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Italian Tax Booklet Case law in the Supreme Court regarding Transfer Pricing

30th September 2016

Prepared by:

MM & Associati - Dottori Commercialisti CONTACTS:

Mr Alessandro Madau Partner Email: alessandro.madau@mmassociati.net Mr Andrea Zago Email: andrea.zago@mmassociati.net

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INDEX 1. Introduction 3 2. Supreme Court 15st April 2016, n. 7493 4

3. Supreme Court 21st July 2015, n. 15298 5

4. Supreme Court 21st July 2015, n. 15282 6

5. Supreme Court 23rd December 2014, n. 27296 8

6. Supreme Court 8th May 2013, n. 10742 9

7. Supreme Court 13th July 2012, n. 11949 9

8. Supreme Court 31st March 2011, n. 7343 11

9. Supreme Court 16th May 2007, n. 11226 13

10. Supreme Court 13th October 2006, n. 22023 14

11. Supreme Court 24th July 2002, n. 10802 15 12. Supreme Court 26th October 2001, n. 13233 17

13. Supreme Court 31st May 2001, n. 3861 18

14. Supreme Court 26th January 2001, n. 1133 19

15. Supreme Court 24th March 2000, n. 3547 20

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ABSTRACT – Italian law is increasingly involved with disputes regarding transfer pricing. However, there is no affirmed school of thought in this matter, especially with regards to issues such as the burden of proof, the qualification of the transfer pricing regulations, the documentary obligations and the correct transfer pricing methods.

1. Introduction Over the last decade there has been a considerable increase in disputes involving transfer pricing and investigations by the Inland Revenue in their application of art. 110, paragraph 7 of the Consolidated Income Tax Act (referred to hereinafter as the “TUIR”). Despite the growing trend in the number of proceedings that have been initiated by the Inland Revenue in this field, which then passed to the examination of the court regarding their merit and legitimacy, to date there is no affirmed legal school of thought that is able to guide the interpretation when intercompany transactions are reconstructed. The theory put forward by the courts who have handled transfer pricing cases, is based on their conviction that the fair value should be determined using internationally approved methods (e.g. OECD Guidelines), while always bearing in mind that national tax law given in the TUIR, orders the use of the normal value parameter to identify the arm's length price. In analysing the transfer pricing case law, a distinction has been made between sentences that have been issued regarding tangible assets and those regarding intangible assets and services. In any case, it is important to mention the, often excessive, fragmentary nature of the various schools of thought and the lack of sentences relative to transfer pricing involving intergroup exchange of tangible assets. Indeed, it should be pointed out that the Inland Revenue has mainly focused its attention on intra-group transaction involving services and the exploitation of intangible assets, such as operations involving royalties, interests and various intra-group services. Operations involving the exchange of tangible assets are particularly complex given the intrinsic nature of the assets involved, and are notably difficult in determining the intra-group transfer price. When intangible assets are transferred, despite the numerous cases that have been brought to court, the operations are particularly difficult not so much for the intrinsic

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complexity of the assets but for the basic lack of comparable independent transactions. There is an ongoing debate regarding transfer pricing as to the burden of proof and the documentary obligations that multinational enterprises must provide, when required, to back up the transfer prices they apply to their intra-group transactions to ensure they comply with the arm’s length principle. This report presents a brief analysis of the main sentences issued by the Supreme Court regarding transfer pricing cases. 2. Supreme Court 15th April 2016, n. 7493 With this sentence, the Supreme Court modified its case law in relation to the pertinence of the transfer pricing regulation to non-interest-bearing loans. The Inland Revenue, after investigation, issued notice of assessment taxing interest income from a funding disposed by E. S.p.A. to a foreign subsidiary, supposed to be a loan bearing interests, and as such, falling into the transfer pricing scope. The Company, however, qualified the funding as a non-interest-bearing contribution for future capital increase, consequently part of Net Equity. The Tax Commissions, considering how the Company booked the funding, stated that it was naturally unproductive of interests. Such formal aspect determined the impossibility to assume the funding to be interest-bearing. According to the Tax Commissions, the non-remuneration of the funding excluded the application of the transfer pricing regulation. This approach was in line with previous decisions of the Supreme Court. The Inland Revenue appealed and requested the Sentence of the Regional Tax Commission to be reversed. Notwithstanding the previous sentences, the Supreme Court asked to decide on the matter, did not share the approach of the preceding degrees of judgement, stating that the transfer pricing regulation provides for the possibility of subjecting to taxation the profits ensuing from intercompany transactions that have been concluded at different conditions, specifically in terms of price, from those that would have been agreed between independent enterprises in a comparable transaction on an arm’s length basis. The valuation of the transaction according to the “normal value”, as required by the TUIR, is not related to the original capacity of the transaction to generate income and, therefore, it’s independent from any obligation eventually negotiated by the parties relating to the payment of a consideration.

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Hence, it is necessary to examine the economic substance of the transaction and compare it with similar operations carried out, in comparable circumstances, at arm’s lengths conditions between independent parties. The remuneration or non-remuneration of the funding, negotiated by the parties, is irrelevant, not being suitable for excluding the application of the “normal value” evaluation criteria. The Supreme Court accepted the Inland Revenue’s appeal stating the even a non-interest-bearing loan could be subject to the transfer pricing regulation and consequent evaluation at “normal value”, reverting the lawsuit to another Chamber of the Regional Tax Commission. The Court, anyway, did not judge on the possibility to requalify a net equity contribution into a loan. 3. Supreme Court 21st July 2015, n. 15298 Alfa S.p.A. received notice of assessment relating to income generated from transactions with company Beta, established in the United States, and controlled by Alfa. The Company appealed against the assessment, challenging the notice in front of the Provincial Tax Commission, which rejected the appeal confirming the legitimacy of the assessment. The Company, then, appealed against the sentence of the first degree of judgement. The Regional Tax Commission rectified the first sentence stating that the assessed income did not constitute transfer pricing for lack of the necessary assumption relating to identity of the product and terms of sale. Indeed, according to the Commission, Alfa proved evidence of the substantial difference between the products sold to its subsidiary in the United States and the benchmark transactions considered by the Tax Authority. Differences could be detected in several aspects: quality of the products, volumes of sales, terms of sale. The described differences directly affected the pricing, so that the transactions concluded with Beta could not be compared with other transactions concluded by Alfa with third independent parties. The Supreme Court, following to appeal of the Inland Revenue, overturned once again the previous degree of judgement, since the Regional Tax Commission failed to properly consider the factual information provided by the Tax Authority supporting the substantial equivalence of the transactions analysed. The Court stated that the transactions carried out with companies not established in the national territory and controlled directly or indirectly must be evaluated according to the “normal value”, defined as the average price charged for similar goods or services with independent parties and at the same marketing stage.

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Therefore, “normal value” is considered the ordinary prices of goods and services charged at arm’s length conditions, referring, as much as possible, to “pricelists” and “rates”. The transfer pricing regulation is aimed at suppressing the economic phenomenon itself, regardless of the eventual evidence of higher national taxation. The Inland Revenue doesn’t have to prove the elusive aim, but only the existence of transactions between affiliated companies. Then, it will be up to the taxpayer to prove that the transactions have occurred at market values deemed to be “normal” as determined by the TUIR. In the Supreme Court opinion, the Regional Tax Commission generically affirmed that the Company demonstrated the substantial difference between the products sold to its subsidiary and the ones considered as benchmark, without adequately considering the contrary evidences shown by the Inland Revenue. The Supreme Court, therefore, reverted the lawsuit to another Chamber of the Regional Tax Commission for a new judgement. 4. Supreme Court 21st July 2015, n. 15282 In this judgment, the Supreme Court has defined its position with regard to the assessment methods applicable for the determination of the “normal value” in transactions between related companies, claiming that the TUIR does not expressly refers to and, therefore, does not necessarily require the application of the Comparable Uncontrolled Price method (CUP). Nonetheless it is eligible and correct the use of other methods such as, for example pertinent with the case under review, the Cost Plus Method (CPM). Company Alfa S.p.A. received a notice of assessment in relation to the annuities 1998, 1999 and 2000, for undeclared revenues relating to the supply of goods to foreign affiliated companies at a price lower than their nominal value, and for acquisition costs of goods from foreign affiliated companies at a price higher than their common sale price. The Company appealed to the notice, resulting in a rejection in both the Tax Commission degrees (Provincial as first degree and Regional as second degree). Alfa S.p.A., in relation to the claimed undeclared revenues, challenges the choice of the tax officers to use the Cost Plus Method, stating that the only method of assessment of the “normal value” allowed by the TUIR is the Comparable Uncontrolled Price method. Indeed, the Italian law defines the “normal value” as the price or the compensation charged on average for goods and services of the same or

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similar species, at arm’s length conditions and at the same stage of marketing, at the time and in the place where such goods and services were acquired or provided or, failing that, in the nearest time and place. In order to determine the “normal value” reference is made, whenever it is possible, to the relevant “pricelists” and “rates” of the operator who supplied the goods or services (so called internal comparison) or, failing that, to the relevant market reports, pricelists of the Chambers of Commerce and professional fees (so called external comparison), considering the discounts applied in the normal practice. Notwithstanding this, the Supreme Court confirmed the decisions of the previous degrees of the proceedings, stating that it is irrelevant to ascertain whether it is correct to apply the Comparable Uncontrolled Price method or the Cost Plus Method within the framework of the traditional methods based on the “normal value”. The Inland Revenue used the same method used by the appealing company in order to determine the “normal value” of intercompany transactions, that is the Cost Plus Method. The comparison was carried out among identical or similar goods by associating actual costs and revenues provided by Alfa S.p.A. itself. For the purposes of verifying the transfer pricing issue, the Inland Revenue compared the mark-up rates applied in transactions with the foreign affiliated companies with the mark-up rates applied in transactions with third independent parties established in Italy. Therefore, it is correct for the Inland Revenue to have performed the assessment and the price comparison required by the relevant legislation adopting a method accepted by the regulation, applying, besides, the same “normal value” applied by the Company. On the contrary, the appeal of company Alpha S.p.A. relating to the acquisition cost of goods from foreign affiliated companies at a higher cost than the common sale price, was accepted by the Supreme Court, which recognized that the same product code, since it was dealing with tractors, could have different fittings, interiors or exteriors and technical configurations, resulting in considerable differences in their cost and, hence, in their price. Furthermore, it seemed not possible to consider as "same place where goods and services are purchased or provided", on the one hand, the Italian market and, on the other hand, the Swiss, German and Polish markets. As well as, it seemed not possible to consider "at the same stage of marketing" the sales towards foreign affiliated companies, aimed to the worldwide commercialisation and distribution of the products, and the sales carried out to Italian independent companies, deemed to be final customers.

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5. Supreme Court 23rd December 2014, n. 27296 Company [Omissis] S.p.A. appealed against a notice of assessment by which had been assessed omitted revenues relating to sales transactions towards its German sister company, [Omissis] Gmbh, performed at a price lower than the “normal value”. Such detected inconsistency constituted presupposition for subjecting the present case to the transfer pricing regulation. The Provincial Tax Commission rejected completely the notice of assessment, and the Regional Tax Commission confirmed the sentence of the first degree of judgement. The judges of the two Commissions excluded the pertinence of the transfer pricing regulation to the present case due to the fact that it was not recognizable the elusive intent of the Company in the transaction, considering that:

1. in the period under review the taxation in Germany was deemed to be higher than in Italy so that no tax advantage would have occurred by shifting the profits;

2. even assuming that the detected “normal value” was higher than the actual price agreed between the parties, the Inland Revenue has determined such “normal value” focusing on contract with different nature and object, not comparable with the transactions with the affiliated German company.

The Tax Authority appealed against the Regional Tax Commission decision, claiming that the previous degrees sentences wrongly required, in order to apply the transfer pricing regulation, the existence of irrelevant conditions not mentioned by the regulation itself, such as the elusive intent and the concrete tax advantage. According to the Inland Revenue the detection of the anomaly of the transaction should be considered a sufficient requirement. Moreover, the Inland Revenue stated that specific circumstances regarding the transactions should have been properly considered: the prices set between [Omissis] S.p.A. and [Omissis] Gmbh were two/three times lower than the prices charged to an independent Italian final customer, the products were perfectly identical in both the type of transactions and there was full-identity of the markets too. The Supreme Court focused on the second claim, rejecting the appeal proposed by the Inland Revenue. The Court, indeed, believed that the previous decisions of the Tax Commissions based on the consideration of the complex contractual relationship between the two affiliated company and with the third independent company. Conditions that directly affected the pricing. Indeed, [Omissis] S.p.A. in relation with the affiliated company was a mere manufacturer, with a license contract, of a product that have to be provide to the German company. The German company, moreover, owned the intellectual property of the production know-how. On the contrary, in relation with the third independent company, [Omissis] S.p.A. assumed the risks of the transaction having obtained the right to manufacture and

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sell the products. The different bargaining position of [Omissis] S.p.A. in the two considered transactions, justified the different price and led to the incomparability of them. The Court did not judge on the first claim, relating to the required existence of a concrete tax advantage, considering the matter absorbed by the rejection of the second claim. 6. Supreme Court 8th May 2013, n. 10742 With the present judgment, the Supreme Court reformed the sentences of the previous proceedings that annulled a notice of assessment issued against Op S.r.l. regarding the taxation of income generated through transactions with subsidiaries at a price deemed to be below the “normal value”. The Inland Revenue appealed against the Regional Tax Commission sentence asserting that, considering the overt proof of the gap between the usual prices invoiced and the ones applied to the foreign subsidiaries by means of “rebates”, it would be the Company burden to prove that these rebates were normally applied in each individual market, i.e. in the countries of residence of each subsidiary. The Court accepted the appeal stating that transfer pricing constitutes, on the economic side, an alteration of the arm’s length principle with prices that do not correspond with those charged with third independent parties. As a result, the phenomenon leads to the shift of taxable income allowing the reduction of the tax base in countries with a higher taxation. However, the Court states that the transfer pricing regulation do not require the demonstration of a higher Italian taxation. The scope of this anti-avoidance regulation is to repress the phenomenon of transfer pricing itself, with the purpose of preserving the exact tax claim of each country involved. According to the Court point of view, it is necessary for the Inland Revenue to identify the existence of transactions between affiliated companies, then, it is burden of the Company to prove that the transactions were performed at arm’s length conditions to be considered as “normal value” according to the TUIR. 7. Supreme Court 13th July 2012, n. 11949 With sentence n. 11949/2012, Italian law was again concerned with the matter of the burden of proof in transfer pricing disputes.

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With sentence n. 164/4/09 filed on 27th November 2009 and notified on 19th January 2010, the Lombardy Regional Tax Commission overthrew the appeal put forward by the Inland Revenue against the sentence issued by the Provincial Tax Commission, which had accepted the appeal by T. S.r.l. against the investigation notices it had received regarding IRPEG, VAT and IRAP for the 2003, 2004, 2005 and 2006 tax years. T. S.r.l. is entirely controlled by H. S.A., registered in Switzerland, and is part of the American multinational group T., being its only branch in Italy for the exclusive marketing of its software products (games for personal computers, play station, etc.). T. S.r.l. imports these products through T. Ltd (which is also part of the same multinational group and controlled by the same parent company), which is registered in the United Kingdom and is the sole supplier of the products that are marketed by the Italian branch. On 31st October 2004 (the last day of the financial year), T. S.r.l. posted an invoice that the British company T. Ltd had issued on that date for £ 947,456. This accounts document referred to “Price adjustment to product sold during FY 2003/2004”, and charges the Italian company with adjustment increases to previously applied prices relative to certain software products the company had purchased during the aforesaid financial year. The Inland Revenue challenged the operation claiming it was evasive, and addressed to reducing the taxable profit of the Italian company by the abusive use of transfer pricing. To back up its claims the Inland Revenue emphasised that:

• the operation was carried out on the last day of the financial year; • it involved posting an invoice for the adjustment increases to previously

applied prices by the English supplier company; • the prices differ from the average purchase price for the same products by

T. S.r.l.. The Lombardy Regional Tax Commission overthrew the claims of the Inland Revenue, as it felt that the burden of proof regarding the taxpayer’s evasive behaviour is the responsibility of the Inland Revenue (in the case in question, the Inland Revenue had not satisfied this requirement) and that the taxpayer’s evasive behaviour and a consequential tax benefit had not been demonstrated. When called on by the Inland Revenue, the Supreme Court established that:

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“(…) the application of transfer pricing regulations does not fight the concealment of the price, which is a form of evasion, but the manoeuvres that affect an evident price, allowing the surreptitious transfer of profits from one country to another, which has a tangible effect on the applicable tax regime. Therefore, given these essential requirements it must be considered that this regulation constitutes – according to the more widespread interpretation in case law in this court – an anti-avoidance provision (…)”. The infringement of an anti-avoidance provision means that the burden of proof for recourse to this premise of fact, in principle is the responsibility of the Inland Revenue office that intends carrying out the controls. Therefore, the Supreme Court felt that: “(…) when determining company income, or rather, the problem of sharing the intra-group costs, the question of pertinence must be considered as well as the existence of the declared costs further to charging for a service or asset transfer to the subsidiary from the holding, or another company that is controlled by the same company (…). The burden for demonstrating the existence and pertinence of these negative income items, and, as in the case in question, it concerns costs derived from services or assets loaned or transferred by a foreign holding to an Italian subsidiary, each element that enables the inland revenue to verify the arm’s length value of the relative costs – further to the so-called principle of sphere of influence– can only be the responsibility of the taxpayer”. Transfer pricing legislation is included among the anti-avoidance dispositions, as it is addressed to fight the transfer of income from one country to another by “manipulating” the intra-group costs. Consequently, the burden of proof that there are the premises of fact of evasion lies, mainly, with the Inland Revenue, which should prove the grounds for the adjustment, or the deviation from the applied cost with respect to the arm’s length value. However, as the sharing of intra-group costs also involves the matter of whether the costs exist and are pertinent, the burden of proving the pertinence of the costs to the company’s business lies with the taxpayer according to the Supreme Court. 8. Supreme Court, 31st March 2011, n. 7343 With its sentence n. 7343 of 31st March 2011, the Supreme Court had to pronounce regarding transfer pricing, considering, in particular the discounts that N. S.p.A. granted to the exclusive benefit of its affiliates.

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In particular, the company had transferred assets to foreign associates at lower prices than those applied to third independent companies, even though the transferred products were identical, and also applied a 2, 3 or 4% reduction on the sale prices to certain foreign affiliates resident in the European Union. The Inland Revenue issued an investigation notice for the 1996, 1997 and 1998 tax years, which the taxpayer appealed against. The Milan Provincial Tax Commission overthrew the taxpayer’s appeal and agreed with the Inland Revenue. At a later date the Lombardy Regional Tax Commission accepted the petitioning company’s appeal, then finally the Inland Revenue appealed and requested the sentence of the Regional Tax Commission be reversed. The Supreme Court mainly considered the matter of identifying the function of the transfer pricing regulation and, incidentally, the question of the methods for determining the transfer prices. The sentence partly changed the position that had been stated in the historic decisions in the “Ford” case, where the Supreme Court expressly assigned an anti-avoidance nature to the transfer pricing regulations, claiming that the Inland Revenue had not proved the fact that, in the foreign affiliate’s country of residence where Ford Italy had carried out the transactions, the tax regime was less rigid than the Italian one. However, with sentence n. 7343 on 31st March 2011, the Supreme Court stated that the function of transfer price regulations is to avoid “artificial price adjustments for the transfer of assets and services (which the companies in question could do as they reported to a single financial holding and, therefore, a single decision taking centre), addressed mainly (in the view of the tax legislator, not just the Italian one) to move abroad cash flows produced within the country” and that they are by nature anti-avoidance, in a purely ancillary manner. With this claim the Supreme Court sustained the international transfer pricing principles. In fact, it should be remembered that the OECD Guidelines state that the function of transfer pricing regulations has two aims:

• share the taxation rights between the contracting countries, and • prevent dual taxation, as no anti-evasion aim is expressly assigned to the

regulations.

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The Supreme Court also assigned the transfer pricing regulations the nature of the “only legal criterion to adopt for assessing the income of a specific economic transaction, independently from the agreed price therefore, and consequently the effective economic reasons why the taxpayers set a lower price are totally irrelevant”. In relation to the methods that can be applied to determine the transfer prices, the Supreme Court also stated that, to determine the calculation method, art. 9 of the TUIR must be applied, selecting from the criteria proposed by the OECD Guidelines and preferring the traditional method of price comparison. The so-called “remise”, or the percentage price reductions between companies as considered in art. 110, paragraph 7 of the TUIR, do not constitute the “use discounts” that are considered in art. 9, paragraph 3 of the TUIR, because percentage reductions on “pricelist” prices and/or “rates” that legislation considers as “use discounts”, are only those which are normally applied by the “subject” in its “pricelists” or “rates” (if they exist), for transactions that are concluded on “arm’s length terms”, i.e. for economic transactions concluded with subjects outside the group. The Court accepted the Inland Revenue’s appeal in relation to the “use discounts”, and revoked the impugned sentence for the motives that were accepted, referring the case, including the Supreme Court expenses, to another session of the Lombardy Regional Tax Commission. 9. Supreme Court 16th May 2007, n. 11226 With sentence n. 11226/2007, the Tax Session of the Supreme Court stated that the burden of proof of the failure to respect the arm’s length principle in relationships between affiliate companies registered in different countries lies with the Inland Revenue. With its material statement, the Tax Police Department concluded a tax assessment that was carried out on F. S.p.A. Italy for the 1987 to 1992 tax years, after which the Direct Taxation Office in Rome issued a notice assessment providing the “recovery” of IRPEG and ILOR for the 1991 tax year. In particular, unpaid taxation was revealed for “overbilling” cars purchased by the Group’s foreign branches, for expenses in intra-group services and public relations and promotional expenses that were not pertinent. Moreover, higher costs were presumed for the repair and maintenance for the new vehicles by F. S.p.A in favour of foreign affiliates, but without any sums having been paid.

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When the petitioner’s claims were accepted in both the first and second instance, the Inland Revenue presented its petition to the Supreme Court. The Inland Revenue claimed that: “without prejudice to contractual autonomy as international transactions are involved, the trading relations should also have considered, for tax purposes, the national laws regarding evaluations and, in the case in question, the dispositions given in art. 76 of the TUIR, D.P.R. n. 917/1986 (now art. 110), regarding the arm’s length value of transferred assets, which had not been done if F. Italia S.p.A. had taken on the entire economic burden of changing and repairing vehicles that had production faults, repaying the authorised dealers and garages for the materials and labour they had used in numerous jobs”. The question before the Supreme Court also referred to the posting and deduction of costs for the purchase of assets by the Italian trading company of the F. Group. The Inland Revenue felt these costs were excessive, as they included the repair and maintenance costs that had been charged to the Italian company on the basis of an intergroup agreement. The Supreme Court established that these intra-group agreements are fully relevant for the purposes of the relations with the Inland Revenue in the Countries of establishment, in any form that they may be drawn up. The Italian Inland Revenue should have complied with the OECD Guidelines, according to which the proof of the presumed tax evasion is the responsibility of the Inland Revenue, with the liability to compare the transaction prices with those in comparable transactions between independent parties, possibly leveraging the discrepancy that is found to protest the transfer of the taxable base to other countries with lower tax regimes. The taxpayer is not obliged to demonstrate the correctness of the transfer prices that are applied, until the Inland Revenue has proved the failure to respect the “arm’s length value” principle. According to the Supreme Court the Italian Inland Revenue, in compliance with the aforesaid principles, should, first of all, have ascertained whether, at the time of the facts, the applicable Italian tax regime was stricter that the one in force in the countries where the vehicles came from. Consequently, for the purpose of unpaid taxes, the Inland Revenue should have checked the effective price levels applied in comparable transactions by independent competitors. 10. Supreme Court 13th October 2006, n. 22023 This sentence originated from an investigation notice sent to F.I. S.p.A. on the basis of the material report of the tax police regarding a tax control for the 1987 to 1992 tax

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years. The Inland Revenue had found that the foreign affiliates resident in countries with lower taxation levels than in Italy had declared higher profits, presuming a higher cost than the normal one for the purpose of applying art. 76 of the TUIR (now art. 110 TUIR). F.I. S.p.A. produced cars that were sold to its affiliates which, in turn, sold them in various countries around the world. These intra-group transactions include maintenance costs, which were governed by a group contract dated 1967. The investigating office felt that the price paid for the vehicles was too high, as the maintenance costs for the Italian company should have created a price reduction for the cars. Anyway, no proof was provided about the tax benefit that the group received, nor were the different tax levels demonstrated among the various countries concerned. The Regional Tax Commission overthrew the controls carried out by the Inland Revenue, claiming an infringement of the Vienna Convention of 11th April 1980. As the appeal in question referred to international law, it should have complied with the directives and principles that are established by the Convention, which include the freedom of form in concluding a contract. The Supreme Court stated that, in these cases, the applied price should include a reserve clause regarding the liabilities to accept the warranty and future maintenance work. The Inland Revenue had not provided the proof that this reserve had not been included in the applied price, and therefore it was impossible to accept the reasons for the investigation. The aforesaid 1967 contract is not without economic and strategic grounds because, in terms of image and economy, it provides the obligation to service the sold cars for the affiliates that sell them in the countries where they are operative. In refusing the main petition by the Inland Revenue, the Supreme Court accepted the position of the appealing company stating that the contract clauses to accept the warranty and maintenance costs for the sold cars are legitimate, if they are consistent with principles of inexpensiveness and as long as a price reserve is included in the purchase or sale price for these future liabilities. 11. Supreme Court 24th July 2002, n. 10802 The Italian company S.E.A.S. S.r.l. received an investigation notice for the 1987 to 1991 tax years, in which the Inland Revenue objected the taxpayer company’s right to deduct, as negative income components, the costs for using the boats and vehicles hired to the taxpaying company by the holding company Finanziaria Commerciale

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Marittima (FCM), which bought them from its subsidiaries to, then, hire them to the same companies. The Trieste investigating office felt this deduction was inadmissible, because a cost is sustained that is inevitable, therefore it is not a “legitimate choice by the economic subject” regarding which party – within a group – should be responsible for the cost. S.E.A.S. S.r.l. made an appeal which was accepted by the Trieste Provincial Tax Commission. The Inland Revenue then presented its appeal to the Friuli Venezia Giulia Regional Tax Commission which, with its sentence in July 1997, partly accepted the gravamen (just for the unpaid taxes on certain non-deductible postings), substantially confirming the first instance sentence. The Inland Revenue presented an appeal with their deed notified on 29th October 1998, claiming, in the only impugnation statement, that there were premises that could prove the effective evasion in the transaction. According to the Inland Revenue, the amounts paid by S.E.A.S. S.r.l. for the hire to the holding F.C.M., were unjustified and “outside any economic logic”, making the evasive nature of the transaction clear as it benefited from reduced taxation as provided by the “Trieste Law” n. 26 of 29th January 1986. The Inland Revenue controlled the taxpayer’s income, as it felt there was an infringement of art. 37 of Presidential Decree. n. 600/1973. The Supreme Court stated that this disposition is not applicable in the case in question, because it refers to a case of a sham transaction. Furthermore, the Supreme Court explained that, in the case whereby a taxpayer behaves in a manner that is contrary to the principle of inexpensiveness, the investigation is legitimate pursuant to art. 39, paragraph 1, of Presidential Decree n. 600/1973. In relation to this the trial judge “to be able to annul the investigation must specify, with valid arguments, the reasons why it is felt that the anti-inexpensiveness of the taxpayer’s behaviour is not symptomatic of possible infringements of tax dispositions”. Company business must be conducted with a vision of inexpensiveness, and must not be addressed to undue tax savings. In the second instance the court should have excluded that the paid amounts were effectively consistent with a commercial strategy and not simply addressed to pursuing an undue tax benefit. The second instance sentence just declared that the business choices were unchallengeable and did not enter into the merit of the consistency of the sustained costs. The Supreme Court accepted the office’s appeal, repealing the sentence and referring the case to another session of the Friuli Venezia Giulia Regional Tax

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Commission. Among the various motives, the conclusions that the second instance Commission reached were considered insufficient, as it had not entered into the merit of the consistency of the sustained costs. According to the court, the company is not assigned an unquestionable right of choice regarding its economic initiatives that can differ from a strategy that is consistent with principle of inexpensiveness. 12. Supreme Court 26th October 2001, n. 13233 For the 1989 tax year, N. S.r.l. received an investigation into the purchase of bearings by the foreign associates C. and L.. The Inland Revenue felt that these were not at the arm’s length value, and therefore recovered taxes for 51,855,000 Lire. The Campania Regional Tax Commission accepted the appeal made by N. S.r.l. and through the second instance sentence the Inland Revenue proposed taking the case to the Supreme Court. The Supreme Court stated that the transaction had taken place between an Italian company that bought a certain asset from its holding, with a price applied that the Inland Revenue felt too high with respect to the arm’s length value. The Supreme Court, then, provided a definitive interpretation of the “arm’s length” concept. Pursuant to art. 9 of the TUIR, the arm’s length value of a transaction must be determined “on the average price or cost for the goods or services of the same or similar type, at normal conditions and at the same stage of marketing, time and place where the goods or services are bought or loaned, and if these are not available the closest time and place”. In defining the expression “arm’s length” one must not consider the abstract notion given in political economics manuals: a market cannot be considered with an unlimited number of agents and consumers and with a perfect exchange of information. The definition of arm’s length must be adapted to the transfer pricing regulations. In the case under review, an “arm’s length” situation is excluded up front, because the transaction took place between a holding and a subsidiary. The Supreme Court agreed with the trial judge that the price applied to the goods was reasonable and overthrew the appeal by the Inland Revenue.

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13. Supreme Court 31st May 2001, n. 3861 On 18th December 1992, the British firm T. received an investigation notice at its permanent office in Milan to control the declared income for IRPEG and ILOR purposes. According to the Inland Revenue, management costs were sustained that were not pertinent, and therefore adjusted the relative deductions and increased the taxable income for the period. The first instance court partially accepted the appeal from T., but in the second instance the Regional Tax Commission judges accepted the motives of the Inland Revenue. T. put forward its appeal with the Supreme Court. With its sentence n. 4355 on 16th May 1997, the Supreme Court stated that: “A company’s branches, even if they are organised as companies themselves, are not considered as legally attributed independent centres: their registration with the Registrar of Companies, in compliance with articles 2197 and 2299 of the Italian Civil Code, is not addressed to highlight a juridical separation from the head office, but to manifest the organic bond of the company with its branches”.

There are no exceptions for these principles even for branches of foreign companies,

which are considered as “operative structures” of the foreign company, and again in

this case a subject is required (so-called “permanent representative”) that is

appointed to act in the name and on the behalf of the company in that specific

territory.

The second instance sentence recognised that “permanent establishment do not

constitute legal subjects that are distinct from the foreign companies”. However, in

relation to the decisional capacity of the former, the Regional Tax Commission stated

it is impossible to deduct the management costs, claiming that “permanent

establishment would not have any decisional power over such costs, which

consequently could not be considered pertinent in producing income”.

According to the Supreme Court “if permanent establishments are an integrative part

of the business conducted by the foreign company, the latter, no matter what the

attitude of its internal organisation and hierarchy of decisional powers, must be

considered in its entirety”.

The motivation for the second instance sentence was considered unfounded with

regards to management costs, because the permanent establishment by its nature is

not an autonomous legal subject and, therefore, without any decisional powers of

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its own, and therefore the attribution of non-deductibility of the sustained costs is

not admitted, as established by the parent company.

Therefore, the Supreme Court accepted the appeal from T. and revoked the second

instance sentence.

14. Supreme Court 26th January 2001, n. 1133 For the 1984 tax period, the Milan Direct Tax Office issued an investigation notice regarding IRPEG and ILOR to the permanent organisation in Italy of the French company B.N.P., as it felt that costs sustained for management expenses were not pertinent. It also adjusted the deductions for insurance costs for the Group’s employees that had been sustained by the branches. The first instance Tax Commission recognised the legitimacy of recovering unpaid IRPEG taxes for 1,831,476,000 Lire for:

• non-pertinent management expenses; • tax credit interest; • undocumented contingent liabilities.

With its sentence on 4th March 1997, the Lombardy Regional Tax Commission partially rejected the adjustments claimed by the Inland Revenue, stating that tax recovery was illegitimate for the tax credit interests, and felt that the adjustments were valid for the non-deductible costs for management expenses. This sentence affirmed the principle whereby overheads must satisfy the requirements of certainty, responsibility and pertinence. B.N.P. was against the decision and appealed to the Supreme Court. The Inland Revenue replicated by filing a counterclaim. In particular, to back up its position, the Inland Revenue adopted the principles given in art. 75 of the TUIR (now art. 109 TUIR), which state that costs and charges can be deducted when they refer to the business that creates income and profits, as they need not necessary directly produce income. The infringement of the convention against dual taxation between France and Italy was also protested. Management expenses for the two entities (i.e. the French company and the Italian permanent organisation) which are not distinct subjects, cannot be charged to the French company and then proportionally charged back to the Milan branch. The deduction of the expenses sustained for the purposes of the permanent

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establishment is also allowed by the Italy-France Convention against Double Taxation. B.N.P. claimed that being able to charge the permanent establishment a part of the overhead and administration expenses, without there being a specific relation between these costs and the permanent organisation’s business, is recognised by the SECIT Coordination Committee decision n. 60 of 17th July 1995. According to the Supreme Court, the sharing of management costs is licit in the case that these costs satisfy the requirements of certainty, responsibility and pertinence. The consistency of this principle is confirmed by circular n. 30 of 7th July 1983, which, after stating that “(…) all the costs and charges can be deducted if they satisfy the requirements of certainty, responsibility and pertinence”, states that the concept of pertinence “(…) is no longer tied to the company’s income but to its business”. Therefore, the criterion to share the expenses of B.N.P. was founded on valid systematic economic reasons in line with the national legislation. The school of thought whereby charges can be deducted, even if there is no direct link with the income, is reconfirmed in resolution n. 158/E of 28th October 1998, whose principles were then transposed into the TUIR. With regards to allocating costs sustained by the parent company to the permanent establishment, the Supreme Court stated that the theory upheld by the Inland Revenue in the present case was in contrast with art. 7, paragraph 3 of the OECD Convention Model. Finally, it stated that the deduction of insurance expenses was consistent with the employment contracts between the Group and its employees; as the health and accident insurance costs are an integrative part of the employment contract, they had to be considered as pertinent. Consequently, the Supreme Court accepted the appeal annulling the cost adjustments for insurance cover – as these items are consistent with the general category employment contract – and revoked the sentence, concluding that the burden of demonstrating the inconsistency of the costs lies with the Inland Revenue. 15. Supreme Court 24th March 2000, n. 3547 For the 1984 tax year, the Local Direct Tax office adjusted the declared loss by S., ascertaining an income of 272,123,000 Lire relative to royalty payments to the

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holding company P.S.A., which were considered subject to taxation in Italy pursuant to art. 11 of the dual taxation convention between Italy and France. According to the first instance court, the fact that a French company has a 99.95% participation in an Italian company allows qualifying the subsidiary as a permanent establishment, and this condition does not allow the ipso facto application of a tax withholder on the paid royalties. The Inland Revenue impugned the second instance sentence before the Supreme Court, and S. presented its counterclaim. The Inland Revenue claimed the infringement of art. 11 of the Italy-France Convention, of art. 75 of Presidential Decree n. 600/1973 and of art. 74 of Presidential Decree. n. 597/1973, claiming the second instance judge’s motivations were insufficient and inconsistent about the decisive points of the dispute. S. protested the grounds for the appeal and claimed that art. 75 of Presidential Decree n. 600/1973 should have been interpreted in the sense that international conventions against dual taxation do not prejudice the application of more favourable internal regulations. The Supreme Court affirmed that, under the terms of the Italy-France Convention (note between the Ministries for Finance in office at that time) the premise of control is not sufficient to re-qualify a company as a permanent establishment. In particular, control is not a sufficient element to demonstrate that a company has no juridical nature, and therefore can be considered as a permanent establishment. Moreover, the link between the parent company and subsidiary cannot in itself be considered a sufficient reason for considering the organisation as a sham corporation. Therefore, the subsidiary has the full right to use the perceived intangible assets for the sustained cost, and this cost should be subjected to the regulations regarding negative income items. The Supreme Court rejected the main appeal presented by the Inland Revenue, stating that, as affirmed by the European Union Court of Justice in its sentence on 28th January 1986, art. 62 of the EC Treaty on the one hand grants economic operators the right to freely choose the most suitable juridical form for their business in a member country, and on the other hand prohibits member countries from limiting this faculty of choice by issuing tax dispositions that discriminate non-residents in favour of residents.