The Italian Revenue Agency and Supreme Court issue guidelines on the application of transfer pricing principles

On May 24, the Italian Revenue Agency published a Circular Letter (n. 16/E of 5.24.20221) which provides important guidelines on the correct interpretation of the concept of “arm’s length range” for the purposes of the application of the transfer pricing rules provided by the Italian Income Tax Code (art. 110, par. 7) or Double Taxation Treaties (where article 9 of such treaties complies with the OECD Model Convention). Pursuant to these rules, transactions between associated enterprises are to be determined in accordance with the conditions and prices which would have been agreed upon between independent parties.

A few days earlier, the Italian Supreme Court (judgment n. 15668 of 5.17.20222) issued clarifications concerning the reliability of the transfer pricing methods, by attributing the necessary relevance to the single phases underlying the application of such methods.
In analyzing the general transfer pricing principles both the Italian Revenue Agency and the Supreme Court recall the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.

The “arm’s length range” is defined by the latter as “a range of figures that are acceptable for establishing whether the conditions of a controlled transaction are arm’s length and that are derived either from applying the same transfer pricing method to multiple comparable data or from applying different transfer pricing methods”.

Pursuant to the domestic legislation (Ministerial Decree 5.14.2018) implementing the general principles adopted at OECD level, a range of figures is within arm’s length when formed by the financial indicators selected in applying the most appropriate method to each transaction between independent parties, which is regarded as comparable to the controlled transaction. In particular, given a transaction between related parties and having identified the arm’s length range:
•    if the financial indicator is within the range, the transaction complies with the arm’s length principle, provided that the figures refer to a number of uncontrolled transactions, each comparable to the one in scope;
•    if the financial indicator is not within the arm’s length range, the tax authorities perform an adjustment in order to bring the indicator within the range, notwithstanding, on the one hand, the associated enterprise’s right to submit elements demonstrating that the controlled transaction complies with the arm’s length principle and, on the other, the tax authorities’ power to disregard such elements, by providing an adequate statement of reasons;
In the outlined context, the Italian Revenue Agency – recalling §§ 3.55 - 3.66 of the OECD Guidelines – has confirmed that:

a) the application of the arm’s length principle produces a range of figures all of which are relatively equally reliable (from the lower to the higher one); differences in the figures that comprise the range may be caused by the fact that in general the application of the arm’s length principle only produces an approximation of conditions that would have been established between independent enterprises or by the application of different prices for comparable transactions;

b) transactions between independent enterprises having a lesser degree of comparability should be eliminated  from the arm’s length range;

c) any remaining comparability defects should be eliminated by – if the range includes a significant number of observations and by means of specific supporting arguments – (i) the use of “statistical tools” that consider the central tendency to narrow the range (e.g. the interquartile range), thus enhancing the reliability of the analysis; (ii) the application of more than one method; in such case, each range could be used to define an acceptable range of arm’s length figures or to reconsider the accuracy of the adopted methods;

d) a substantial deviation among points in the range could indicate that the data used in establishing some of the points is not reliable, thus requiring further analysis of the comparables to maintain or remove;

e) transactions or comparable enterprises realizing exceptionally high profit or losses impact the adopted financial indicator; therefore, a further analysis is required (in this respect, according to the OECD Guidelines, these enterprises should not be excluded solely due to the differences with other comparable enterprises; rather, significant comparability defects previously disregarded should be verified) and shall be excluded from the list of comparables where the results do not reflect the normal business conditions or reflect level of risks not comparable to the one assumed by the associated enterprise (thus, defining the level of comparability on the basis of elements different than the financial data).

In the event the tax authorities claim that the financial indicator does not fall within the arm’s length range, the associated enterprise shall provide arguments (i.e. adequate documentation) that the conditions of the controlled transaction satisfy the arm’s length principle and that the result is within the arm’s length range. If the taxpayer fails to provide such evidence, the tax authorities will determine the point within the arm’s length range (eventually adjusted in presence of comparability differences) as follows:
•    if the range comprises results of relatively equal and high reliability, the financial indicator is adjusted by positioning the price at the lower or higher range value (cd. “full range”);
•    differently, where a value range has been eventually adjusted, the financial indicator is set at the 1° interquartile or 3° interquartile. If comparability defects remain, the use of a central value within the range (the median, the mean, the weighted average etc., depending on the specific characteristics of the data) although allowing to minimize the risk of error, is limited to cases where the range does not include figures having sufficient degree of comparability; a specific motivation of the underlying reasons should be provided for.
Most importantly, the Italian Revenue Agency acknowledges the validity of all the figures within the range. Therefore, in presence of a full-range, the tax authorities shall position the financial indicator identified by the enterprise by considering the “lower” or “higher” arm’s length range value which first crosses the identified one. If instead statistical tools are used, the figures within the restricted range may be used.

By contrast, reference to a central figure within the range should be expressly motivated and limited to cases where the range does not include sufficiently comparable figures.

The complexity of the analysis leading to the application of a reliable transfer pricing method is not limited to the definition of an arm’s length range. Rather, it assumes a series of steps recently stated by the Italian Supreme Court in judgment n. 15668. In the specific case examined by the Court, the Transactional Net Margin Method was applied.

The Supreme Court summarized the relevant stages as follows (i) choice of the tested party; (ii) determination of the financial results of the transaction; (iii) selection of the period in scope; (iv) identification of the comparable entities; (v) accounting adjustments linked to different accounting practices; (vi) assessment of any adjustments required to consider differences in terms of risks assumed or functions performed; (vii) selection of a reliable profit indicator.

It follows that, in the event of litigation between the tax administration and the taxpayer regarding the abovementioned process (in the case examined by the Supreme Court, the comparability standards) the validity of the lower Court’s decision is affected where the taxpayer’s claims are not properly assessed. A new examination of the substance of the controversy regarding the comparability standards has been therefore deferred to the Regional Court.

The guidelines issued by the Italian Revenue Agency and the Supreme Court undoubtedly represent an important milestone with respect to the appropriate application of transfer pricing principles.
  
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1. CIRCOLARE N. 16/E
2. Civile Sent. Sez. 5 Num. 15668 Anno 2022