Italy—Transfer Pricing Adjustments and Their Impact on VAT and DAC6

Multinational groups normally adopt transfer pricing (TP) adjustments to set intercompany prices for goods or services exchanged on a regular basis, so that transactions meet the arm’s-length requirement.

Normally, TP adjustments need to be implemented by using transactional profit methods. Unlike traditional transaction methods, profit-based methods measure the net operating profit from controlled transactions and compare them to the profit of third-party companies making comparable transactions; they therefore do not examine the terms and conditions of specific transactions.

Recent developments have shown that TP adjustments have an impact beyond corporate income tax issues.

TP adjustments have recently been the object of several Italian Revenue Agency rulings aimed at answering specific requests from taxpayers regarding their value-added tax (VAT) treatment. A relevant ruling has also been provided on a specific request aimed at understanding whether TP adjustments may fall within the reporting obligations provided by DAC6 legislation.

Transfer Pricing Adjustment and VAT

A debate on the impact of TP adjustments on the VAT treatment of the underlying transactions has occupied tax experts at the European level and has been analyzed in detail in two documents; Working paper 923 of 2017 published by the European Commission , and a document from the VAT Expert Group of the European Commission, VEG No. 071/Rev 2, “Possible VAT implications of Transfer Pricing” of April 18, 2018.

The EU documents, following the fundamental principles of VAT, concluded that TP adjustments will have an impact on the VAT taxable base of the transaction, and therefore will require an increase or decrease in the sale price of goods or services for VAT purposes, when the following three conditions are simultaneously met:

• there must be a consideration, in cash or in kind, for such adjustment of transaction margins;
• the supplies of goods or services to which the consideration relates could be identified;
• there must be a “direct link” between the TP adjustment and the supply of goods or services.

Therefore, in absence of the above-mentioned “direct link,” TP adjustments will not be subject to VAT, since the TP policy would then be aimed at defining just a minimum guaranteed profit to meet the arm’s-length principle and not at amending the specific price of the products or of the services.

However, the same document of the VAT Expert Group mentioned that TP adjustments should not have an adverse VAT impact on businesses, and in particular, possible mistakes in the VAT treatment should not lead to the application of penalties or late payment interest. Moreover, there is a recommendation that any possible audit should not put any obstacle in the way of the right to obtain the refund/or deduct VAT that arises from the adjustment.

Italian VAT law does not include any specific provision or indication with regard to the implications for the VAT side of TP adjustments. As a result, considerable uncertainty arose among multinational groups, due to the potential situation that in case of audit, companies might face negative consequences with possible criminal ramifications.

In particular, if tax auditors do not agree with the application of VAT on certain TP adjustments, they may deny the right of deduction for the company receiving the TP adjustments, requesting the repayment of the VAT and applying penalties ranging from 90% to 180%.

In addition, if the tax authorities do not agree with the decision of the parties to consider the transaction out of scope of VAT, they may challenge the omitted issuance of invoices, with consequent application of penalties for this omission (ranging from 90% to 180% of the VAT), and for unfaithful filing of the tax return (also ranging from 90% to 180%).

Tax auditors tend to apply penalties in the case of challenges; and the cancellation of these penalties, prompted by the uncertainty of the legal provisions, is in general granted by the tax courts in cases of litigation. This is why taxpayers try to prevent possible risks by filing specific requests to the Revenue Agency to obtain answers in their case.

The Revenue Agency has to date published three rulings on this specific topic, with the last ruling issued Dec. 30, 2021.

In this latest ruling, the Revenue Agency was asked to provide indications with respect to upward TP adjustments made by Italian companies to some of their foreign affiliates to increase the cost of the goods sold and consequently decrease their operating margin to align it with the TP policy of the group.

In order to establish whether these adjustments are relevant for VAT purposes, the Revenue Agency verified whether such adjustments could be considered: (i) the consideration for a new supply transaction; or (ii) the increase of the VAT taxable basis of the original supply transactions.

In dealing with the first analysis, the Revenue Agency concluded that the case could not fall within the definition of new sale of goods/provision of service in absence of a direct link between the adjustment and a new supply transaction. The Revenue Agency came to such conclusion acknowledging that the adjustments were made only to put the remuneration of the controlled companies within the correct range of the benchmark analysis, without any possibility to qualify them as consideration for a specific supply transaction. Such analysis is in line with the agency’s Ruling No. 60, which dates to 2018.

In the second instance, the Revenue Agency analyzed whether the adjustments could be considered as an upward adjustment of the VAT taxable basis of the initial supply transactions (as per Article 13 of the Italian VAT Law).

In dealing with this second analysis, the Revenue Agency relied on indications included in the European Commission VAT working paper 923, and their conclusion was that, in the case at hand, the three required simultaneous conditions were not met, lacking a direct link between the supply transactions already concluded between the parties and the TP adjustment. As a result, the Revenue Agency concluded that the TP adjustment had to be considered out of VAT scope.

The principles outlined in the above ruling are consistent with those adopted by the Revenue Agency in an August 2021 ruling, No. 529, although in that case it was concluded that VAT should apply to TP adjustments since they were undoubtedly linked to the original supply transactions.

The facts were indeed different and involved a group active in the pharmaceutical business, where the Italian company was dedicated to the development of the active ingredient and the foreign company to the manufacturing and distribution of the final products. The price of the active ingredient was provisionally established by the Italian company, which waited for the computation of the profit earned in relation to the sale of the final products. Once the profits were determined, the price of the final products was accurately determined and linked with the developed active ingredient.

As a result, the taxpayers provided evidence to the Revenue Agency of the presence of a “direct link” between the transfer pricing adjustment and the original supply.

Transfer Pricing and DAC 6 Reporting Obligations

In the context of the different initiatives taken at the level of the Organization for Economic Cooperation and Development (OECD) to tackle tax evasion and the avoidance of tax rules, the Base Erosion and Profit Shifting (BEPS) Project Action 12, “Mandatory Disclosure Rules” provided recommendations for OECD countries regarding the introduction of reporting obligations on aggressive tax planning. Along the same lines, EU Council Directive 2018/822 dated May 25, 2018 (“DAC6”) introduced the mandatory reporting of potentially aggressive cross-border tax planning arrangements.

In Italy, DAC6 has been implemented by Legislative Decree No. 100, dated July 30, 2020. Ministerial Decree dated Nov. 17, 2020, the Regulation of the Revenue Agency Director no. 364425, and the Circular Letter of the Revenue Agency no. 2, issued Feb. 2, 2021 provided guidelines and clarification on the national reporting regime.

In general, the reporting obligations are required by the participants (i.e., intermediary and/or taxpayer) to the cross-border arrangements falling within one of the hallmarks provided by DAC6 legislation, in line with the DAC 6 Directive. Moreover, in the case of certain hallmarks (i.e., hallmarks A, B, C and E), it is also required that the cross-border arrangement implies the reduction of taxes in Italy or in the corresponding EU country, while in other cases (i.e., hallmarks A, B and C with certain exceptions), it is also required that the main benefit test is met.

The Revenue Agency has been asked to analyze the application of the DAC6 legislation with respect to TP adjustments performed by an Italian entity in favor of non-resident companies, and has issued a specific ruling on the topic, No. 78/E dated Dec. 31, 2021.

The Revenue Agency confirmed that TP adjustments should be included among reportable cross-border arrangements for DAC6 purposes if they are performed in favor of companies based in zero/low taxation countries or in jurisdictions which are deemed not to be cooperative for tax purposes, and underlined that even TP adjustments will have to be considered as falling within Hallmark C1(b)(i) and (ii).

In this regard, the Revenue Agency, in line with the DAC6 Circular Letter, confirmed that TP policies are agreements between associated entities, legally binding, and as such, falling within the notion of “agreements” included in DAC6 Italian law when defining cross-border arrangements.

In its reply to the ruling request, the Revenue Agency also focused on the timing of the reporting obligations. In general, the disclosure of the cross-border arrangement is made within 30 days following the date in which the transaction is made or planned to be made. In the case commented on in the ruling, the Revenue Agency considered that the approval of the financial statement of the controlling company making the TP adjustment should be identified as the starting date for the calculation of the 30 day-period to make the communication.

It remains unclear whether the approach adopted by the Italian Revenue Agency can be shared, since it requires compliance with reporting obligations in apparent absence of any actual tax benefit potentially arising from the transaction. Indeed, the TP adjustment would actually be aimed at complying with TP principles and avoiding tax issues which otherwise may arise in breach of the principles.

Relevant Response

It is now clear that TP adjustments not only have corporate income tax implications but should also be analyzed from different aspects such as customs duties, VAT, and DAC6 provisions.

The lack of specific rules creates uncertainty and potential negative ramifications. For the purpose of preventing tax risk, a ruling request to the Revenue Agency may be recommended.

However, it would also be desirable for the Revenue Agency to release official guidelines to provide clearer indications relevant for the generality of taxpayers, mirroring the conclusions of the EU VAT Expert Group to expressly acknowledge that the uncertainty of the legislation should not have negative financial impacts on taxpayers with respect to the application of penalties, interest and VAT refunds.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Giuliana Polacco is Senior Counsel and Annarita De Carne is Associate with Bird & Bird Italy.

The authors may be contacted at: giuliana.polacco@twobirds. com; annarita.decarne@twobirds.com