How to make a more reasonable comparison in comparability analysis? The Italian court ruled

1. Case Introduction

UFI Group (hereinafter referred to as “U Group”) is an Italian multinational company, whose main business is the research and development and manufacturing of filtration systems. Company A and Company B are subsidiaries of U Group established in China, engaged in filter manufacturing.

U Group has been purchasing filter products from Company A and Company B for a long time. In 2009, the Lombardy Tax Office of Italy, based on its analysis of the purchase prices of related goods between U Group and its Chinese subsidiaries, believed that the prices of related transactions between Company A, Company B and U Group were too high and that U Group had transferred profits, and therefore sent a tax assessment notice to U Group, requiring special tax adjustments to be made on the related transactions between it and its Chinese subsidiaries.

U Group filed an administrative reconsideration with the Milan Provincial Taxation Bureau on the tax assessment. After being rejected by the Milan Provincial Taxation Bureau, it filed a lawsuit with the Lombardy Regional Court. The Lombardy Regional Court supported U Group’s lawsuit and ruled that the tax assessment by the tax authority was invalid. The Lombardy Tax Bureau was dissatisfied with the court’s decision and appealed to the Supreme Court, which was ultimately rejected by the Supreme Court.

2. Focus of the Dispute

According to Article 110, paragraph 7 of the Italian Income Tax Law: “If a transaction between an enterprise and an enterprise it directly or indirectly controls results in a reduction in the enterprise’s revenue or an increase in costs, the transaction price shall be determined in accordance with the fair market price.” Article 9, paragraph 3 of the Italian Income Tax Law stipulates: “The fair market price refers to the market price of the same or similar goods or services obtained or provided at the same time and place in the open market.”

The Lombardy Tax Office believes that the income of Company A and Company B mainly comes from related-party transactions with Group U. Given that the markup rates of Company A and Company B’s products are 39.77% and 17.20% respectively, which are much higher than the normal market prices, there is a possibility of transferring Group U’s profits through related-party transactions. In accordance with the OECD “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations”, the tax authorities determined the cost-plus method as the transfer pricing method for this case, selected 6 Chinese companies as comparable companies for Company A and Company B, determined the cost-plus rate that complies with the arm’s length principle, and issued a tax assessment notice to Group U accordingly.

U Group believes that the transactions between Company A, Company B and U Group were determined with reference to market prices, which complies with the principle of independent transactions. There is a deviation between the actual cost markup rate and the situation calculated by the tax authorities, and there is no situation of transferring the profits of U Group to Company A and Company B. At the same time, Company A and Company B are full-function enterprises with R&D, production, marketing and sales. Based on the overall functions of the enterprises, the comparable enterprises determined by the tax authorities have incomparable factors, which are inconsistent with the actual situation of Company A and Company B. Therefore, it is not reasonable for the tax authorities to implement special tax adjustments on U Group.

3. Final Decision

On March 20, 2024, the Italian Supreme Court rejected the tax authorities’ appeal and ruled in favor of the taxpayer for the following reasons:

First, the products produced by the six comparable enterprises identified by the tax authorities are significantly different from those of Company A and Company B. Second, the geographical location of the six comparable enterprises is relatively remote compared with Company A and Company B, and their comparability is insufficient. Third, the tax authorities’ determination of the functional risks of the six comparable enterprises is based only on the balance sheet data of the enterprises, and there is a lack of specific analysis of the functional risks of the comparable enterprises. The determination of comparable enterprises is unconvincing. Fourth, the proportion of related-party sales revenue to the total sales of Company A does not exceed 10%, and the enterprise’s intention to evade taxes is not obvious, which is inconsistent with the claims of the tax authorities.

Ultimately, the Italian Supreme Court supported U Group’s claims, determining that the Lombardy Tax Bureau’s comparability analysis of the case was insufficient and that the related-party transactions between U Group and Company A and Company B were reasonable business practices and did not constitute tax avoidance.

4. Implications for “Going Global” Enterprises

First, pay attention to the risk of transfer pricing investigation in the host country. Multinational companies use transfer pricing to evade taxes internationally, and are the focus of crackdowns by tax authorities in various countries. In the process of “going out”, companies often involve more cross-border related transactions, which are easy to become the target of investigation by the tax authorities of the host country. For related transactions, companies should sign and retain written contracts in advance, and make clear agreements on payment, payment standards and apportionment principles, so as to provide sufficient “ex ante” evidence during transfer pricing investigations.

Second, make reasonable use of advance pricing arrangements. In order to avoid potential anti-tax avoidance investigation risks, enterprises can choose to use policy tools such as advance rulings and advance pricing arrangements to ensure tax certainty and reach a consensus with the tax authorities on the transfer pricing method in advance. In particular, bilateral advance pricing arrangements can effectively avoid or eliminate international double taxation through mutual consultation between tax authorities, providing tax certainty for taxpayers.

The third is to use legal tools to safeguard their own interests. When tax disputes occur with the host country, enterprises should actively use legal channels to maintain communication with tax authorities and courts, understand local laws and regulations, and prepare relevant supporting materials in accordance with legal requirements. At the same time, enterprises can also resolve tax disputes with the host country by initiating mutual consultation procedures under tax treaties.

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