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Transfer pricing: burden of proof on tax administration — Orbitax Tax News & Alerts

The Italian Supreme Court gave its decision on 26 June 2006, registered on 13 October 2006, in Case No. 22023. Details of the decision are summarized below.

(a) Facts. An Italian company purchased vehicles from its foreign affiliates and distributed them on the Italian market. The costs for the (i) maintenance and repair and (ii) the liability for damages from the use of the vehicles, which would in principle lie with the foreign manufacturers, stayed with the Italian company. According to Art. 1490 of Italian Civil Code, the responsibility for repair and maintenance remains with the manufacturing company. However, in the case at hand, these risks were taken over by the Italian company which did not receive any fee or compensation for relieving its foreign affiliates of these risks.

(b) Issue. The tax administration argued that the price paid by the Italian company to its foreign affiliates was not at arm's length because the former did not receive any compensation for the maintenance and repair risks assumed. The tax administration argued that the price paid by the Italian company was higher than the arm's length value that should have been calculated according to the transfer pricing provisions set out in Art. 76 of the Italian Tax Code (now Art. 110) and that, consequently, the costs incurred unlawfully reduced the Italian company's taxable income to the benefit of its foreign affiliates.

(c) Decision. The taxpayer prevailed at all three jurisdiction levels. In particular the Italian Supreme Court, in ruling against the tax administration, pointed out the following:

-   the transactions at issue are international transactions subject to the provisions contained in the Vienna Convention of 11 April 1980 as ratified by Law No. 765 of 11 December 1985 (in force on 1 January 1988), and not merely to the provisions of Italian civil law. According to Art. 11 of the Vienna Convention, "[a] contract of sale need not be concluded in or evidenced by writing and is not subject to any other requirement as to form. It may be proved by any means, including witnesses". Indeed, the Italian company and its affiliate could freely choose the negotiation form to reach the agreement under which the maintenance and repair costs would have been borne by the Italian company. Moreover, in 1967, the US head office issued a directive according to which all the maintenance and repair costs should remain with the retailing affiliated companies (e.g. the Italian company). Consequently, the Italian Supreme Court took the view that, notwithstanding Art. 1490 of the Italian Civil Code, the transfer of such costs to the Italian company is acceptable from the perspective of the legislation on international sales of goods.
-   based on the above conclusion, the Italian Supreme Court determined that the tax administration should have proved that (i) the rule related to the transfer of the maintenance and repair costs was not respected in the case at issue, and, (ii) the Italian taxpayer moved the income to a foreign low-tax jurisdiction. In this respect, the Italian Supreme Court rejected the appeal of the tax administration since: (i) the tax administration should have proven, firstly, that the tax jurisdiction to which the Italian company has supposedly transferred its income was a low-tax jurisdiction, and (ii) secondly, should have recalculated the arm's length value of the transfers. Since none of the above evidence has been provided by the tax administration, there were no grounds for the Italian Supreme Court to accept the assessment.

In reaching the above conclusion, the Italian Supreme Court reiterated the position expressed in its previous case law whereby the burden of proof in transfer pricing cases lies with the tax administration. Further, as stated in the transfer pricing guidelines, where as a matter of domestic law the burden of proof is on the tax administration, the taxpayer may not have any legal obligation to prove the correctness of its transfer pricing unless the tax administration makes a prima facie showing that the pricing is inconsistent with the arm's length principle.