Debt and equity financing: the Italian rules

• Author: Fabio Marchetti - Federico Rasi
• Position: Associate Professor of Tax Law at LUISS G. Carli University - Ph.D. in Company Tax Law and lectures at LUISS G. Carli University
• Pages: 1-38

European Tax Studies 1/2010

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Debt and equity financing: the Italian rules

Fabio Marchetti and Federico Rasi1

1. Introduction.

The issue concerning the tax neutrality among the ways available to finance

a business (i.e. the use of debt financing instead of equity financing) is well

known to the Italian legislator that, as better described in the following

paragraphs, has more than once regulated the matter, albeit without finding

a fully satisfactory solution.

Based on economic literature2, a neutral, correct and efficient system is that

under which interest expenses (i.e. the debt financing cost) are deductible

for tax purposes in the hands of the company paying it and taxable for

individual income tax purposes in the hands of the recipient, whilst profits

(i.e. equity financing cost) are taxable in the hands of the entity paying

them, however such taxation qualifies only as a form of advance payment

of the personal income tax due by the shareholder on dividends (the

distribution of which is not deductible for the company paying them). Such

a system provides for a uniform tax treatment applicable to interest and

dividends, limiting the possible distortions in the choice of financing

mechanisms available for a business to the sole different tax treatment

applicable to retained profits, which are subject to the sole corporate

income tax until they are distributed to the shareholders.

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1 Prof. Fabio Marchetti is Associate Professor of Tax Law at LUISS G. Carli University; Dr.

Federico Rasi is a Ph.D. in Company Tax Law and lectures at LUISS G. Carli University.

Prof. Fabio Marchetti is responsible for paragraphs 3 and 4 (and the related sub-paragraphs).

Dr. Federico Rasi is responsible for paragraphs 1 and 2 (and the related sub-paragraphs).

2 S. Giannini, Gli interessi passivi nel quadro della tassazione societaria internazionale, in

Dial. trib., 2008, p. 14.

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European Tax Studies 1/2010

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Italy3 differs from such benchmark4.

Interest expenses, deductible for tax purposes in the hands of the company,

are subject to taxation through final withholdings at 20%5; profits, which

are not deductible for tax purposes in the hands of the company, are either

partially taxable in the hands of the recipient or subject to a substitutive

taxation regime so that their “aggregate” taxation (i.e. taxation in the

hands of both the company and the shareholder) now ranges between

35,8% and 43%. The above regime favours the use of debt financing and

thus the Italian legislator sets out from time to time different rules aimed at

limiting the thin capitalization of companies.

It can be immediately seen that the main action taken by the legislator in

order to fight the thin capitalization is that of limiting and conditioning the

deductibility of interest expense for corporate taxpayers. Conversely, the

tax treatment of recipients of the interest payments has not been amended

in any material way. The tax treatment of both dividends and interest in the

hands of their recipients (especially if individuals) follows its own rules that

aim at guaranteeing the tax neutrality among corporate financing

mechanisms, although in a rather indirect manner.

This paper shall first examine the provisions enacted by the Italian legislator

in order to contrast the thin capitalization of corporate entities and then the

provisions governing the tax treatment of dividends and interest in the

hands of their recipient. Please note that their analysis gives the impression

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3 In brief it is recalled that, as far as it may be of interest for the present purposes, resident

companies and commercial entities are subject to a proportional tax levied at 27,5% on the

worldwide income and named Corporate Income Tax (IRES). Resident individuals are subject

to a proportional and sliding scale personal income tax (IRPEF) levied on their worldwide

income levied at 23% (for income up to 15.000 euro), at 27% (above 15.000 euro and up to

28.000 euro), at 38% (above 28.000 euro and up to 55.000 euro), at 41% (above 55.000

euro and up to 75.000 euro), at 43% (above 75.000 euro). Moreover, economic (corporate

and self-employment) activities are subject to a Regional Tax on Productive Activities (IRAP)

levied at a base rate of 3,9% on a wide taxable basis (including personnel expenses and

interest expenses).

4 S. Giannini, Gli interessi passivi nel quadro della tassazione societaria internazionale,

quot., p. 15.

5 Such tax rate is that resulting after the amendments to the tax system made by the Law

Decree no. 138 of 13 August 2011, converted into Law no. 148 of 14 September 2011. Such

amendments replaced the existing tax rates applicable on income from capital and on capital

gains having a financial nature of either 12.5% or 27% with a flat tax rate levied at 20%.

Such flat rate applies on interest, premiums and any other proceed amounting to income

from capital, as well as on capital gains respectively becoming due or realized after 1st

January 2012; the flat rate applies to dividends and proceeds of a similar nature received

after 1st January 2012, irrespective of the date in which the distribution was resolved.

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European Tax Studies 1/2010

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that the Italian tax system is not neutral and leaves great possibilities of tax

arbitrage between debt or equity financing. As described in the following

paragraphs, the use of debt financing rather than contributions in cash is far

more tax effective for taxpayers.

2. The tax deductibility of interest expense in business income.

As already highlighted, the basic guideline followed by the Italian legislator

in order to reach a balance between the tax treatment of debt financing and

that of equity financing is that of limiting, either totally or at given

conditions, the reduction of interest expense for tax purposes. Such position

(or rather, such different positions adopted from time to time) affected the

amount of interest expenses which could be deducted, instead of affecting

the deduction right itself.

Under such perspective, indeed, the theoretical issue that arose (and which

was positively solved) is whether interest expense deductibility in business

income must first be examined in the light of the general principles

governing such category of income. Also such item of income should,

indeed, be subject to the criteria set out by art. 109 of the Income Tax Act

(hereinafter “ITA”), i.e. to (i) the accrual principle (taxation of interest in

the year in which it accrued), (ii) the prior accounting in the P&L and to (iii)

the inherence principle (inherence of interest expense to the business

carried out)6.

Whilst the applicability of the first two principles (accrual and prior

accounting in the P&L) is certain, doubts exists as to the applicability of the

inherence principle7. The Supreme Court, which examined the matter more

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6 L. ROSA., Il principio di inerenza, in Il reddito di impresa, G. Tabet (ed.), Padua, 1997, p.

138.

7 It is renown that such principle must be interpreted as granting relevance, for the

purposes of determining the business income, to costs that are connected with the activity

carried out by the entrepreneur or by the company. Also case law confirmed this

interpretation, please see: Supreme Court decision no. 10257 of 21 April 2008; Supreme

Court decision no. 16824 of 30 July 2007; Supreme Court decision no. 22034 of 13 October

2006; Supreme Court decision no. 19610 of 13 September 2006).

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