Italian Supreme Court Ruling on Transfer Pricing: Inclusion of Loss-Making Entities in Comparability Analyses

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Ruling Information

• Court: Italian Supreme Court (Corte Suprema di Cassazione)
• Ruling Date: 12 August 2024

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In August 2024, the Italian Supreme Court issued a landmark ruling on transfer pricing that requires the inclusion of loss-making entities in comparability analyses. This decision underscores the importance of a comprehensive approach to transfer pricing, aligning with the OECD Transfer Pricing Guidelines. The ruling responded to a case where the Italian tax authorities had excluded certain companies from a benchmarking analysis solely because they had incurred losses. The Supreme Court criticized this practice as overly simplistic and contrary to international best practices.

Key Points of the Ruling

Background

The case involved an Italian company that provided services to a subsidiary in the Netherlands. The company applied a 5% markup based on a comparability analysis, which the Italian tax authorities later reassessed to 7.42%. The reassessment excluded entities that had losses in two out of three fiscal years, a decision that the company challenged in court.

Core Dispute

The primary dispute was whether companies experiencing losses or lower profit levels should be automatically excluded from transfer pricing comparability analyses. The Italian tax authorities argued for exclusion, while the company contended that such exclusion was unwarranted and contrary to the OECD Transfer Pricing Guidelines.

Court Findings

The Supreme Court determined that it is improper to exclude potential comparables solely because they have incurred losses or reported lower profit levels in certain years. The Court stressed that in a competitive market, it is common for some companies to experience losses or lack specific accounting data. These circumstances should not automatically disqualify these entities from being included in comparability analyses.

Referring to the 2022 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, the Court highlighted that these guidelines encourage the consideration of entities’ business strategies. The guidelines specifically recognize that companies might temporarily reduce prices or incur higher costs to gain market entry or increase their market share, which could result in lower profit margins. As such, these entities should not be automatically excluded from comparability studies.

Additionally, the Supreme Court pointed out that the OECD Guidelines suggest that only in specific cases—such as with start-ups or companies in bankruptcy—should entities be excluded from comparability if they are clearly not appropriate comparables. The Court criticized the Regional Tax Court of Lombardia for not comprehensively analysing the excluded comparables.

Outcome

The Court ruled in favour of the taxpayer, invalidating the tax authority’s reassessment. The ruling mandates a holistic approach to comparability analysis, which includes entities with temporary losses or lower profit margins, as long as they are otherwise comparable.

Transfer Pricing Method Used

The case primarily revolved around the Comparable Uncontrolled Price (CUP) method, where the tax authorities recalculated the markup by excluding loss-making entities.

Major Issues or Areas of Contention

The key issue was whether loss-making entities could be considered comparables in a transfer pricing analysis. The controversy stemmed from the tax authorities’ decision to exclude these entities, arguing that they skewed the results. Following OECD guidelines, the Supreme Court’s decision to include them was seen as a reaffirmation of international best practices.

Expected or Controversial Decision?

This decision was somewhat expected, given the increasing alignment of Italian courts with OECD standards. However, it was still significant because it challenged the practices of the Italian tax authorities, which had routinely excluded loss-making entities from analyses.

Significance for Multinationals

This ruling is highly significant for multinational enterprises (MNEs). It clarifies that MNEs operating in Italy must ensure that their transfer pricing documentation includes a comprehensive comparability analysis that considers all relevant entities, including loss-making ones. This approach aligns with global standards and reduces the risk of tax adjustments by authorities.

Significance for Revenue Services

The ruling imposes a stricter standard on the selection of comparables for revenue services. Tax authorities must now ensure that their assessments are based on a nuanced analysis that considers all potential comparables rather than relying on exclusionary criteria that could lead to incorrect conclusions.

Importance of Engaging Transfer Pricing Experts

This case underscores the critical need for MNEs to engage with transfer pricing experts. Such experts can help navigate complex international guidelines, ensuring that documentation and comparability analyses are robust and defensible in court. Engaging experts early can prevent disputes and ensure compliance with global standards.

Preventative Measures: Implementing Proper Tax Risk Management

To avoid similar disputes, MNEs should implement a robust tax risk management process. This includes establishing a tax steering committee* that regularly reviews transfer pricing policies, ensuring they are in line with the latest legal developments and international guidelines. This proactive approach can help identify potential issues before they escalate into legal disputes.

*Click here to download our exclusive (FREE) eBook: “The Essential Role of a Tax Steering Committee.”