Italy: Supreme Court rules Subject-to-Tax Test does not require actual payment of tax in Switzerland; grants full relief from withholding tax on royalties paid to qualifying Swiss recipient.
The case and the decision
On 6 June 2023, the Italian Supreme Court decided the case of a Swiss-resident company seeking the refund of the Italian withholding tax throughout the years 2005, 2006 and 2007.
More specifically, the Swiss-resident had entered into a service contract with its Italian subsidiary, in pursuance of which the latter would have paid royalties amounting to more than EUR 7 million to the former. Such royalties were subject to a withholding tax of 5% under Art. 12 of the Italy-Switzerland double tax treaty.
The refund request was instead grounded on the EU-Switzerland Savings Agreement of 26 October 2004, which extends to Swiss corporate recipients, under slightly modified conditions, the benefits of the EU Parent-Subsidiary Directive and Interest and Royalties Directive. More specifically, Art. 15.2 of the Savings Agreement provides that “interest and royalty payments made between associated companies or their permanent establishments shall not be subject to taxation in the source State, where […] – jointly with other requirements – all companies are subject to corporation tax without being exempted in particular on interest and royalty payments and each adopts the form of a limited company”.
After a silent denial by the Italian Tax Authority (“ITA”), the case was brought before the Italian Tax Courts of first and second degree. Despite confirming that this royalty payment could be eligible for exemption under the EU-Switzerland agreement, those courts held that there was no proof of actual taxation of the royalties received in Switzerland, whereas the evidence certifying residence status and general taxpayer’s liability to Swiss tax were found allegedly insufficient to justify the refund request. As then specified by the second-degree Tax Court, the proof of actual taxation of royalties in Switzerland was opposed in order to prevent double non-taxation, intended as a “double deduction of taxes paid in each jurisdiction that is a party to the Convention”.
The Swiss company appealed the lower courts decisions and filed two arguments before the Italian Supreme Court.
- The lower courts’ decisions violated Art. 15.2 of the EU-Switzerland Savings Agreement and of Art. 31 of the Vienna Convention on the Law of Treaties, as well as of Art. 216.2 of the Treaty on the Functioning of the European Union (TFEU), given that the international treaties entered into by the EU bind all the EU Member States and that literal interpretation is a guiding principle in treaty law.
- The same decisions violated domestic procedure rules (namely, Art. 115 of the Italian Civil Procedure Code) stipulating that the courts shall ground their decisions on evidence provided by the parties and on non-contested facts (and the ITA had never raised an objection on the alleged lack of Swiss taxation on royalties).
With respect to the first ground of appeal, the Supreme Court recalls that the bilateral agreement between the EU and Switzerland transposes (adjusted) provisions of the EU Interest and Royalty Directive and Parent-Subsidiary Directive, granting (as of 1 January 2005) measures equivalent to the tax treatment applicable to dividend distributions or interest and royalty payments between associated EU companies.
The Supreme Court decision expressly mentions that the case law in this matter has evolved over time, and – after the change of its doctrine – now a settled case law requires only a theoretical subject-to-tax test on the royalty, interest or dividend income in the hands of the non-resident recipient. Consequently, the actual payment of tax on the same income in the residence jurisdiction is not relevant.
As a result, relevance is given to wider taxing power in the hands of the State of the recipient, which aligns with the purposes of the double tax treaties aimed at preventing (i) the juxtaposition of tax jurisdictions, (ii) a higher tax burden on foreign-sourced income and, more in general, (iii) unduly burdensome constraints on business activity and international investments. More specifically, in the similar field of cross-border dividends, the Court remarks that the later (and current) doctrine meets the ECJ Commission v. Italy standards (provided by the ECJ in case no. 540/07, of 19 November 2009) as well as the rationale of Art. 10 of the Italy-Switzerland double tax treaty.
Furthermore, the Court’s decision points out that international tax neutrality and efficiency are different principles compared to tax equalization, and therefore the proof of actual payment of taxes on cross-border income to the residence State is not correct. Conversely, the proof of the mere inclusion of the relevant income in the taxable base would suffice.
In light of the above, the appeal is upheld as to the first ground (without the need to scrutinize the second ground of appeal) and, in acknowledging that the lower courts failed to comply with the said principles, while both already assessed the eligibility for exemption under the EU-Switzerland Savings Agreement, the Supreme Court decision deems further assessment of facts and circumstances by the lower courts unnecessary. Consequently, the refund has been immediately granted to the taxpayer.
The state of play of Italian case-law in similar cross-border matters
The decision on this case embodies the latest (favorable) case law on the interpretation of the subject-to-tax requirement for partial or full relief from withholding tax on dividends, interest and royalties under tax treaties. Nevertheless, the applicability of this doctrine to the EU-Switzerland Savings Agreement remained uncertain. The Supreme Court decision now clearly confirms that the interpretation of the subject-to-tax condition developed with respect to tax treaties equally applies to the application of the EU-Switzerland Savings Agreement.
Furthermore, such doctrine is more broadly encompassed by the principle of literal interpretation of tax treaties, due to the rules set out in the Vienna Convention of 1969, which has reached now the status of guiding light of the Supreme Court decisions also in other treaty matters, e.g. the treaty exclusive attribution of the power to tax to a jurisdiction that does not impose any tax in practice on that income or the Italian foreign tax credit eligibility for foreign partnership dividends subject to Italian substitute tax.
Conversely, the Supreme Court is pursuing a different path when it comes to beneficial ownership, deemed as a specific anti-avoidance rule, and holding that it must be implicitly read in any rule providing for partial or full relief from withholding tax on dividends, interest and royalties, i.e. even where the legal instrument allowing such relief does not expressly provide for a beneficial ownership test. That opens up grey areas of uncertainty, especially where the relevant relief measure is granted under domestic rules (e.g. 1.2% withholding tax on EU or EEA dividends) that are not stemming from Directives or treaties and still do not mention or make any reference to beneficial ownership in their wording.
