In layman's terms, transfer pricing is all about the price at which goods or services are sold between different companies within an international group of companies. It is important for the authorities to monitor a company's setting of transfer prices as in some instances businesses can use the system to avoid taxation by manipulating transfer prices to shift profits from one jurisdiction that has a high tax liability to another jurisdiction where the effective rate of tax is lower.
In Italy, the new tax package offers an exemption from tax penalties deriving from transfer pricing adjustments.
To secure the exemption, Italian resident companies with cross-border operations must prepare what is referred to as ‘adequate documentation' to demonstrate that the prices paid to or charged by fellow group companies outside Italy are set at arm's length. By arm's length the tax authorities mean that the group must set prices as though the goods or services were being supplied between two entirely independent companies. Accordingly, the Italian company must be able to show that it is not using these prices to transfer profits from one jurisdiction to another simply in order to obtain a tax advantage by arranging for those profits to be charged at a lower rate of tax.
Francesco Mantegazza, a partner in Pirola Pennuto Zei's London and financial sector tax division, says “The new transfer pricing rules are not really telling us anything we didn't know before. There are multi-national groups already well placed to provide the necessary documentation. In this case, the new rules really only require a collecting together of work that is already available and packaging it into the requisite form (possibly translating it into Italian). In some cases local benchmarking may be advisable where world-wide transfer studies may be looking at samples that are not relevant to the Italian market. As a firm we specialise helping these multinational clients to comply with the Italian rules with the minimum of duplication of effort.”
In some other instances, clients are not so well positioned and a significant investment will have to be made in order to prepare the appropriate documentation in support of transfer prices.
The OECD and EU have for some time been producing guidelines on what constitutes ‘adequate documentation.' For the most part, the new Italian regulations follow these international guidelines, while at the same time inserting a series of detailed requirements specifying the kind of documentation that is required for different types of company and also setting deadlines for the preparation of this documentation.
In order to obtain entitlement to protection from the penalties, taxpayers must notify the authorities on an annual basis of the fact that the taxpayer considers that it holds adequate supporting documentation as prescribed in the regulations. Where notification is made the company will be entitled, assuming the documentation proves to be adequate on a future inspection, to exemption from penalties, in the event of any future transfer pricing adjustment relating to those years.
Part of this documentation is a report of comparable transactions – a study of similar transactions carried out between third parties who deal with each other at arm's length. The good news for small and medium sized enterprises (SMEs) is that while the transfer pricing documentation generally needs to be prepared for each accounting period, the study of comparable transactions only needs to be made only once every three years.
Transfer pricing and the EU Arbitration Convention
Any discussion on transfer pricing brings to mind the EU Arbitration Convention, a treaty that marks its 20th anniversary this year. The convention aimed to create a procedure for the resolution of disputes between taxpayers and tax authorities where the dispute gives rise to potential double taxation in two member states as a result of an upward adjustment in the profits of a multinational business's operations in one member state.
The theory behind the Arbitration Convention was simple. Instead of a company disputing the transfer pricing adjustment through the domestic courts, the convention puts the two member state's tax authorities with an obligation to reach agreement within a two-year time frame and resolve the issue between them. If this was not achieved within the allotted time, the dispute would go before an arbitration panel.
Unfortunately, the convention has been fraught with difficulties of various kinds. Although the treaty includes a provision for a corresponding downward adjustment in profits, because it is merely an agreement and not enforced by EU regulation or directive, it does not create a binding obligation on the member state to eliminate the double taxation. It is a multilateral agreement, more difficult to enforce than a bilateral treaty, and which does not create any direct legal rights for the taxpayer as against the member state.
Many member states, Italy included, have not made any legislative provision for the convention beyond a short law stating that the convention is to have effect generally. Compared to the voluminous guidelines mentioned above explaining the compliance obligations for Italian taxpayers in support of their group transfer pricing policies there is no guidance whatsoever from the tax authorities detailing the procedures to be followed for initiating a claim under the convention. There is no mechanism requiring either the Italian tax authorities or the judiciary to stay local proceedings through the local courts and tax collection service pending the outcome of proceedings under the convention. Taxpayers on receipt of an assessment must make an immediate decision whether to settle and pay up or appeal (and pay part of the tax claimed “on account”). What is clear is that once an Italian court has made a final decision in relation to a particular case, any decision under the Arbitration Convention cannot take effect. Thus taxpayers find themselves in a kind of double jeopardy situation, either having to give up domestic proceedings in the hope that arbitration will work or proceed on the domestic front thereby giving up all rights under the Convention.
A harmonised tax regime for Pan-European companies
Another of the measures in the Summer Tax Package aimed at encouraging inward investment consists of the opportunity for companies resident in an EU Member State other than Italy to elect to apply, to their Italian operations, the tax regulations in force in their member state of origin instead of the Italian ones.
The idea behind the legislation stems from EU proposals for enabling SMEs to use their Home State tax regime, thereby reducing the costs for these taxpayers of tax and accounting compliance in all jurisdictions in which they operate. The premise is that whereas SMEs play an important role in the economic development of the EU, nonetheless they play a much smaller role in terms of trade between member states compared to larger organisations, principally as a result of difficult and prohibitive fiscal regimes. In turn, this results in economic inefficiencies and a reduced potential for economic growth and job creation.
According to this concept, the profits of a group of companies active in more than one member state would be calculated according to the rules of just one company tax system, namely that system employed in the Home State of the parent company or head office of the group. Therefore, an SME wishing to expand its operations to other member states would be able to use the tax rules with which it is already familiar. In an ideal Europe, all companies – and especially SMEs – who do not have the resources to cope with the vast array of tax and accounting regimes across member states should be able to prepare accounts and corporate income tax returns in one state and then divide up the profit between the states in which they operate according to some easily defined ratio, such as turnover or headcount.
The concept of Home State taxation is a very promising way of tackling the tax issues associated with cross-border trade. The EU is currently considering testing the concept in member states with similar tax systems.
One anticipated stumbling block to a roll-out of this system, however, would be in convincing member states to subscribe to a centralised system whereby an EU institution might take an active role in their tax policy.
The new proposed regime for Italy requires further legislation before it can take effect and it is debatable whether the Italian authorities will continue their pioneering approach on this front or whether they will wait for similar regulations to take effect in other member states or even a further push from the European Commission.
There is fundamental tension in the EU between member states' tax sovereignty and harmonisation. Allowing member states to keep close control over tax policies leads to tax competition, with taxpayers shopping between EU jurisdictions to get the best treatment. Ireland, Luxembourg and to a lesser extent the Netherlands and Portugal all offer low tax regimes which have been the subject of what other member states might perceive as abuse, while the EU institutions see it as the result of a simple exercise of freedom of choice.
Pirola Pennuto Zei is very well qualified to assist these clients in all areas of analysis necessary to perform a transfer pricing study and properly document the policies adopted.
It is a pity that there are not more exemptions for small and medium sized companies, especially those with operations exclusively within the EU where there is very little risk of manipulation of transfer prices purely for tax reasons. For small companies and start-ups these new transfer pricing rules may impose a significant burden. The Italian authorities, like many other European tax authorities, are set on protecting their national revenue streams regardless of whether in doing so they are creating issues of double taxation in another Member State.
Simplification and harmonisation
All of the measures mentioned above will be welcomed by anyone conducting cross border activities either into or out of Italy. Although the transfer pricing rules at first sight may appear to create an extra compliance burden for businesses, the rules really only bring Italian legislation into line with legal requirements in other EU countries and are a step towards a harmonised best practice according to international guidelines. The Home State taxation rules may initially seem a little vague and open to interpretation, but they do represent a positive and confident move by the Italian authorities to help reduce the compliance burden for businesses with cross-border operations. Much more work needs to be done though in order to remove the tax barriers to business in the EU.
Colin Jamieson is a partner at Pirola Pennuto Zei & Associati, working in their London and Milan offices