Italian Supreme Court Decision No. 3380 of 3 February deals with the interpretation of the beneficial owner (BO) requirement under the Interest and Royalties Directive (IRD) and the abuse of that directive.

The decision held that the BO requirement should be interpreted based on the definition of BO in the current Commentary on Article 11 (Interest) of the OECD Model Tax Convention. This was based on the European Court of Justice’s judgment in the Danish conduit cases, which deals with the application of the anti-abuse rules under the IRD.

The facts 

The case concerned interest paid by an Italian company (Alfa) to its controlled, Luxembourg company (Alfa International) following a debt restructuring at Alfa’s level. Since Alfa’s articles of association prevented it from issuing a debenture loan, Alfa requested that Alfa International issues a bond, which was subscribed for by US investors. The funds raised by Alfa International were used to finance Alfa via an interest-bearing loan. The basic terms – duration, interest rate and amount – of the loan were the same as those of the bonds issued by Alfa International to the US investors.

The Italian tax authority (and also the regional tax court) denied the withholding tax exemption under relevant provisions of the Italian legislation implementing the IRD (Article 26-quater of Presidential Decree No. 600 of 1973) on the grounds that Alfa International had received no benefit from the transaction because any interest paid by Alfa was immediately and fully transferred to the US investors (Alfa International did not make a margin). Alfa International was, thus, a mere conduit company, and the US investors were the BOs of interest sourced in Italy (and consequently subject to 12.5% withholding tax (WHT)).

Supreme Court Decision 3380/2022

The Court overturned the Lombardy Regional Tax Court Decisions 100/11/12 and 102/11/12 by finding that Alfa International was the BO of the interest and, therefore, entitled to benefit from the IRD.

The decision stated the following:

• A BO clause is a general clause of international tax law to tackle treaty shopping.
• The interpretation of the definition of BO in the current OECD Commentary on Article 11 is also relevant to the application of the IRD.
• The assessment of the BO requirement should aim exclusively at determining whether the recipient has the full right to use and enjoy the income free from legal obligations to pass it on to another entity (OECD Commentary on Article 11, paragraph 10.2).
• A sub-holding company should be considered the BO of the income insofar as it meets this requirement and regardless of whether it performs very limited activities. The assessment of the BO requirement should not be based on the material structure of the recipient, as the presence of staff, premises, and equipment are substantially immaterial. Similarly, no decisive relevance should be attributed to the fact that the assets of the holding company consist only of shareholdings and intercompany loans or as to whether the company is directly or indirectly controlled by an entity resident in a third country.
• The assessment of the BO requirement in relation to the relevant transactions is linked to the prohibition of abusive tax practices (in this regard the Court referred to the Danish conduit cases).

The Court concluded that Alfa International was the BO of the interest sourced in Italy based on the following factors:

• It was established more than 50 years ago.
• It has ‘substance’: Alfa International has an effective operational structure and does not constitute a shell company.
• Its business purpose is the management of shareholdings.
• Its net profits were appropriate for the activities performed.
• There was a separate cause for the two loans (linked to Alfa’s temporary inability to issue a debenture loan).
• Interest paid to Alfa International was subject to tax in Luxembourg.
• There was no contractual or legal obligation for Alfa International to pass on the interest to another entity.
• Alfa’s shares had been used as collateral for the US investors.

In essence, the Court ruled that the WHT exemption cannot be denied if the recipient has no obligations to transfer to another State interest with an Italian source and has entrepreneurial autonomy over and financial responsibility for the assets it holds.

Brief remarks

With this decision – which is consistent with caselaw on the notion of BO, including Supreme Court Decision No. 14756 of 10 July 2020 – the Court has reduced the importance of the terms of closely related loans (e.g., duration, interest rate, and timing of the payment).

In the Court’s view, what matters is that the intermediate company’s remuneration is appropriate for the overall functions performed and is consequently taxed in its State of residence. Essentially, it seems that the application of the benefits of the IRD triggers the requirement to comply with the general anti-abuse clause rather than the BO one. This implies that a sub-holding company must demonstrate that it performs a business activity (i.e., satisfy the ‘minimum substance’ requirement) rather than requiring an examination of the destination of a given income stream.

Useful indicators of ‘minimum substance’ for tax purposes may be derived from the European Commission’s Unshell proposal (previously covered by Isabella Zimmerl). In this respect, it is paramount to provide for the possibility of exemption for undertakings which are considered prima facie shell companies but whose interposition has no actual advantageous impact on the overall tax position of the undertaking’s group or of the beneficial owner(s).

One may wonder whether Decision 3380/2022 and the Unshell proposal (if passed) would reduce the number of BO-related disputes.