Can a taxpayer rely on a treaty exemption on the disposal of a shareholding if the gain is not taxed in the taxpayer’s state of residence? In decision no. 2734/2025, the second-instance Lombardy Tax Court said “no” and made treaty exemption conditional on “effective taxation” in the state of residence of the transferor. That conclusion is difficult to reconcile with the provisions of double tax conventions (DTCs) and EU law principles, particularly the prohibition on discrimination arising from the free movement of capital.

What was the case about?

The dispute concerned the denial of a refund of the 26% substitute tax on the capital gain realised by Alfa (a company resident in Luxembourg) when it transferred its shareholding in Gamma, a company resident in Italy. Alfa was wholly controlled by Beta (also a company resident in Luxembourg), which was owned by two individuals resident in Saudi Arabia.

Alfa argued that Article 13(3) of the Italy-Luxembourg double tax treaty (the DTT), which provides that gains from the transfer of shareholdings are taxable only in the contracting state in which the transferor resides, applied.  Alfa also had a couple of alternative arguments. First, that the participation exemption under Article 87 of the Italian Income Tax Code (IITC) applied. Second, if the participation exemption rule did not apply, under the EU principle of free movement of capital there should be elimination of the discriminatory effect arising from the higher taxation (at 26%) compared to that applicable to resident companies (at 24%).

The Italian tax authority (ITA) challenged the applicability of the DTT on the grounds that:

• Alfa was not the beneficial owner of the capital gain;
• the Italy-Saudi Arabia DTC applied because the ultimate shareholders are resident in Saudi Arabia; and
• no evidence was provided of the effective payment of taxes on the capital gain in Luxembourg.

What did the first instance court decide?

The first-instance Milan Tax Court ruled in Alfa's favour, holding that the DTT does not require the transferor to be the beneficial owner. In any event it found that Alfa is the beneficial owner, given that the profits realised from the transfer of Gamma were neither immediately nor entirely distributed up the shareholder chain to Beta or the ultimate beneficiaries but were instead used by Alfa to distribute a dividend and repay a loan.

The ITA appealed the decision before the second-instance Lombardy Tax Court and won.

On what grounds did the second instance court allow the ITA’s appeal?                                    

Although the taxpayer lost the case (for reasons which are erroneous), one helpful aspect of the case is that the court held that, on the facts, the DTT applies regardless of whether the beneficial owner is Alfa or Beta, because both companies are resident in Luxembourg. The court also ruled that the ITA’s claim to “pierce the corporate veil to reach the ultimate shareholders” appeared ungrounded.

The court concluded that the conditions for the substitute tax refund were not met, dismissing all three of Alfa’s arguments but for unconvincing reasons which it is hoped will be overturned by the Supreme Court.

Why is the prevention of double non-taxation argument erroneous?

The court held that the taxation of the capital gain must be “required by law and effective” in both contracting states. The court cited a 2015 Italian Supreme Court decision as authority that no DTC can permit an ‘abuse’ in the form of double non-taxation. According to the Lombardy Tax Court, Alfa did not provide evidence of the payment of tax in Luxembourg but did admit that it had benefitted from exemption rules in Luxembourg (similar to the Italian participation exemption). Granting a refund would have thus resulted in a double non-taxation.

This reasoning is flawed and unsupported by case law and ITA practice as can be illustrated by three examples. First, the fact that a given income is exempt from taxation cannot in any way affect the taxpayer’s residence for treaty purposes. On several occasions, the Italian Supreme Court has held that the requirement of being subject to tax – which is a prerequisite for residence for treaty purposes – cannot be reduced to the circumstance of the effective payment of taxes; rather, it is sufficient to demonstrate that a person is liable to tax in the state of residence. The Italian Supreme Court has recognised that, in light of the clear wording and objective of the treaty provision – which requires Italy to exempt certain capital gains realised by persons resident in the other contracting state – the fact that the capital gain is not taxed in that other contracting state does not relieve Italy of its obligation to grant the exemption. 

Second, the ITA itself agrees with that interpretation regarding the distribution of Italian-source dividends. Indeed, in 2019 the ITA gave a ruling in a case in which dividends received by a Swiss parent company were subject to the ordinary intra-group dividend taxation rules in force in Switzerland, consisting of the application of the ‘participation reduction’ (in substance, a full exemption) – concluded that those rules cannot be regarded as favourable tax rules which render the Agreement between the Swiss Confederation and the European Union of 26 October 2004 inapplicable. In other words, the fact that dividends are exempt at parent company level does not prevent the parent company from qualifying as a company subject to corporate income tax for treaty purposes.

Thirdly, a 2023 Italian Supreme Court decision on the interpretation of Article 29 of the Italy-Switzerland DTC, reiterated that in order to benefit from DTCs, taxpayers are not required to prove that income is effectively subject to foreign taxation. Rather, it is sufficient to demonstrate ‘tax liability’, i.e., the fact that the taxpayer is ‘theoretically’ subject (i.e. liable) to local income tax. According to the Italian Supreme Court, this requirement can be proved directly through a residence certificate issued by the foreign tax authority. Furthermore, the dividend/participation exemption rules in force in many European countries, including in Italy and Luxembourg, are designed to eliminate double taxation of corporate profits. This principle would be infringed if taxation on those profits were levied first on the subsidiary that realised them (i.e., Gamma); and subsequently on the shareholder upon payment of the dividend or realisation of the capital gain (i.e., Alfa).

Is the Italian participation exemption limited to partnerships?

The court held that the participation exemption does not apply, as it is limited to “capital gains realised on shareholdings in entities referred to in Article 5 of the IITC”, namely general partnerships (società in nome collettivo) or limited partnerships (società in accomandita semplice) resident in Italy.

This is surprising (and wrong) because the provision expressly refers to “shares or quotas in entities referred to in Article 5, excluding simple partnerships and entities equated thereto, and in Article 73 [emphasis added]”. Article 73 includes all limited liability companies (among others). This is a manifest error in interpretation of the law.

Additionally, the Italian legislator has extended the participation exemption – previously limited to capital gains from the transfer of shareholdings realised by resident companies only – to capital gains realised by EU companies without a permanent establishment in Italy. The amendment is intended to align national tax rules with Italian Supreme Court caselaw which has consistently held that the failure to grant non-resident entities the possibility to benefit from the participation exemption for capital gains on Italian shareholdings is incompatible with the fundamental freedoms under the Treaty on Functioning of the European Union (“TFEU”). Once it is established that domestic legislation envisages the application of the participation exemption to the transfer of shareholdings in limited liability companies, the extension of that exemption to transfers of those shareholdings carried out by non-resident companies is automatic.

Free movement of capital: absence of discrimination because of different factual situations

The court concluded that in this case there was no discrimination under Article 63 of the TFEU (the principle of free movement of capital) between the taxation of a capital gain realised by a non-resident company and that realised by a resident company, as these involve “different factual situations” and no discrimination can be envisaged “in the presence of taxation agreed upon by the States in the Convention”.

This is clearly a case of discrimination contrary to Article 63. Reference should be made to Case C-190/12 (among others). In that case, the CJEU held that Polish legislation was contrary to EU law insofar as it taxed dividends paid to an American investment fund but exempted the same dividends when paid to investment funds established in Poland, notwithstanding the DTC between the two countries. The principle expressed by the CJEU that case is extremely clear: “Article 63 TFEU on the free movement of capital applies in a situation, such as that at issue in the main proceedings, where, under national tax legislation, the dividends paid by companies established in a Member State to an investment fund established in a non-Member State are not the subject of a tax exemption, while investment funds established in that Member State receive such an exemption”. 

A clear discriminatory effect thus ensued in the Alfa case from the fact that a non-resident company was subject to a 26% substitute tax on capital gains, whereas a resident company was subject to corporate income tax at 24%.

What next?

The reasoning underlying the second-instance tax court’s decision is erroneous for the reasons set out above. One can only hope that the Italian Supreme Court will overturn the decision and restore the proper allocation of taxation rights between the two states in relation to capital gains on the transfer of Italian shareholdings.