On March 30, 2016, the Italian Tax Authorities ("ITA") issued Circular n. 6/E ("Circular") to clarify certain tax aspects of leveraged buyout and merger leveraged buyout transactions ("LBO" and "MLBO" respectively). The Circular also provides important guidance on the tax treatment at source of outbound payments of interest and dividends by the Italian target.
LBO and MLBO transactions are often scrutinized by the ITA. In particular, the ITA often challenge the deduction of interest expenses for bank and/or shareholder loans granted to an Italian acquirer of an Italian target company in either an MLBO or an LBO followed by a tax group consolidation election. The ITA's challenges are mainly based on the argument that the transactions have the exclusive purpose of deducting interest payable from the income of the target without any other valid economic reason (and in this sense, they are abusive).
The Circular contains comments and guidance of a general nature. Consequently, each LBO and MLBO transaction should be assessed and evaluated on a case-by-case basis in light of the individual factual circumstances of each case.
Deduction of Interest Expenses and Carry-Forward Tax Losses and Expenses
The Circular acknowledges that LBO and MLBO transactions should not generally be deemed abusive. They are expressly contemplated by the Italian Civil Code that provides for a complex procedure to verify the financial sustainability of the debt by the target company. Also, the Circular recognizes that LBO or MLBO structures are typically requested specifically by the lenders to ensure an effective security package in their favor.
The Circular states that interest expenses incurred by the Italian acquirer can be fully deductible from the income of the target both in the case of a merger and in the case of a tax group consolidation post-acquisition—subject to the limits provided for by the general rules of the tax code governing interest deduction, and always in accordance with the transfer pricing principles, where applicable. In addition, the Circular clarifies that if the so-called equity and vitality requirements provided by Italian tax law in order for the acquirer to be entitled to carry forward tax losses and interest expenses in a merger scenario are not met by the acquirer, the acquirer should still be in a position to use the carry-forward by obtaining a prior ruling from the ITA.
Management and Other Service Fees
The Circular addresses also the issue of the tax treatment of the management and other fees charged by private equity firms to the Italian acquirer or to the target. In particular, according to the ITA, such fees are not deductible by the acquirer or by the target to the extent the services have been provided for the benefit of the investors (only), rather than of the Italian entities. The Circular contains guidance to the tax inspectors on how to identify the clauses in agreements that are typically executed according to market practice and that can potentially lead to abusive behaviors.
Moreover, the Circular clarifies that the VAT charged in connection with the above-mentioned services is not deductible by the Italian acquirer if the acquirer is a mere holding company that does not provide any services to the target.
Withholding Tax on IBLOR and Other Financing Structures
According to the Circular, in the case of nontransparent IBLOR structures—i.e., where a pool of nonresident lenders lend to the Italian acquirer through an Italian bank or through an Italian permanent establishment of a nonresident bank acting as the front lender—the interest paid to the Italian front lender cannot benefit from the Italian domestic withholding tax exemption. The Circular states that in these cases, the Italian acquirer should apply the withholding tax as if the interest were paid directly to the nonresident lenders.
If the debt has been pushed down to the acquirer through an EU holding company that is a mere conduit, the exemption provided for by the EU interest and royalties directive does not apply either. However, no withholding tax is levied if the nonresident lenders qualify for the domestic exemption that is provided on medium–long-term financings granted by EU banks, EU insurance companies, and whitelisted institutional investors that are subject to regulatory supervision.
The Circular has clarified that, in certain factual circumstances, shareholders' loans granted to the acquirer by foreign investors may be recharacterized as equity and, as a result, no interest can be deducted (e.g., the repayment of the shareholders' loan is postponed to the payment of the third party's loan and/or is subject to the same restrictions applicable to dividend payments and to equity distributions). In the case of recharacterization of the shareholders' loan as equity, the equity can qualify for the allowance for corporate equity or notional interest deduction (so-called ACE) and, in addition, the withholding tax treatment typical of dividends applies to the distributions of proceeds to the "lender."
Dividends and Capital Gains on Exit
Finally, the Circular addresses the tax treatment of dividends and of capital gains on exit. In principle, (i) cross-border dividends may benefit from the exemption under the EU parent–subsidiary directive or from the reduced withholding tax rate applicable under domestic law or under a double tax treaty; and (ii) capital gains may be exempt under domestic rules or under the applicable double tax treaty. This tax treatment can be denied by the ITA if the nonresident holding company does not have an adequate economic substance or if it is a mere conduit company.