Following an audit of Sadepan Chimica S.R.L., the Italian tax authorities issued an assessment of additional taxable income relating to non-interest bearing loans and bonds granted by Sadepan Chimica S.R.L. to its subsidiaries. The tax authorities considered that, in the financing relationship between the subsidiaries and the foreign associates – Polena S.A., based in Luxembourg, and Sadepan Chimica N.V., based in Belgium – the former had applied interest rates that did not correspond to the arm’s length value referred to in Article 9, paragraph 3, of the Italian Income Tax Code. U.I.R. As a result, the authorities issued separate tax assessments for the year 2013 claiming the higher amounts of interest income, calculated by applying an average rate of 3.83% for loans and 5.32% for bonds. Not satisfied with the assessment, Sadepan Chimica S.R.L. filed an appeal. The Regional Tax Commission (C.t.r.) confirmed the assessments and Sadepan Chimica S.R.L. filed an appeal with the Supreme Court. In the appeal Sadepan Chimica S.R.L. and its subsidiaries stated that the C.t.r. judgment were ‘irrelevant’ for not having analysed the general and specific conditions in relation to which the loans had been granted, and in so far as it held that it was for the taxpayer to provide evidence that the agreed consideration corresponded ‘to the economic values that the market attributes to such transactions. First of all, they claimed that the rules on the allocation of the burden of proof have been infringed; secondly, they complained of the failure to assess the evidence; they also claimed that the Office had used as a reference a market rate extraneous to the case at hand in that it was applicable to the different case of loans from financial institutions to industrial companies whereas it should have sought a benchmark relating to intra-group loans of industrial companies. They added that they had submitted to the judge of the merits, in order to determine in concrete terms the conditions of the financing, a number of elements capable of justifying the deviation from the normal value and, precisely a) the legal subordination of the financing b) the duration, c) the absence of creditworthiness, d) the indirect exercise of the activity through the subsidiaries; that, nevertheless, the C.t.r. had not assessed the economic and commercial reasons deduced. Judgement of the Supreme Court The Court ruled in favour of Sadepan Chimica S.R.L. and annulled the judgment under appeal on the grounds that it had failed to take account of the specific circumstances (solvency problems of the subsidiaries) relating to the transactions carried out by the related parties. Excerpts (English translation) “In fact, it still remains that a non-interest-bearing financing, or financing at a non-market rate, cannot be criticised per se, since it is possible for the taxpayer to prove the economic reasons that led it to finance its investee in the specific manner adopted. The rationale of the legislation is to be found in the arm’s length principle set forth in Article 9 of the OECD Model Convention, which provides for the possibility of taxing profits arising from intra-group transactions that have been governed by terms different from those that would have been agreed upon between independent companies in comparable transactions carried out in the free market. It follows from this conceptual core that “the valuation ‘at arm’s length’ disregards the original capacity of the transaction to produce income and, therefore, any negotiating obligation of the parties relating to the payment of consideration (see OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, paragraph 1.2). It is, in fact, a matter of examining the economic substance of the transaction that has taken place and comparing it with similar transactions carried out, in comparable circumstances, in free market conditions between independent parties and assessing its compliance with these (Cass. 20/05/2021, no. 13850 Cass. 15/04/2016, no. 749) Moreover, it is not excluded that intra-group gratuitous financing may have legal standing where it can be demonstrated that the deviation from the arm’s length principle was due to commercial reasons within the group, connected to the role that the parent company assumes in support of the other companies in the group (Court of Cassation 20/05/2021, no. 13850).” “In the OECD report published on 11/02/2020, on financial transactions, it is reiterated (as already stated in the OECD Commentary to Article 9 of the Model Convention) that, in intercompany financing transactions, the proper application of the arm’s length principle is relevant not only in determining the market value of the interest rates applied, but also in assessing whether a financing transaction is actually to be considered a loan or, alternatively, an equity contribution. It is also emphasised that, in order to distinguish a loan from an equity injection, among other useful indicators, the obligation to pay interest is of independent relevance. With reference to Italy, however, based on the application practice of the Agenzia delle Entrate (Circular No. 6/E of 30 March 2016 on leveraged buy-outs), the requalification of debt (or part thereof) into an equity contribution should represent an exceptional measure. Moreover, it is not ruled out that intra-group free financing may have legal standing where it can be demonstrated that the deviation from the arm’s length principle was due to commercial reasons within the group, related to the role that the parent company plays in supporting the other group companies. The Revenue Agency itself, already in Circular No. 42/IIDD/1981, had specified that the appropriateness of a transfer pricing method must be assessed on a case-by-case basis. “9.6. That being stated, this Court has clarified that, the examination by the court of merit must be directed along two lines: first, it must verify whether or not the office has provided the proof, which is due to it, that the Italian parent company has carried out a financing transaction in favour of the foreign subsidiary, as a legitimate prerequisite for the recovery of the taxation of the interest income on the loan, on the basis of the market rate observable in relation to loans ...

SASU Menarini Diagnostics France (a French subsidiary in the Italian Menarini Group) buys and resells diagnostic equipment and products for self-diagnosis and laboratories. Since its creation it had recurring operating losses, despite the profitability of each business line and irrespective of sales trends, and even though it was no longer in a market penetration phase. An audit was initiated by the tax authorities for fiscal 2011-2013, which revealed that the pricing of intra-group transactions was not at arm’s length and that overpricing of products purchased from two related parties in Italy had resulted in an indirect transfer of profits within the meaning of Article 57 of the French General Tax Code. Menarini Diagnostics France appealed against the assessment with the Montreuil Administrative Court which rejected its request for discharge of these taxes. An appeal was then filed with the Administrative Court of Appeal. Judgement of the Court The Administrative Court of Appeal dismissed the appeal of Menarini Diagnostics France and upheld the decision of the Administrative Court. “12. Firstly, with regard to the application of the comparable price method, the applicant company criticizes the single reference, namely the G-ECCH product range, used by the tax authorities, which, in its view, does not represent a representative sample of the relevant market enabling a satisfactory statistical distribution to be made in accordance with the recommendations of the Organization for Economic Cooperation and Development. It adds that the French authorities have not carried out any analysis of the factors of comparability in terms of products, volumes, functional and market analysis, nor made any adjustments to compensate for the lack of comparability, even though the specific features of the G-ECCH and G-IHCO ranges are different. However, it is common ground that the administration used only internal comparables corresponding to products acquired directly by the company from third-party suppliers. In addition, it is clear from the investigation that these two product ranges are aimed at the same clientele, in the same sector of activity, that the G-IHCO product range represents a share of sales within the G range that is sufficiently representative, that the mere fact that there is only one comparable product range does not make it any less reliable as such, and that the applicant company does not, moreover, mention any adjustments that might need to be made. Finally, the fact that another product in the range, not purchased directly from a third party and representing a very marginal share of sales, generates a lower average gross margin than the G-IHCO range does not call into question the validity of the method used by the authorities. 13. Secondly, with regard to the application of the transactional net margin method, AMDF argues first of all that the tax authorities do not validly question the resale price method used, which has been validated by an independent firm and is recommended by the Organisation for Economic Co-operation and Development. However, it follows from the investigation that the resale price method, which is certainly recommended by the Organisation for Economic Co-operation and Development, is only relevant when the margin is sufficient to cover selling costs. In this case, however, the margin is very low, or even negative, and in any case, AMDF has not provided the marketing contracts concluded at group level in order to study the breakdown of costs and margins achieved. On the other hand, the transactional method, which applies the net margin rather than the gross margin, takes into account all the expenses incurred by the company, and thus makes it possible to examine the company’s overall remuneration in relation to the functions it performs and the entirety of its operational activity. After analyzing AMDF’s distribution functions, the tax authorities were entitled to use the panel of comparable companies operating in a similar market to compare net margins on all AMDF’s activities. If, as the applicant company maintains, some of the companies on the panel have lower or, on the contrary, higher sales than its own, it does not follow from the investigation that, given the net margin rates compared, taking them into account would be unfavorable to it. Furthermore, if the two companies with the most distant activity from the applicant were excluded from the panel, the recalculated median would be higher and therefore unfavorable to the applicant company. Lastly, the applicant company does not present any alternatives, merely arguing that no external comparables are available. Consequently, AMDF has no grounds for questioning the validity of the transactional net margin method. 14. Lastly, the applicant company asks the Court, in the alternative, that instead of the median used by the administration to determine the arm’s length range, which constitutes the acceptable price range, the low interquartile range be used to calculate the increases resulting from the application of the transactional net margin method. However, on the one hand, the administration compared the company’s net margin with the panel’s interquartile median, thus eliminating extreme values and risks of error, and retained two different periods in order to take account of the economic difficulties invoked by the company. Furthermore, and in any case, the company has not justified that the application of a low interquartile range would be more appropriate for the calculation of uplifts. Under these circumstances, the low interquartile range should not be used to calculate the said increases.” Click here for English translation Click here for other translation ...