particular, the issue has practical implications when the relevant participation is held by a company resident in a country with which Italy has concluded a tax treaty that allows the source state to tax the capital gains derived from the sale of the Italian participation.
The case before the Provincial Tax Court of Pescara and, subsequently, the Regional Tax Court of Pescara involved a French company that sold its shares in an Italian subsidiary. The French company paid a tax rate of 11% on the capital
gains from the sale of the shares; as noted above, had the gains been derived by an Italian company, the effective tax rate would have been 1.375%. Under the provisions of the Italy-France tax treaty, such capital gains are taxable in Italy where the French seller holds at least 25% of the voting rights of the Italian company.
Both Italian tax courts held that the Italian domestic tax rules violate the freedom of establishment and the free movement of capital principles in the TFEU, and that the restriction could not be justified. The courts’ decisions are particularly relevant in cases where the legislation of the residence state does not provide for a full exemption for the gains or a foreign tax credit that would prevent the (partial) double taxation.
The courts supported their conclusions by referring to a 2009 decision of the Court of Justice of the European Union (CJEU) – also involving Italy – in which the CJEU held that the previous Italian tax legislation on dividends paid to a
recipient in the EU/European Economic Area (EEA) was incompatible with the EU treaty. Italy’s legislation that applied until 2007 provided for a domestic withholding tax on dividends paid to such recipients that was higher than the final tax rate applicable on dividends paid to another Italian tax resident company. According to the Italian tax courts, the same principle could be applied to conclude that the current Italian participation exemption regime for capital gains realized by EU/EEA recipients infringes EU law.
Source: Deloitte