IFA BRANCH REPORT ITALY

SUBJECT 1: CROSS-BORDER BUSINESS RESTRUCTURING

Dr. Giammarco Cottani

Summary and Conclusions

Italian tax law does not endorse specific provisions dealing with cross border business restructurings from a transfer pricing perspective. This entails that the domestic provisions of Article 110 (7) and 9 (3) of the Income Consolidated Tax Act (“ICTA”) – the latter including a reference to the concept of “normal value” as equivalent to the arm’s length principle - are the only legal basis to address the reallocation of functions, assets and risks taking place within a multinational group (“MNE”). In addition, reference to domestic administrative provisions (embedded in the Circular Letter No. 32 of 1980, the 29 September 2010 General Commissioner’s Decree implementing the new domestic documentation requirements provided for by Article 26 of Law Decree No.78/2010 with the subsequent Circular Letter No. 58 of 15 December 2010 thereof) and to the 22 July 2010 version of the OECD Transfer Pricing Guidelines (“TPG”) are of utmost importance for providing guidance to taxpayers and the tax administration in situations involving business restructuring. However, absent any specific guidance on the topic arriving at firm conclusions may prove challenging, i.e. the outcome will always depend on the facts and circumstances of the case.

From Italy’s Revenue Agency standpoint the main issue with regard to those types of restructurings is to determine whether the transactions taking place trigger a transfer of a business, an ongoing concern (or a branch of business) that would justify the payment of an arm’s length compensation. In particular, based on practical experience and from the (scarce) interpretation of transfer pricing legislation as stemming from case law, it is not always clear whether the transfer of contractual rights, tangible and intangible assets and workforce in place should be remunerated on arm’s length conditions.

To this end, it seems that any such restructuring might trigger a taxable event insofar as the assets can be bundled together from an economic standpoint so as to express an ability to generate income, irrespective of the legal characterization given to the transfer. In particular, absent any specific provision dealing with cross border business restructurings, the general interpretation of the arm’s length principle as endorsed by the domestic legislation would allow to focus on what third parties would have done and whether compensation would have been agreed, irrespective of the legal form followed to execute the transfer. In this respect, it is worth noting that the correct approach to applying the arm’s length principle entails an economic analysis to substantiate the legal identification of the actual facts and circumstances of the related party transaction at stake.

Lately, a trend arose during audit activities whereby the tax authorities challenged the restructurings of manufacturing or distribution of activities carried out in Italy by resorting to the permanent establishment concept. In this respect, official Italian interpretations of the permanent establishment (PE) concept have led to some misunderstanding if compared with the criteria and guidance contained in the OECD commentaries. This is particularly true with reference to the conditions required for the existence of an agency PE and to the

identification of the so-called “multiple PE”, which is indeed a term originated by the Italian Supreme Court’s jurisprudence.

As regards reorganizations involving the transfer of intangible property, Italian tax law does not provide what an intangible asset is. Being a civil law jurisdiction, generally the Italian tax system should give prominence to the notion of legal ownership of intellectual property over economic considerations. However, the notion of economic ownership of IP is gaining ground in particular in the context of manufacturing subsidiaries and distribution affiliates contributing to the enhancement of the IP value exploited within the supply chain. Indeed, the identification of intellectual property has been interpreted widely lately, i.e. without being limited to the assets that have been accounted for in the balance sheet of a company1

Within this scenario, it is likely that Italy’s Revenue Agency is keen to follow the approach of the newly introduced Chapter IX of the TPG particularly by deeming the notion of profit potential as a valuation element to be attached to an identifiable transfer of “something of value”. Such a notion is slightly different from that of goodwill, the latter being identifiable as a separate intangible asset for accounting purposes when acquired against the payment of a consideration. To this end, goodwill is construed as the residual item arising from the amount left in the context of a purchase price allocation (“PPA”) when a transfer of a business or an ongoing concern (or a separate viable part of it) takes place. It is the author’s view that from an Italian transfer pricing standpoint goodwill can neither be transferred in isolation from the bundle of assets to which is attached to nor being completely erased in the event only some of the assets constituting the going concern are transferred in the context of a restructuring.

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The above entails that in case of a legally separate transfer of assets which are connected on an economic basis, the tax authorities will likely be following a “substance over form” approach, i.e. the separate assets transfers will likely be recharacterized as a sale of a going concern and valued accordingly. On the other hand, a mere change of the existing contractual arrangements without any substantive redeployment of functions and risks would generally not lead to an exit charge, as the amendments to the contractual arrangements would not fall into the qualification of a business restructuring taking place.

Italy as a civil law country takes the view that the payment of an indemnification should always depend from the underlying contractual arrangements. However, the tax authorities may contend that in a transfer pricing context the termination or non-renewal of an expired contract could lead to an indemnification had a third party in a comparable situation requested such a payment.

According to the Italian legal system, business restructuring transactions may be challenged either by means of a general express anti-avoidance clause, a (more debated) unwritten one referring to the notion of “abuse of law” or by using paragraphs 1.64 to 1.69 of the TPG should the restructuring fall into the scope of Article 110 (7) of the ICTA. However,

1 See the Ruling No.124 of 7 November, 2006, whereby the tax authorities contended that customer lists and know, although not accounted for in the books of the company, should be subject to taxation at “normal value”.

disregarding or recharacterizing a transaction is the exception to the general rule of respecting the arrangements as structured by the taxpayer.

Finally, Italy’s domestic transfer pricing provisions seem not lead to any major conflict as far as an EC law perspective is concerned, although some scholars in the past have argued against such compatibility2

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2 See E. Della Valle, G.Melis, Possono essere ripresi a tassazione gli interessi relativi ad un finanziamento infruttifero erogato a consociate estere comunitarie, in Diritto e Pratica Tributaria Internazionale, 2007, p. 509

Part One: Domestic provisions with an international scope which apply in business restructuring cases 1.1 General overview

From a general standpoint, Italy stands more as an “exit” rather than an “entry” country with respect to cross-border reorganisations, as in the last few years several industrial conglomerates in key sectors such as pharmaceuticals, apparel retailing and fashion leveraged on certain favourable tax provisions3

The most common types of restructuring carried on in the country involved:

(then repealed) to leave the country towards more favourable tax jurisdictions (within Europe and overseas) by stripping out key functions, assets and risks from local entities together with a subsequent shift of taxable income overseas.

(i) As concerns production activities, the conversion of domestic full-fledged manufacturers into contract or toll manufacturers4

(ii) As regards distribution activities, the adoption of limited-risk distribution or commissionaire structures; and

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(iii) As regards the management of valuable intellectual property, the transfer of either trade or marketing intangibles to principal companies located abroad.

Italian tax law does not have any specific provision dealing with cross border business restructurings. Thus, the general provisions of Article 110 (7) and 9 (3) of the ICTA5

3 Reference is made in particular to the 2003 tax reform whereby a provision was introduced allowing the payment of a special 19% tax levied on the amount of a merger deficit so that the parent company could buy the right to revalue the assets of the target up to their market value and allocating any excess value to goodwill.

are the legal basis for the analysis of business restructurings from a transfer pricing standpoint. Recent developments suggest that a closer scrutiny of the tax consequences of the reorganisations of the supply chains of MNEs stands high on the agenda of the Italian tax authorities. To this end, audits concerning the proper application of the arm’s length principle in intercompany relationships have increased over the last five years. The Administrative Circular No. 20/E of 16 April 2010 – providing directives and instructions for the 2010 audit programme, should be noted. In particular, Sec. 2.1. (b) highlights the need to focus audit activities on international issues, with an explicit reference to transfer pricing. This section

4 See for instance the recent judgment of the Provincial Tax Court of Milan No. 396/1/2010 in, Il Sole 24Ore, Norme e Tributi, December 2010.

5 See G. Maisto, Il Transfer Price nel diritto tributario italiano e comparato (Padua, Cedam,1985); R.Cordeiro-Guerra, La disciplina del transfer price nel diritto tributario italiano, Rivista di Diritto Tributario 4 (2000), pp. 2170 et seq.

specifically relates to audits of large business taxpayers and, therefore, business restructurings seem to be under the spotlight.

Given this scenario, one might expect the arm’s length principle in the context of cross-border business restructurings to be further construed in courts. However, to date relevant Italian case law available on the topic is almost absent. In the author’s view this may be due to the fact that the Italian tax authorities became very approachable on transfer pricing issues since the launch of the unilateral APA programme6

Based on this premise, on the basis of the existing provisions and principles it is possible to maintain that a business conversion requires a compensation only to the extent that the operation gives rise to a transfer of assets, including intangibles, rights, contracts, know-how and going concern or to the termination of contracts requiring an arm’s length indemnification. As a result, the sole transfer of functions not connected to the transfer of a business, going concern or any other assets and rights, in principle should not give rise to the payment of a compensation unless it can be proved that third parties would have agreed otherwise. In this respect, a thorough functional and comparability analysis will play a major role to solve such dilemma.

. In principle, the latter instrument has made possible to have content-based discussions between these authorities and Italian taxpayers so as to obtain rulings focused on cross-border restructurings and avoid costly litigation.

When Italy stands as an “entry country”, i.e. the Italian affiliate of an MNE is the recipient of functions, assets and any other legally identifiable right, the key issue will be determining the valuation of those assets on the basis of their “normal value”. 1.2 The arm’s length principle and cross-border business restructurings

According to its domestic tax system, Italy endorses the application of the notion of “normal value” as the equivalent of the arm’s length principle in the OECD TPG. However, it is currently debated whether the concept of “normal value” as embedded in Article 9 (3) of the ICTA is fully consistent with the internationally accepted arm’s length standard of the TPG and recalled in the vast majority of the bilateral tax treaties entered into by Italy.

As mentioned, Arts. 110(7) and 9(3) of the ICTA are the only relevant domestic legislative provisions dealing with transfer pricing in the Italian legal system. Art. 110(7) of the ICTA states that income derived by a resident enterprise from transactions entered into with non-resident companies that either: (1) directly or indirectly, control the enterprise; or (2) are controlled by it or by the same company that controls the enterprise, must be valued on the basis of the “normal value” of the goods transferred, services provided or services or goods received if a corresponding upward adjustment in taxable income is 6 The unilateral APA Programme was introduced by Article 8 of Legislative Decree 269/2003, converted into Law 26 of 24 November 2003 (the “APA Law”).

thereby derived. This provision also applies if the result is a downward adjustment in taxable income, but only insofar as it is the outcome of binding agreements concluded with the competent authorities of a contracting state pursuant to a mutual agreement procedure provided for by international tax treaties. Further, Art. 110(2) of the ICTA states that the “normal value” of the goods transferred or services rendered or received must be determined on the basis of the principles set forth by Art. 9(3) of the ICTA. The latter provision provides the statutory mechanism instrumental to determining the arm’s length value of an intercompany transaction. Art. 9(3) of the ICTA stipulates that the “normal value” corresponds to the average price or consideration paid for goods and services of the same or similar type, adopted in free market conditions and at the same level of commerce, at the time and place in which the goods and services were purchased or performed, or, if there is no exact time or place, at the time and place nearest thereto. In particular, in determining the “normal value”, reference must be made to professional tariffs, taking into account normal discounts. Furthermore, as far as price control is concerned, reference must be made to the applicable regulations in force, if any. In addition to the legislative provisions, the Ministry of Finance issued Circular letter 32/9/2267 on 22 September 1980 (“the Circular”) following the release of the1979 OECD Report on “Transfer Pricing and Multinational Enterprises” (“the 1979 OECD Report”). The Circular’s aim was to provide guidance in interpreting the legislative provisions that governed transfer pricing matters prior to the enactment of the ICTA. Despite not being legally binding, the Circular was until recently acknowledged by both the tax authorities and taxpayers (at least formally) as the primary interpretative tool in respect of transfer pricing issues7

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However, the recent Circular letter No. 58 of 15 December 2010 regarding the newly introduced documentation requirements provided additional substantive guidance to the former administrative document by referring to the July 2010 update of the TPG as the primary tool to construe the domestic notion of “normal value”8

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As a result, the Italian tax authorities acknowledge the authoritative guidance of the arm’s length principle in the TPG and in its further refinement by the new Chapter IX on business restructurings. Hence, the fundamental issue is to determine whether or not the “normal value” concept, as embodied in Art. 9(3) of the ICTA, complies with the concept of the arm’s length principle as

7 The Ministry of Finance provided additional guidance in Circular letter No. 42 of 12 December 1981, which implemented minor amendments to the current transfer pricing regime. 8 See paragraph 1, page 6, of the Circular Letter No. 58/E of 15 December 2010.

endorsed in Art. 9 of the OECD Model and therefore can be successfully applied in the context of cross border business restructurings. The author contends that a conceptual discrepancy exists between the purpose of the domestic transfer pricing provision and the ordinary purpose of transfer pricing rules as embodied in Art. 9 of the OECD Model. However, any such inconsistency triggers only minor material consequences. The Circular No. 32 of 1980 already attempted to bridge the gap between the two concepts by stating that: “... the notion of “normal value” as defined by tax law already includes the principle of an open market price, as recommended by the OECD for calculating the transfer price; that is, the price that would have been fixed for similar transactions by independent enterprises. (author’s unofficial translation)”. In addition to the Circular Letter No. 58/E of 2010 – where a number of references to the arm’s length principle are included9 - the tax authorities issued also their first International Standard Ruling Report (“the Ruling Report”)10

. This document is relevant as it is the first report on Italy’s advance pricing agreement (APA) programme, providing details concerning applications that were submitted to the International Ruling Office of the Central Directorate for Tax Assessment from 2004 to 2009. The Ruling Report showed significant figures with regard to the percentages of application of transactional profit methods as opposed to traditional transaction methods. Transactional profit methods were adopted in 79% of cases, while traditional transaction methods (CUP, resale price and cost plus) accounted for the remaining 21%.

This entails that, in practice, the tax authorities are rightfully disregarding the limitations imposed by the strict wording of Art. 9(3) of the ICTA by providing a dynamic interpretation of the Revised TPG and by preventing conflicts with the application of Art. 9 of the OECD Model as implemented by Italy and its treaty partners. As a result, an alignment between the domestic and the international provision is guaranteed. Against this background, the author is of the view that the framework an Italian court may follow in dealing with cross border business restructuring cases would be firstly to identify what is the actual legal characterization of the reorganization (e.g. is it a mere transfer of risks and functions? Are any intangible assets involved? Is there a transfer of a business or 'going concern' involved? Does the restructuring trigger the termination or substantial renegotiation of existing arrangements?).

9 See also Paragraph 4 of the Circular Letter No. 58 of December 2010, that expressly refers to the application of Chapter I of the 2010 TPG.

10 See Italy’s Revenue Agency Ruling Report at http://www.agenziaentrate.gov.it/wps/wcm/connect/a091c080426dddc1860a9fc065cef0e8/Bollettino_URI+2010_ENGLISH_+21+4+10.pdf?MOD=AJPERES&CACHEID=a091c080426dddc1860a9fc065cef0e8.

Once the legal characterization of the restructuring has been completed, an economic analysis may be required to consider whether and to what extent an appropriate valuation of the assets or enterprise transferred or an appropriate indemnification upon contract termination would be required. In this respect, the following of remarks can be made.

Firstly, the documentation requirements set forth in the Commissioner’s Decree of September 201011

Secondly, even if no asset can be legally identified in the context of a cross border restructuring, this does not mean that taxation will always be excluded. On the contrary, based on the alignment expressed by the recent Circular Letter No. 58/E with the 2010 update of the TPG, it seems reasonable to argue that not every transfer of profit or loss of profit potential should lead to taxation. Accordingly, a mere decrease in profitability should not be deemed as a measure for taxation unless accompanied by reallocation of “something value” amongst group entities.

and in the Circular Letter No. 58/E of 2010 will play a major role when it comes to identify business restructurings. To this end, according to the new administrative guidance Italian taxpayers would not be deemed to submit adequate documentation had they limit themselves to label the risk profile of the entity (e.g. “contract manufacturer”, “limited risk distributor” etc.) without providing a description of the actual functions performed and assets used by the enterprise if compared to the group’s supply chain overall activities.

1.3. General and specific provisions with international focus or effect in business restructuring cases According to Italian tax law, there are no specific domestic provisions dealing with cross border business restructurings. Therefore, the guidance provided for by Article 9 (3) and 110 (7) as earlier discussed endorsing the equivalent notion of the OECD’s arm’s length principle is of direct application.

However, when entering into those types of reorganizations taxpayers have to carefully consider the impact of an array of provisions existing in the Italian tax system that may produce some hindrance to the implementation of new supply chain models.

In particular, three domestic provisions – amongst the number anti-abuse rules embedded in the Italian system and discussed at paragraph 1.4. – are worth mentioning here:

(i) article 23 (1) (e) of the ICTA, whereby business earned by a foreign person may be subject to tax in Italy only if earned through a permanent establishment;

(ii) article 110 (10) of the ICTA, better referred to as the “anti-tax haven” legislation; and

(iii) article 166 of the ICTA, regarding the transfer of the corporate seat abroad. 11 See in particular paragraph 5.1.2 (b) that requires an…

As concerns (i), the significance of the issue is emphasized by the circumstance that, over the years, several multinational groups have organized their Italian manufacturing activities by means of toll manufacturers and they re-organized their distribution operations through commissionaire arrangements or other forms of limited-risk distributors. The business model has then been faced with the need to come to terms with the interpretation of the concept of "permanent establishment" as set out by the Italian Supreme Court in the Phillip Morris case. The doctrine of the Supreme Court broadened the definition of "permanent establishment” and by doing so the latter concept climbed the top of the arguments normally brought forward during the audits of cross-border restructurings.

As regards (ii), the provision stipulates that in computing business income no deduction is allowed for costs and expenses arising from transactions with entities established in States or territories having a privileged tax regime, unless the Italian taxpayer could demonstrate that (I) the foreign mainly carries out an actual commercial activity (active business test); or (ii) the transaction presents a commercial rationale and actually took place (sound business purpose test)12. The practical application of the latter provision gave rise to a number of heavy discussions between taxpayers and tax authorities, as the proof of the sound business purpose test is often questioned when tax havens’ jurisdictions are involved as part of reorganization13

As finally concerns (iii), the provision stipulates that in the event one of the entities listed in Article 73 (a) and (b) of ICTA transfer its residence abroad, such event will trigger the taxation at normal value of the assets constituting the going concern unless the above assets will be retained in a permanent establishment located in Italy. The latter provision can be particularly relevant in the context of a cross border restructuring.

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1.4. The relationship between the domestic business restructuring provisions and tax treaties

The relationship between domestic law and tax treaties is an issue that the Supreme Court (Corte di Cassazione) has tackled in a number of instances. The judges had affirmed in the past that a tax treaty could not generate a tax claim that did not exist under domestic law14

12 See C. Galli, “Transfer Pricing rules for transactions involving low-Tax countries”, in International Transfer Pricing Journal, 2008, p. 44.

. More recently, however, the Supreme Court followed different approach, though with reference to specific cases concerning the taxation of employment income to the employees

13 It is worth recalling here that the anti-tax haven regime does not apply to transactions with foreign entities subject to the Italian CFC legislation, as embedded into Article 110, paragraph 12 of the ICTA.

14 See Supreme Court, Tax Chamber Decision No. 3414 of 21 February 2005, whereby the judges expressly stated that, absent a domestic tax provision providing for the taxation of a specific item of income, Italy’s entitlement to tax as endorsed in a tax treaty could not be exercised, unless such a specific provision would have to be enacted. See also, Supreme Court, Tax Chamber Decisions No. 143 of 21 February 2005; No. 18388 of 13 September 204 and No. 18312 of 10 September 2004.

of the national company running the national train system15. With regard to these circumstances, the Supreme Court has recently affirmed that Italy could tax employment income even in the absence of a domestic provision empowering Italy to tax it16

As a result, the principles outlined by the Supreme Court lately, whereby Italy could tax even absent a domestic tax provision if the tax treaty so provides, appear to be in conflict with other precedents of the Court

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17 and has been criticized by some scholars18

1.5. Business restructurings and domestic anti-abuse rules

. Accordingly, it would be desirable that the issue were to be clarified by the Supreme Court in a Joint Session, i.e. a plenary session whereby conflicts of interpretation arisen in the past amongst chambers on a certain topic are settled.

According to Italian tax law, taxpayers are generally free to arrange their business operations as they see fit. This holds true in particular in the context of cross-border business restructurings, as disregarding or recharacterizing an arrangement as entered into by an entity part of a multinational group should be the exception to the general rule of respecting the structuring as adopted by the taxpayer.

Accordingly, although in Italy there are no specific transfer pricing provisions dealing with cross border restructurings, transactions entered into with the sole purpose of obtaining an undue tax saving could be challenged either by the application of a (semi-) general anti-avoidance rule provided for by Article 37-bis of the Presidential Decree No. 600 of 1973 (the “Income Tax Assessment Code”)19 or by the application of a deemed general written anti-abuse rule (so-called “abuse of law” theory)20

15 Specifically, the case related to the application of the exclusion from the personal income tax basis of employment income exercised abroad on a continuous basis, provided for by domestic law applying up to 1 January 2000.

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16 See, inter alia, Supreme Court Tax Chamber Decisions No. 29455, 29456, 29457, 29458, 29459, 29460 of 17 December 2008.

17 See Supreme Court Tax Chamber Decision No. 1540 of 3 February 2003

18 See P. Tarigo, Doppia imposizione e criteri di collegamento, in Rassegna Tributaria, 6, 2009, p. 2010.

19See G. Maisto, Italian anti-avoidance rules and Tax Treaties, in Bulletin for International Taxation, No. 8/9/2010, p. 441; F. Gallo, Brevi spunti in tema di elusion e frode alla legge (nel reddito d’impresa), in Rassegna Tributaria, 1989, I, p. 11.

20The use of the concept of abuse of law has been recently sparked by a number of judgments of the Corte di Cassazione (see judgments of the Tax Chamber of 21 October 2005, No. 20398; No. 280816 of 26 October 2005). First, the Court argued that such a concept stemmed directly from EU principles. In particular, the Italian court based its assumption on the case law of the European Court of Justice, particularly by referring to the Halifax (C-255/02) and Part Service (C-426/06) cases. The Supreme Court contended that the doctrine of abuse of law was expression of an underlying principle applicable also to taxes not harmonized, such as corporate income taxes. Afterwards, in its plenary session (see judgments No. 30055 and 30057 of 2 December 2008), the judges departed from the EU origin of the theory and instead hold to the doctrine of an unwritten anti-abuse rule according to the constitutional principle of ability to pay.

However, based on the current domestic legislation and on recent case law no relevant guidance exists – other than the administrative one recently provided for by the Circular Letter 58/E of 201021

It is the author’s view that when either the anti-abuse and transfer pricing rules in principle both may apply, the former should prevail over the latter.

- in order to apply the notion of “disregarding” or “recharacterizing” transactions under a mere transfer pricing standpoint.

As a result, should either Article 37-bis or the abuse of law doctrine be applicable, the transaction as entered into by the taxpayer will be disregarded and there would not be room to apply any transfer pricing provision in order to set or test the arm’s length conditions of the restructuring (i.e. the transaction is erased or tamquam non esset).

On the other hand, in case the anti-abuse provision leads to a recharacterization of the transaction, then the substituted transaction should comply with the arm’s length principle.

Nevertheless, irrespective of the application of Article 37-bis or to the abuse of law doctrine, where tax savings stem from the actual relocation of certain activities outside of the Italian jurisdiction, it may be argued that from a mere transfer pricing standpoint the tax reduction is not undue but originates from the newly intervened arrangement of the group’s supply chain that will be respected to the extent the conditions of the restructuring are arm’s length. Should the arm’s length conditions of the restructuring not be met, then the application of article 1.64-1.69 of the TPG will be entitled to challenge those structures.

The opposite conclusion would be reached in case the restructuring occurred only at the level of the legal framework without any substantive change in the actual way the business is carried on in Italy (e.g. a conversion from a fully-fledged distributor into a commissionaire with a change occurred only at the level of the contractual arrangements without any actual transfer of risks and functions),

For further references see A. Fantozzi, G. Mameli, The Italian Abuse of Law Doctrine for taxation purposes, in in Bulletin for International Taxation, No. 8/9/2010, p. 445.

21 In this respect, see Part I, Section 4, of the Circular Letter No. 58/E of December 2010, which expressly acknowledges the guidance of paragraphs 1.64-1.69 regarding the recognition of the actual transactions as undertaken by the taxpayer.

Part Two: Tax Effects of Cross Border Business Restructurings

2.1. General overview

Although Italian tax law does not contain any specific provision addressing the tax effects of cross border business restructurings, the provisions of Article 110 (7) and 9 (3) of the ICTA allow to reach the conclusion that arrangements involving the cross-border redeployment of functions, assets and risks have to respect the arm’s length principle. This holds true both with respect to “exit scenarios”, i.e. when something of value is transferred from Italy overseas and “entry scenarios”, i.e. when functions, assets and risks flow to Italy. To this end, the following four situations are envisaged:

• As concerns the transfer of functions and risks, the key question is whether such event may trigger taxation at normal value of the built-in gains embedded in the assets transferred, if any, or whether a comparable charge may be envisaged in the entry scenario. In the author’s view, this is not always the case both from a legal and an economic perspective;

• As regards cross-border restructurings involving the transfer of intangible assets, the most controversial points focus on (i) the legal identification of the intangible asset vis-à-vis its economic exploitation, (ii) how to value the intangible property and (iii) how to assess whether the terms and conditions of the intangible transfer are arm’s length;

• The cross-border transfer of a going concern is arguably the most controversial

scenario to be addressed. From Italy’s tax standpoint, the legal characterization of what is meant by going concern in principle may influence the tax and transfer pricing consequences of it, although an “arm’s length substance over form” approach is increasingly gaining ground in the tax authorities’ view. Valuation issues – particularly those surrounding the identification of goodwill – play a prominent role in the analysis as well;

• Paragraph 2.5 discusses what the tax consequences may be in case of a termination or

substantial renegotiation of existing arrangements. The approach to be likely followed here is a two-pronged one, and namely (i) an analysis of the underlying contractual arrangements is required so as to identify whether an indemnification clause was expressly included and (ii) the determination of whether a third party would have claimed an indemnification – irrespective of the provision of any contractual clause – in the event of an abrupt termination due to a restructuring.

2.2. Transfer of risks and functions

Italian tax law takes a legalistic approach in order to identify whether an event occurring in the life of a business triggers a taxable event. In other words, only insofar as the transfer of risks and functions is embedded into a (i) legally identifiable transfer of assets, (ii) a disposal of a going concern (or a branch of business) or (iii) the provision of services, an arm’s length compensation will be due.

Against this background, it is worth recalling that the Italian tax authorities have recently clarified their adherence to the 2010 TPG in interpreting the domestic provision concerning the arm’s length principle.

This entails the major consequence that by reasoning purely in an arm’s length terms, and with specific reference to Part II of Chapter IX of the TPG, an intra-group transfer of functions and risks may potentially lead to taxation in the event it can be proved that independent third parties would have agreed to a compensation if something of value is transferred, irrespective of its legal characterization.

On the other hand, it is worth noting that the expectation of lower future profits does not necessarily lead to a compensation being due. Indeed it is a reality that businesses may face developments hampering their financial results, in most cases without any form of compensation. As a result, the transfer of profit potential cannot occur on a stand-alone basis unless attached to some identifiable assets.

Hence, on the basis of the Italian tax system the expectation of future profits has to be related to something identifiable, being a valuable asset or a going concern itself. As a result, on the basis of the existing principles the mere flight of functions and risks not connected with the transfer of “something of value” should not give rise to taxation in Italy insofar as third parties would not have acknowledged any compensation whatsoever.

From an “exit scenario”, it is interesting to recall a recent ruling of the Provincial Tax Court of Milan22

From an “entry perspective”, the main issues to be taken into account relate to how the Italian entity would value the functions and risks attached to the assets. In this respect, there is no prescribed valuation method under Italian tax law in case of a transfer of risks and functions. The price has to be at arm's length, on basis of article 9 (3) of the ICTA. Any reasonable method may be utilized.

, which held for purposes of the application of transfer tax (imposta di registro) that the reallocation of customer lists, inventory, know-how and the secondment of an employee of an Italian affiliate to its Swiss principal does not meet the requirements of the disposal of a going concern, but simply the “ transfer of certain coordination activities at the European level” without triggering the levy of an exit charge.

22 See Provincial Tax Court of Milan No. 396/1/2010.

2.3. Transfer of intangible assets

Arguably, the transfer of intangible assets is emerging in Italy as one of the most controversial areas when a cross border business restructuring is implemented. The prominence of this area has been confirmed by the Circular Letter No.1 of 2008 by the Italian tax police (Guardia di Finanza), which highlighted that IP transfer is one of the areas where tax avoidance could easily takes place. Accordingly, Italy’s Revenue Agency – in the Circular Letter No. 20 of 2010 above mentioned– highlighted that a detailed scrutiny shall take place for business restructuring operations involving the transfer of intangible assets.

According to Italian law, the identification of the owner of intangible property for transfer pricing purposes should follow the rules set forth by the Italian Civil Code and by special legislation23

From a regulatory standpoint, Italy’s Revenue Agency issued limited guidance on this issue. The Circular Letter No. 32 of 1980 addressed in its Chapter V some of the issues concerning the transfer of intangible property in a group context

. Generally, according to Italian tax law the legal title should be driver for identifying the existence of IP within a business as the notion of economic ownership has not been directly address by the domestic provisions.

24

Interestingly, Chapter V refers to two methodologies, one “technical”, the other “juridical”, to determining an arm’s length compensation upon the transfer of an intangible. As regards the “technical” evaluation of the IP, it will be necessary to identify its technical features, its uniqueness and the expected results arising from its exploitation; as concerns the “legal” evaluation, an analysis of the contractual terms underlying the licensing of a patent or trademark will be required for the purposes of a comparability analysis.

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Chapter V mainly focused on the licensing of intangible property, without directly addressing the issue of transfer of intangible property. However, the Chapter acknowledges that in certain instances the remuneration for the commercial exploitation of the intangible is embedded in the consideration paid for the purchase of the product. In particular, the Circular No. 32/1980 draws a distinction between (i) manufacturing subsidiaries and (ii) distribution subsidiaries25

23 In particular, see reference to articles 1100 et ss. of the Italian Civil Code, Article 6 of the Legislative Decree No. 30/2005 regarding the co-ownership of intangibles and Article 138 and 139 of Legislative Decree No.30 of 2005 concerning the registration of industrial property with the Italian Patent and trademarks office in order to obtain protection against claims by third parties.

. As regards (i), the recognition of a royalty payment to the parent company licensing the IP should be acknowledged, whereas (ii) Chapter V seems to infer that in case of distributors acquiring products incorporating a trademark or a trade name from a related

24 See for further reference on the transfer pricing issues involving intangible property G. Cottani, Italian transfer pricing legislation: An International Perspective, in Bulletin for International Taxation, No. 8/9/2010, p. 470.

25 See paragraph 5 of Chapter V of the Circular Letter No. 32 of 1980.

party the remuneration for the use of the intangible should be embedded in the purchase price26

Nevertheless, an increasing trend has been witnessed by tax authorities assessing that a transfer of intangible property took place irrespective of its legal identification in a cross border restructuring, i.e. the notion of economic ownership of IP is slowly gaining ground as regards the transfer pricing implications of a restructuring.

.

Absent any specific guidance, the author maintains that in order to determine whether a conversion of the activities of an Italian company entails the transfer of an intangible, it will be necessary to perform a thorough functional and comparability analysis (before and after the restructuring) so as to understand whether a transfer of “something of value” took place. In other words the Italian tax authorities, in a manner consistent with the OECD guidance in Chapter IX of the TPG, tend to place more reliance on the actual conduct and true terms of the restructuring rather than limiting themselves to examine the contractual conditions only. From a transfer pricing standpoint, the assets do not need to be recorded in the taxpayer's financial statements either.

Lately, there have been a number of instances whereby the tax authorities have interpreted the notion of intangible property widely, i.e. without limiting it to the assets accounted for in the balance sheet of an Italian company. Such an approach holds true when know-how, customer lists, assignment of employees and goodwill are transferred so as to justify an arm’s length compensation. For example, Italy’s Revenue Agency - in a ruling concerning the cessation of the activities of the permanent establishment of a foreign insurance company - maintained that the operation gives rise to the taxation at normal value of all the assets transferred, including customer lists and know-how although not expressly reported in the branch accounts27

As concerns the assignment of employees and the identification of goodwill, see the analysis at paragraph 2.4. below.

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26 This position has been challenged by courts. In particular, the Provincial Tax Court of Rome, in its judgments No.65/04/1999 of 5 March 1999 and No. 410 of 2 June 2000 held that royalties paid by an Italian distribution subsidiary of a pharmaceutical group could be deducted on the ground that their amount was computed as a percentage of volume of sales and therefore inherently embedded in the business of the Italian company.

27 See Ruling No. 124 of 7 November 2006.

2.4. Transfer of going concern

In am manner similar to what has been argued concerning the transfer of intangible property, the analysis of the transfer of an ongoing concern in a cross-border context should depart from the legal characterization to be the main driver of the analysis over a pure economic approach.

Article 2555 of the Italian civil code defines a going concern as a set of assets organized for carrying on a business. As a result, the key elements to be taken into account to determine whether the assets of an enterprise could qualify as a going concern are (i) the “organisation” necessary and (ii) the “attitude” needed to carry on a business. Based on these grounds, the key question to be addressed in the context of a cross border business restructuring would be to ascertain whether the transfer of a going concern (azienda) or a branch of business (ramo d’azienda) actually took place. If the answer is affirmative, then it will be necessary to investigate what is the value of the whole bundle of assets transferred, including goodwill.

As concerns the first question, the transfer of a going concern entails that the key elements of a business are passed on to the transferee. In particular, the author contends that in the events the transferor retain essential features (assets, contracts, people) to run the business without discontinuing it, no transfer of a business takes place. In the author’s experience, there have been some instances where in the course of an audit the tax authorities have qualified the transfer (or even the secondment) of the employee of an Italian company to its foreign affiliate as a transfer or a going concern. In particular, the Labour Section of the Italian Supreme Court maintained that a transfer of personnel could be deemed by itself as the disposal of a going concern where the people are organized and co-ordinated between them and possess specific skills.

In addition, another decisive aspect not to be overlooked is the treatment of goodwill, something other than the profit potential attached to the assets to be transferred.

In particular, it is debatable whether the arm’s length principle also requires a remuneration to be paid between related parties in case activities that do not meet the Italian requirements for identifying a going concern are transferred. A proper answer may be found by scrutinizing the actual, economic terms of the transfer without limiting the analysis to its legal characterization.

Italian law does not provide a relevant definition for legal purposes of what is meant by goodwill. On the contrary a definition may be inferred by looking at article 2555 of the Civil Code and at case law.

In this respect, goodwill is highlighted as the inherent attitude of a business of generating profits in an amount greater than the ordinary28

28 See Supreme Court (Corte di Cassazione) judgment No. 613 of 13 January 2006.

. For accounting purposes, goodwill can be

accounted for in the balance sheet as an intangible only in the event it is acquired against the payment of a consideration in the course of an acquisition. For tax purposes, acquired goodwill can be capitalized and amortized in line with its economic lifetime on the basis of the provisions of Article 2426 (6) of Italian Civil Code and according to IAS 38.

Based on this premise, it is the author’s view that goodwill exists and assumes relevance only if considered together with the business as a whole and not on a stand-alone basis. Therefore, a compensation for the transfer of goodwill should be paid only insofar as a transfer of a going concern (or a branch of business) has been identified. Nevertheless, the tax authorities may approach the goodwill issue in the context of the transfer of a going concern in a substantive manner, particularly in light of the framework of Part II of Chapter IX of the TPG. This would entail that at arm’s length the provider of a package of interrelated transfers and services would not settle for a separate valuation of each transaction if an aggregated valuation of the transactions would yield a higher value. As a result, the focus should be on the full valuation of the controlled transactions actually undertaken rather than on the identification of purportedly legally separate transactions.

2.5. Termination or substantial renegotiation of existing arrangements

In case of a contract termination or substantial renegotiation, an indemnity payment may be due under arm's length requirements. According to Italian tax law, there are no specific regulations on this topic. However, relevant guidance is provided for by the Italian Civil Code, which stipulates – by means of Articles 1373 and 1671 – that an indemnity payment has to be acknowledged in the event a party withdraws by a contract in an unjustified and unforeseeable manner. If so, the party claiming the damage will be entitled to receive an indemnification the amount of which will encompass the future expected profitability arising from the activity to be performed29

In this respect, indemnification claims under civil law may be an indication by default of an arm’s length behaviour

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30. Therefore the question to be always posed is whether independent parties in similar circumstances would have agreed for an indemnification to be paid to the restructured entity31

In the event a contract includes a termination clause and the terms and conditions set out in the agreement are followed upon termination of it, the termination itself would not trigger any exit taxation in Italy, provided that the terms and conditions are arm’s length. However, the answer may vary depending to the actual facts and economic circumstances of the case.

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29 In this respect, it is worth to note the judgment of the Supreme Court (Corte di Cassazione) No. 8448 of 1 April 2008 with respect to the unilateral termination of a long term contract concerning the provisions of services.

30 See M. Franzoni, A.Gentili, F.Roselli, G.Vettori, Effetti del contratto, Giappichelli editore, Torino 2002, p.686.

31 See reference to Article 9.100 OECD Guidelines.

There is a wide variety of elements that may be taken into account in determining whether a termination period should be applied. Key elements include the nature and terms of the contractual arrangements, the dependence of one party on another and whether or not investments have been made. From a transfer pricing standpoint, another relevant factor relates to the opportunities the terminated party will be granted to obtain alternative business opportunities. This appears specifically relevant in the context of a cross border business restructuring, as it is frequent in practice that in a group context the terminated party having its contract terminated will be entering a different agreement with another affiliate within the group.

2.6. Recognition of the actual transactions undertaken

As earlier discussed, the Italian tax authorities have clarified, by directly referring to paragraphs 1.64-1.69 of the TPG in the Circular Letter No. 58/E of 2010, to limit and endorsing the non-recognition of the actual transaction or arrangement undertaken by the taxpayer to exceptional cases. Hence, in cases where the requirements of paragraph 1.65 TPG are not met, it is expected that the arm’s length principle can be satisfied by determining an arm’s length pricing for the restructuring as actually undertaken or structured.

2.7. Permanent establishment issues

Cross-border business restructurings may result in the creation of a permanent establishment (“PE”), either in the form of a 'fixed place of business' as well as a 'dependent agent'. The latter can be considered as the most common risk to factor in as a result of the conversion of the supply chain activities (either at the manufacturing or at the distribution level) in particular when Italy stands as the “entry county”. Therefore, this Report will limit itself to discussing the concept of a dependent agent PE.

The significance of the PE issue within a restructuring is emphasized by the circumstance that, over the years, several multinational groups have organized their Italian manufacturing or distribution operations either through a toll manufacturer or through commissionaire arrangements or other forms of limited-risk distributors. The business model required then to be aligned with the interpretation of the concept of as set out by the Italian Supreme Court in the Phillip Morris case32

A definition of the term "permanent establishment" has been introduced into domestic legislation in 2004 by Art. 162 of the ICTA. The definition follows the wording of the 1963 version of

. The doctrine of the Supreme Court has indeed broadened the PE definition, and by doing so has brought permanent establishments to the top of the list in tax audits of cross-border business restructurings.

Art. 5 of the OECD Model Convention, although certain deviations (regarding the definition of agency PE) from the Model definition may be identified33

32 See L. Favi, Italy, in IFA 2009 Cahiers de Droit Fiscal International; C. Romano, Subsidiaries as Permanent Establishments: The Philip Morris Case, European Taxation 9, 1998, p. 315.

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33 A relevant deviation worth highlighting relates to an entity (other than a broker or a commission agent or other independent agent acting in the ordinary course of its business) that habitually conclude contracts in the

Having regard to the definition of the term “permanent establishment”, the Italian practice and case law had previously followed the interpretation set out in the OECD Model Commentary to article 5. As a result:

– In order to constitute an Italian permanent establishment of the foreign principal, it was not necessary that the contracts entered into by the dependent agent were formally "in the name" of the foreign principal, being sufficient that the dependent agent could factually bind the principal vis-à-vis third parties; an agent could be deemed to have an authority to conclude contracts in the name of the foreign principal (thus binding the latter) if it was substantially negotiating all elements and details of a contract in a way binding on the foreign enterprise, regardless of whether the agent was formally signing the agreement.

However, since as a commissionaire was not able legally bind the principal vis-à-vis third parties, a permanent establishment exposure was avoided unless it was acting outside its ordinary course of business.

Nevertheless, this interpretation was challenged by the principles set forth by the Italian Supreme Court in the Philip Morris case. Indeed, the Italian Supreme Court held that:

– an Italian company can be the permanent establishment of a group of companies (i.e. evidence regarding one entity can be used to claim the existence of a permanent establishment also for other foreign affiliates);

– the “power to conclude contracts” should not be interpreted having regard solely to the power to legally “bind” under civil law, but may occur even if representatives of the Italian subsidiary are simply physically present to the negotiations between the representatives of the foreign company and their Italian counterparts; and the assessment of the permanent establishment, must be made according to the actual conduct of the parties.

Based on this premise, in the event a conversion of a fully fledged entity triggers the existence either of a toll manufacturer or a commissionaire, a permanent establishment may be deemed to exist in Italy only insofar as it could be deemed to be a dependent agent of the foreign company, i.e. a person other than an independent intermediary acting within the ordinary course of its business. In evaluating the issue of dependency, it would be useful investigating whether the Italian entity is acting solely for one foreign principal. If that is the case, it would have to be regarded as “dependent” for purposes of claiming the existence of a PE.

Italian law does not contain any specific provision on the attribution of profits to an Italian permanent establishment of a foreign entity. Reference would be normally made to the latest version of the OECD Report on Attribution of Profits to Permanent Establishments.

name of a non-resident, that will constitute a permanent establishment of the non-resident unless the agent’s activity is limited to the purchase of goods.

As regards the profits or losses attributable to a PE, there is no guidance provided for by Italy entailing that in the event the remuneration paid to an agent is at arm's length, there would be no point in assessing a permanent establishment of the foreign principal. In other words, the assessment of the existence of a permanent establishment would not be hampered by the fact that the party identified as an agency permanent establishment is earning an arm's length remuneration, as the authorized OECD “dual taxpayer” approach is likely to be followed.

Part Three: Tax effect of typical business restructuring cases 3.1 Change of a full-fledged distributor into commissionaire or a low risk distributor

The model example discussed here refers to an Italian full-fledged distributor in charge of distributing finished products provided for by a manufacturer which signs with a related party a low risk distributor or commissionaire agreement. As a result, part of the functions and risks previously exercised and undertaken by the Italian distributor are transferred to a foreign related party and the new remuneration of the low risk distributor or commissionaire is reduced to the level appropriate to its new reduced function and risk profile.

From an Italian standpoint, the vast majority of cases involving business restructurings focus on a conversion of distribution activities primarily from an “exit country” perspective. In this regard, the main concern from the tax authorities’ standpoint is that those types of conversions at times are implemented by amending the contractual arrangements without any actual restructuring taking place in the underlying functions performed and risks assumed.

As a result, when such conversions are implemented the tax authorities will first look at the legal characterization of the restructuring, but will then emphasize the importance of the examination of the factual changes in the economic reality of the restructured entity irrespective of what has been contractually agreed by the related parties upon the restructuring.

By starting from the legal characterization of the conversion (whereby an Italian fully fledged entity enters into a limited risk distributor or a commissionaire), this should be characterized as a contract termination, i.e. the current distribution agreement will be terminated and a new agreement will be entered into by the Italian affiliate with its foreign principal. In this respect, if the distribution agreement is terminated in accordance with the terms and conditions as provided for in the contract, the termination in itself should not give rise to an indemnity payment. Such conclusion may be different depending on the facts and circumstances of the case, e.g. in the event a distributor has recently made a significant investment and has not yet been able to get a reasonable return on the investment, an arm’s length indemnification should be acknowledged.

In the second part of the restructuring, the Italian entity is stripped of certain functions and risks (e.g. the inventory and credit risk) in favour of a foreign affiliate acting as the principle. Such a transfer by itself should not trigger a taxable profit in Italy unless it is characterized as the transfer of an economic bundle of assets constituting a going concern or a branch of business.

In other words, although a transfer of functions and risk per se may not result in a taxable event, two questions will need to be addressed. Firstly, upon the implementation of the

restructuring the main issue to focus on will relate to whether the conversion triggered the actual transfer of a going concern or a branch of business.

Absent any specific provision dealing with the transfer pricing aspects of cross-border restructurings, those questions will have to come to terms with the basic principles governing Italian transfer pricing legislation.

Accordingly, it has first to be examined whether the assets transferred (both tangibles and intangibles) may be bundled economically together so as to form a going concern (or a branch of business). The author contends that according to Italian law the legal characterization would be relevant only if consistent with the actual conduct of the parties. As a result, the downsizing of an Italian distributor stripped of certain functions and risks in principle would not result in the transfer of an ongoing concern, unless those assets can be bundled together (both from a legal and an economic standpoint) so as to meet the definition of article 2555 of the Italian Civil Code34

In practical terms, such a legal analysis has to come to terms with the Italian tax authorities’ position according to which the recommendations provided for by the OECD TPG will be used in construing domestic legislation. This entails that the above type of described conversions might lead to taxation insofar “something of value” has been actually transferred. The latter term refers in particular to the identification of valuable property such as customer base or distribution channels.

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As regards the customer base, it can either be characterized as a separate intangible asset or computed in the goodwill value (in this case, though, a transfer of an ongoing concern must take place as goodwill cannot be transferred in isolation from the bundle of assets to which it is attached). More troubled is identifying whether a “business opportunity” (such as a sales market access) can be separately transferred. The author believes that under domestic law there is no room for qualifying a business opportunity or a profit potential as an asset, as those elements would normally be taken into account in calculating the goodwill.

In must be noted that the transfer of the customer base overseas is often accompanied by a transfer of the credit risk. Italy would generally consider that a network of contracts is to be treated as an asset, in particular when current agreements where entered into in advance by the Italian entity or if the Italian company had a long term relationship with its clients. As a result, the key question here would be whether a third party would dispose of such a valuable asset without requiring an arm’s length compensation.

In addition, the conversion of the Italian entity into a limited-risk distributor or commissionaire would result in the reduction of the profitability of the stripped entity, being an inevitable consequence of the linkage between functions performed, assets used and risks assumed with the expected profitability. Such a reduction of profitability of the restructured entity would trigger extensive investigations by the tax authorities in the course of an audit. 34 Article 2555 of the Italian Civil Code reads as follows: “A going concern is composed by the assets organized by the entrepreneur to carry on a business” (Reporter’s unofficial translation)

As concerns the second question, i.e. how to determine a compensation for the restructured entity, absent any specific guidance normal valuation methods - with a preference for Discounted Cash Flow (“DCF”) analysis - will be used in determining a compensation for the restructured entity.

In the event Italy is the “entry country”, i.e. a principal company acquires functions, valuable assets and entrepreneurial risks from a related party, then the acquired assets (in particular intangibles) may be accounted for in the balance sheet of the purchaser and depreciated accordingly.

3.2 Change of manufacturing activities

The model example described in the General Report refers to a fully-fledged manufacturer converted into a low-risk toll- or contract-manufacturer, i.e. a manufacturer which has borne the market risk, the credit risk, the volume risk etc. now enters into a contract with another group company located in a low-tax jurisdiction and assumes those risks accordingly. The toll manufacturer will be remunerated on a cost plus basis.

Assuming Italy as the “exit country” and based on the model example, the main issues to be considered upon the restructuring will be whether the downsizing of the activities of the Italian manufacturer and its conversion into a contract or toll manufacturer triggers an exit charge.

Similarly to what has been outlined for a change of the distribution activities, the first question to be addressed is the legal characterization of the restructuring. In this regard, the key elements to be taken into account would include the contractual features of the agreement to be terminated, such as the duration, the termination period, the provision of an indemnity clause, the investment level sustained by the manufacturer and the options realistically available for the Italian company to continue its business in order to determine whether it will be able to claim a compensation.

According to Italian domestic tax law the other decisive question would be whether the main effect of the conversion of the Italian entity leads to a transfer of an ongoing concern or a branch of business. The answer will always be subject to the specific facts of the case, and in particular to identify what type of assets have been transferred and whether unrelated third parties would have agreed for a compensation. In the model example described by the General Reporters it is assumed that the manufacturing know-how remains with the (Italian) restructured entity. Therefore, neither a transfer of tangible assets, such as machinery or industrial equipment nor a sale of IP (such as manufacturing know-how) can be envisaged. In other words, since the Italian entity will still be acting as a manufacturer, though in a limited risk role, it is unlikely that the manufacturing IP (and the relevant functions to be performed in order to fully exploit it) would be transferred. From a tax standpoint, this will entail investigating what functions and risks will be actually transferred from the Italian entity to the foreign principal in order to claim that a restructuring took place.

From a practical standpoint, it can only be hypothesised which position the tax authorities will assume in the event a waiver of profit potential is triggered as a consequence of the conversion. The author believes that in an arm’s length scenario waiving the continuation of a profitable business activity without having agreed upon a relevant compensation would not meet the requirements of the arm’s length principle. Accordingly, to the extent that the loss of profit potential is accompanied by the transfer of functions and risks embedded into certain assets, Italy would claim the taxation at market value of the bundle of assets leaving its jurisdiction.

Notwithstanding the above, based on the principles of Italian tax law governing transfer pricing, neither profit potential nor a business opportunity may qualify ex se as intangible assets, but they are generally computed in goodwill valuation insofar as a going concern or a branch of business is identified.

3.3 Centralisation of intangible property rights and research and development (R&D) activities in a specific IP company

In this scenario an MNE has several entities in different jurisdictions including an Italian affiliate. All group companies own valuable intangible property and each of them conduct their own research and development (R&D) activity. In the course of a group restructuring the existing property rights for intangible and R&D activities are centralized in a newly established “IP company” located in a favourable tax jurisdiction against the payment of a consideration.

All future R&D is carried on by the IP company, so that the latter is deemed to be the owner of all newly developed property rights. The IP company enters into a license agreement agreements with the Italian affiliate granting the latter the right to use the intellectual property owned by the IP Company.

Over the past few years Italy has witnessed an increase of valuable intangibles, being either patents or trade names (normally referred to as “crown jewels”) leaving the country towards more favourable “low-tax” jurisdictions (e.g. Ireland, Luxembourg or Switzerland) where the management of those assets is normally centralized.

In the model example discussed above, two questions that need to be addressed:

(i) First, whether an actual sale of an intangible took place; and then

(ii) What type of valuation is going to be utilised for determining the consideration in the hands of the transferor and the economic use of it by the transferee.

As regards the question sub (i), assuming that the Italian entity actually sold the intangibles, such a transfer would generally be acknowledged and considered a taxable event. The arm’s length amount subject to tax will be constituted by the difference between the arm’s length value of the asset and its tax book value. The fact that the Italian entity may also transfer its license arrangements with respect to previously developed intangibles to the IP Company as

well as the question whether or not part of its R&D staff is relocated have to be carefully considered for purposes of identifying what type of assets have been transferred and the arm’s length compensation to be paid to the Italian entity.

Against this background, it is worth noting that the Italian tax authorities have increasingly challenged “back to back” schemes of valuable IP on the grounds of the lack of any economic substance by resorting to the application of the anti-avoidance rule of Article 37-bis. It is the author’s view that such arrangements may also be challenged on the grounds of paragraph 1.65 TPG, the applicability of which may nowadays be invoked by Italy’s Revenue Agency, in particular where the business restructuring provides for a transfer of an intangible asset followed by a new arrangement whereby the transferor will continue to use the intangible transferred. If that is the case, the entirety of the commercial arrangements between the related parties should be assessed in order to assess whether the transactions are arm’s length.

In practice, the Italian tax authorities should be expected first to closely scrutinize whether the IP Company is the actual economic owner of the intangibles and assess whether it is the actual recipient of the royalty streams as well. Then, the arm’s length nature of the royalty payment with respect to both previously developed assets and newly developed assets will have to be benchmarked to what third parties would have charged in a comparable situation.

As regards intangibles valuation, there is no guidance provided for by domestic provisions as to identifying the best method to properly value the intangibles. However, it can be reasonably expected that a relationship will be looked after by the tax authorities regarding the determination of an arm’s length compensation for the transfer, the determination of an arm’s length compensation for the post-restructuring transactions in relation to the transferred intangible (e.g. future licence fees payable by the transferor to be able to continue using the asset) and the expected future profitability of the transferor from its future use of the asset.

Lastly, should Italy be the country of localization of the IP Company, the royalty income received will be taxed as ordinary business income and the assets received valued at fair market value.

3.4 Substitution or discontinuation of a specific product without any change in numbers of employees or turnover when such product is now produced by a related party.

The model example presented in the Report refers to the situation where there is the discontinuation of a specific product line (e.g. a tire of a specific size for a certain car model) without a change in number of employees or turnover, when that tire is now produced by a related party in another, low-cost of labour country. As the manufacturer of the car X in country A has now moved the production of the car X to a low cost country, it requires the production of the tire also in this country. Therefore, the tire manufacturer in country A licenses the tire technology to a subsidiary in the low cost country, which now produces the tire for the car X model and sells it to the subsidiary of the car manufacturer.

Assuming Italy as Country A, the facts and circumstance of the model case suggest that the manufacturing know-how with respect to the old product has now been licensed out to the related party located overseas.

To this end, Italy should first try to identify what type of assets left the country. In the case of, e.g. a brand new manufacturing plant with the hire of a new workforce, it is likely that some sort of know-how (e.g. technical training to the newly hired employees) will be transferred together with the manufacturing IP needed for the tyres’ production. As a result, the transferring Italian entity will be entitled to receive an arm's length licence fee under this arrangement, the amount of which will likely take into account part of the goodwill being transferred and related to those assets that will likely be considered economically bundled. The opportunity attributed to the entity acquiring the manufacturing know-how of increasing its profitability as a result of that agreement would have to be considered in setting an arm's length licence fee. In this respect, it is debatable whether in setting the arm’s length fee also the entire value of goodwill should be taken into account. Depending on the actual facts and economic circumstances of the case, the author believes that in the proposed model example the goodwill owned by the Italian company will not be erased by simply transferring some of the assets to the new manufacturing plant. The outcome would be different though in the event of a mere closure of a plant and opening of a new one in a different country with the hire of new personnel and no transfer of significant manufacturing know-how. The latter event would not give rise to an arm’s length compensation as no related party transaction would be deemed to occur.

From an Italian “entry” perspective, it is unlikely for the recipient to pay an amount for the concession of profit potential alone. In other words, it can be expected that the profit potential would be effectively embedded in periodical royalties that will be charged to the Italian entity for exploiting the manufacturing know-how. The arm's length royalties would then be deducted from the Italian tax base accordingly.

Relationship with EC Law

From an EC law perspective, the key question to be posed relates to whether cross-border business restructurings are treated less favourably than domestic types of reorganisations. As for the time being it is difficult to answer properly to this question, the author attempts to focus on a pending issue that might require legislative intervention.

As regards exit taxation, the Italian domestic system allows with Article 166 of the ICTA for the taxation of the built-in gains on assets’ emigration unless the latter are attributable to a PE located in Italy.

Notwithstanding some amendments, the provision in principle would appear incompatible with the European Court of Justice (“ECJ”) case law on the application of the primary right

of establishment to direct tax law35. As a result, some scholars have invoked a legislative intervention so as to remove such inconsistency36

Nevertheless, it seems likely that a convergence action will be brought along, as a new proactive approach by the Italian legislator towards EU law in the field of direct taxation as interpreted by the ECJ is on its way to guarantee a higher degree of consistency between national and EU level.

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35 See the De Lasteyrie (Case C-9/02) and N case (Case C-470/04).

36 See P. Pistone, The Impact of ECJ Case Law on National Taxation, in Bulletin for International Taxation, 8/9, 2010, p. 412