On 27 July 2007, the Italian tax authorities issued Ruling No. 184 dealing with the deductibility of a deficit (badwill) derived from a transfer of a going concern.
(a) Facts. An Italian NewCo paid a lower price than the net value of the assets received as part of an acquisition of a going concern. This difference represents a deficit (badwill) for the purchaser and is applied to expected losses for the next 3 years. The Italian NewCo posted the badwill in a reserve for future risks (fondo per rischi e oneri) on its balance sheet. Such provision would be utilized to cover future losses.
(b) Issue. Whether (i) from an accounting perspective, the allocation of the badwill to a reserve for future risks is correct and (ii) such reserve can be utilized to cover future losses without triggering any taxable income.
(c) Tax authorities' opinion. First, the tax authorities clarified that they cannot provide an answer to the first issue above as it relates to accounting principles and not to tax provisions. However, where the allocation of the badwill to the reserve for future risks is correct from an accounting perspective, then, from a tax perspective, it follows that:
|-||the badwill (i.e. the reserve) must be included in the taxable income of the Italian NewCo in order to cover/compensate the losses incurred in years following the one in which the acquisition took place;|
|-||starting from the year in which the Italian NewCo makes a profit, the residual amount of the badwill (i.e. the reserve), if any, must be recaptured and included in taxable income.|
In reaching the above conclusion, the tax authorities pointed out that as the provision on account of badwill does not fall within the scope of Art. 107 of the Italian Income Tax Code (ITC), its tax treatment follows from its accounting treatment (Art. 83 ITC – principio di derivazione).
Interaction between participation exemption regime on dividends and controlled foreign company regime
On 27 July 2007, the Italian tax authorities issued Ruling No. 191. The Ruling relates to the applicability of the participation exemption regime (PEX) on dividends, paid by a company resident in a tax haven, out of income that has been already taxed in Italy under the controlled foreign company (CFC) regime.
(a) Facts. An Italian company owns 65% of a company resident in Hong Kong (HK). The latter owns 100% of a company resident in China (People's Rep.). Honk Kong is a tax haven country for Italian tax purposes, included in the "black list" (Ministerial Decree 21 November 2001). The only income collected by the HK company is represented by dividends paid by the Chinese company. On the contrary, the Chinese company is carrying out an effective industrial activity in China. The HK company is subject to the Italian CFC regime.
(b) Issue. (i) How the taxable base of the HK company should be determined under the CFC regime, and (ii) whether the PEX is available on dividends paid by the HK company to the Italian shareholder, exceeding the income that has already been taxed in the hands of the Italian recipient under the CFC regime.
(c) Tax authorities' opinion. First, the tax authorities recalled Paragraphs 1 and 6 of Art. 167 of the Italian Income Tax Code (ITC) where it states that:
|-||profits of a foreign black listed entity are attributed to the Italian company at the last day of the financial year of the foreign entity, in proportion to the shareholding owned;|
|-||the attributed income is computed by applying the Italian provisions regulating the computation of business income;|
|-||the attributed income to the Italian shareholder is taxed separately (i.e. CFC income cannot be offset by the Italian person's losses) at the taxpayer's average tax rate. This average rate cannot, however, be lower than 27%.
Hence, with regard to the first issue, the tax authorities stated that attributed income qualifies as business income and, therefore, such income is computed according to the general corporate income tax rules.
Then, the tax authorities recalled Art. 89(2) and (3) of the ITC dealing with the PEX regime. In particular, pursuant to Art. 89, a foreign company is entitled to the PEX regime if its controlled companies distributing dividends are not located in a tax haven. It follows that the PEX regime is applicable also to dividends distributed by a foreign company not placed in a tax haven (i.e. the Chinese company) to a company resident in a black listed country (i.e. the HK company), when the income of the latter is attributed to the Italian shareholder under the CFC regime. Indeed, if (i) the entire income of the HK company is formed by dividends distributed by the Chinese company and (ii) HK company does not distribute dividends to the Italian shareholder, then, the income of the HK company attributed to the Italian shareholder under the CFC regime is exempt up to 95%.
In principle, if the HK company distributes dividends to the Italian shareholder, the PEX regime is not available. In such a case, pursuant to Art. 167(7) of the ITC, dividends paid by a CFC company are not subject to tax only for the part of the amount exceeding the income that has been already taxed in the hands of the Italian recipient under the CFC regime. It follows that dividends distributed by a CFC company out of income that has not been already taxed in Italy under the CFC regime, are fully subject to tax in Italy (Art. 89(3) of the ITC), unless an advanced ruling has been submitted to the tax authorities. In fact, where the Italian taxpayer, in an advanced ruling, can prove that the participation in the foreign company (i.e. in the HK company) does not achieve the localization of income in a tax haven country, the PEX regime becomes available also on dividends distributed directly by the HK company.