By Paolo Ippoliti and Carlo Hassan

The Italian tax authorities issued a ruling (187/E) on 5 May 2008 on the tax treatment of income earned by a company based in Cyprus with a branch in the United Arab Emirates (specifically, in Dubai).

According to the facts of the ruling request, an Italian investor is in the construction business and, together with French and Swiss investors, equally funded a company in Cyprus (chosen for geographical and cultural reasons), which in turn established a permanent establishment (PE) in Dubai for the construction of a light rail transportation system. The Italian investor requested the ruling to prevent application of the Italian controlled foreign company (CFC) rules on the grounds that actual business activities were carried on in Cyprus and in Dubai and/or to demonstrate that the income was not localized in a “black list” country. Under Italian law, an advance ruling is required to avoid application of the CFC rules.

In essence, the Italian CFC rules attribute income to an Italian shareholder/investor (whether profits are distributed or not) if such income is earned by a (directly or indirectly) controlled foreign company and the foreign company is located in a low tax jurisdiction included on Italy’s “black list.” (Somewhat different rules apply for foreign black-listed companies that are controlled by an Italian resident and companies in which the investment is below the “threshold” for the control, but the different criteria for attributing the CFC income to the controlling entity versus non-controlling investor are not addressed here.)

As noted above, an Italian taxpayer can avoid triggering application of the CFC rules if it can demonstrate one of the following:

From the ruling, it appears that the operations are carried out in Cyprus and in the United Arab Emirates, both of which are on Italy’s black list of low tax jurisdictions. The Italian investor hoped that the ruling would demonstrate that both conditions to avoid the CFC regime were satisfied and, therefore, none of the income earned would be subject to the CFC regime. It is worth noting that, in a previous ruling involving similar facts, the Italian authorities stated that an adequate level of activity is required in both the country of residence of the company and in the country where the branch is situated to avoid application of the CFC rules.

With respect to the Dubai operations run by the local branch of the Dubai joint venture, the Italian authorities acknowledged, upon a review of the documentation, that real business activities aimed at operating a construction business were carried on. However, the CFC rules require that both the PE and the company located in a low tax jurisdiction must pass the activity test by demonstrating there is adequate substance for the activities performed in the territory where it is located (i.e. Cyprus).

According to the ruling, the taxpayer did not provide sufficient evidence to demonstrate that the Cyprus company was engaged in business activities. The tax authorities stated that the structure of the Cyprus company seemed to be in a “merely embryonic” state, with no apparent management or actual decision-making activities. Among other factors, the authorities noted that the accounting, tax consultancy and audit services would be performed by an external provider, thus supporting a finding that “the personnel available in Cyprus are legally unrelated to the company.” As a result, and notwithstanding the adequate activities related to the PE in Dubai, the exception to the CFC rules cannot be claimed under the first test above.

With respect to application of the second test, the Italian authorities clarified that the income generated in a low tax jurisdiction must somehow be subject to regular tax (under the rules of a non-low tax jurisdiction). Under the facts of the ruling request, the authorities found that, notwithstanding the investors commitment to distribute all the profits after completion of the project, neither of the countries involved (i.e. Cyprus and the United Arab Emirates) subjected the income to taxation under their regular tax regimes. Presumably, the authorities also determined that the countries of destination for dividends paid by the Cyprus entity did not ensure the desired level of taxation. Hence, the Italian tax authorities concluded that the second test was not passed and, ultimately, that the investment held by the Italian company was subject to the CFC rules, making the income currently attributable to the Italian investor.

The ruling emphasizes the restrictive approach taken by the Italian tax authorities in determining whether the substance requirements of the exceptions to the CFC rules have been met and, with reference to the second exception, confirms the need for taxpayers to demonstrate that a CFC’s profits are actually subject to tax in a non-black listed jurisdiction.

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