On March 30th, 2016 the Italian tax authorities issued the Circular Letter No. 6/E (the "Circular Letter") dealing, amongst others, with certain tax issues related to leverage buy out ("LBO") and merger leverage buy out ("MLBO") transactions.
Indeed, in the most recent years, the Italian tax administration heavily scrutinised LBO, as well as MLBO, and often challenged the deductibility of interest payments related thereto. Such challenges were mainly based on the following arguments:
- Lack of inherence for passive interests paid by the special purpose vehicle (the “SPV”) for the acquisition of the target company (the “Target") with regards to LBO/MLBO transactions.
- Lack of valid economic reasons other than reduction of taxation for LBO/MLBO transactions (i.e. abuse of law).
- Existence of a positive items of income (in an amount equal to the passive interest paid) for the SPV, as remuneration for a service rendered to the foreign entities pertaining to the same group with regards to the financing syndication activity.
The comments provided with the Circular Letter, as outlined at paragraph 1 below, should finally relieve many taxpayers who were under litigation with the tax administration on such matter and provide more certainty for future transactions.
The Circular Letter has also commented on a number of other matters, which are of relevance for the private equity sector, such as:
- Tax deduction of transaction costs charged to the Target or to the SPV by private equity fund managers.
- Withholding tax on financings structured as IBLOR.
- Tax treatment of shareholders' loan
- Tax issues related to non-resident intermediate holding companies investing into Italy.
It must be noted that, whilst the conclusions of the Circular Letter, with the only exception of the clarifications on interest deductibility, do not provide any material change to the general practice of interpretation, they could increase the level of scrutiny of relevant tax offices in certain areas, especially with regard to international acquisition structures as outlined at paragraphs 4 and 5 below.
Please find here below a brief summary of the interpretations provided by the Italian tax administration.
1. Deductibility of interest payments arising in LBO/MLBO transactions
As with regard to interest payments on LBO/MLBO transactions, the Italian tax authorities seem to accept, in general, the tax deductibility on the basis of the following arguments:
- Interests paid by the SPV with the purpose of acquiring shareholdings shall be deemed as functional to the acquisition of the target, both in the event of the subsequent merger as well as in the hypothesis of deduction by mean of application of the tax consolidation regime (section 2.1 of the Circular Letter).
- LBO/MLBO are transactions generally grounded on valid economic reasons other than reduction of taxation, therefore they do not convey the achievement of undue tax savings, as provided by the general anti-abuse principle. It must be noted that, the transactions at hand may still be subject to scrutiny by the Italian tax authorities where, for example, they are not aimed at the acquisition of the shareholdings by third parties but it is carried out by the same shareholders (section 2.2 of the Circular Letter).
- In the event the SPV, established in Italy for the purpose of the acquisition of the Target, directly obtained financial resources for the purpose of carrying out the transaction, such situation does not entail the existence of any intra-group service to be adequately remunerated in the hands of the SPV (section 2.3 of the Circular Letter).
Further on the analysis regarding deductibility of passive interests, the Circular Letter clarifies that in the event of MLBO transactions, the ordinary tax provisions limiting the right of deduction for interest payments (and tax losses) carried forward by the entity resulting from the merger shall not apply when the company, by filing a preliminary tax ruling with the competent authorities, proves that the excess of passive interests and tax losses carried forward derives directly from financings provided in the context of the MLBO transaction.
2. Tax treatment of fees paid for transaction costs
The Circular Letter has commented also on the deductibility of transaction fees and other fees typically charged by the management company of a private equity fund to the SPV or directly to the Target. To this regard, the tax authorities argue that, since the fees paid to the manager are usually offset against the management fee, it could easily inferred that they are paid in relation to the management activity and, therefore, for the benefit of the fund rather than of the payer (i.e. the SPV or the Target).
In conclusion, in order to admit the deduction for corporate income tax (IRES), as well as for value added tax (VAT) purposes, of the fees charged to the SPV or to the Target by the management company, it is necessary that the services are rendered for the exclusive benefit of the recipient and that they do not refer to the investment, monitoring or divestment activities in favour of the fund or of its investors.
The same paragraph of the Circular Letter has also commented on the VAT status of the SPV used for private equity investments. More in particular, the tax authorities clarified that, in order to be considered as a VAT taxable person, hence, having the right to deduct input VAT, the SPV must carry out administrative, financial, commercial or technical services, other than the mere ownership of the participation in the Target.
3. Applicability of withholding taxes upon intervention of IBLORs
With reference to the tax treatment of interests channelled through entities acting as Italian Bank Lender Of Record (“IBLOR”), the Circular Letter clarifies that:
- When the contractual terms prove that the Italian resident bank acts as a mere conduit entity in respect to other financing entities established abroad, interest payments shall be subject to tax in Italy by mean of withholding tax.
- The exemption on such withholding tax may still be applicable in case the foreign financing persons are banks established in the EU, insurance companies authorized by EU Countries or institutional investors of white list countries, subject to regulatory supervision in the country of establishment, as provided by relevant provision of laws.
4. Tax treatment of shareholder loans
In the event financial resources used for the acquisition have been granted by foreign shareholders by mean of interest bearing loans, the Italian tax authorities may requalify the funding transaction as a capital contribution.
According to the Circular Letter, such re-qualification may be based on an assessment of the economic rationale and the contractual provisions of the loans, such as, for instance, in the event of terms providing for subordinated principal repayment, other limitations to interest and capital repayments or in the case where such loans are excluded from the “financing” definition according to covenants included in other third parties’ financing (section 3.3 of the Circular Letter).
In the event of re-qualification of a shareholder loan into equity:
- Interest payments shall not be deductible for IRES purposes in the hands of the SPV.
- Such interest payments shall be subject to the same tax treatment provided for outbound dividend payments (i.e. application of withholding taxes, if due).
- The amount granted by the shareholders shall qualify for ACE (Allowance for Corporate Equity) deduction, according to which a deduction from the taxable base for IRES purposes, equal to a fixed percentage of contributions or retained earnings, is granted to a company upon increase of its net equity.
5. Tax treatment in the hands of the foreign investors upon exit
As anticipated, the Circular Letter comments on intermediate holding structures typically set up by international private equity firms investing into Italy (section 3.4). More in particular, reference is made to proceeds paid out by the Italian Target to, or capital gains realised upon disposal of the same Target by, a non-resident entity.
To this regard, the tax administration recall the concept of “economic substance” in order to ascertain whether the non-resident vehicle may claim treaty protection or the application of the EU directives on dividend or interest payments.
According to the Circular Letter, evidence of the absence of true economic substance of the foreign entity may be found in:
- The existence of a “light” organizational structure, so that the intermediate entity lacks of (i) any effective activity, which means having no effective operations (such as personnel, premises and structures) in the country of establishment and (ii) lack of any actual power of disposal with regard to the Italian investment, so that such entity simply executes investment decisions carried out by other persons. or
- The existence of a financial “conduit” structure, i.e. when upon accrual of interests, dividends and capital gains from the target, the entity is required to pay symmetrical amounts (in terms of values, durations, terms and conditions) to investors and other lenders, aiming at the applicability of neither outbound taxation nor withholding taxes in the country of establishment.
It must be noted that each of the provisions mentioned by the Circular Letter, such as double tax conventions and EU Directives, already provide for proper beneficial owner clauses and specific antiavoidance provisions, which end up in setting the framework for the quoted “economic substance” test. Hence, the comments on this matter do not add any specific innovative concept to the previous administrative practice.