According to 2023 Budget Law, profit and non-distributed profit reserves accrued by foreign participated company, benefitting from a preferential tax regimes, can voluntarily be subject to a reduced substi…
The Milan Provincial Tax Commission, in its decisions No. 1138/2/2020 of 17 January 2020 and No. 1207/2/21 of 18 December 2020, ruled inter alia on the relevance of intra-group discounts in transfer pricing audits.
The dispute arises from a claim that some of the costs incurred by an Italian company for the purchase of chemical products from its Hungarian parent company were not deductible for IRES (corporation tax) and IRAP (regional tax on production) purposes in years 2013 and 2014.
In particular, on the basis of a specific contract, the Hungarian company sold the products in question to the Italian subsidiary at a predetermined price, with a trade discount on invoice.
The Italian subsidiary prepared appropriate documentation in support of the compliance of intercompany transfer prices with the arm’s length principle, in accordance with the provisions of Article 110(7), of Presidential Decree No. 917/1986 (Consolidated Law on Income Tax, “TUIR”). To this end, it adopted the so-called Transactional Net Margin Method (“TNMM”), comparing its own operating margin (i.e., EBIT/sales revenues) with that achieved by comparable companies in similar circumstances.
During the audit, the Revenue Office classified the discount on invoice applied by the Hungarian parent company as a “financial” discount, thus excluding it from the calculation of the EBIT relevant for the purpose of determining the operating margin. In a nutshell, according to the auditors, the potential or actual economic influence of the parent company on its subsidiary did not justify the application, in intra-group transactions, of a “trade” discount aimed at stimulating the purchase of products.
As a result, the Italian company’s operating margin was reduced, dropping below the average operating margin of the third companies identified as comparable, with the difference being considered as an increase for IRES and IRAP purposes.
Below are some considerations and analyses concerning the issue of intra-group discounts for the purpose of determining tax-relevant transfer prices, followed by the examination of the position taken by trial judges in the decisions in question.
A “trade” discount is typically a discount affecting directly and unconditionally the price of goods on the basis of specific contractual provisions.
Trade discounts are relevant for VAT purposes, according to the law, as they directly reduce the taxable amount of a sale of goods, whereas “financial” discounts - in principle - do not directly reduce the taxable amount, since they are granted after the invoice has been issued, typically in connection with an advance payment.
In this respect, the Court of Cassation decision No. 21182 of 08/10/2014, ex multis, sets out two conditions for identifying VAT-relevant discounts (trade discounts):
– “that (...) a discount is given on the sale price;
– that the reduction of the consideration to the customer is the result of an agreement, whether documentary, verbal or even subsequent, since the rule makes no distinction whatsoever”.
Irrespective of any assessment as to their nature, discounts (on purchases) are recognized in the accounts as positive income components that contribute to the determination of the IRES and IRAP tax base and increase the overall marginality.
The practice of offering price reductions (or discounts) to entities belonging to the same group is quite common in the pricing policies of multinational groups and in normal practice.
The discount is typically granted in return for the associated company performing certain functions, including - in particular - promoting the sale of products. Lower purchase prices allow the (intragroup) distributor to operate in the local market with greater commercial competitiveness, in particular when the application of discounts is a widespread practice in the reference market and/or when the associated company and/or the parent company already apply discount policies to their customers - whether internal or external to the group.
Article 110(7) of the TUIR, in its current wording, provides that the components of income arising from transactions with companies not resident in the territory of the State, which directly or indirectly control the company, are controlled by it or are controlled by the same company controlling the company, shall be determined by reference to the terms and prices that would have been agreed upon between independent parties operating in conditions of free competition and in comparable circumstances, if they result in an increase in income.
By contrast, the wording of Article 110(7) in force in the years covered by the decisions in question (2013 and 2014), expressly referred to the “normal” value defined in Article 9 of the TUIR for the determination of intra-group transfer prices.
Article 9 of the TUIR provides that, in order to determine the “normal” value, it is necessary to consider, as far as possible, the price lists or tariffs of the entity that supplied the goods or services and, failing that, the market reports and price lists of the chambers of commerce and professional fees, “taking into account customary discounts”, without exception and without nominal distinctions.
Therefore, according to the tax legislation, discounts granted to group companies are not unlawful.
However, the Supreme Court decisions No. 7343/2011 and No. 24005/2013 interpreted the reference to “customary discounts” under Article 9 of the TUIR in a formalistic way, thereby considering as such only those discounts usually applied by the entity in its own price lists or tariffs (if any) for transactions made under arm’s length conditions, i.e. for economic transactions carried out with entities outside the group, thus excluding discounts granted in intra-group transactions from the determination of the normal value. So, according to said decisions, the normal value to be attributed to intra-group transactions must certainly take into account discounts, but only if they are also granted to entities not belonging to the group.
The interpretation given by the above-mentioned decisions does not appear to be applicable in all cases and circumstances. The analysis of the conformity of the discounts granted to associated companies (i.e. of the sales prices charged) with the principle of “normal” value must be carried out, de facto - before even considering the possibility of classifying them as “customary discounts” - through an investigation that takes into account the “role” played by such components in the value chain of a group, determining whether price reductions are actually intended to remunerate additional, or in any case different, functions or risks with respect to those assumed by third party purchasers; or, otherwise, are due to a real difference in the marketing stage where the “compared” transactions take place.
Indeed, in this regard, the OECD Guidelines, which the Italian tax legislator has followed with respect to the taxation of intra-group transfer prices, allow the distributor to receive additional remuneration in the form of a reduction in the supply price.
In particular, with regard to the remuneration of distributors, the 2017 OECD Guidelines provide that “An independent distributor in such a case [i.e., when performing promotional and marketing activities that generate a future benefit for another entity in the group such as the supplier of the good] would typically require additional remuneration from the owner of the trademark or other intangibles. Such remuneration could take the form of higher distribution profits (resulting from a decrease in the purchase price of the product), a reduction in royalty rate, or a share of the profits associated with the enhanced value of the trademark or other marketing intangibles, in order to compensate the distributor for its functions, assets, risks, and anticipated value creation” (OECD Guidelines, par. 6.78).
Therefore, in such circumstances, the application of a discount to the purchase price is admitted in the presence of a distributor (belonging to a group) which, in the ordinary course of its business, is also engaged in promotional activities, thereby directly bearing the costs of market development to an extent exceeding the investments of an “independent” distributor.
In the absence of any contractual obligation to refund the costs incurred for such activities, the distributor must therefore be granted additional remuneration in the form of a reduction in the supply price.
The Italian Tax Authorities themselves allow the granting of intra-group discounts in such circumstances, in accordance with the indications contained in the Revenue Office Circular No. 1/E of 15/02/2013. In particular, the issue brought to the attention of the Authorities concerned the adoption by an Italian company of a legitimate transfer pricing policy based on discounts and aimed at guaranteeing to its foreign subsidiaries, entrusted with the performance of a distribution activity (accompanied by an “essential promotion function”), a minimum remuneration for such activities. The answer given in this regard makes reference to the general principles set forth in the OECD Guidelines, according to which - in order to determine the normal value of intra-group transfer prices - it is always necessary to take into account all comparability factors between companies belonging to groups and independent parties. By this reference, the Revenue Office accepts the possibility of applying discounts in order to remunerate the additional activities carried out by the foreign affiliate.
It is, therefore, advisable that any assessment of the consistency of intra-group discounts with the principle of normal value be expressed on the basis of an accurate economic analysis aimed at weighing their appropriateness to the specific case.
The discount granted to a company operating in a market (such as the Italian and European market) which is highly competitive on prices, is nothing more than a “commercial” measure allowed, and perhaps even necessary, to the acquiring subsidiary in order to adequately compete with its competitors. An additional discount margin may become - in such a context - the “commercial” element that “makes the difference” with respect to competitors.
In the judgments under review, the Milan Provincial Tax Commission upheld the taxpayer’s appeals and invalidated the related IRES and IRAP assessments.
First of all, the judges held that the Office’s arguments in support of the reclassification of discounts from trade discount to financial discount were flawed by a certain generality, and lacked detailed arguments with respect to the functions and risks respectively assumed by the group contractors.
On the merits, the judges valued the fact that transfer prices were regulated by a written contract between the parties, drawn up according to market standards. The Office’s unproven claim that the contract had not been negotiated was dismissed on the basis that it was considered likely that the management of the Italian company had acted within the scope of its management duties, seeking to maximise the profit of the company run by it.
According to the judges, the discount may well find its rationale - even intra-group - in commercial reasons, such as the drive to sell products and increase market share, which cannot be generically dismissed. The fact that the Italian company only markets products under the brand name of the foreign parent company, and is the sole distributor of the group in Italy, is likewise irrelevant.
So, the Commission upheld the appellant’s claim that the tax legislation does not establish the unlawfulness of discounts granted to group companies operating on an exclusive basis, since Article 9 of the TUIR refers to “customary discounts” with no exception whatsoever.
Moreover, in the case in question, the prices of sales from the foreign parent company to the Italian subsidiary, albeit net of discounts, were lower than the minimum prices quoted on official international price lists for the products involved in the controlled intra-group transaction. Therefore, according to the judges, the discount granted was logical in order to be able to properly compete with competitors.
Finally, the judges pointed out that the trade discount provided for in the contract is genuine and has led to a tangible increase in the Italian tax base, a factual circumstance which - according to the judges - deprives the Office’s arguments of any logical sense. Indeed, irrespective of the nature of the discount, it is a fact that the discount in question was recognised in the accounts as a positive income component which contributed to the determination of the appellant company’s IRES and IRAP taxable base in the years subject to audit.
In summary, the decisions under review confirm the relevance of trade discounts applied in intra-group transactions for the purpose of assessing the compliance of the relevant transfer prices with arm’s length principles, in the context of a careful comparability analysis between intra-group transactions and transactions between independent third parties as required by the OECD and Tax Authorities guidelines.
