European Union: The Parent Subsidiary Directive & Recent Italian Supreme Court Cases

The use of Luxembourg as an intermediary holding company location is well known and whilst the rulings of yesteryear are no longer a feature of the regime, it nonetheless has many significant benefits that puts it alongside the UK in the premier league of go-to jurisdictions. In addition to the holding company regime (or Participation Exemption or PEx as it is better known as), there is a comprehensive funds regime, IP Box regime, extensive treaty network and a stable economy.

Given the above benefits Luxembourg is widely used as a platform for investment into Germany (in particular real estate) and Italy. Luxembourg companies are, of course, able to benefit from the EU Parent Subsidiary Directive (PSD) which, when coupled with the PEx, allows dividends to flow from one member state to another free from tax.

Well, that's the theory. Over the past 3 years or so there has been a slew of cases before the Italian Supreme Court on the application of the PSD to dividends paid by Italian companies to their Luxembourg (and Dutch) parents. The Supreme Court has, unfortunately, flip-flopped all over the place such that their rulings are inconsistent, unhelpful and in some cases undeniably wrong. Before looking at a handful of the cases in question, it's perhaps helpful to remind ourselves of the salient features of the Luxembourg PEx and also the PSD.

The Luxembourg PEx

Under the PEx, dividends received by a Luxembourg resident company are exempt if the following conditions are met:

1. a minimum participation of at least 10% or with an acquisition price of at least ?1.2mn is held;
2. the participation is held in:
   1. capital company that is fully subject to Luxembourg corporate income tax or a comparable foreign tax (i.e. a tax rate of at least 9% and a comparable tax base; a 'Comparable Tax'); or
   2. an EU entity that qualifies for the benefits of the EU Parent-Subsidiary Directive; and
3. on the distribution date, the holding company must have held a qualifying participation continuously for at least 12 months (or must commit itself to hold such participation for at least 12 months).

Directive 2011/96/EU (The Parent Subsidiary Directive or PSD) 

The purpose of the PSD is to allow frictionless distribution of profits between companies established within the EU, thus eliminating double taxation.

Under the PSD:

1. the member state in which a qualifying subsidiary is resident may not impose withholding tax (WHT) on distributions made to its EU parent company (with some exceptions); and
2. the member state where the parent company is resident must give credit for the underlying corporate tax that relates to the distribution or it must exempt the dividends from tax.

Both parent and subsidiary must satisfy the following conditions in order for the PSD to apply:

1. the company must be in one of the legal forms listed in the annex to the PSD;
2. the company must be deemed to be a resident of an EU member state under its domestic law and "is subject to one of the taxes listed in Annex 1, Part B, without the possibility of an option or of being exempt, or to any other tax which may be substituted for any of those taxes"; 
3. the parent company must hold at least 10% of the capital (or voting rights) of the subsidiary; and
4. the minimum holding period requirement, if any, must be met (member states have the option to require that a parent company hold the subsidiary shares for at least two interrupted years).

The Subject to Tax Requirement 

The subject-to-tax requirement highlighted above has traditionally been interpreted as being 'potentially liable' to corporate tax, rather than requiring the recipient company to actually pay tax on the income in question (i.e. the dividend it receives under the PSD). The fact that the recipient may benefit from an exemption in respect of certain items of income under a domestic PEx (as is quite common throughout Europe) is not the same as being exempt from tax altogether, a point borne out in the CJEU case Wereldhave.

In Wereldhave,  a Belgian entity distributed dividends in favour of two Dutch recipient companies that qualified as "fiscal investment institutions" benefitting from a 0% tax rate to the extent that all their profits would be distributed to their shareholders. As a brief aside, could the Dutch companies be considered the beneficial owners of the income if they were under an obligation from their shareholders to distribute?  Strictly speaking this doesn't matter as the concept of beneficial ownership isn't a condition of the PSD....or is it?

Back to Wereldhave. The court posed two questions as to the PSD:

1. can the PSD apply to a parent company, that whilst liable to tax is exempt therefrom if all the profits are distributed to its shareholders; and
2. does the free movement of capital and freedom of establishment preclude the taxation of the dividends at source?

As to the first question, the Court considered the wording of Article 2 of the PSD and found that there were two requirements, both of which must be met:

1. a positive requirement that the company to which the Directive applies must be liable to one of the taxes listed in that provision; and
2. a negative requirement that the company does not have the possibility of having an option to be subject to or of being exempt from that tax.

As a consequence, companies that are subject to tax at a rate of 0% are not entitled to the PSD nor are companies that benefit from exemptions in relation to all of their income.

Italy

Having clarified the scope and intent of the PSD in Wereldhave, we now turn our attention to the Italian cases. Per the PSD, as implemented under Italian law, the paying company can either:

1. withhold tax at source on the dividend thus allowing the recipient to claim a refund; or
2. pay the dividend gross having satisfied itself that the recipient meets the conditions set out above.

In most of the cases considered in this article, the paying company has withheld tax at source leaving it to the recipient to claim a refund. Unfortunately, this is where the Italian Supreme Court has decided to go off piste as we will now discover.

Decision No. 32255/2018 

In this first decision, the Italian paying company applied a 27% withholding tax upon distribution of a dividend to its Luxembourg parent. The Luxembourg company (which was liable to tax in Luxembourg but able to benefit from the PEx) filed a claim for a refund of the WHT and eventually found itself at the mercy of the Supreme Court.

The Supreme Court found, upholding the position of the Italian tax authorities, that the imposition of WHT was justified on the basis that double taxation was avoided by the fact that the dividend was exempt in Luxembourg. In other words, the purpose of the PSD is to prevent double taxation and not allow double non-taxation.

It is widely thought that the decision of the Supreme Court is incorrect for the following reasons:

1. the aim of the PSD is to eliminate economic (and juridical) double taxation within the EU. To this end, the PSD provides an exemption from WHT on dividends in the member state of the distributing company and an exemption from taxation (or indirect credit) of the same dividends in the hands of the recipient company. Granting the WHT exemption only to the extent the dividend is effectively taxed in the state of the recipient company is inconsistent with the PSD, since economic double taxation is not eliminated; and
2. the Supreme Court misinterpreted the subject to tax requirement for the recipient company under the PSD. In Wereldhave, the CJEU held that the PSD did not apply to companies that were subject to tax at a rate of 0% (i.e. substantially exempt from corporate income tax). By contrast, the case dealt with before the Supreme Court concerned a dividend exemption regime in line with the provisions and objectives of the PSD.

Decision No. 25490/2019

In the next case, also involving a dividend paid to a Luxembourg parent, WHT was levied at the reduced treaty rate of 15%. The Luxembourg parent claimed a refund under the PSD which was denied by the Italian Revenue which subsequently assessed the full domestic 27% WHT on the basis that the Italy/Luxembourg treaty didn't actually apply!

The Supreme Court held that the "subject to tax" test contained in the PSD requires the item of income (i.e. the dividend itself) to be liable to tax in the recipient state. Furthermore, the objective of the PSD (the avoidance of double taxation) is achieved by the application of the PEx in the recipient state and the combination of the PSD and a PEx, such as the one available to regular companies in Luxembourg, gives rise to an unintended double (non-taxation) benefit.

Decision No. 14527/2019

This case centres around the refusal to refund WHT on dividends paid by an Italian company to its Dutch parent on the basis it was a fictitious entity, had been incorporated in the Netherlands only to benefit from the PEx there and that the company wasn't resident in the Netherlands since its directors resided in Italy and the UK.

It seems whimsical, if not bizarre, given the other cases considered in this article, that that the Supreme Court went on to find in favour of the taxpayer - but that's exactly what they did. The Supreme Court held as follows:

1. a pure holding company is not per se a fictitious entity;
2. to carry out a mere investment management activity is consistent with the nature of the holding even though it limits its activity to managing the shareholdings, board meetings and the payment of dividends and the fees to consultants and directors without carrying any commercial activity;
3. a holding company cannot be fictitious if there is an administrative and finance structure able to prove the main management decisions are autonomously taken and properly documented; and
4. the fact that the holding company is resident in a jurisdiction that provides a tax advantage is irrelevant.

Decision   No. 2313/2020

In this case the Supreme Court had to consider the refund of the dividend tax credit (imputation credit) under Article 10 of the Italy/UK tax treaty. In a well-received decision, the Supreme Court helpfully made a distinction between juridical and economic double taxation:

• Juridical double taxation occurs when a person is subject to tax on the same income or capital in more than one jurisdiction.
• Economic double taxation occurs if more than one person is subject to tax on the same item of income or capital.

In this regard the refund of the imputation credit is meant to eliminate economic double taxation, whereas the exemption from withholding tax is meant to eliminate juridical double taxation.  The two reliefs are therefore not incompatible.

Decision  No. 2617/2020 and No. 2618/2020

These decisions are slightly off topic, but bear with me a moment. They concerned the application of the 1988 Italy/UK tax treaty (DTA) to an English trust. The claimant was the trustee of a trust governed by English law and tax resident of the UK that received dividends from Italian companies.

The Italian tax authorities denied DTA benefits on the grounds that the trust was not a "person" for treaty purposes. The trustee challenged this, producing a certificate of residence (CoR) issued by HMRC confirming that the trust was tax resident and subject to taxation in the UK.

The Tax Court and the Tax Court of Appeals upheld the conclusion of the Italian tax authorities arguing that:

1. the trust did not fall within the definition of "person" provided by Article 3(1)(d) of the DTA;
2. the trustee did not prove that the Trust was the beneficial owner of the dividends; nor
3. that the dividends were effectively taxed in the UK.

The Supreme Court confirmed that trusts can qualify as "persons" for tax treaty purposes and that the definition of "person" per Article 3(1)(d) of the DTA should be interpreted broadly (taking into account whether the relevant entities/arrangements are recognised as legal persons under the laws of the contracting states).

The decision confirms that trusts are, in principle, entitled to treaty benefits provided:

1. they qualify as tax residents of one or both Contracting States; and
2. they are the beneficial owner of the item of income in question and not subject to an obligation to pass on that item.

Now, the reason for including this case in this article is because it's interesting and hopefully relevant to you. The main reason though is because the Supreme Court found that the granting of the treaty benefits was also subject to the proof that the dividends had been effectively subject to tax in the UK. Interestingly, the Court supported its conclusion by referring to case No.25490/19 (see above) which dealt with the application of the PSD, where the Judges (wrongly) denied the withholding tax exemption based on the argument that double taxation had been already eliminated by the dividend exemption granted by the State of the Parent company.

It is worth highlighting that the PSD and most Italian tax treaties do not contain a subject to tax requirement. I guess the Court just couldn't help itself!

Summary

This is something of a dog's breakfast and it follows that the Italian Tax Authorities will continue to challenge structures with low levels of substance and, in particular, those where they consider the recipient entity is not the actual beneficial owner of the dividend or interest flows. The fact that the Supreme Court cases are not binding means that investments into Italy, and the application of the PSD and treaty reliefs, will remain a lottery for taxpayers for the foreseeable future.