Italy: The new Controlled Foreign Companies (CFC) regime - Simplifications and coordination with Pillar 2

published on 8 March 2024 | reading time approx. 4 minutes

After the enactment of Legislative Decree no. 209 of 27 December 2023 ("Decree"), which implements the general principles of international tax law, the criteria for determining income subject to taxation in Italy have been revised. This revision includes the simplification of the Controlled Foreign Companies (CFC) regime and aims for greater coordination with the domestic provisions implementing Directive 2022/2523 on the "global minimum tax".

Article 167 of the TUIR establishes that income generated by a foreign entity (company, entity or permanent establishment) must be imputed to the Italian entity 'based on transparency', even if no actual distribution has occurred, where the following conditions are jointly met:

there is direct or indirect control, as defined in Article 2359 of the Civil Code, or more than 50 per cent of the profits are held directly or indirectly through one or more subsidiaries, as defined in Article 2359 of the Civil Code;
the foreign company is subject to an effective tax rate of less than 15 per cent, based on the financial statements of the foreign subsidiary. The financial statements must be audited or certified. If this condition is not met or the financial statements are not certified, the foreign company is subject to an effective tax rate of less than half of what it would have been if it were an Italian resident;
the foreign company owns more than one-third of the passive income that has been realized.

It is important to remember that, as stated in Article 167, paragraph 5 of the TUIR, the CFC regime can be disregarded (also known as the 'exemption') even if all the requirements for an entity to be classified as such are jointly met, if the taxpayer can prove that the non-resident subsidiary conducts genuine economic activity, using personnel, equipment, assets and premises.

Regarding the amendments made by the Decree, the calculation of the effective tax rate is considerably simplified compared to the previous rules. In practice, the new article classifies foreign entities as residents of a privileged tax country if they are subject to effective taxation of less than 15 per cent. This is based on the ratio between the sum of current taxes and deferred tax assets and liabilities entered in the subsidiary's financial statements and pre-tax profit.

However, this simplified criterion only applies when the financial statements of the foreign-controlled entity are audited and certified by licensed professionals in the foreign state.

This simplification avoids the complex calculation of the 'virtual' domestic taxation of the foreign entity according to Italian tax rules and the subsequent comparison with the actual level of foreign taxation, provided that the aforementioned conditions are met.

In order to promote coordination between the new CFC rules and the 'Pillar 2' rules, paragraph 4-bis has been added to the revised wording of Article 167. This paragraph states that, when verifying the actual taxation of a foreign entity, the equivalent domestic minimum tax (referred to as the 'QDMTT') that may have been paid by the foreign entity in accordance with the local implementing regulations of the 'global minimum tax' must also be considered.

Lastly, Article 167 of the TUIR now includes paragraphs 4-ter and 4-quater. These paragraphs allow controlling entities to pay a substitute income tax of 15 per cent of the net accounting profit for the year, without factoring in taxes that contributed to determining that value, write-down of assets, and provisions for risks. This option is available to non-resident controlled entities as an alternative to calculating the level of effective taxation. The substitute income tax rate is consistent with the 'threshold rate' provided by the 'Pillar 2' rules.

This is an optional regime that provides various simplifications through the payment of a substitute tax. By paying the substitute tax, one is exempt from determining the effective taxation of the foreign controlled entity, both in terms of the tax base and the tax rate. Furthermore, this option would prevent the foreign subsidiary's income from being imputed based on transparency, without requiring verification or demonstration of the actual economic activity. It is unclear whether taxes paid by the non-resident subsidiary abroad can be used as a tax credit.

The substitute tax option is irrevocable for three years and tacitly renewable. Additionally, it follows the 'all in/all out' rule, meaning that the optional regime applies to all CFCs that earn passive income for at least one-third of their total income, thus avoiding cherry-picking.

It is important to consider the CFC regime that applies to foreign entities, as well as the economic benefits of using the substitute tax, in conjunction with the rules set out in Articles 89 and 47 bis of the TUIR. These rules concern dividends from entities that are resident or located in states or territories with a privileged tax regime.