The Italian Revenue Agency opened a public consultation on a draft Circular letter on transfer pricing documentation

The Italian Revenue Agency has published a draft of the Circular letter providing clarifications on the Provision of the Revenue Agency Director published on 23 November 2020 (the “Provision”) regarding the new transfer pricing documentation requirements introduced by.

The Italian Revenue Agency invites practitioners and taxpayers to comment the draft Circular letter, which is expected to be finalized it within the next few weeks before the theoretical deadline for tax return filing (hence, for the preparation of the transfer pricing documentation).

Background

Starting from fiscal year 2020, the Provision sets for the taxpayers intending to benefit from the penalty protection regime a new structure and prescribed methods for the preparation of the transfer pricing documentation. Specifically, the Provision reconciles the structure of the Masterfile and Local File in compliance with the indications of the 2017 OECD Transfer Pricing Guidelines and extends the obligation to make available the Group Masterfile also to Italian resident entities which are not holding/sub-holding companies.

More importantly, the Provision introduces the formal requirement for the documentation to be contemporaneous by requiring that the transfer pricing documentation is digitally signed with a time stamp by the date of submission of the tax return.

The new measures introduced by the Provision require the taxpayer to carry out a highly burdensome analysis triggering a significant effort in terms of information disclosure, although the draft of the Circular letter sets broad indications resulting into interpretation doubt and dilemmas not duly resolved.

Specifically, the most compelling topics for the open debate are analysed as follows:

I. The case of permanent establishments

The new measures should apply to Italian resident companies that are part of a multinational group with intercompany transactions with non-resident entities, to Italian based permanent establishments of non-resident companies and to foreign permanent establishment of resident entities that have opted for the so-called branch exemption regime. Nevertheless, when dealing with the documentation in the case of permanent establishments, the draft Circular letter refers to foreign permanent establishments of resident entities operating both under the branch exemption regime and under the ordinary one. Such a specification may potentially introduce the penalty protection also in case of adjustments to the tax credit referred to the taxes paid on the income earned by such permanent establishments in the country.

II. Materiality threshold

With reference to possible size limits or materiality thresholds concerning the intercompany transactions to be described in Chapter 2 of the Local File, the Provision and the draft Circular letter refer to “any transaction or homogeneous group of intercompany transactions that is not material with respect to the total amount of intercompany transactions in which the entity is involved”.

The draft Circular letter clarifies that a non-material transaction or a category of homogeneous non-material transactions is a transaction generating income or costs that exceeds 5% of respectively the total inter-company income or inter-company costs as indicated in the relevant box of the annual tax return. This provision leaves room for several questions.

First, measuring the materiality threshold with regard to intra-group costs or revenues only leads to distortions and differences in treatment between taxpayers depending on the characterisation of the entity entitled to prepare the documentation. For example, for entities with significant intercompany costs (such as a distributor), several transactions other than the purchase of products could be not material, while the same transactions carried out by another entity with a different characterization would easily meet the materiality threshold. On this point it would seem appropriate to introduce a correction by making reference instead to the taxpayer's total costs and revenues in line with paragraph 5.32 of the OECD Guidelines, also mentioned in the draft Circular letter on this point.

Secondly, considering the alternative reference to a single transaction or a category of homogeneous transactions it is not immediately evident how this threshold should be measured in the event of several transactions belonging to the same category, i.e., whether in such a case the threshold should necessarily be measured regarding the overall category of homogeneous transactions.

Additionally, it would also be welcome if the draft Circular letter would clarify that the threshold is assessed at the time of preparing the documentation and not ex post, in the event of any adjustments by the tax authorities (even if significant).

III. Information on single transactions

3.1 Value of the transactions

According to article 2.3 of the Provision, sub- paragraph 2.1.1 of the Local File should provide the amount of payments made and/or received broken down by each tax jurisdiction of the non-resident payee or payer. According to the draft Circular letter, payments made and/or received are to be understood as the amount of income or costs that have contributed to the business income in the relevant year. The draft Circular letter, however, specifies that amounts of interest and royalty payments shall be reported in the transfer pricing documentation based on the “cash method” (and apparently not based on the accrual method) for the purposes - in the event of adjustment of the deemed arm’s length value of such flows - of the application of the so-called excess of arm's length principle according to which the interest and royalty directive or double tax treaty benefits cannot be recognised on the value of royalties and interests that exceeds the arm's length value.

The purpose of this provision is not entirely clear. In the first instance, it certainly appears necessary for the taxpayer to indicate the amounts relating to royalties and interest also on an accrual basis, since any adjustment of their value would affect this amount.  Moreover, considering that the disclosure of cash amounts is relevant for the purposes of disapplying the Interest and Royalty Directive or a specific Treaty, it would be appropriate to consider how such amounts may relate to previous years, considering that no adjustment on the arm’s length nature of the relevant flows was made or that the statute of limitation already expired. Therefore, the disclosure of cash amounts should clearly be limited to the relevant royalty and interest flows accrued in the same year.

3.2 Low value-added services

The Provision introduced a specific documentation scheme for low value-added services for which the taxpayer has decided to adopt the simplified valuation approach provided for in the Decree of the Ministry of Economy and Finance of May 14, 2018. The simplified approach establishes a common approach for the tax authorities to reduce the administrative costs, guarantee certainty and simplify the audit that could be based on best practices. As stated in Section D of Chapter VII of the OECD Guidelines published in 2017, a markup of 5% should be applied to services qualifying as low-value-added and no benchmarking study is required.

Differently from the Provision, the draft Circular letter seems to clarify that the information specifically requested by article 7 of the Provision would replace the information ordinarily required in Chapter 2 of the Local File for other transactions and thus it would not be an autonomous documentation.

Specifically, the Provision requires the following information:

1. a description of the categories of low value-added services provided (with specific indication, among others, of the underlying reasons for the provision of the services, as well as of the benefits obtained or expected and of the prescribed allocation criteria);
2. the contractual terms or agreements in place between the entities involved;
3. the detailed process that has led to the identification of the amount of direct and indirect costs on which the markup is applied;
4. and the calculations demonstrating the application of the allocation criteria.

Nevertheless, when the resident entity is the beneficiary of low value-added services, the information on the allocation/calculations could be excessively burdensome for the taxpayer, which may not have such information; therefore - also considering that the option for the simplified approach should be aimed at streamlining the assessment procedure during the analysis of the documentation - it would be more appropriate to request such level of detailed information during the audit rather than attached to the documentation.

Secondly, given the alternative treatment for services qualifying as low value-added, it is not clear whether the taxpayer who does not opt for the simplified approach and prepares the documentation in accordance with the contents of paragraph 2.1.1-2.1.5 should in any event also include the information indicated in paragraphs 7.1-7.4 of the Provision. From a practical perspective, in case of management fees, a taxpayer opting for the simplified approach shall provide the allocation drivers together with the related calculation. This information it is not expressly required in case the taxpayer should decide to fully document the transaction for which a specific benchmark analysis shall be prepared. Therefore, it would be reasonable to conclude that the information concerning the allocation criteria and the related calculation shall be provided also in the case in which the taxpayer does not opt for the simplified approach.

IV. Annexes to the Local File

Prior to the publication of the new Provision, the only annexes required to the Local File were transaction flow diagrams and intercompany agreements related to the transactions analysed. As a result of the new measures, the scope and content of the annexes to the Local File significantly changed. Specifically, the structure of Chapter 3 requires to provide the following documentation:

1. the financial statement of the local entity (with the report of independent auditors, if applicable);
2. the reconciliation between the economic data and the financial indicators used in applying the selected transfer pricing method and the financial statement or other equivalent documentation;
3. a summary of the relevant financial data of comparable companies used in the analysis with indication of the sources used.

Differently, Chapter 4 is devoted to the annexes which, apart from a copy of all the intercompany agreements/guidelines related to the described transactions, must also include a copy of the existing unilateral and bilateral/multilateral Advance Pricing Agreements and of cross-border advanced rulings related to the transactions described.

4.1       Financial information

As previously outlined, the Provision introduced the obligation to include in the Local File the reconciliation statements between the economic data and the financial indicators used for the application of the transfer pricing method and the financial statements or other equivalent documentation. The draft Circular letter clarifies that the economic data should be meant as the accounting entries recorded in the general accounts; in cases where it is deemed more appropriate to refer to the accounting entries recorded in the analytical or industrial accounts, the taxpayer must provide a reconciliation of the overall data found in such accounts with the overall data indicated in the financial statements or in the statement of income and assets. Profit level indicators are the price, the gross or net profit in terms of an appropriate measurement basis depending on the circumstances of the case (including costs, sales revenues, and assets), and the percentage of profit or losses allocation.

While some guidance is provided in the draft Circular letter, a clarification is necessarily due to address to what extent the reconciliation of the overall data reported in the analytical or industrial accounts and in the financial statements is assessed by the administration. In fact, it is an extremely burdensome exercise (where possible) to reconcile the individual items (even at the level of overall data) of management accounting to those of the statutory financial statements in view of non-homogeneous principles, criteria and classification. Therefore, the reconciliation on an overall basis would rely on the possibility of a reconciliation of the operating result in analytical/industrial accounts and in the financial statements similarly as in the Patent Box established practice procedures with the recognition of the so-called statutory-managerial differences. Considering the short timeframe in which the transfer pricing documentation should be finalised, this point requires a prompt and resolving clarification in the final version of the Circular letter.

In any case, the draft Circular letter merely sets out an overly general requirement for reconciliation and does not set out the parameters for an actual practical application (nor, indeed, does it reveal the information objectives). Specifically, no comments have been made about:

• Method of reconciliation. If the economic data are presented directly or indirectly in the analytical or industrial accounts, is it sufficient to show the reconciliation with the overall result (in terms of operating profit?) of these accounts and, in turn, the latter with the result in the statutory financial statements?
• Type of economic data subject to reconciliation. The Provision and the drat Circular letter refer to the need to reconcile the financial data used in applying the transfer pricing method for the purpose of setting the transfer prices, although the latter may differ from the method selected to test the arm’s length nature of the transaction.
• Possible segmentation and capillarity of the same. The Provision and the draft Circular letter refer to mere reconciliation and, consequently, they seem not to necessarily require the comprehensive segmentation of financial results by functional profiles other than those tested.
• Types of transactions subject to reconciliation. The Provision and the draft Circular letter do not distinguish the different types of transactions; therefore, it is not clear what kind of disclosure is required for directly ascertainable transactions such as, for example, in the case of service provision (recharge of costs with mark-up). Additionally, prices are included in the list of financial indicators: it is not clear whether the reconciliation is intended to provide a reconciliation of invoices issued or received with details showing the application of prices (including royalty rate and base, interest rate and principal amount, etc.). This exercise would be excessively burdensome in the documentation preparation phase since the value of the revenues and/or costs are in any case reconciled as a whole and the assessment is reasonably feasible during the audit phase, also through sampling procedures.

An attempt has been made to summarize the expected reconciliation for the application of the different financial indicators in the light of the incomplete information provided so far:

Table 1: Reconciliation of financial data and transfer pricing methods

In summary, the activities required for reconciliation purposes appear to be far too extensive for any taxpayer to carry out successfully. In addition to the traditional difficulties in recovering financial information of foreign entities (which will lead many taxpayers to select domestic entities as test parties whenever slightly possible), reconciliation with financial statement entries may be almost impossible as well as completely unnecessary for several transactions. It is hoped that the Agency will quickly revise its position, limiting such activities to those transactions whose fairness test is done through income methods and to those transactions that represent the predominant activity of the taxpayer (or at least one of the core activities).

4.2       Advance Pricing Agreements

The Provision requires to attach the existing unilateral and bilateral/multilateral Advance Pricing Agreements, as well as cross-border Advance Rulings the taxpayer is not a party of but that are in any case “connected” to the intra-group transactions. In this regard, the draft Circular letter does not provide any clarification on what need to be considered "in any event connected". A clarification in this respect would be appropriate given the high level of information required to the taxpayer in the event of a broad interpretation of the provision, as well as considering the unavailability of such information when the taxpayer is not directly involved in the agreement. 

4.3       Operational structure

According to paragraph 2.3 of the Provision, Chapter 1 of the Local File must contain a description of the operational structure of the legal entity together with the organizational chart indicating the names of the individuals to whom the local management functions report and the country where the “main offices of such individuals” are located. Additionally, the draft Circular letter specifies that the names of the individuals to whom the local management functions report must be indicated in both hierarchical and functional terms. This provision leads to implementation difficulties for larger multinational groups, both insofar as it requires the names of employees and insofar as it does not clearly define what is meant by “main offices of such individuals”.

V. Communication of documentation availability

As for the past, the documentation availability must be disclosed by checking the corresponding box when filing the tax return. Differently from the Provision, the draft Circular letter clarifies if and how the taxpayer is allowed to correct any omission in this respect. In particular, the draft Circular letter takes an important position on the applicability of the so called “remissione in bonis”. The cases the draft Circular letter deals with are the following:

1. Declaration submitted within 90 days: whether submitted for the first time or as a corrective measure, the disclosure of the transfer pricing documentation availability must be made at that time - therefore, the time stamp must refer to the effective date of tax return submission.
2. Remissione in bonis: the draft Circular letter expressly admits the applicability of the remissione in bonis with reference to the communication of the transfer pricing documentation availability. However, the documentation availability and the time stamp are required to meet the requirement to access to the remissione in bonis. This limits the use of remissione in bonis to cases where the taxpayer simply forgets to check the flag in the tax return, in line with administrative practice on the matter.  However, the draft Circular letter requires time stamped signing within the date of submission of the tax return with which the remissione in bonis is exercised. It would therefore seem necessary to keep two sets of identical documents with two different time stamps to benefit from the institute.
3. Supplementary tax return for TP purposes: the draft Circular letter covers two possible situations, namely:

• Notification of the documentation availability in the tax return (both within the regular deadline and within 90 days): in case of submission of a supplementary unfavourable tax return to correct transfer pricing errors or omissions, as already provided for by the Provision, it will be possible to also modify the transfer pricing documentation - to make it consistent with the correction made. In this case, the updated documentation will have to be re-signed and temporally marked using as reference the date of submission of the supplementary tax return. Therefore, the interpretation that, except in the case at hand, it is no longer possible to modify the original documentation once signed and temporally marked seems confirmed. It is not clear, however, whether the amendment may also include further sections of the documentation not strictly related to the need for consistency with the correction made. Moreover, it is not clear whether the taxpayer may prepare ex post supplementary documentation to include information that is qualitatively relevant but does not affect the assessment of the tax in such a way as to require the submission of a supplementary tax return.
• Failure to disclose the documentation availability in the tax return (either within the regular deadline or within 90 days): in this case, the draft Circular letter is not entirely clear on the logic followed where it links the possibility to overcome the omission at issue to the possibility to amend the transfer pricing documentation. In summary, in the event of submission of a supplementary unfavourable tax return to correct transfer pricing errors or omissions, it would not seem possible to overcome the failure in communicating the documentation availability, unless the taxpayer has applied for the remissione in bonis within the time limits provided for by law. In the event the taxpayer has regularized his position by opting for the remissione in bonis, in case of future supplementary unfavourable tax return they will be able to modify the documentation prepared and will have to mark it again (thus, it would appear that the sets of documents to be retained for the purposes of the exemption would increase to three). If, on the other hand, the taxpayer has not opted for the remissione in bonis, then it seems not possible to overcome the omission with the subsequent supplementary tax return. 

The key critical points mentioned above will be highlighted in more detail in our comments which will be submitted in response to the consultation and will hopefully be incorporated at least in part in the final version of the Circular letter.

For further information please contact:

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