Penalty protection strengthened through the adequate transfer pricing documentation

Transfer pricing, decree issued by the Italian Ministry of Economy and Finance

On May 14, 2018, the Ministry of Economy and Finance issued a decree containing the guidelines over transfer pricing guidelines (hereinafter “Decree”), published on the Official Journal (Gazzetta Ufficiale) on May 23, 2018.

In detail, the Decree, referring to the article 110 (7) of the Italian income tax law (D.P.R. 22 December 1986, n. 917 – TUIR), reviews some of the fundamentals of the article 110 itself, consistent with article 9 of the OECD Model concerning transfer pricing.

Among the key points in the Decree, there is a reinterpretation of the hierarchy in the transfer pricing methods applied so far, indicating the traditional methods (CUP, resale price, cost plus) as preferred methods with respect to the transactional profit methods (transactional net margin and profit split) and highlighting the CUP method as on top of such hierarchy.

Another relevant change in the discipline refers to the limits imposed to the Italian tax auditors in adjusting the results of the intra-group transactions, now possible only when they do not fall within the range resulting from a benchmark analysis process.

Also a brief mention is made by the Decree to the transfer pricing documentation, that can be retained as “adequate” even if, respecting the contents required by the law, is affected by omissions or partial inaccuracies that do not jeopardize the auditing activity by the Tax Administration.

Exploiting in more detail the contents of such Decree it is worth to highlight how, consistently with the OECD Guidelines issued in July 2017, the Decree under article 4 states that the evaluation of a controlled transaction on the basis of the arm’s length principle is determined through the application of the most appropriate methodology, given the specific circumstances. While referring to the traditional and transactional methods, as above mentioned, the strengths and weaknesses of each method should be taken into account, together with the appropriateness of the method given the nature and the features of the controlled transaction, the availability of reliable information and the degree of comparability between controlled and uncontrolled transactions.

Moreover, it is stated that, when both a traditional and a transactional methodology can be potentially applied, the traditional method, according to the Decree, it would be preferable (but not obligatory, as in the original draft) to adopt the traditional method.

In addition to this, the Comparable Uncontrolled Price Method shall be preferred, only when there is the same degree of reliability of the other methods. This principle is in line with the jurisprudence, for instance the sentence of the C. T. Province of Milan, n. 6248, October 17, 2017, where it is repeatedly highlighted that, although difficult to apply concretely, in theory the CUP is the methodology to adopt with priority.

The article 4 of the Decree, paragraph 6, is even more interesting. In its exercise of testing a controlled transaction on the basis of the arm’s length principle the Decree states that, whenever a firm adopts a methodology that respects what mentioned above and if the conditions of the controlled operations are consistent with the arm’s length principle, the tax audit performed by the Tax Administration must be based on the same method used by the taxpayer. This principle is based on the idea that the taxpayer, while setting the transfer prices, has already undertaken an adequate comparability analysis, with the necessary insight into the underlying economic substance of the transaction. Therefore, whether a firm has adopted a methodology consistent with the principles of the paragraphs from 1 to 5 of article 4 of the Decree, or in other words, has chosen the most appropriate methodology with the related description of the selection criteria  and has also respected the hierarchy of the methods already mentioned, this methodology cannot be discussed by the Tax Administration anymore, as the latter will have to abide by the method chosen by the taxpayer.

Article 6 of the Decree explicitly specifies that the arm’s length principle is respected if the price or margin of the controlled transaction lies within the range of values of independent transactions. A controlled transaction, or a set of controlled transactions, are considered compliant with the arm’s length principle when the related financial indicator in the controlled transaction lies in the above mentioned range. Only when the financial indicator of a controlled transaction, or of a set of controlled transactions, does not fall within the arm’s length range, hence the Tax Administration can adjust the values to bring back the given indicator into the range.

A clarification is eagerly expected from the Tax Administration, as regards the practice put in place by the latter according to which adjustments for higher taxable income during tax audits were performed by automatically setting the profit level indicator up to the median value of such arm’s length range, a behavior hardly sustainable according to us also considering that, given the details as published by the Decree, it would be sufficient to bring back the indicator inside the range (e.g. even at the lower bound of the interval itself).

Among the news introduced by the Decree, there is also a simplified calculation reserved to low-value added services. Article 7 of the Decree, in fact, disciplines a simplified approach for testing these low value added services according to which, as long as they are adequately supported by specific documentation, it would not be requested to perform a specific benchmark analysis but only to give evidence of the sum of the direct and indirect costs of the service, plus the mark-up applied on such costs which is now allowed within the value of 5%,.

Finally article 8 of the Decree, contains a measure that, in case of a tax audit, ensures more certainty for taxpayers in terms of appropriateness (“adequacy”) of the documentation for the application of the penalty protection (please remember that penalties for transfer pricing violations range from 90% to 180% of the major tax being ascertained). It is indeed stated that the documentation can be considered compliant (hence granting penalty protection) in case the necessary information for a correct transfer pricing analysis is presented to the tax auditors, regardless of the methodology adopted to test the transfer pricing transactions or the selection of the comparable third parties or transactions. In case omissions or inaccuracies are detected, provided they are  not jeopardizing the analyses by the tax auditors, the documentation cannot be deemed as invalid.