Tax treatment of LBO transactions explained by the Italian tax authorities
On 30 March 2016, Italian Tax Authorities issued Circular Letter No. 6/E (hereinafter the “Circular”), which provides significant guidance on the tax treatment of Leveraged Buy Out (hereinafter “LBO”) transactions.
The Circular provides clarification on: (i) the tax treatment of LBO transactions – with a focus on deduction of interest expense for corporate income tax purposes in the post-‐merger structure– and (ii) the tax treatment of specific income items that may arise in the context of an LBO transaction, including exit proceeds.
- Tax treatment of LBO transactions
As outlined in the Circular, the special-‐purpose vehicle (hereinafter the “SPV”) set up for an LBO transaction is usually financed by debt (the “acquisition finance”) in order to acquire interest in the target company (hereinafter the “Target”). Following the acquisition, the SPV and the Target are merged. In certain circumstances in which the merger is not carried out,, a tax consolidation regime is adopted between SPV and Target.
- Deduction of interest expense for corporate income tax purposes
As a result of an LBO transaction, the acquisition debt granted to the SPV is pushed down into the Target, by means of the merger transaction. Italian Tax Authorities have often challenged the deductibility of interest expense, particularly on the basis of the two following arguments: (i) LBO transactions are “abusive” transactions, since mainly aimed at achieving a tax advantage connected with the push down of the debt at the level of the merged target company, or (ii) the interest expense, incurred for the benefit of the investors, should have recharged pursuant to TP rules.
The Circular clarifies the position of the Italian Tax Authorities on LBO transactions and by adopting a different approach, affirms in principle the legitimacy of these transactions (unless elements exist that deviate from the typical feature of LBO transactions). Therefore, interest expense for acquisition debt should generally be considered as a deductible business expense in accordance with the provisions of Italian tax law, i.e. subject to the 30% EBIDTA limitation, either at the level of the SPV, before the accomplishment of the merger, or .at the level of the company resulting from the merger between SPV and target (regardless of the fact that the merger is a direct or a reverse merger).
In addition to the above, in case of cross-‐border intercompany financing, the provisions on transfer pricing will also apply, with the consequence that, for deduction purposes, interest expense should comply with the arm’s length principle.
- Tax treatment of the merger between Target and SPV
Italian tax law provides for different “tests” that limit the possibility for a post-‐merger entity to carry forward the tax losses and interest expenses of the companies involved in the merger. These tests are (i) the so-‐called “vitality test”, aimed at proving that a company has carried out real business activities prior to the merger , which is a condition to be met in order to allow the carry-‐forward of tax losses; and (ii) the net equity test, aimed at determining the maximum amount of tax losses and interest expenses that can be carried forward, without taking into consideration the equity contributions of the last 24 months prior to the merger.
SPVs usually do not meet the above tests. The Circular recognises that they should be weighted for SPVs, in light of their specific nature and purpose. Therefore, Italian tax Authorities would view favourably the submission of advance rulings (so-‐called “interpello”) in order to ask for the non-‐ application of the above tests in the circumstance in which the tax losses and interest expenses at the SPV’s level derive only from the acquisition debt obtained to finance the LBO transaction.
- Tax treatment of specific income items connected with LBO transactions
The Circular also clarifies the tax treatment of specific income items that may arise in complex LBO transactions. More specifically, the Circular focuses on (i) fees that may be charged to the Target particularly in private equity acquisitions , (ii) interest paid to non-‐resident lenders if the acquisition is financed through an “IBLOR structure”, (iii) interest expense associated with shareholder loans, and (vi) capital gains and dividends upon exit.
- Tax treatment of fees charged to Target
If the management company of the private equity fund charges fees to the Target (such us management fees and monitoring fees), their deductibility will first depend on the connection of such fees with the business activity of Target. More specifically, it should be verified to which services the fees relate and whether such services were actually provided to the benefit of the Target, rather than to the benefit of other entities (e.g. the investors in the private equity fund).
Once it has been verified that the fees satisfy the business purpose test, their deductibility will also be subject to compliance with transfer pricing rules.
Finally, as far as the VAT treatment of fees is concerned, the Circular provides that input VAT on fees is not deductible by the SPV if the latter’s exclusive business is to hold shares, as a mere holding company that do not carry out a business activity in the meaning of the VAT laws .
- Withholding tax on outbound interest to non-‐resident lenders – IBLOR structures
In the past, Italian Tax Authorities challenged the non-‐application of withholding tax on interest in respect of IBLOR structures, on the ground that, in such structures, the beneficial owner of the interest is a non-‐resident lender. With respect to the past, the Circular confirms said approach, while recognising however that, since the tax law provisions in question were not sufficiently clear, administrative penalties should not be charged in case of tax audit.
In any event, the Circular recalls the specific withholding tax exemption provision on interest on mid-‐ long term financing granted by qualified lenders, as provided by Article 26, paragraph 5-‐bis of Presidential Decree No. 600/1973 (as recently amended)
- Tax treatment of shareholder loans
If the acquisition is – even partially – financed by shareholder loans, the deductibility of interest expense incurred in connection with such loans is subject to (i) the general limits applying to interest expense deductibility under Italian tax law (i.e. 30% of EBIDTA), and (ii) compliance with transfer pricing rules.
In addition to the above, bearing in mind the OECD Guidelines, the Circular provides that for shareholder loans it is possible to re-‐characterise debt into equity. The risk of re-‐characterisation into equity primarily arises when the legal form of a transaction is not in accordance with its economic substance.
Further to that, taxpayers are cautioned by the Circular on the conditions requested to achieve withholding tax relives on outbound interest payments, either under a double tax treaty or under the s.c. Interest and Royalties EU Directive. For shareholder loans, the requirements in terms of beneficial ownership will be very sensible, particularly in those cases where a back-‐to-‐back arrangement is in place.
- Tax treatment of capital gains and dividends upon exit
In LBO transactions, the private equity fund usually exits from the investment either through: (i) the sale by the non-‐resident holding company of the interest in the SPV merged with Target, realising a capital gain; or (ii) the sale by the resident SPV of the interest in the Target, with subsequent distribution of dividends to the non-‐resident holding company.
In both cases, the possible presence of multiple intermediate vehicles, incorporated in EU, may result in significant tax reduction when applying either the European Union’s tax Directives or Double Tax Treaties.
According to the Circular, Italian Tax Authorities would not challenge the benefit arising from the presence of intermediate vehicles insofar as they meet the applicable economic substance and beneficial ownership requirements (i.e. are not merely “conduit” companies).
According to the Circular, indicators of the absence of economic substance and beneficial ownership in non-‐resident vehicles are: (i) a light organizational structure (i.e. the company does not carry out real business activities and has no decision-‐making power; the circumstance that employees, building and other assets are provided by a local domiciliation agent can be an indicator too); and (ii) a financing structure specifically tailored to finance the LBO transaction and the circumstance that no withholding tax on outbound flows is provided for by the tax law of the jurisdiction in which the vehicle is located.
Should the economic substance of intermediate vehicles be challenged, Italian Tax Authorities might disregard the tax benefits deriving from the presence of intermediate vehicles by applying a “look-‐ through approach”.