Intercompany royalties at risk of disputes in the absence of suitable documentation and technical data
The Supreme Tax Court with the decision n. 9615/2019 ruled that the royalty-rate agreed between associated enterprises was not compliant with the arm’s length principle with respect to the exploitation of a trademark licensed from a Swiss parent company to a controlled Italian subsidiary.
As a result, the royalty paid in tax year 2005 by the Italian company to the Swiss company – which was calculated as the 3,5% of the net sales of the licensee, to which there should be added an extra 1,6% of the net sales as contribution for marketing expenses incurred by the parent company, was considered as being not compliant with the domestic Law on transfer pricing, thus the Tax Office re-determined the royalty-rate from 3,5% to 2%.
The Italian company filed a tax appeal against the rulings issued by the Tax Courts.
The Supreme Court pointed out that the Tax Office had worked to verify the existence of transactions between related companies and to establish arm’s length value for transfer pricing purposes.
The Tax Office provided a structural overview of the organization and the entities within it, and identified the functions performed, risks assumed, and assets used by each of these entities and how they affect the context within which the taxpayer operates.
The Supreme Court ruled that, in this case the burden of proof lies with the taxpayer as per art. 2697 of the Italian Civil Code; the taxpayer must provide evidence that the cost related to an intercompany transaction among related entities be the same as if it had occurred between independent parties.
The transfer pricing is an accounting and taxation practice that allows for pricing transactions internally within businesses and between subsidiaries that operate under common control or ownership. However, groups at times can also use this practice to altering their taxable income thus saving taxes, as transfer pricing mechanisms allow room to shift tax liabilities to low-cost tax jurisdictions.
In these cases, it is required that the various actions undertaken by each entity meet the related economics, based on the compliance with the arm’s length principle. Therefore, if prices or margins are manipulated against tax authorities’ interest, they must be replaced by the so-called “normal value” (i.e. the arm’s length value) of the goods or services being exchanged within the group, in comparable circumstances.
Based on the criteria established in the Circular of the Ministry of Finance n.32/80, since the “intercompany” nature of the transaction was verified, and it was established that it was not conducted at arm’s length, despite the documentation that was provided by the Italian licensee in the first two Tax Courts, the Supreme Court confirmed the assessment operated by the Tax Office, for which the royalty rate of 3.5% (over 1.6% as a marketing contribution) cannot be considered adequate, and has to be redetermined at the lower value of 2%.