• Post referendum 'Brexit'
    What are the tax consequences to UK businesses in Italy?

    By Elio Palmitessa

    02-08-2016

    On June 23, the United Kingdom (England, Scotland, Wales and Northern Ireland) held a referendum on whether to stay or leave the European Union. The majority of voters opted to leave, i.e., for Brexit. As a result, although there is no precedent about the mechanism for leaving the EU (Article 50 of the Treaty on European Union), some conclusions can be drawn to highlight the implications in the field of direct taxation for UK businesses carried-out in Italy.

    1. CORPORATE TAX DIRECTIVES

    A pillar of tax policy, in the form of secondary legislation, are European Directives. As a general rule, they are not directly applicable on the domestic legislation. However, each Member State is required to achieve results and objectives stated by these Directives, being free to decide how to implement the legislative tool. Brexit could lead to a quick erosion of their effects, as the application of Directives would no longer be required. As a result, the following would cease to be applicable:

    • Parent-Subsidiary Directive (Council Directive 2011/96/EU of 30 November 2011) - it eliminates juridical and economical double taxation on profits distribution between associated companies situated in different EU Member States. The Directive provides for a zero withholding tax on dividends paid from an EU subsidiary to its EU parent company. As a result of Brexit, dividends distribution from an Italian to a British company (and vice-versa) would be subject to article 10 of the Double Tax Convention between Italy and the UK (hereinafter "DTC"), which allows the source country to tax at a rate not exceeding 5% of the gross amount of the dividends (if the beneficial owner is a company who controls at least 10% of the paying company) or 15% in all other cases;
    • Interest and Royalties Directive (Council Directive 2003/49/EC OF 3 June 2003) - it provides for the elimination of double taxation on cross-border payments of interest and royalties between associated companies in different EU Member States. Accordingly, a tax exemption would be granted under the Directive. As a result of Brexit, interest and royalty payments between companies resident in Italy and the UK would be subject to article 11 and article 12 of the DTC, respectively. The former provides for the right to tax in the source state, but not exceeding 10% of the gross amount of the interest paid (if the recipient is the beneficial owner of the interest). The latter provides for a taxation in the source state limited to 8% of the gross amount of the royalty paid (if the recipient is the beneficial owner of the interest);
    • Merger Directive (Council Directive 2009/133/EC of 19 October 2009) - it applies to cross-border mergers between EU Member States that meet certain conditions, whereby (in broad terms) relief or deferral of the tax on gains arising from qualifying transactions(such as mergers, divisions, partial divisions, transfers of assets, exchanges of shares) would be granted. As a result of Brexit, cross-border transactions between Italian and British entities may result in a more burdensome output (since the deferral of gains arisen from qualifying transactions until the assets are effectively realized would no longer be available) as well as eliminating the possibility of tax neutralization. Conversely, domestic provisions on cross-border reorganizations involving non-EU members as well as rules for cases of inbound and outbound migration of entities would be applicable.

    2. ANTI-TAX AVOIDANCE DIRECTIVE

    On January 28, the European Commission published an anti-tax avoidance package to address certain 'base erosion and profit shifting' issues, to boost tax transparency and to create a level playing field for all businesses in the EU. Political agreement on the proposed directive was reached during the ECOFIN held on June 17, and formally approved on June 20 (subject to a 'silence procedure'). Consequently, on July 19 the Council Directive 2016/1164 of 12 July 2016 was published in the Official Journal of the EU. The Directive contains legally binding measures to fight tax avoidance and tackle harmful tax practices in the following areas: interest deduction, exit taxation, general anti-abuse rule, CFC legislation and hybrid mismatches. Specific rules shall be implemented by Member States before 31 December 2018. As a result of Brexit, the UK may decide to not implement the aforementioned measures into its domestic legislation, assuming that, by 2018, the withdrawal process is completed. Nonetheless, it will be regarded as a third country by the EU, unless some other agreement is reached. However, the UK could still be affected from such initiatives, given the broad and general Scope of the Directive "(…) including permanent establishments in one or more Member States of entities resident for tax purposes in a third country".

    3. CORPORATE TAX SYSTEM

    Withdrawal from the European Union would also affect UK entities with subsidiaries or permanent establishments in Italy, considering that several (and favourable) domestic rules are applicable only to EU Member States and EEA (European Economic Area) countries (these include the EU Member States plus Iceland, Liechtenstein and Norway). In case of UK entities without a permanent establishment in Italy, business income such as dividends, interest or royalties paid from an Italian entity would be subject to a final withholding tax, possibly reduced by treaty provisions. In case of UK entities with a permanent establishment in Italy, business income paid by an Italian company would be subject to (corporate income) tax in Italy as if it would have been paid to a resident company.

    3.1 International aspects - following a summary on the main tax consequences by comparing the situation before and after the British exit from the European Union.

    • Dividends - no withholding tax, under the rules and conditions of the EU Parent-Subsidiary Directive. As a result of Brexit, UK entities would be subject to a final withholding tax at 26%. However, UK entities could claim for a refund of an amount up to 11/26 of the withholding tax paid in Italy, giving evidence that that item of income has been subject to final taxation in the UK. If the UK becomes a member of the European Economic Area, UK entities would benefit of a reduced withholding tax at 1,375% (5% of the ordinary income rate of 27,5%). Very likely, from fiscal year 2017 the withholding tax will be further reduced to 1,2%, given a general reduction of income tax rate from 27,5% to 24%;
    • Interest - no withholding tax, under the terms and conditions of the EU Interest and Royalties Directive. However, it is worth to mention the Circular No 6/E issued on 30 March 2016 by the Italian Tax Authorities dealing with the tax treatment of LBO transactions. It confirmed that, to prevent abusive schemes, an analysis of the requirements of beneficial ownership of the recipient of the interest income would be requested. As a result of Brexit, UK entities would be subject to a final withholding tax at 26%. However, several rules would apply in respect of particular items of interest derived from domestic tax legislation. In addition, same considerations for LBO transactions are maintained, in order to decide if the ordinary withholding tax at 26% on interest borne in connection with acquisition loans (and paid to foreign lenders) may be reduced by treaty application;
    • Royalties - no withholding tax, under the terms and conditions of the EU Interest and Royalties Directive. As a result of Brexit, UK entities would be subject to a final withholding tax at 30%. However, given that for some items of royalties the withholding tax would generally be levied on 75% of the gross amount, it would result in an effective taxation at 22,5%;
    • Capital gains - if UK entities operates in Italy on behalf of a permanent establishment, all gains realized in the course of business activities are taxed in the hands of the permanent establishment (business income). If the gains realized in Italy are not attributed to a domestic permanent establishment, they are taxed separately (subject to a final withholding tax) depending on the kind of property sold (movable or immovable property, shares, bonds, financial instruments, etc). As a result of Brexit, for taxation of capital gains in Italy, there are not differences as to whether they are generated by a non-resident entity resident in an EU Member State or EEA country, or third country. Typically, capital gains generated in Italy are subject to a final withholding tax at 26%. However, depending on the item of income, a number of exceptions may apply;
    • Other business income - UK entities are taxed in Italy on business income only if derived through a permanent establishment. If UK entities are not carrying-out the business through a permanent establishment in Italy, they are subject to final withholding tax on all sources of income derived from Italy. As a result of Brexit, no changes in regards to taxation of other business income.

    3.2 Horizontal tax unit regime - qualifying resident companies (as well as Italian permanent establishments of EU and EEA qualifying entities) may enter into a fiscal unit regime if they are held by a common parent company established in any EU Member State or qualifying EEA countries that have concluded an exchange of information agreement with Italy. As a result of Brexit, and in absence of further information about the possible association to the EEA, Italian subsidiaries (or Italian permanent establishments) of UK entities would no longer be allowed to opt for such preferential tax regime;

    3.3 CFC legislation - CFC rules do not apply for foreign entities resident in EU Member States or qualifying EEA countries that have concluded an exchange of information agreement with Italy. As a result of Brexit, UK entities would no longer be automatically exempt from the Italian CFC legislation, given that the conditions set by law to third countries may apply;

    3.4 Exit taxation - in compliance with EU tax law, resident companies may transfer their tax residence to others EU Member States or qualifying EEA countries, deferring the exit taxation until the underlying capital gain is realised. As a result of Brexit, the UK would no longer be a 'friendly' jurisdiction where to transfer tax residence, since no tax deferral or neutralization would be possible.

    4. DOUBLE TAX CONVENTION BETWEEN ITALY AND THE UK

    Brexit would have no direct impact on the tax treaties signed by the UK, since they are not based on EU membership. Italy entered into a Double Tax Convention with the UK (and Northern Ireland) to avoid double taxation on income and property. Treaty benefits are granted only to persons who are resident in Italy and/or in the UK (article 1) and taxes covered therein refer to personal and corporate income taxes (article 2). Further, a preventive determination of the 'residence state' of the person is requested for the purposes of the allocation of taxing rights between Italy and the UK (article 4).

    Accordingly, given that a company (article 3) resident in the UK is entitled to treaty benefits, conventional withholding tax rates may apply if lower than domestic rates.

    4.1 Treaty withholding tax rates and allocation of taxing rights - following a summary of the withholding tax rates applicable to items of income, such as dividends (article 10), interest (article 11) and royalties (art. 12), for payments made by Italian companies to UK entities doing business in Italy.

    • Dividends - tax treaty rate at 5% of the gross amount, if the recipient is the beneficial owner of the item of income, and 15% in all other cases. Residence state has the right to tax, but source state may also be entitled to tax;
    • Interest - tax treaty rate at 10% of the gross amount, if the recipient is the beneficial owner of the item of income. Residence state has the right to tax, but source state may also be entitled to tax;
    • Royalties - tax treaty rate at 8% of the gross amount, if the recipient is the beneficial owner of the item of income. Residence state has the right to tax, but source state may also be entitled to tax.

    4.2 Allocation of taxing rights for other items of corporate income - as general information, the following summary provides an overview on the allocation rules between Italy and the UK, with reference to other relevant items of corporate income:

    • Immovable property - residence state has the right to tax, but source state may also be entitled to tax;
    • Shipping and air transport - exclusive right to tax in the state where the place of effective management of the enterprise is situated;
    • Capital Gains - for immovable properties and movable properties (as business property of a Permanent Establishment in the other State), residence state has the right to tax, but source state may also be entitled to tax. For ships or aircraft operated in international traffic, exclusive right to tax in the state where the place of effective management of the enterprise is situated. For any other property not mentioned above, residence state has the exclusive right to tax;
    • Other income (not dealt with other articles of the DTC) - residence state has the exclusive right to tax.

    5. TRANSFER PRICING DISPUTES

    Transfer pricing adjustments are commonly made in respect of commercial and financial transactions, which differ from those which would be made between independent enterprises. Accordingly, under the current framework, to resolve disputes that may occur in relation to double taxation as a result of an upward adjustment of profits made by a tax administration ('Agenzia delle Entrate' in Italy or 'HM Revenue & Custom' in the UK), taxpayers may invoke:

    • the Mutual Agreement Procedure, by bringing the case before the Competent Authority, or
    • the EU Arbitration Convention (Convention 90/436/EEC of 23 July 1990), thus starting the 3-year period during which taxpayers can introduce a request to apply the Arbitration Convention, and also starting the 2-year period in which the competent authorities must reach an agreement on the elimination of double taxation.

    As a result of Brexit, the UK would no longer be bound by the Code of Conduct for the implementation of the Arbitration Convention, which deals with "[...] EU transactions involved in triangular cases among Member States". Moreover, it is not clear whether the referendum result might lead to a prior termination of UK's adhesion to the EU Arbitral Convention, and, therefore, the potential consequences in case of dispute resolutions between taxpayers and tax administrations.

    6. FINAL REMARKS

    Consequences of the British exit from the European Union are highly uncertain. As many commentators have pointed-out, lots of different scenarios are possible depending on the status of the UK after the negotiations (and before its effective withdrawal) and on what the post-Brexit relationship between the UK and the EU would look like. For instance, is might create an important push for the independence of Scotland, Wales and/or Northern Ireland, which might decide to take advantage of the referendum result to declare independence from the UK and re-join the EU. Certainly, leaving the European Union will result in the disintegration of many rights and obligations imposed under the EU laws. In the field of direct taxation, the exemption to UK businesses on cross-border transactions (granted, under certain conditions, by secondary EU law) would automatically cease to apply. Consequently, the outcome of such transactions would be burdensome for UK businesses, given that the application of bilateral tax treaties rates may result in a less favourable treatment due to higher withholding taxes at source or even the complete absence of some protections (e.g. for mergers or exit taxation deferral), since the EU laws cover a much wider range of topics than bilateral treaties usually do.

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  • The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.

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