Italy's Supreme Court Follows OECD Guidelines on Comparables

This article was originally published in Bloomberg on 22 August 2024 and is reproduced with permission from the publisher.

 

Introduction

The Italian Supreme Court ruled in favor of the taxpayer in a July 16 transfer pricing case, stating that when applying the transactional net margin method, or TNMM, the Italian tax authority can’t automatically reject comparable entities with low or negative margins.

This is the first time the Italian Supreme Court has accepted the use of loss-making comparable entities in a benchmark analysis, acknowledging that the OECD Transfer Pricing Guidelines allow this under certain circumstances.

The TNMM is one of the available methods to evaluate whether a transaction between related parties - a “controlled transaction”- is carried out at arm’s length. This is done by comparing the net profit margin of the tested party through a profit level indicator, such as sales, costs, or assets, with that of similar companies, known as “comparables.”

In this context, comparables are independent companies or transactions with similar characteristics to the controlled transaction, used to benchmark the appropriate profit margin to ensure compliance with transfer pricing regulations.

The court’s decision reaffirmed the pivotal role of the Organization for Economic Cooperation and Development’s guidelines in the selection criteria of comparables when performing benchmarking analysis.

The decision marks a significant shift in the application of transfer pricing principles in Italy, particularly concerning the acceptance of comparables with low or negative margins. It deviates from the position often taken by the tax authority in tax audits where they automatically reject comparable entities with negative results in two out of the three years selected.

 

Impact for enterprises

For enterprises, this ruling underscores the importance of a taking a nuanced approach to benchmarking analyses when applying the TNMM. This decision highlights that loss-making companies can be valid comparables in certain circumstances, particularly when such losses are part of a strategic corporate approach aimed at future gains.

The judgment also emphasizes the need for a comprehensive analysis of comparability factors, including corporate strategies and market conditions, rather than a rigid application of financial criteria. Going forward, enterprises should carefully consider these elements in their transfer pricing documentation to ensure compliance and mitigate potential risk of disputes with tax authorities.

 

Setting a possible precedent

This ruling could influence not only future tax audits in Italy but could also set a global precedent. The court highlighted the need for a thorough examination of all relevant comparability factors, rather than a rigid exclusion of entities with negative results. As taxpayers often struggle to find appropriate comparable companies when preparing their benchmarking analyses, more flexibility would be helpful, especially when dealing with loss-making companies.

If this approach is followed by other jurisdictions, it could lead to a more harmonized and consistent application of the transfer pricing guidelines, reducing litigation, and increasing certainty among taxpayers.

 

The Case

The case relates to tax assessment notices issued by the Italian tax authority in 2012 concerning corporate income tax, regional production tax, and value-added tax for the fiscal years 2008, 2009, and 2010.

Specifically, the Italian tax authority challenged the markup applied to certain intragroup “call center” services provided by the taxpayer, Convergys Italy S.R.L., to a related Dutch entity, arguing that it should have been higher than 5%. This conclusion was based on a revised benchmark analysis conducted by the tax authority, which differed from the one included in the taxpayer’s transfer pricing documentation.

In 2012, the taxpayer attempted to resolve the issue through a settlement process with the tax authority, which didn’t succeed. Consequently, the taxpayer initiated legal proceedings before the first instance court, the Provincial Tax Commission, where they received a partially favorable decision. The tax authority subsequently appealed the decision before the second level court, the Regional Tax Commission, or CTR, which ruled in favor of the authority. The taxpayer then appealed this decision to the Italian Supreme Court.

 

Issues raised by the tax authority

The tax authority argued that based on its benchmark study, the 5% markup determined by the taxpayer to remunerate the intragroup services wasn’t appropriate for the transaction in question.

The taxpayer’s benchmark study had resulted in the 5% mark-up which was at the upper part of the interquartile range. However, on review, the tax authority amended this analysis using different criteria, eliminating some comparables that either didn’t report financial data or had negative results in two years out of the three-year period. As a result, the tax authority reassessed the arm’s-length range and selected the median value of 7.42% as a more appropriate remuneration for the intragroup services provided.

 

The judgment

The Italian Supreme Court partially overruled the CTR’s decision, entirely rejecting the approach of the tax authority that had been validated by the CTR. The Supreme Court considered that the CTR wrongly accepted the tax authority’s revised benchmark study, as the amended criteria selected by the authority were not aligned with the OECD Transfer Pricing Guidelines and contradicted the principles set out in them.

The court stated that it wasn’t possible to exclude potentially comparable companies solely because they have recorded low and/or negative margins in some years. In the normal course of business, loss-making companies do exist.

Referring to paragraph 1.59 et seq. of the OECD guidelines, the court highlighted that one of the factors for determining comparability is corporate strategy. This allows for the inclusion in benchmark analysis of companies that, in order to penetrate a given market or increase their market share, set prices lower than the market price or temporarily incur higher costs than other taxpayers operating in the same market.

The court emphasized that the OECD guidelines don’t support the outright elimination of companies with low or negative margins if such results are incurred to achieve better outcomes in future years.

According to paragraph 3.43 of the OECD guidelines, certain companies may be excluded only in particular situations if it’s clear that these situations represent a factor that excludes comparability. This analysis was completely omitted by the CTR, which clearly accepted the tax authority’s criteria without assessing the reason for rejecting comparable companies in special situations.