For a change of administration, says Giuseppe Pirola, Founder and Senior Partner at Studio Pirola Pennuto Zei & Associati, the Italian headquartered tax and legal advisory firm, is often accompanied by a change in the taxation and legal provisions, something that the country’s professional services advisers have become only too accustomed to in recent years.

Shifting sands of taxation
A good example of the shifting uncertainties of investing in Italy is the tax treatment of goodwill. Over the past few years, what was a particularly favourable tax regime for acquisitions, in terms of the provisions relating to tax relief for goodwill, has grown much less attractive.

“Twenty five years ago, tax relief for goodwill was as high as 52 percent, and more recently 36 percent,” says Pirola. “It was possible to make an acquisition, do a merger, step up the value of the assets, the liabilities in the company acquired, and get tax relief for that goodwill, write it off against taxes over a period five years.”

Successive Finance Acts have extended the goodwill write off period – the time taken to get the tax relief – first to 10 and now 18 years. And tax relief was only available if there was a clear business case, so when investors had to reorganise after an acquisition, they would only get tax relief if there was a bona fide commercial reason for the reorganisation, and it was not just being done to crystallise the tax relief.

Then tax relief on goodwill was removed entirely, other than in some limited cases when taxes are paid upfront. Substitute tax provisions have been introduced in various Finance Acts over the past few years usually as “one off” provisions. With the substitute tax, the taxpayer paid a reduced rate of tax typically between 10 percent and 18 percent in advance, on a revaluation of assets, to get the tax back over a 10 or 18 year period at the standard rates.

“Now, the Finance Act 2008 has reintroduced the concept, with the option of paying 12 to 16 percent in advance to get the tax back over 18 years,” says Pirola. “For many taxpayers, however, the reality is that an 18 year recovery period means that, paying tax up front, albeit at 16 to 18 percent, is not worth it.”

Although it is worth noting, that for an asset with a shorter amortisation or depreciation period, such as a patent, where depreciation is over the life of the patent, but there are only three or four years left for the patent to run, then there will be some benefit, as you will get tax relief in shorter period of time. So opportunities do exist to take advantage of the substitute tax.

The recent Finance Act has, unsurprisingly, introduced more than one change to the tax regime. The corporate income tax rate (IRES), for example, has been reduced from 33 percent to 27.5 percent.

This move makes Italy very competitive with respect to corporation tax. Although, in terms of tax relief, with the tax rate reducing from 52 percent, to 36 percent, 33 percent and now 27.5 percent, payback on the substitute tax is reduced.

There is also a regional production tax (IRAP) to contend with. This tax has been contested in the European Courts, but the Italian authorities won the case, and the tax seems to be here to stay. In the 2008 Act the standard rate was reduced by from 4.25 percent to 3.9 percent, and rules simplifying the computation of the taxable base have been introduced. Labour costs are not deductible in computing the taxable base which is based on the gross margin shown in the statutory profit and loss account. Successive governments have met the criticism that IRAP is a tax on jobs with a series of measures providing IRAP relief for businesses taking on new employees.

“The reduction in top line tax rate is consistent with a general trend among countries in Europe to reduce the top line tax rate, but increase the taxable basis,” says Pirola. “So at the same time as cutting the IRES rate, the Finance Act introduced a series of restrictions, such as a limitation on the possibility of claiming tax accelerated depreciation, for example, that increased the taxable base.”

The attitude of successive governments has been to simplify the system, and reduce the tax rate, in exchange for better and more accurate profit reporting by taxpayers. They have also targeted tax relief at enhancing growth in the economy. The recent introduction of 10 percent tax credit for research and development costs is a good example; the percentage is increased to 40 percent for costs incurred in connection with arrangements with universities and certain other public institutions.

Recent changes have also boosted the prospects of planning investments through the use of partnerships or tax transparent companies.

Capital gains and tax relief for interest
Another area where investors are faced with uncertainty and constant change in tax regulations, are the rules relating to participation exemption on capital gains deriving from disposals of shares, and other instruments that benefit from the participation exemption.

The rules, which were introduced in 2004, started with the exempted element at 100 percent, but in the space of three years that moved to 92 percent, 84 percent and now, after the 2008 Act, back up to 95 percent. On the other hand the minimum holding requirement in order to benefit from the participation exemption has reduced from 18 to 12 months.

Over recent years the government has also changed its approach towards the thin capitalisation rules that deal with the tax treatment of debt financed deals, and the deduction of interest. Thin capitalisation rules are designed to deny or restrict tax deductions for interest paid to related parties, and prevent companies from being artificially geared up with shareholder loans.

“Initially, a carrot approach saw an incentive to put funding into companies using equity capital, in the form of a reduced tax rate,” says Pirola. “Those rules were then replaced by more standard thin cap rules which denied deduction for interest in situations where a company exceeds a certain debt ratio; in this case four parts debt to one part capital. Exceed the debt ratio cap and you lose the tax deduction for the interest on the excess debt over and above the cap.”

 There were also some intricate rules deigned to stop an interest deduction on borrowings used to purchase shares.

These rules lasted for three years, from 2004 until 2008, and have now been replaced with yet another approach to the deduction of debt interest. “The government has introduced interest cover rules – a regime that focuses on net interest expenses – so the debt equity relationship is no longer important,” says Pirola. “Instead, you get a tax deduction for net interest expenses – interest expenses which exceed interest income – up to a limit of 30 percent of EBITDA as shown in the annual statutory profit and loss accounts.”

The impact of the new provision depends on the type of organisation or structure involved and the type of activity. “For private equity investors the new rules will have a significant impact,” notes Pirola. “Previously, acquisitions could be structured so as to get the debt to equity exactly right and maximise tax efficiency. Now, as it is not often possible to know the level of profits in advance, it is difficult for private equity to judge the most beneficial level of gearing.”

With MNCs, however, the effects of the new provisions are less clear cut. Many MNCs with manufacturing or sales operation in Italy, for example, have transfer pricing mechanisms in place designed to ensure a correct allocation of profits to the various countries in which they operate around the world. The profits and risk of the MNC’s global business may be the HQ of the business, and with good tax planning MNCs can structure their tax affairs to take advantage of the new provisions.

Real estate sector
The theme of uncertainty and opportunity continues with the real estate sector, in which there have been a number of interesting developments over the last few years,

Until recently the best way for foreign investors to make a real estate investment in Italy was to set up a company as a Special Purpose Vehicle (SPV) and then perform acquisitions through that SPV.

In 2000 the first SGR-managed vehicle, a speculative real estate investment fund, which currently has a minimum investment requirement of one million Euros, was launched. In 2003, a change in the law paved the way for open-ended ‘flexible’ real estate investment funds, in which at least two thirds of the overall value of the fund is represented by real estate, rights in property, or holdings in real estate companies – companies engaged in the building, purchase, sale, and management of real estate. (Closed-end real estate funds have been regulated in Italy since 1994).

Following on from the real estate fund, the Italian government proposed a new structure, the Italian version of Real Estate Investment Trusts (REITs). REITs and similar entities have existed in various countries such as the US and UK, for example, for some time, and were introduced in Italy for the first time by the 2007 Italian Financial Law, under the name of SIIQ (Società di Investimento Immobiliare Quotata).

SIIQs are qualified as a listed real estate investment company, explains Pirola. The qualifying features are: that shares of the company shall be listed on an Italian stock market; the company’s main business must be real estate lease; no shareholder can hold, directly or indirectly, more than 51 percent of the voting rights and a 51 percent share of the company’s profits; and at least 35 percent of shares must be held by shareholders, each of them holding, directly or indirectly, no more than one percent of the voting rights and a one percent share of the company’s profit.

Promising as the SIIQ is, implementation has proved slow. The law on SIIQs was approved at the end of 2006, and investors were expected to be able to use the new structure from the beginning of 2008. Early in 2008, however, the SIIQ still has to take-off.

“Today we don’t have SIIQ already up and running, we have a lot of announcements by real estate groups or listed companies that are planning to convert their companies into SIIQ,” says Pirola. “But it is a regime that probably has not confirmed its validity in full, and the market has no experience of SIIQs operating in investments.”

Moreover, a government commission is about to look at wholesale tax reform of the real estate sector, and is expected to submit proposals by June 2008.

The Finance Act 2008 states that the commission’s proposals may lead to the introduction and enactment of new rules that may apply retrospectively from January 2008. This means that a real estate business could look at an investment, make evaluations based on the current tax regime and find that after the proposals are announced in June, any business plan assumptions have been rendered incorrect, for the entire year.

Expert assistance
It is clear that the tax regime for investors is highly complex and picking your way through it requires the assistance of advisers with extensive local expertise.

“As you may appreciate when you speak with foreign investors approaching the Italian market, they can find the market confusing,” says Mr Pirola. “For example, with real estate, it is not easy to explain that a business looking to make an investment may perform valuations now, prepare a business plan, define prices and pay money, based on assumptions underlying the business plan, and then find that those assumptions will not be confirmed in six months time because of changes in the law.”

Studio Pirola Pennuto Zei & Associati is a firm with a very strong presence in Italy, with a total head count of 520, including 80 lawyers and 350 tax experts and accountants, located in 9 offices spread over the main Italian industrial areas. The firm also has an international presence, with offices in London and, in the near future, Paris and Brussels.

“We are a one stop shop, providing a full range of tax and legal services to our clients,” says Mr Pirola. “To do this we rely on the strength of our technical skills and knowledge, but also the close relationship we have with our clients. Because, in this business it is important to take pro-active approach, to provide solutions for our clients and point out the opportunities, not just answer their questions.”

For further information
Tel: +39 02 669 95203
Email: giuseppe.pirola@studiopirola.com
www.studiopirola.com