1. Case Introduction

Company E is a limited liability company registered and operated in Italy, engaged in the resale of household appliances and related parts. In 2002 and 2003, Company E purchased a variety of products from Company A in the same group located in China and deducted the purchase cost of the above products when calculating its operating income.

When the Italian tax authorities conducted a tax audit on Company E, they questioned whether the prices of products purchased from related companies in the 2003 fiscal year were in compliance with the arm’s length principle, and made a tax assessment decision ordering it to pay back taxes. Company E was dissatisfied with the tax authorities’ decision, so it filed a lawsuit with the Regional Tax Court of Lombardy. After hearing the case, the Regional Tax Court supported Company E’s lawsuit and did not recognize the tax authorities’ assessment decision to pay back taxes. Subsequently, the tax authorities appealed to the Italian Supreme Court, arguing that the judgment of the Regional Tax Court was an improper application of the transfer pricing rules, and that they were dissatisfied with the judgment that “the burden of proof that the prices of related transactions were in line with the market prices should be borne by the tax authorities, not the taxpayers.” The Italian Supreme Court later supported the tax authorities’ claim.

2. Focus of the Dispute

The focus of the dispute in this case is the rationality of the transaction price of related enterprises and the basis for determining the subject and scope of the burden of proof.

(I) The tax authorities believed that Company E had violated Article 76 of the old Italian Income Tax Law (from January 1, 2004, Italy implemented the new Income Tax Law. The Article 76 of the old Income Tax Law referred to by the tax authorities was Article 110, paragraph 7 of the new Income Tax Law, which was in effect at the time of the lawsuit and was about transfer pricing rules). The reasons were as follows:

1. According to Article 110, paragraph 7, of the new Italian Income Tax Law, if a transaction between an enterprise and an enterprise it directly or indirectly controls results in a decrease in the enterprise’s revenue or an increase in costs, the transaction price shall be determined in accordance with the fair market price, and reference shall be made to the transaction price determined by non-associated enterprises under comparable conditions in accordance with the arm’s length principle.

2. The tax authorities applied comparable analysis to compare the financial data of Company E with other comparable companies to prove whether its related-party transactions were in compliance with the arm’s length principle. After analysis by the tax authorities, it was found that Company E purchased products from its related-party companies in China at prices higher than the market price, which eroded the Italian tax base and required it to pay back taxes as required.

(II) The local tax court held that the tax authority’s decision to pay back taxes lacked effective evidence support, and the evidence provided by the tax authority should fully prove that the price of the related-party transaction between Company E and Company A was significantly deviated from the market price in accordance with the transfer pricing rules. The local tax court mentioned in its judgment that the main purpose of the transfer pricing rules is to prevent companies from transferring profits to countries with more favorable tax rates. The tax authority only selected relevant data of other companies in the same industry for comparison, and failed to fulfill the full burden of proof it should bear, which was insufficient to support its claim that Company E violated the transfer pricing rules and had to pay back taxes.

3. Final Decision

The Italian Supreme Court ruled to revoke the decision of the Lombardy Regional Tax Court and sent the case back to the lower court for retrial. The Supreme Court stated the following in its judgment:

（1） Transfer pricing rules

Transfer pricing rules are an important means to prevent tax base erosion and profit shifting. Their main purpose is to ensure that transaction prices between different entities of multinational corporations comply with the arm’s length principle and avoid using internal transactions to transfer profits.

（2）On the arm’s length principle

The tax authorities’ treatment is in line with the arm’s length principle of Article 9 of the Organisation for Economic Co-operation and Development Model Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital (commonly referred to as the “OECD Model”), which requires that estimates based on the arm’s length principle must reflect the economic substance of the transaction.

（3）Regarding the subject of burden of proof

When providing evidence, the tax authorities do not need to consider whether the taxpayer has actually obtained tax benefits. The burden of proof is only to prove that there is a transaction between related parties and that the transaction price is “significantly lower” than the market price. The burden of proof that the transaction price is in line with the market price should be borne by the taxpayer, that is, if the tax authorities believe that the transaction price deviates from the normal level, the taxpayer should provide evidence that the transaction price is in line with the market price.

4. Implications for “Going Global” Enterprises

In this case, the Italian Supreme Court clarified the rules for the allocation of the burden of proof between the tax authorities and taxpayers in transfer pricing cases, and the burden of proof that the transaction price is in line with the market price should be borne by the taxpayer. The Italian tax authorities are very concerned about the tax avoidance behavior of taxpayers using transfer pricing. When taxpayers “going out” conduct transactions with related companies, they should pay attention to identifying and preventing tax risks.

First, reasonably and legally plan related transactions within the group. Before “going global”, enterprises can consider sorting out and analyzing the global value chain and functional risks at the group level in advance, and reasonably plan transaction types and pricing policies based on the business content and scale of the enterprise to effectively deal with possible tax-related disputes.

Second, the original evidence of legality should be carefully preserved. Be prepared and take the initiative to preserve evidence that can prove that related transactions comply with the principle of independent transactions. For example, pricing policy documents, functional risk analysis, economic analysis and other materials.

Third, actively use legal tools to safeguard their own interests. Have a deep understanding of the host country’s legal procedures for resolving tax disputes. At the same time, enterprises can consider reaching an advance pricing arrangement with the host country’s tax authorities on the pricing principles and calculation methods of the company’s related-party transactions in future years to improve tax certainty and avoid potential double taxation risks.