Italian Revenue Agency expressed itself once again on the "arm's length principle"

After a brief regulatory digression focusing on the Italian transfer pricing regulation and the relevant OECD provisions, the Circular examines the concept of “arm’s length range”, already specified by Art.6 of the Decree of 14 May 2018, in application of the provisions set out in Article 110, paragraph 7, of the Italian Tax Code or the provisions contained in the Double Tax Treaties entered into by Italy in compliance with the OECD Model Convention.

The Circular first points out that following Article 6 of the Decree, the range of figures resulting from the financial indicator selected to apply the most appropriate method shall be considered at arm’s length where the figures reflect a number of uncontrolled transactions, each of which is equally comparable to the controlled transaction.

Therefore, a controlled transaction is deemed to have been carried out complying with the arm's length principle if the relevant financial indicator is within this range. In particular:

(i) if the analysis performed is reliable and all the identified transactions have the same degree of comparability with the controlled transaction, the full range of values resulting from the application of the selected financial indicator should be considered;

(ii) if the transactions do not have the same degree of comparability, it will be necessary to refer to the so-called “statistical tools” identified by the OECD Guidelines in order to narrow the range and strengthen its reliability.

In both cases, all values within the range must be considered compliant with the arm's length principle and, therefore, if the financial indicator falls within the range (full or narrow), no adjustment should be made. If, on the other hand, the financial indicator falls outside the arm's length range, the company must provide appropriate documentation to avoid the tax recovery. If such evidence is not provided or is unsatisfactory, it will be up to the Tax Administration to identify the “point” that most closely satisfies the arm's length principle within the range in order to make the tax recovery.

On this last aspect, the Circular provides two important clarifications:

• it is recommended, first and foremost, that adjustments involving the identification of the above-mentioned “point” be fully argued by the Tax Office;
• it is further stated that, for the purposes of this identification, the financial indicator used by the company must be placed on the "minimum" or "maximum" value of the arm's length range that first meets the one identified by the Administration.

This last clarification, which is also supported by numerical examples, is particularly relevant since Art. 6 of the 2018 Decree merely “overcame” the concept of adjustment to the median value, opening up the use of a range of values for the assessment of compliance with the arm's length principle, without providing any further guidance as to what the most correct positioning within such range should be.

Today the use of a central value (such as the median), in the case of a range “narrowed” through statistical tools, must be specifically justified by the Tax Administration and is, in any case, limited to situations where there is a total absence of comparable and reliable values.

Analysis

The Circular under review certainly contributes to increasing the effectiveness of transfer pricing documentation in dealings with the tax authorities, bringing greater certainty to the definition of an arm’s length range and incorporating further concepts already expressed in the past by the OECD in its Transfer Pricing Guidelines.

These latest clarifications provided by the Italian Revenue Agency highlight how complex transfer pricing issues are, for both taxpayers and tax authorities, and how they often require particularly technical and precise assessments.

The importance of a full understanding of these issues was also recently highlighted by an important ruling of the Court of Cassation (Judgment No. 15668 of 17 May 2022), which emphasised the centrality of the comparability analysis in the application of transactional profit methods (in this case, the TNMM, one of the most widely used methods) for verifying the arm's length nature of intra-group transactions.

In particular, the Court - which upheld the taxpayer's appeal on this point - clarified that “the reliability of the TNMM method presupposes the following steps: selection of the tested party for the analysis, determination of the financial results of the controlled transactions, selection of the period of investigation, identification of the comparable companies, accounting adjustments to the financial statements and adjustments necessary to take account of different accounting practices, adjustments to take account of differences in functions and selection of the PLI". Based on this principle, the Court concluded that the taxpayer's failure to address its complaints had, in fact, undermined the reliability of the method applied.

The ruling is particularly relevant as it establishes the need for a thorough and precise assessment of transfer pricing issues, which are increasingly the subject of disputes between taxpayers and tax authorities.