US Citybank was performing activities in Italy by means of a branch/permanent establishment.
The Italian PE granted loan agreements to its Italian clients. Later on, the bank decided to sell these agreements to a third party which generated losses attributed to the PE’s profit and loss accounts.
Following an audit of the branch concerning FY 2003 in which the sale of the loan agreements took place, a tax assessment was issued where the tax authorities denied deduction for the losses related to the transfer of the agreements. The tax authorities held that the losses should have been attributed to the U.S. parent due to lack of financial capacity to assume the risk in the Italien PE.
First Citybank appealed the assessment to the Provincial Tax Court which ruled in favor of the bank. This decision was then appealed by the tax authorities to the Regional Tax Court which ruled in favor of the tax authorities. Finally Citybank appealed this decision to the Supreme Court.
Judgement of the Supreme Court
The Supreme Court reversed the judgement of the Regional Tax Court and decided in favor of Citybank.
“This Court, recently (Cass. 19/09/2019, no. 23355), dealing with the Convention between Italy and the United Kingdom on double taxation (Article 7 of which has the same content as Article 7 of the cited Convention between Italy and the United States of America), has specified that:
(a) the permanent establishment, from a tax point of view, is a distinct and autonomous entity with respect to the ‘parent company’, the income of which, produced in the territory of the State, is subject to tax, pursuant to Article 23, paragraph 1, letter e), T.U.I.R.;
(b) Article 7, paragraph 2, of the Convention between Italy and the United Kingdom against double taxation, entered into on 21 October 1988 (and ratified by Law n. 329 of 1990, ), provides for the application of Article 7, paragraph 2, of the Convention between Italy and the United Kingdom.
(b) Article 7, paragraph 2, of the Convention between Italy and the United Kingdom for the avoidance of double taxation, concluded on 21 October 1988 (and ratified by Law No. 329 of 1990), which provides that where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.
(c) the OECD Commentary (§ 18. 3.), with respect to the said Article 7, has clarified that the permanent establishment must be endowed with: “a capital structure appropriate both to the enterprise and to the functions it performs. For these reasons, the prohibition on deducting expenses connected with internal financing – that is to say, those which constitute a mere allocation of the parent company’s own resources – should continue to apply generally.”.
In the present case, the Regional Commission complied with the above principles of law when it held that the Convention placed limits on the deductibility of the negative components of the Italian branch’s income, understood both as interest expense and as expenses connected with the management of the loan (in the case at hand, these were losses on loans and commission charges for the assignment of loan agreements).”
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>Italy vs Citybank 140420 Courte di cassazione No 7801-2020,