The regime introduces a whole new method of measuring the amount of interest that can be deducted in the case of leveraged acquisitions. The new benchmark for deductions and related expenses is now firmly tied to pre-tax income. The high ground is fixed at 30 percent of adjusted EBITDAR in any given year. Inspired by similar legislation introduced as part of Germany’s crackdown on the claims based on carrying costs, the main objective is to simplify the tax system by establishing an easily understood and recognisable yardstick from which all parties can work.

However practitioners in general agree that the overall effect of the new regime is considered to significantly limit the options of Italian corporates in the deduction of interest expenses, especially when involved in large-scale acquisitions.

A carry-forward mechanism has been introduced, but it is likely to prove ineffective for businesses with a relatively steady turnover and financing structure. Thus the new rules will impact significantly on the way businesses finance themselves in the future.

Not all taxpayers come under the regime’s umbrella. For instance, the banking and insurance sectors are excluded. And at least temporarily, so is in part the real estate market which is still free to claim for interest incurred through mortgage loans on rentable property.

Comparisons with the previous regime
The old regime relied on an entirely different method of assessing liabilities in acquisition finance. In this, the main constraint in the design of financing structures was the rules applying to thin capitalisation. The main principle was that they limited the deduction of interest on related party debt in cases where it exceeded adjusted equity by four times.

Importantly however, the regime applied only to related party debt. In turn, this had a direct effect on the way shareholders structured their financing in order to comply with the rules, as well as on the design of guaranteed third-party debt. For example, if such debt was guaranteed by a related party, it was treated for tax purposes as debt held by the latter.

However relatively generous debt to equity ratios softened the blow. Under the rules of thin capitalisation, the maximum permissible debt-to-equity ratio was 4:1. Additionally, the rules had applied for four years and were well understood by all practitioners involved in designing tax-efficient acquisition financing. The result was that, provided deals were underpinned by soundly leveraged structures, arrangements were generally green-lighted by the authorities.

Similarly, the rules limiting deductions in the case of eligible participations could generally be overcoming by opting into tax consolidation. Thus overall, the limitations did not really constitute an insurmountable hurdle.

All in all, the old regime required careful attention to the structure of the financing architecture. But provided that was the case, the authorities could hardly ever disallow claims for substantial portions of interest expenses. In short, expert practitioners could generally manage the regime in ways that delivered highly efficient solutions for clients.
Implications for leveraged acquisitions

Although all parties are still feeling their way through the new arrangements, it is clear there has been an important sea change. It is more difficult than before to obtain tax advantages, even in structures that employ levels of leverage that were once perfectly acceptable. This is because the regime now applies to all kinds of interest costs including that anchored on third parties. Thus the umbrella extends across the whole spectrum of leverage, not just intra-group financing established for tax-planning purposes.

Also, since EBITDAR has become the starting point for the measurement of what is deductible and what is not rather than the overall financing structure of the relevant company, the previous yardstick of capitalisation no longer applies. Thus it is no longer possible to secure or even predict the amount of deductible amounts by capitalising the company.

At this stage practitioners are still learning how to navigate the regime. Uncertainty about the exact scope may induce creativity in the use of alternative forms of finance as practitioners work their way towards what is or is not an acceptable form of financing. As yet, no firm conclusion can be reached and in the long run uncertainty may prove detrimental rather than not.

Temporary reprieve for commercial property
Rationally, interest expenses incurred in mortgages incurred on rental property are temporarily exempt. This is probably for the obvious reason that otherwise the regime would have blocked the legitimate deduction of expenses on purely business-driven financial structures as distinct from tax-driven ones. While the property sector is still waiting for clarification on these details, its is likely the new regime will prove to be of benefit to it.
Tighter interpretations

All parties are in the middle of a steep learning curve as they learn how to work within the new boundaries. However it is already clear that the concept of what is deemed “legitimate” tax planning in financial structures has shrunk considerably, especially in the light of rulings by the tax authorities. The nub of these rulings is how the tax authorities determine what constitutes an abusive structure.

So far, any structure has been deemed abusive if it produces a tax advantage without generating an overwhelming non-tax advantage that could not be achieved through an alternative structure. In practice that means the reason behind the option adopted for the financial structure must reflect a significant — and fully corroborated — business motivation. Also, they make no distinction between onshore and offshore financing, applying equally all kinds of debt including bank borrowings.

Cross-border structures
In the meantime cross-border structures have come in for special attention. As we have seen, on the one hand foreign-based structures are challenged if they cannot show a specific, non-tax advantage that could not otherwise be achieved in a domestically-based structure. This is why the use of foreign holding companies often faces objections on the grounds that the structure could just as easily take the form of a domestic entity.

Normally, the line of challenge is based on the place of effective management of the relevant foreign company. Thus the final decision comes down to where the executive team is located. If the entity is an offshore structure but the management is clearly based locally, the structure can be expected to come under scrutiny.

Applying similar principles, tax authorities are also challenging foreign tax structures if in their view they reveal a lack of substance and are thus designed for tax-planning purposes rather than for commercial gain. In fairness however, several of the entities that have come under scrutiny so far have most of the executive team centred within Italy. It could therefore be argued that so far it has been the less legitimate structures have been affected by these stricter interpretations.
Anti-abuse principles invoked

The marked and growing tendency by the authorities to dispute previously acceptable structures has been growing over recent years. It suggests a concerted strategy by the tax authorities. However the position taken by the tax authorities in the growing volume of challenged structures seems motivated by a desire to boost tax revenue rather than by an interest in making impartial judgements on the different circumstances that may lie behind a particular structure.

Although this may be understandable in the case of the tax authorities, many practitioners believe the weight of judicial decisions has been less helpful. The Supreme Court in particular has consistently issued judgements on tax matters that appear to rely on a blanket, anti-abuse principle embedded in the code. This provides the courts with a reason to challenge transactions even in cases where there is no obvious anti-avoidance element.

However practitioners believe the reference to a vague principle rather than more or less specific provisions only serves to increase uncertainty in the interpretation of what is considered abusive and what is not.

However in principle, the new emphasis on genuinely commercially-based structures is seen as helpful and more balanced than in the past. It is clear that the prime inspiration behind the architecture of acquisition finance must be business-driven rather than tax-driven.

Verdict still out on IAS accounting
As part of the general reform, new legislation allows IAS adopters to use the international system for computing taxable income. The laws are not yet complete and follow-up work still has to be done. However it looks as though IAS-adopters will benefit from greater simplicity and clarity because there are likely to be fewer deviations from existing law under the code.

Similarly, it is probably too soon to make a decision about the effect that IAS will have on the assessment of levels of taxable profits. Secondary legislation will also complete the picture in this case.

Under present Italian standards, not all companies are permitted to adopt the international accounting standards. The exceptions are banks, insurance companies and listed companies. However, the authorities may decide to widen the scope of IAS accounting and bring more companies into the net. We believe IAS will become more widespread and eventually provide the foundation for assessing taxable income in an increasing number of companies.

Meantime the government has promised to introduce laws that harmonise local accounting principles more closely with international standards. This move will lead to an important simplification of the relationship between tax and accounting.

For further information:
Tel: +39 02 776 931
Email: P.Ludovici@maisto.it
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