Italy—Obtaining Penalty Protection in Tax Audits under New Regulations on TP Documentation

The Italian Revenue Agency has recently introduced new regulations on transfer pricing documentation (Revenue Agency Regulations n. 360494 of November 23, 2020) (the new regulations) which will have a significant impact on how multinational groups will have to handle formalities to be compliant with the Italian transfer pricing law (see Article 110, paragraph 7 of the Consolidated Income Tax text) starting from the current year.

The new regulations replace those which are presently in force and which date back to 2010. As a result, their scope is not only to update the previous regulations in order to take into account the amendments to transfer pricing legislation introduced in 2018 (see the Decree issued by the Minister of Finance on May 14, 2018), but also to capture all the topics and issues that were particularly the object of disputes in tax audits between taxpayers and the Italian Revenue Agency and in the context of tax litigation focused on transfer pricing challenges.

It should be noted the new regulations are also focused on low value-added services and management fees deductions, for which reference was still made to the circular letter of the Ministry of Finance n. 32 of 1980).

Moreover, specific details are included as to the formalities to be complied with in connection with the filing of a tax return. As a result, starting from the fiscal year in force as of the date of the publication of the new regulations (i.e., in case of a calendar year, as of FY 2020), taxpayers will be required to implement certain changes to the approach currently used to handle transfer pricing documentation.

Transfer Pricing Documentation

As in the past, the transfer pricing documentation should be qualified as adequate by the tax auditor in order to obtain relief from penalty application. In fact, compliance with the regulations and indications provided will allow taxpayers to benefit from the disapplication of penalties for “unfaithful” filing of a tax return in the event of a tax audit focused on transfer pricing issues (so-called penalty protection), which may range from 90% to 180% of the tax adjustment.

The presence of adequate transfer pricing documentation will also protect taxpayers in case of challenges deriving from adjustments to royalties and interest expense exceeding the alleged normal value, when the Italian Revenue Agency does not recognize the reduced tax rates provided by tax treaties against double taxation or the EU Interest and Royalties Directive (Article 1, paragraph 6 and Article 2, paragraph 4-ter, of Legislative Decree no. 471 of December 18, 1997).

The scope of the new regulations is clearly mentioned in the motivations included in them, which reassure taxpayers that the transfer pricing documentation regime applied with diligence and good faith, “responds, on the one hand, to a demand for certainty on the part of taxpayers by identifying the elements and rationale used by the tax administration during tax audits and, on the other hand, increases the effectiveness of the tax risk assessment and possible audit activities.”

The main aspects of the new regulations which, as discussed, may have important impact on transfer pricing audit activities, protecting taxpayers from the application of penalties, are considered below.

Master File and Country File

The developments introduced in the new regulations will expand the documentary burden on taxpayers, providing an obligation to put in place both a master file and country file together with specific attachments that were not previously mandatorily requested (although generally asked for in case of investigation).

Based on the regulations issued in 2010, transfer pricing documentation had to follow a specific structure, i.e., a format which represented a unique approach for Italian purposes and required additional effort, being a special format only for one country. Not using the recommended format would have a negative impact on penalty protection and the evaluation of “adequateness,” taking into account also that the tax authorities adopt a very formalistic approach during tax investigations.

The new regulations have introduced, for both master file and country file, a specific format which is more in line with Action 13 of the BEPS Project and the Organization for Economic Co-operation and Development (OECD) 2017 Transfer Pricing Guidelines, with the result that the same structure (at least for the country file) could be aligned for more countries.

However, differently from the past, the new regulations require that the local subsidiary must be ready to provide both the master file and the country file to the Italian tax authorities in case of audit. Previously, only holding or sub-holding companies were obliged to draft and present a master file. This new measure will require a taxpayer to ensure that the information included in the master file and in the country file is fully aligned and complete, taking into account the broad scope of the master file and the significant number of attachments that need to be collected (e.g. consolidated financial statements, international rulings).

As to the format, the master file will consist of five chapters. The first two will be dedicated to a description of the group’s organizational structure and the activities carried out, with a focus on the value chain and the main profit-generating factors, as well as the reference markets and any corporate reorganization operations.

The third chapter should include a description of the intangible assets owned by the group and any agreements relating to them, the group’s policies on transfer pricing for research and development activities, as well as any significant transactions involving intangible assets.

The fourth and fifth chapters are dedicated to the description of intra-group financial assets, and the related transfer pricing policies applied, or of the group’s financial relationships, including the listing and description of any advance pricing agreements or prior cross-border rulings on financial transactions between group companies.

In the country file, the taxpayer will also be required to enhance the level of information provided to the Revenue Agency, since they will be required to attach to the document not only copies of intra-group contracts but also of existing unilateral and bilateral/multilateral transfer pricing agreements and cross-border prior rulings to which the domestic company is not a party but which are “linked” to the intra-group transactions described in the documentation.

Clarifications are expected in relation to the relevance of that “link” which will entail the mandatory collection of additional documentation to the country file of a subsidiary in Italy.

The new regulations maintain the same approach used in the past for small and medium-sized enterprises (SMEs), which will only be required to update the benchmark analysis on a three-year basis. The new regulations provide a definition of SMEs, clarifying that SMEs are those enterprises which have a turnover lower than 50 million euros ($61.2 million) per year, but also that are not directly or indirectly controlled by an entity not qualifying as an SME. Belonging to a multinational group may therefore involve an Italian SME in annual updating of the transfer pricing documentation, in light of the new regulations.

Signature Formalities Essential for Penalty Protection

The current legislation grants taxpayers penalty protection not only if the transfer pricing documentation is qualified as adequate, but also taxpayers must have checked the specific box in the tax return disclosing to the tax authorities that transfer pricing documentation is available. The documentation must be signed by the legal representative of the company and handed over to the tax auditors within 10 days from their formal request.

From a “procedural” point of view, one of the main innovations introduced by the new regulations is the requirement to sign the transfer pricing documentation using the electronic signature of the legal representative (or his delegate) and affix a time stamp with a date that should be prior to the date of submission of the tax return. Starting from fiscal year 2020, the above formalities will be mandatory in order to be granted the benefit of penalty protection.

Consequently, the documentation will have to be “contemporaneous,” i.e. be ready and already signed at the time of filing the annual tax return. No actual filing of the transfer pricing documentation will be required though. The documentation will have to be delivered exclusively in electronic format within and no later than 20 days of the relevant request made by the tax auditors. In the event of a request by the financial administration offices for additional documentation, the same must be delivered within seven days, which is more extensive in view of the complexity of the request.

This provision is intended to enhance the level of compliance of taxpayers, ensuring that the transfer pricing documentation is ready at the time of filing of the tax return and of the communication made therein. This will prevent taxpayers from only finalizing the transfer pricing documentation at a later stage or at the time of the tax audit, even though the appropriate box in the tax return was checked.

Attention will also have to be paid to the new documentary requirements and any misalignment that could occur in relation to the responsibility of the entity drafting the master file and country file and related timing.

When Documentation is “Adequate”

The new regulations focus much attention on the notion of “adequacy.” During tax audits, this concept was not always applied in a consistent manner by tax auditors, who in some cases did not grant penalty protection following a narrow interpretation of the concept.

The new regulations clarify that the documentation must be qualified as “adequate” on the basis of the quality of the information provided, regardless of whether during the audit the tax authorities do not agree with the transfer pricing method or the selection of transactions or comparables adopted by the taxpayer. Even partial omissions or inaccuracies that do not affect the audit activity may be considered excusable by the auditing bodies.

Taxpayers must pay the highest attention to the qualitative aspect, describing precisely and accurately the activities and functions carried out by the relevant Italian entity. This is important to consider, since in case of tax audit the Revenue Agency is entitled to interview employees and identify the actual activities performed.

Company reorganizations must also be mentioned and explained, with consequent identification and evaluation of whether an exit tax should be received by the Italian tax authorities.

A cherry-picking of the intercompany transactions to be tested can be performed and this is a new opportunity, as in the past not including all intercompany transactions could affect the penalty protection regime in transfer pricing challenges.

How and When to Make the Communication

According to current regulations, the possession of the documentation must be communicated to the Revenue Agency by ticking the appropriate box in the annual tax return sent electronically. However, questions arose in the past on whether the communication could have been made later, through the filing of an amended tax return.

The new regulations solved this issue by stating that if the communication is initially omitted, taxpayers may amend their option by submitting a supplementary tax return, but only if it is necessary to correct errors and omissions arising from non-compliance with the arm’s-length principle which brought about a lower taxable basis or lower tax or a higher tax credit. This is the sole circumstance which entitles taxpayers to modify and supplement the relevant communication to the Revenue Agency by filing a relevant amended tax return. In practice, an amended tax return will have to be filed (and an amended version of the transfer pricing documentation drafted) only to correct mistakes in the original tax return, in favor of the Revenue Agency.

In the case of submission of the supplementary declaration, made by December 31, 2020, and with exclusive regard to tax periods prior to that pending at the date of publication of the new regulations, no penalties or interest shall be imposed.

Low Value-Added Intra-Group Services

The new regulations dedicate a specific paragraph to the documentary requirements for infra-group services qualified as “low added value,” for which the Decree of 2018 had indicated typical features (e.g. routine services of a supportive nature that are not part of a multinational’s core business) and had foreseen a simplified approach, in line with the OECD 2017 Transfer Pricing Guidelines.

In general, low value-added services are those rendered within companies belonging to the same group, such as administrative, legal, IT, marketing services, etc., which were deeply analyzed in Action 10 of the OECD BEPS Action Plan and valued through reimbursement of direct and indirect costs, increased by a mark-up ranging from 2% to 5%, without the need to perform a specific benchmark analysis.

Experience on the tax audit side shows that the issues arising from the deduction of costs for low value-added services are twofold.

On one hand, tax auditors analyze the transfer pricing aspect, i.e., the method to calculate the service fee and the arm’s length of the mark-up applied. For this purpose, the new regulations confirm the simplified approach already regulated in the Decree issued in 2018, with the acknowledgment that a 5% mark-up on the recharged costs could be acceptable.

However, the new regulations also seem to address the issue of the deduction of the costs for corporate income tax purposes, since they introduce specific documentation requirements in order to ensure the deductibility of the related costs.

More specifically, the new regulations require the preparation of specific documentation aimed at describing the services in question, explaining the reasons for their inclusion in the category of low value-added services, the perimeter of the beneficiaries, the criteria for their valorization, the benefits expected or obtained, the allocation keys used to re-charge the aggregate costs, together with the relative underlying reasons for their selection.

This documentation must be supported by intra-group agreements, as well as by calculations and spreadsheets that highlight the criteria and the distribution of costs between the companies benefiting, in clear contrast with the claimed simplified approach.

The requirements specified in the new regulations are nothing new for multinational groups that have experienced tax audits on management fees: they are generally asked for the same amount of information. It might be seen as a simplification to the extent that procedures are established at group level and the same information is provided to the different beneficiary entities. It is expected that the new regulations will be supplemented with practical examples of documentation that will be acceptable to prove, for instance, the benefits of the shared low value-added costs (e.g. cost savings, allocation keys for the different services) and restrain the tax authorities from reviewing and challenging the benefits.

It is finally worth noting that clarifications are expected with regard to the possible or mandatory inclusion of the information related to such category of intra-group services in the transfer pricing documentation, with consequent possible application of penalty protection.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Gaetano Salvioli is a Partner, Giuliana Polacco is Senior Counsel and Annarita De Carne is Senior Associate with Studio Legale Bird & Bird.

The authors may be contacted at: gaetano.salvioli@twobirds.com; giuliana.polacco@twobirds.com; annarita.decarne@twobirds.com