International tax highlight: Beneficial ownership and back-to-back financing under the Interest and Royalty Directive

Italian Supreme Court Judgment no. 3380 of February 3, 2022

In back-to-back financing structures, the application of the withholding tax exemption under the Interest and Royalties Directive on interest paid to an EU group company does not require the presence of a mark-up margin for the EU recipient.

This is the conclusion drawn by the Supreme Court in the above captioned judgment which follows a precedent (Supreme Court judgment no. 14756 of July 10, 2020), based on the case law of the ECJ (judgment of February 26, 2019 relating to joined cases C-115/16, C-118/16, C-119/16 and C-299/16).

In the 2020 decision, the Supreme Court stated that the withholding tax exemption under the Interest and Royalties Directive (implemented by art. 26-quater of Presidential Decree 600/73) was applicable to the interest on the financing between an Italian company and its EU parent company which, in the context of an MLBO transaction, mirrored the financing between the parent company itself and its higher-level parent company, which had in turn obtained an upstream financing.

In 2020, the Court stated that for the purpose of determining the status of beneficial owner of the EU parent company’s interest income , the right to enjoy the income must not be limited by legal or contractual obligations to transfer the sums to third parties. On the other hand, not much importance was given to the exiguity of the mark-up (0.125%) earned by the EU parent company.

In the 2022 decision, the Court again confirmed this principle in a case where the EU parent company earned no mark-up at all; the case concerned a loan between an Italian company operating in the publishing sector and its 99% Luxembourg parent company, financed under the same conditions by its US parent company.

The Supreme Court recognized that the Luxembourg parent company did not act as a mere conduit, on the basis of the following parameters:

1. the substance of the Luxembourg parent company, which existed for more than 50 years and had a genuine operating structure;
2. the corporate purpose of the Luxembourg parent company, i.e., holding of equity investments in publishing companies;
3. the significant economic results of the Luxembourg parent company (eight million euros of profits, so that – just as highlighted by the ECJ judgments on cases C-115/16, C-118/16, C-119/16 and C-299/16 – it could not be considered an entity “that only makes an insignificant taxable profit”, which might indicate the status of conduit company);
4. the autonomous cause of the two financings, linked to a temporary inability of one of the parties involved to issue a bond;
5. the circumstance that the interest income was taxable in Luxembourg;
6. the circumstance that the Luxembourg parent company could fully enjoy the interest, in the absence of contractual obligations to repay them; and
7. the circumstance that securities had been placed as collateral for US investors.

In substance, under this new interpretation by the Italian Supreme Court, the status of beneficial owner cannot be denied where:

1. there are no limitations or conditions that envisage the transfer to another country of the income received from Italy, and
2. full entrepreneurial autonomy and patrimonial responsibility is attributable to the EU parent company.