1. Background.
Italian tax law does not provide for a specific audit procedure for transfer pricing matters. Transfer pricing issues are generally examined as part of a broader tax audit, which may involve an on-site inspection, a short-notice visit to collect documents and information followed by an off-site review, or a formal request for information.
Where an audit concerns cross-border transactions with foreign related parties, the Italian tax authorities may conduct an on-site inspection to obtain a comprehensive view of the taxpayer’s accounting records, contractual arrangements, and internal business records and communications.
On-site inspections can be particularly significant in transfer pricing audits because they enable the tax authorities to review contemporaneous business communications — including emails and other electronic records — which may provide evidence regarding the actual conduct of the parties and the substance of the intercompany arrangements beyond the terms reflected in the underlying contractual documentation.
2. Structure and conduct of transfer pricing inspections.
In practice, the Italian tax authorities generally approach cross-border dealings with foreign related parties in the following sequence:
a) verifying the tax residence of the foreign related party;
b) determining whether the foreign affiliate has a hidden permanent establishment in Italy through its dealings with the audited entity, or whether the audited entity has a permanent establishment in the foreign jurisdiction; and
c) assessing whether the transfer pricing rules have been properly applied to the relevant transactions and whether the taxpayer has maintained the required Italian transfer pricing documentation.
Where the counterparty is an Italian tax resident, the transfer pricing rules generally do not apply, and the relevant transaction is treated as a domestic transaction for Italian tax purposes.
3. Organizational and legal “structuring” of the multinational group.
Advisors play a critical role in helping multinational groups achieve an appropriate level of structuring across several dimensions:
a. establishing and maintaining an appropriate governance framework for the group’s various legal entities;
b. identifying, through functional analysis, the intercompany transactions and flows that fall within the scope of the transfer pricing rules, with particular attention to potential areas of risk; and
c. appropriately documenting and formalizing the arrangements among group entities, including the manner in which the parties conduct their dealings with one another.
Pursuant to Circular no. 1/2018 of the Italian tax police (“Guardia di Finanza”), which remains applicable, tax auditors are expected to examine the substance of intra-group relationships rather than relying solely on their formal characterization. It is therefore critical that the legal and documentary framework accurately reflect the parties’ actual conduct from the outset of an audit.
4. Document collection in the context of tax audits.
Information gathered before a tax audit is critical to preparing for the inspection, which typically involves on-site access, a review of accounting and other records, and interviews with relevant personnel.
Once the audit is underway, the tax authorities will typically examine the taxpayer’s statutory accounting records and other business documentation, including materials relevant to the audit, such as the group’s transfer pricing policies and related documentation.
Documentation typically requested and collected at the outset of an inspection includes:
a) tax returns, which allow the tax authorities to determine whether the taxpayer has elected to maintain the Italian transfer pricing documentation, thereby obtaining the corresponding penalty protection;
b) trial balances and accounting records;
c) relevant agreements and organizational charts;
d) email correspondence involving tax personnel and senior management;
e) relevant data and information concerning the multinational group; and
f) data exchanged under the Country-by-Country Reporting (CbCR) framework.
What do the tax authorities do with this information? The tax authorities use this information to identify functions performed by the Italian entity that may not have been formally documented, reconstruct the scope and nature of its dealings with foreign related parties, map the transactions carried out in the Italian market, and identify potential instances of under-remuneration relative to the assets employed and the functions and risks actually assumed by the Italian entity.
5. Evaluation of the adequacy of the transfer pricing documentation to qualify for penalty protection.
To qualify for penalty protection, the taxpayer’s transfer pricing documentation must be found to be “adequate” by the tax authorities.
As a threshold matter, adequacy is assessed against the structure prescribed by the Italian Revenue Agency’s Provision of 23 November 2020.
Consistent with the OECD Guidelines and the EU Code of Conduct, the 2020 Provision requires taxpayers to prepare a Master File and a Local File.
Under Circular no. 15/E of 2021 and Circular no. 16/E of 2022, which provide relevant administrative guidance, penalty protection may be denied where the documentation, notwithstanding its compliance with the prescribed formal structure, is materially incomplete or otherwise fails to satisfy the applicable substantive requirements. This may be the case, for example, where the documentation has not been digitally signed and time-stamped as required.
Potential deficiencies include: failure to disclose the group’s complete organizational structure, incomplete disclosure of advance pricing agreements, functional analyses that fail to accurately reflect the Italian entity’s actual operations, and inaccurate or unsupported comparable-company data.
Penalty protection may nevertheless remain available where certain intercompany transactions are not documented, provided that those transactions are “marginal” and their omission does not undermine the reliability of the taxpayer’s overall analysis or the correctness of the resulting transfer pricing outcome.
As a rule of thumb, transactions may be regarded as marginal, for transfer pricing documentation purposes, where their aggregate value does not exceed 5% of the total absolute value of the positive and negative income components reported in the taxpayer’s tax return, as indicated by Circular no. 15/E of 26 November 2021.
6. Transfer pricing and criminal conducts.
The Italian offense of filing an inaccurate tax return, which may give rise to criminal liability, is structured in a manner that makes criminal exposure for transfer pricing adjustments relatively uncommon.
Under Italian tax law, the arm’s-length value of transactions between associated enterprises may be substituted, for tax purposes, for the price actually agreed between the parties.
Determining the arm’s-length value is inherently a valuation exercise. Accordingly, Article 4, paragraphs 1-bis and 1-ter, of Legislative Decree no. 74/2000 excludes criminal liability for certain valuation differences where the taxpayer has disclosed the criteria applied in making the relevant valuations, as well as where the aggregate difference between the values declared and the correct values is less than 10%. This 10% threshold is distinct from the 5% threshold used to identify marginal transactions for purposes of administrative penalty protection, discussed above.
This protection does not extend to arrangements that are characterized as transfer pricing matters but in substance involve other forms of misconduct, such as sham interposition arrangements or other tax-evasion schemes.