For decades, the Bloomberg Tax International Forum has convened international tax experts from all over the globe. In this series, Forum members will regularly share their views on current and important topics. Read the full archive of the Bloomberg Tax International Forum articles here.
The Italian Supreme Court, the country’s highest (tax and non-tax) tribunal on matters of law, is developing a trend in denying the exemption from Italian withholding tax on dividend under Directive 2011/96/EU (the Parent–Subsidiary Directive, PSD) on distributions to eligible EU parents benefiting from the participation exemption on dividends received. This approach may impact all EU parents receiving or having received Italian source dividends, including U.K. parent companies receiving dividends until the end of the transition period (currently December 31, 2020).
Under Article 2(a)(iii) of the PSD, an eligible parent company is a company that, among others, “is subject to one of the taxes listed in Annex I, Part B, without the possibility of an option or of being exempt, or to any other tax which may be substituted for any of those taxes.”
In the case of outbound dividends, the implementation of the PSD in Italy appears to be substantially compliant with the PSD, since it provides for the refund of the dividend withholding tax where the recipient is a EU resident company having one of the forms listed in Annex I, Part A of the PSD and is subject to one of the taxes listed in Annex I, Part B.
As a matter of practice, where the relevant conditions are met, the distributing company may opt, at its own risk and under its own responsibility, for the direct application of the exemption at source (relieving the recipient company from the onus of obtaining a refund from the Italian tax authorities). However, the Supreme Court is proclaiming its own interpretation of the subject to tax test.
First Decision—Refund of Dividend Withholding Tax Denied
The first decision (No. 32255, December 13, 2018) concerned the denial of the refund of dividend withholding tax on a distribution by the Italian subsidiary to its eligible Luxembourg resident parent. The Luxembourg company was an ordinarily taxable company, taking advantage of the Luxembourg participation exemption on eligible dividends (under Article 166 of the Luxembourg income tax law—LIR).
The Italian Supreme Court upheld the position of the Italian tax authorities as confirmed by the Court of Second Instance (regional court) that refused to refund the amount of withholding tax, arguing that the dividend withholding tax exemption is meant to avoid double taxation and, because of the exemption in the hands of the Luxembourg parent under the local participation exemption, “no double taxation could occur.”
The appellant also argued that the taxation of dividends at source could be in breach of two EU fundamental freedoms, namely the freedom of establishment and the freedom of movement of capital. The Supreme Court also rejected these arguments, arguing that the then applicable tax regime of dividends received by Italian companies was full taxation (the case was about pre-2004 dividends) thus defeating any case for discrimination against companies established in different member states.
Subsequent Decision—Luxembourg Holding Company Again Denied Relief at Source Under the PSD
Scholars and commentators strongly disagreed with the conclusion of the Supreme Court. However, in a subsequent decision (No. 25490, October 10, 2019) the Supreme Court was again confronted with the case of a Luxembourg holding company, otherwise eligible for the exemption under the PSD, that had originally suffered a 15% withholding tax.
The tax authorities—again, the Pescara Office, competent for refunds to nonresidents—refused the refund of the withholding tax and, in return, claimed the application of the full 27% tax under domestic law, challenging the application of the Italy–Luxembourg tax treaty as originally applied. The case was litigated by the taxpayer.
The Supreme Court refused to refer the case to the ECJ and rejected the appeal by the taxpayer arguing that the “subject to tax” test in the PSD is not meant to be in the abstract but, rather, as actual subjection of the specific dividend to taxation, which did not happen under the Luxembourg participation exemption. Indeed, according to the Supreme Court, the tax exemption in the hands of the recipient and the exemption from withholding tax at source should not be enjoyed together, since the aim of the PSD, i.e. the elimination of double taxation of dividends, is fully achieved through the exemption in the hands of the recipient, so that the exemption at source constitutes a double benefit.
Apparent Change of Direction—Dividend Tax Credit Under Italy–U.K. Tax Treaty
In a more recent decision (No. 2313, January 31, 2020) the Supreme Court apparently reversed its approach and turned down the decision of the Court of Second Instance of Pescara (again, the case moves from application of refund with the Pescara tax office). The case is somewhat different, since it does not concern the application of the PSD, whose exemption at source had been fully enjoyed by the taxpayer, but the refund of the dividend tax credit (imputation credit) under Article 10 of the Italy–U.K. tax treaty.
Until 2004, the Italian tax system provided for the elimination of domestic economic double taxation through the indirect credit method. Under certain tax treaties, namely those concluded in the early 1990s with France and the U.K., Italy granted the partial or total refund of the imputation credit to eligible recipients resident of the other Contracting State.
The relevant treaty provisions are independent from the application of the PSD, albeit meant to achieve the same purpose (mitigation or elimination of economic double taxation). On the other hand, Article 7(2) of the PSD expressly provides that “This Directive shall not affect the application of domestic or agreement-based provisions designed to eliminate or lessen economic double taxation of dividends, in particular provisions relating to the payment of tax credits to the recipients of dividends.” Having enjoyed the exemption from dividend withholding tax under the PSD, the taxpayer went on applying for the refund of (50% of) the imputation credit under the treaty.
Having disbursed the refund, the tax authorities claimed it back after several years. The tax authorities argued that the exemption from dividend withholding tax under the PSD already achieved the elimination of double taxation, so that the refund of the imputation credit was a duplication of relief. The Supreme Court recalled the ECJ decision in the Brussels Securities case (C-389/18) and argued that the taxation of cross-border dividends should be governed by a principle of neutrality.
Most importantly, it finally made a distinction between juridical and economic double taxation and made the point that the refund of the imputation credit is meant to eliminate economic double taxation, whereas the exemption from withholding tax is meant to eliminate juridical double taxation. Hence, the two reliefs are not incompatible. The same principles had been put forward by the Supreme Court in decision Nos 30140/2019 and 29635/2019, confirming that the full exemption on inbound dividends, provided under the Italy–Germany tax treaty, was meant to eliminate economic double taxation and was not dependent on actual taxation in the state of source.
Back onto the Old Track—No Relief at Source if Dividends Exempt in the Hands of the Recipient
Decision No. 2313 was saluted with great praise by the professional community. However, the relief was short-lived. Through Decision No. 2617 of February 5, 2020, the Supreme Court went back to the old ways. Again, the case concerned the refund of the imputation credit under Article 10(4) of the Italy–U.K. tax treaty.
The applicant had originally obtained the refund under the treaty then the Pescara tax office retracted the refund and reclaimed. While the bulk of the decision is about the eligibility of a trust for the application of double tax treaty, the Supreme Court seized the occasion to reassert that the “subject to tax” taxed under the PSD required the actual application of tax on the dividends, so that no exemption at source could be made available if dividends were for whatever reason exempt in the hands of the recipient.
The position by the Italian Supreme Court in Decision Nos 32255/2018, 2617/2020 and 2545/2019 is highly questionable, for several reasons.
Firstly, it ignores that the aim and function of the PSD includes the elimination of economic double taxation, i.e. the taxation of the same profits in the hands of the distributing company and, in its own state, in the hands of the parent company. This is what participation exemption and indirect tax credit regimes are for. They should not interfere with the lifting of the withholding tax on the same dividends, as this is meant to eliminate juridical double taxation, also one of the aims of the PSD.
Secondly, the decisions of the Supreme Court postulate that “subject to tax” should be interpreted as actual application of the tax on the specific dividends and not, as clearly set out in the PSD, as the entity being ordinarily subject to tax in the abstract, regardless of whether it may take advantage of specific regimes meant to eliminate economic double taxation. However, since Italian courts are traditionally reluctant to refer cases to the ECJ, the issue may take longer to be resolved, unless the Supreme Court itself acknowledges the conflict between decisions and advocates the case to the united chambers to resolve it.
As a matter of practice, it should be considered the decisions by the Supreme Court are not law, but strong precedents to which the tax authorities refer whenever convenient. Similarly, albeit lower courts are not bound by precedence by the Supreme Court, since virtually any tax dispute ends up in the Supreme Court (after the best part of 10 years), unless and until the ECJ decides on the matter, taxpayers should consider litigation as not unlikely to bring an adverse result in the short and medium term.
It is therefore advisable to ensure that the conditions for the application of the exemptions are present at the time of distribution and have the distributing company applied exemption directly, rather than suffering the withholding tax and then applying for a refund, which would invariably result in litigation. If a dispute arises, all options will have to be considered.
Carlo Galli is a Partner and Head of Tax Practice of Clifford Chance in Milan, Italy.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Read the full archive of the Bloomberg Tax international Forum articles here.