Partner DLA Piper Milan

Attribution of Profit to the Italian Branch of a foreign EU Bank

Selected comments
By Phd Dr Maricla Pennesi, Tax Partner DLA Piper Milan

Recently, it has been noted that the Italian Tax Authorities have sought, with increasing frequency, to make assessments whereby interest charges are treated as non deductible costs.  This has been based on an uncritical and, at times, problematic application of the criteria resulting from the OECD’s observations  on the "attribution of profit to permanent establishments".  In particular, “regulatory” criteria are used for the purpose i.e. "thin capitalisation" in the country where the Branch of the foreign bank is located so as to quantify the amount of the “free” capital that has to be attributed to the Branch depending on the activities it undertakes and the risks it is exposed to.

For the Tax Authorities, the quantification of this “free” capital automatically leads to the partial or total non-deductibility of the interest charges incurred by the Branch which, in the absence of such capital, has had to take on debt to finance its activities and the related risks.

The Tax Authorities’ position on the matter has been well known for some time now.  They have reiterated the concept of deemed free capital for tax purposes only  as from 30 March 2006 when with regard to Ministerial Resolution no 44/E on Thin Capitalization , they observed that it is, first of all, necessary to assess if and to what extent the resources that the parent company makes available, directly or indirectly, to its permanent establishment in the territory of another state can be considered as loans that generate interest deductible from the income of the said permanent establishment. This assessment, the Tax Authorities go on,  is required, especially, when the parent company allocates to the permanent establishment its own resources and/or part of loans arranged by it and on which it incurs interest charges but also where the loan agreement is entered into directly by the permanent establishment.

It is interesting to note that the references to the “reasonableness” of the profit made by a permanent establishment – as determined considering the profits and costs that would have been made and incurred in the case of a distinct and separate entity conducting similar or identical business in similar circumstances and fully independent from the entity of which it is a permanent establishment   - and, in particular, to the matter regarding the correct debt to equity ratio – where it is clear that the calculation of interest charges has a direct impact on taxable income in the host country of the permanent establishment - are used for functional motives  in a ministerial response on the application of the thin cap method to permanent establishments under Art 98 of the TUIR (Corporate Income Taxes Act). While it is also debatable – for the reasons stated in the note – for permanent establishments in general, the ministerial resolution and the criteria laid down in it becomes wholly questionable with regard to the application of the thin cap method to the branch of a foreign bank to which the thin cap method was not applicable– under Article 98 (5) of the TUIR) – in relation to loans made as part of its banking activities.

We have argued that there can be no all encompassing reference to the thin cap rules for branches of foreign banks in relation to the non deductibility of interest charges for tax purposes, given the lack of specific rules on the matter.  Therefore, it must be understood, based on the guidelines issued by the OECD – in its aforementioned report on the allocation of profits to permanent establishments – that the reasonableness of the interest charges incurred by the branch has tot be analysed together with the amount of the free capital for tax purposes and the use of the method required for regulatory purposes for purposes other than the basic ones. As stated in part II (D) of the aforementioned report "Applying the authorised OECD approach to banks operating through a PE" paragraph no 52 , the factual analysis performed so as to allocate the free capital primarily requires a detailed assessment of the risks associated with the activities of the branch.  This is because the free capital must be attributed on an arm’s length basis to ensure the right level of taxable profit for the permanent establishment. So, the OECD lays down a fundamental concept i.e. any reference to capital and its attribution, based on whatever method, must be performed on an arm’s length basis considering the activities undertaken by the permanent establishment and the associated risks.

1 Now contained in a specific report dated 17 July 2008

2 With regard to banks and financial institutions, it must be recalled that the free capital for branches – also for regulatory purpose – can no longer be requested in terms of  

   the EU Directives adopted in 1989 Directive 89/646/EEC of the Council of Ministers of 15 December 1989)

3 Under Art 98 TUIR (Consolidated Income Taxes Act)
4 Principle established by all Double Taxation Agreements entered into by Italy under Art 7, paragraph 2.
5 For functional motives because although the regulations subjectively bring branches under the thin cap rules, the method of application of these rules did not precisely identify with the characteristics of permanent establishments lacking in capital and approved financial statements from which to obtain the net equity for use in calculating the debt equity ratio.

This process cannot be performed automatically merely by referring to principles that act as guidelines  but do not constitute hard and fast rules.  Paragraph 90 provides further guidance stating that, irrespective of the methods used in various countries (regulatory or thin capitalization rules) to determine the correct capitalisation of a branch for tax purposes, reference cannot be made to the book value of the assets or to the information provided by a mere accounting overview.  Instead, the method used to attribute the free capital must be assessed in relation to the risks of the business of the branch that this capital has to cover.  Economic criteria must be borne in mind and paragraph 90 goes on to state that any method based solely on accounting evidence cannot be considered acceptable to the OECD for the purposes set out above. The approach cannot be standardised at the expense of the economic reasonableness of the operating margins of the business represented by the branch on Italian territory.

In conclusion, any analysis performed and findings made with regard to the non deductibility of interest charges cannot be based merely on partial assessments or on accounting records when they also regard regulatory issues.  This is unless the economic unreasonableness of the financial structure i.e. capital and interest bearing debt is first proven and its impact on the reasonableness of the profits considered.

Any attempt by the Tax Authorities to apply the guidelines of international bodies like the OECD to tax matters, solely in order to increase taxable income by disallowing the deduction of interest charges, without performing an economic analysis of the reasonableness of the profits and the cost structure  including financial circumstances – as required by the aforementioned standards – must be rejected as absolutely unfounded and wholly illegitimate.

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