TAX NEWS - January 2010

U.S. Tax Alert: 1999 Tax treaty with Italy enters into force

As announced by the U.S. Treasury Department, the 1999 tax treaty with Italy entered into force on 16 December 2009. The tax treaty will replace the 1984 treaty between the two countries that entered into force in 1985. The new treaty will apply to taxes withheld at source for amounts paid or credited on or after 1 February 2010, and, for other covered taxes, will generally apply to taxable years starting on or after 1 January 2010. Under a transition provision, a taxpayer entitled to the benefits of the 1984 treaty may elect to have it continue in effect for the 12-month period from the date the 1999 treaty would otherwise have effect.


Background

The tax treaty and its protocol (the "1999 treaty") were signed on 25 August 1999, with the U.S. Senate consenting to ratification in November 1999, subject to a reservation and understanding. The reservation requires the deletion of certain language (the "main purpose tests") that appears as the final paragraph of articles 10 (Dividends), 11 (Interest), 12 (Royalties) and 22 (Other Income). For purposes of article 10, the language at issue reads:

The provisions of this Article shall not apply if it was the main purpose or one of the main purposes of any person concerned with the creation or assignment of the shares or other rights in respect of which the dividend is paid to take advantage of this Article by means of that creation or assignment.

The U.S. Senate also conditioned ratification on the understanding that, pursuant to article 26 (Exchange of Information), both competent authorities have the authority to obtain and provide information held by financial institutions, nominees or persons acting in an agency or fiduciary capacity, or respecting interests in a person.

President Clinton signed the U.S. instrument of ratification on 28 December 1999, ratifying the 1999 treaty subject to the Senate reservation and understanding. The reservation, however, required approval from the Italian government. Diplomatic notes were exchanged in 2006 and 2007 in an attempt to further the progress of the 1999 treaty, with the Italian government officially agreeing to the Senate reservation requiring the deletion of the main purpose tests and the understanding on information exchange.


General provisions

The 1999 treaty covers U.S. federal income taxes (excluding social security taxes) and federal excise taxes on insurance premiums paid to foreign insurers and with respect to private foundations. The covered Italian taxes are the individual income tax (l'imposta sul reddito delle persone fisiche); the corporation income tax (l'imposta sul reddito delle persone giuridiche): and, to the extent it is considered an income tax pursuant to paragraph 2(c) of article 23 (Relief from Double Taxation), the regional tax on productive activities (l'imposta regionale sulle attivita produttive or IRAP, as discussed below). For excise tax purposes, however, the treaty applies to U.S. excise taxes imposed on insurance premiums paid to foreign insurers only to the extent that the foreign insurer does not reinsure such risks with a person not entitled to an exemption from the tax under the 1999 U.S.-Italy treaty or any other convention.

In the accompanying protocol to the 1999 treaty, the U.S. retains, within the personal scope provisions, the right to tax its former citizens and long-term residents for a period of 10 years where loss of citizen/resident status had as one of its principal purposes the avoidance of tax. The protocol also refines the residency article, so that the article's provisions apply to determine the residence of an entity that is treated as fiscally transparent under the laws of either state – that is, in the case of a disregarded entity, the term "resident of a Contracting State" applies only to the extent that the income derived by the disregarded entity is subject to tax in that state, either in its hands or in the hands of its interest holders.


Dividends

The dividends article is significantly modified from the 1984 treaty, both in rates and in the treatment of dividends paid by real estate investment trusts (REITs) and regulated investment companies (RICs). The 1999 treaty will exempt dividends if the beneficial owner is a qualified governmental entity that holds, directly or indirectly, less than 25% of the payor's voting stock. The 1984 treaty's 10% rate on dividends is eliminated and the ownership requirement to obtain a new 5% rate is lowered; the beneficial owner need only hold at least 25% of the distributing company's voting stock for 12 months ending on the date the dividends are declared. The rate will be 15% in all other cases. The withholding tax on RICs will be 15% regardless of ownership level. REIT shareholders are ineligible for the 5% rate but may claim the 15% rate (in contrast to the flat 30% withholding tax rate imposed by the U.S. in the absence of a treaty), if one of the following conditions is met:

- The beneficial owner of the dividends is an individual holding an interest of not more than 10% in the REIT;
- The dividends are paid with respect to a class of stock that is publicly traded and the beneficial owner of the dividends is a person holding an interest of not more than 5% of any class of the REIT's stock; or
- The beneficial owner of the dividends is a person holding an interest of not more than 10% in the REIT and the REIT is diversified.


Interest

Exemptions will apply to interest paid to a qualified governmental entity that holds, directly or indirectly, less than 25% of the capital of the person paying the interest; interest paid or accrued with respect to a credit sale of goods, merchandise, or services provided by one enterprise to another; or interest paid or accrued in connection with the credit sale of industrial, commercial or scientific equipment. The rate will be 10% in all other cases. The maximum rate under the 1984 treaty was 15%, with fewer exemptions provided. (Additionally, Italy's domestic rate of 12.5% on loans was lower than the 1984 treaty rate.) The protocol to the 1999 treaty provides that interest that is an excess inclusion with respect to a real estate mortgage investment conduit may be taxed by each country according to its own domestic laws.


Royalties

An exemption will apply for royalties paid for the use of, or right to use, a copyright of literary, artistic or scientific works (excluding royalties for computer software, motion pictures, films, tapes, or other means of reproduction used for radio or television broadcasting). The withholding tax rate will be 5% for royalties for the use of, or right to use, computer software or industrial, commercial or scientific equipment. Otherwise the rate will be 8%. Rates under the 1984 treaty were 5% for literary, artistic or scientific work; 8% for motion pictures and films, tapes, or other means of reproduction used for radio or television broadcasting; and 10% in all other cases.


Limitation on benefits

The limitation-on-benefits provision is included in the accompanying protocol, but does not have a "derivative benefits" test. Thus, an Italian subsidiary of a parent organized in another EU country will not qualify. A resident of the U.S. or Italy not otherwise entitled to treaty benefits may still be granted benefits under the 1999 treaty if the competent authority of the contracting state from which benefits are claimed so determines.

Publicly traded test: A company satisfies this test if either (i) all shares in the class or classes of shares representing more than 50% of the voting power and value of the company are regularly traded on a recognized stock exchange, or (ii) at least 50% of each class of shares in the company is owned (directly or indirectly) by five or fewer companies entitled to benefits under part (i) of this test, provided that in the case of indirect ownership, each intermediate owner also is a person entitled to benefits under the publicly traded test.

Base erosion test: The base erosion test is met if: (i) at least 50% of each class of shares or other beneficial interests in the entity is owned directly or indirectly by qualified residents (i.e. residents meeting one of the limitations on benefits tests) on at least half of the days in the taxable year; and (ii) less than 50% of the entity's gross income for the taxable year is paid or accrued, directly or indirectly, to persons who are not qualifying residents of either contracting state (unless the payment is attributable to a permanent establishment situated in either state) in the form of payments deductible in the company's state of residence.

Active trade or business test: The active trade or business test is met if: (i) the company is engaged in the active conduct of a trade or business in its state of residence; (ii) the income at issue is derived in connection with, or is incidental to, that trade or business; and (iii) the business activity in the state of residence is "substantial" in relation to the business activity in the source state.


IRAP creditability

The 1999 treaty treats a portion of the IRAP as a creditable tax. The 1999 treaty incorporates a formula taken from that adopted in a mutual agreement reached by the U.S. and Italy in 1998, which reduces the tax base for labor and interest deductions not allowed for IRAP purposes. The creditable portion of the IRAP is computed as the "applicable ratio" multiplied by the total amount of IRAP paid or accrued. The "applicable ratio" is the "adjusted base" divided by the total tax base upon which IRAP is actually imposed. The "adjusted base" is the greater of zero or the total tax base upon which IRAP is actually imposed, less the total amount of labor expense and interest expense not otherwise taken into account in determining the total tax base upon which IRAP is actually imposed.

The IRAP recently survived a European Court of Justice challenge involving a VAT issue and remains in effect. Although the Italian government has announced that it is considering phasing out the IRAP in the near future, the government has not publicly taken any concrete, substantive steps in this direction.