The rules on controlled foreign companies in Article 167 of the Corporate Tax Act state that as long as certain conditions are met, profits realised by a foreign enterprise are deemed to be imputed to the Italian ultimate shareholder and are therefore taxed in Italy, even if no dividend distribution takes place.

General provisions on controlled foreign companies were introduced in 2001 and initially applied only to foreign subsidiaries based in blacklisted countries.

In general, the controlled foreign company rules can be disregarded if, through a ruling procedure, the resident taxpayer demonstrates (among other things) that the foreign subsidiary carries on a business activity in the market in which it is established. According to Circular 51/E, which was issued in 2010, the presence of an actual business organisation in the foreign market in question is insufficient in itself for a positive ruling; rather, the Italian ultimate controlling shareholder is required to show that the foreign entity participates in the economy of its host state or territory within the meaning of the European Court of Justice's decision in Cadbury Schweppes.

The controlled foreign company rules can also be avoided if the group's effective tax burden is equal to or greater than the tax burden under the Italian regime (ie, 27.5%).

Since January 1 2010 the rules have applied to foreign subsidiaries that are established in whitelisted jurisdictions if:

  • the effective tax rate applicable to the controlled foreign company is less than 50% of the Italian tax burden on the same income, in the same taxable year;
  • the foreign company derives more than 50% of its proceeds from passive income (ie, dividends, capital gains, interest and royalties) or intra-group activities; and
  • the Italian parent company cannot prove that the foreign company does not constitute a wholly artificial arrangement.

On May 26 2011 the tax authorities issued Circular 23/E, which provides new guidelines on the application of the controlled foreign company rules to foreign companies in jurisdictions that are not tax havens. On the subject of the tax rate test, the circular states as follows:

  • The performance of the tax rate test must exclude provisions that are not found in the act (ie, provisions aimed at limiting interest cost deductions and the applicability of the lump-sum taxable base in specific provisions for non-operating companies). Otherwise, if the foreign-controlled entity meets all of the criteria for a controlled foreign company, the determination of taxable income to be imputed to the Italian ultimate controlling entity shall take account of provisions that are not included in the act.
  • The test must always be applied, even if the foreign entity is in a tax loss position in its state of residence.
  • The test must exclude timing differences arising in fiscal years before the application of the controlled foreign companies rule. If an appropriate ruling request is filed, the authorities will consider the relevance of timing differences arising after the application of the new provision.
  • The test must take account of the accounting principle that applies under the corporate law to which the foreign controlled entity is subject. If the latter applies International Accounting Standards/International Financial Reporting Standards (IAS/IFRS), the relevant provision of Italian law will apply - in principle, IAS/IFRS qualification, classification, timing and imputation criteria are acceptable for tax purposes. IAS/IFRS provisions also apply if the foreign controlled company adopts US generally accepted accounting principles.
  • Final withholding taxes that apply in the foreign controlled entity's state of residence are included in the tax rate for the purposes of the test. Thus, the authorities do not consider final withholding tax suffered abroad to be irrecoverable by the controlled entity: this is a common position in the legislation of some EU member states (eg, Luxembourg and the Netherlands), where domestic and foreign-source dividends are entitled to a full participation exemption. Most experts consider that foreign withholding taxes should be included in determining the actual tax rate of the controlled entity, since to do otherwise would trigger material discrimination in respect of the criteria for determining the corresponding Italian tax rate.

The tax authorities will apply a strict interpretation in the event that an Italian controlling company does not verify the tax rate and the passive income tests in detail. Where both tests are met, the authorities will apply the controlled foreign companies provision to the whitelisted controlled entity in a specific tax year. In this case the Italian taxpayer should file a ruling request for the regime in question to be disapplied in subsequent years, even if the conditions for the application of the controlled foreign companies provision are not verified further. This position appears to be inconsistent with the wording of Article 167 of the act.

For further information on this topic please contact Marco Abramo Lanza, Simona Zangrandi or Franco Pozzi at Studio Legale Tributario Biscozzi Nobili by telephone (+39 02 763 6931), fax (+39 02 780 146) or email ([email protected], [email protected] or [email protected]).