The Italian Revenue Agency (IRA) issued guidelines on LBO/MLBO transactions that: 1) Recognize the deductibility of interest expense on financing used to acquire stakes in target companies. 2) Clarify that transfer pricing rules do not apply to financing obtained from third parties. 3) Acknowledge that MLBO transactions can have valid business purposes beyond tax avoidance if properly structured. 4) State that limitations on carrying forward losses/interest after a merger can be avoided by requesting a ruling from the IRA.

1. 11 April 2016
The Italian Revenue Agency’s
guidelines for LBO/MLBO
transactions

2. 2
Introduction
On 30 March 2016 the Italian Revenue Agency («IRA») issued a comprehensive circular letter
(«Circular») whereby it officially states for the first time its position on merger leveraged buy-out
transactions as well as on several aspects connected thereto, agreeing on the positions of the
industry on the main issues of the above transactions but deviating from the above positions on
some issues of detail.
In particular, the Circular examines the following matters:
a) Deductibility of interest expense;
b) Transfer pricing recharges;
c) Tax avoidance aspects of LBO/MLBO transactions;
d) Carry forward of tax losses and interest expense after merger;
e) Tax treatment of fees charged to SPV/Target;
f) Shareholder loans;
g) Withholding taxes on financing fronting structures;
h) Taxation on exit.

3. 3
Deductibility of interest expense
In the Circular the IRA recognises the tax deductibility of interest expense incurred on the
financing obtained by a special purposes vehicle («SPV») in order to acquire a stake in the share
capital of a Target company in either an MLBO transaction or an LBO followed by a tax
consolidation.
As a consequence the previous approach, which in the past brought various local tax offices to
deem the interest expense on the acquisition finance as not deductible at all, has now been
abandoned.
Therefore, such interest expense is now deductible for corporate income tax purposes according
to the ordinary interest barrier rule (30% of Ebitda as adjusted) but save for what hereinafter
indicated in relation to the shareholder loan.
In the Circular, the local tax offices are asked to change their position in accordance with the
IRA’s current guidelines.

4. 4
Transfer pricing recharges
In the Circular, the IRA clarifies that the transfer pricing rules do not apply when the Italian SPV
controlled by a foreign shareholder has obtained from third parties the financing to acquire the
stake in Target and has pledged such stake in favour of the lender.
Therefore, the previous approach - which has brought various local tax offices to deem the
Italian SPV as a provider of services in the interest of the foreign parent, which should have paid
to the same SPV a fee substantially equal to the amount of the interest expense due by the latter
to the banks - has been abandoned. According to the above-mentioned approach held by the
local tax offices in the past, such a fee should have been seen as a remuneration for the
acquisition finance raising activity carried out by the SPV in the interest of the parent (e.g. on the
investment fund).
Also with reference to this issue, in the Circular the local tax offices are asked to change their
practice in light of the IRA’s current guidelines.

5. 5
Tax avoidance aspects of the LBO/MLBO transactions
In the Circular, IRA points out that sometimes the LBO/MLBO transactions have been considered
as schemes designed to avoid taxes. Specifically, it has been deemed that such transactions, even
if lawfully structured, had the exclusive purpose (otherwise not achievable) of deducting interest
expense and carrying forward losses from the taxable income of Target.
The IRA now acknowledges that the merger is the natural and normal final step of an MLBO
transaction; it recognises that the structure of this kind of transaction meets different business
purposes other than the tax ones and it is often required by the lenders, and thus it could not be
carried out merely to obtain undue tax benefits. In such a context, the merger cannot be
generally deemed abusive because of the tax benefit arising from the deduction of interest
expense in the hands of Target.
Even in this case, in the Circular the local tax offices are asked to change their practice in light of
the IRA’s current guidelines.
A tax avoidance challenge remains possible when an MLBO transaction has been carried out with
the involvement of the same shareholders who, directly or indirectly, already controlled Target
(re-leveraged buy-out).

6. 6
Carry forward of tax losses and interest expense after the merger
The Circular acknowledges that in the MLBO transactions the limitations on the carry forward of
tax losses and interest expenses after the merger (the so called «vitality test» and «equity test»)
cannot be easily satisfied by the SPV. However, by submitting a specific ruling request to IRA
(istanza di interpello) it is possible to claim that these limitations are not applicable.
The IRA clarifies that such a ruling request must be approved when the taxpayer has properly
demonstrated that the interest expense and the tax losses which are asked to be carried forward
after the completion of the merger arise from the MLBO transaction.

7. 7
Tax treatment of fees charged to SPV/Target
In the Circular, the local tax offices are asked to scrutiny the deductibility of the fees (equity fee,
transaction fee, monitoring fee, etc.) charged to the SPV by the investment fund or by entities
affiliated to the latter.
In particular, it has been clarified that those fees paid for services provided in the interest of the
investment fund and/or the fund’s investors rather than for the benefit of the SPV/Target are not
deductible. The Circular provides a non-exhaustive list of criteria to test whether these fees
reflect services beneficial to the investment fund and/or the fund’s investors.
On the other hand, as far as the services provided for the actual benefit of the SPV/Target are
concerned, if such services have been provided by a foreign investment fund the competent local
tax office has to scrutiny whether the amount charged to the SPV is compliant with the arm’s
lenght principle and the transfer pricing rules.
With respect to VAT, the Circular states that VAT paid by the SPV on services rendered by
consultants for the acquisition of Target is not recoverable by the SPV even after the merger with
Target.
Moreover, VAT on the fees charged by the investment fund or another entity is not recoverable in
the hands of SPV/Target if such fees are related to services rendered in the interest of the
investors.

8. 8
Shareholder loans
In the Circular, IRA invites the local tax offices to consider the possibility to re-characterize the
shareholder loan granted to the SPV by its foreign shareholders as equity by applying the OECD
guidelines on transfer pricing, according to which the loan should be deemed an equity
contribution if «taking into account the economic situation of the borrower, the investment
should not have been carried out under such form».
According to the Circular, the re-characterization of the shareholder loan as equity contribution
according to the substance-over-form approach is possible when:
 The shareholder loan has been granted by using financial sources provided by the investors in
the fund;
 The repayment of principal and interest of the shareholder loan is subordinated to the full
reimbursement of all the financing granted by the banks;
 In determining the covenants of the senior loan agreements entered into with the banks, the
shareholder loan is treated as equity and the interest due on the shareholder loan are not
taken into account;
 The repayment of principal and interest of the shareholder loan is subject to the same
contractual restrictions of those applicable for the distribution of dividends.
If the competent local tax office re-characterizes the shareholder loan as an equity contribution,
the interest expense are not deductible in the hands of the borrower and are treated as
dividends for withholding tax purposes.

9. 9
Withholding taxes on financing fronting structures
In the Circular, the IRA acknowledges that in LBO transactions a portion - sometimes a remarkable
amount - of the financing is taken on the foreign market, and the loan is often syndicated through
a fronting structure. According to such structure, an Italian-based bank acts as fronting lender
after having acquired the relevant financial support from foreign providers (such as banks, credit
funds, financial intermediaries, etc.), which substantially take the lending risk (so called Italian
Bank Lender of Record - IBLOR scheme).
Since the lending risk is not born by the Italian fronting bank but rather by the entities which
provide the financial support (CSP – Credit Support Providers), according to IRA such a fronting
loan should be subject to the same tax treatment which would have been applied to a
corresponding loan directly granted by the foreign entities without the Italian bank
intermediating role. As a consequence, the withholding tax applicable to each CSP or the possible
withholding tax exemption applicable to medium-long term credit facilities granted by banks, EU
insurance companies and whitelisted institutional investors subject to regulatory supervision in
their country of establishment, shall apply as the case may be.
Furthermore, the IRA clarifies that such a withholding tax exemption shall apply also in the case in
which the loan is granted to the Italian SPV by its foreign shareholder after that the latter has
been provided with the financial support by one of the above-mentioned entities (according to a
back-to-back financing arrangement).

10. 10
Taxation on exit (1/2)
In the Circular, the local tax offices are asked to scrutiny the applicability of the tax benefits
applied on exit from an investment when such benefits are ensured by the interposition of a
holding company based in a whitelisted country (such as Luxembourg) between the investment
fund and the Italian Target company. According to the Circular, if the intermediate holding
company does not have adequate economic substance, so being deemed to be a «conduit
company», and its existence cannot be justified by material non-tax reasons, all the tax benefits
ensured by its interposition – such as the tax exemption on the capital gain provided for by tax
treaties (if Target is sold directly by the foreign holding company) or the exempt or reduced
withholding tax applicable on dividends distribuited to the foreign holding company (if Target is
sold by an Italian holding company) – have to be denied.
Therefore, further to the denial of the above-mentioned tax benefits, the domestic taxation
which would have been applied if the investment fund directly had realised the capital gain (i.e.,
an effective taxation of 13.67% for qualified stakes and 26% for non-qualified stakes), or if the
dividends had been directly distribuited to it (at 26% rate), shall apply. If the investment fund is
tax transparent in its own country of incorporation, then each of its investors may request the
applicability of the tax treaty in force between the respective country of residence and Italy.

11. 11
Taxation on exit (2/2)
According to the Circular, the foreign intermediate holding company is deemed not to have
adequate economic substance when one of the following situation is verified:
 It has a «light» organizational structure (such as, when it is domiciled at a professional
firm office), without a real own running activity and an actual consistency, and it does not
take decisions on its own (e.g. when the management plan relating to the investment is
predetermined and the foreign holding company just ratifies the decisions taken
elsewhere);
 It has a «pass-through» financial structure, where contractual and economic terms of
sources and uses are almost mirrored.

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