ITALY - attribution of free capital to enterprises carrying out banking business

Decision n° 49121 of 5 April 2016 by the Italian tax authority’s chief executive provides follow-up guidance on how to calculate the amount of free capital to be attributed to non-resident banks.

More specifically, the provisions of said decision indicate the amount of free capital considered adequate for tax purposes to be allotted to Italian permanent establishments of non-resident banks.

Banking enterprises operating in Italy through a permanent establishment decide on the amount of the free capital to be attributed to the PE according to the criteria defined by the OECD and based on the guidelines set forth by the “2010 Report on the attribution of profits to permanent establishment”, thereby taking into account functions performed, assets used and risks assumed by the PE in accordance with the functionally separate entity approach.

Funding costs and – consequently – the free capital to be attributed to the permanent establishment is determined, as concerns risk capital and third-party equity, based on functions performed, assets used and risks borne by the PE. Therefore, once the value of the financial assets and liabilities is determined, it has to be divided between risk capital and third-party equity by preliminarily defining an adequate amount of free capital to support the functions performed, the assets used and the risks assumed by the PE.

Free capital may also be allocated to the permanent establishment just for reporting purposes, i.e. just for tax purposes. The adequate free capital must be compared to the actual free capital: if there is a free capital gap, the actual free capital will be corrected, even if just for reporting purposes, by requalifying debt in non-interest bearing own equity for the amount of the gap. The resulting interest expenses in excess deducted from the income of the permanent establishment will have to be declared in the tax return and will be subject to tax.

If the capital structure of the permanent establishment does not comprehend any interest-bearing debt, (i) the balance sheet must be corrected, if only just for reporting purposes, by allocating a higher amount of free capital to the liabilities side and interest-bearing investments to the assets side of the same amount, whereas (ii) the cash flow statement must be corrected by bringing out the interest income which represents the consideration for the higher amount of funds available (i.e. the so called theoretical yield of the free capital gap).

According to the decision by the Italian tax authority, the adequate amount of free capital to be allocated has to be determined using one of the approaches mentioned in the OECD report, namely:

a) the capital allocation approach which seeks to allocate a portion of a company’s equity to a permanent establishment belonging to the same company;

b) thin capitalisation approach which seeks to allocate to the permanent establishment the same amount of free capital of an independent enterprise carrying on the same or similar activities under the same or similar conditions in Italy.

Alternatively, the quasi thin capitalisation approach may be used. This approach requires the PE to have at least the same amount of free capital required for regulatory purposes as it was an independent banking enterprise operating in Italy.

The quasi thin capitalisation approach is considered by the OECD as a safe harbour.