On May 24, the Italian Revenue Agency published a circular letter (n. 16/E of 24.05.20221) which provides important guidelines on the correct interpretation of the concept of “arm’s length range” for the purposes of applying the transfer pricing rules provided by the Italian income tax code (art. 110, para. 7) or double taxation treaties (when Article 9 of these treaties is in line with the OECD model convention). In accordance with these rules, transactions between associated enterprises must be determined in accordance with the conditions and at the prices which would have been agreed between independent parties.
A few days earlier, the Italian Supreme Court (judgment no. 15668 of 17.05.20222) provided clarification regarding the reliability of transfer pricing methods, attributing necessary relevance to the unique phases underlying the application of these methods. When analyzing the general transfer pricing principles, the Italian Revenue Agency and the Supreme Court recall the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
The “arm’s length range” is defined by the latter as “a range of acceptable figures for establishing whether the terms of a controlled transaction are consistent with the arm’s length principle and which result either from the application of the same transfer pricing method to several comparable data, or from the application of different transfer pricing methods”.
In accordance with national legislation (ministerial decree of 5.14.2018) implementing the general principles adopted at OECD level, a range of figures complies with the arm’s length principle when it is constituted by the financial indicators selected by applying the most appropriate method for each arm’s length transaction that is considered comparable to the controlled transaction. In particular, given a related party transaction and having identified the arm’s length range:
- if the financial indicator is within the range, the transaction complies with the arm’s length principle, provided that the figures refer to several uncontrolled transactions, each comparable to that of the scope;
- if the financial indicator is not within the arm’s length range, the tax administration makes an adjustment to bring the indicator back within the range, notwithstanding, on the one hand, the associated company’s right to present elements demonstrating that the controlled transaction complies with the arm’s length principle and, on the other hand, the power of the tax authorities to disregard such elements, provided that sufficient reasons are given;
In the context described, the Italian Revenue Agency – recalling §§ 3.55 – 3.66 of the OECD Guidelines – confirmed that:
a) application of the arm’s length principle produces a range of numbers that are all relatively equally reliable (from lowest to highest); differences in the numbers that make up the range may be caused by the fact that generally the application of the arm’s length principle produces only an approximation of the terms that would have been established between independent enterprises or by the application of prices different for comparable transactions;
(b) transactions between independent enterprises with a lesser degree of comparability must be eliminated from the arm’s length range;
(c) any remaining lack of comparability should be eliminated by – if the range includes a significant number of observations and by means of specific supporting arguments – (i) the use of “statistical tools” which take into account the central tendency to narrow the range (eg, the interquartile range), thereby improving the reliability of the analysis; (ii) application of more than one method; in this case, each range could be used to define an acceptable range of arm’s length figures or to reconsider the precision of the methods adopted;
d) a substantial difference between the points in the range could indicate that the data used to establish some of the points is unreliable, thus requiring further analysis of the comparables to be maintained or eliminated;
e) transactions or comparable companies making exceptionally high profits or losses impact the financial indicator used; therefore, further analysis is required (in this respect, according to the OECD guidelines, such companies should not be excluded solely on the basis of differences with other comparable companies; rather, one should check for deficiencies in significant comparability previously ignored) and should be excluded from the list of comparables when the results do not reflect normal trading conditions or reflect a level of risk not comparable to that assumed by the associated enterprise (thus defining the level of comparability on the basis different elements of financial data).
In the event that the tax authorities assert that the financial indicator is not within the arm’s length range, the associated enterprise must provide arguments (i.e. adequate documentation) demonstrating that the terms of the controlled transaction satisfy the arm’s length principle and the result is within arm’s length range. If the taxpayer does not provide such evidence, the tax administration will determine the point in the arm’s length range (possibly adjusted in the presence of differences in comparability) as follows:
- if the range includes results of relatively equal and high reliability, the financial indicator is adjusted by positioning the price at the lower or upper value of the range (cd. “full range”);
- otherwise, when a range of values has possibly been adjusted, the financial indicator is set at the 1st interquartile or the 3rd interquartile. If lack of comparability persists, the use of a central value within the interval (the median, the average, the weighted average etc., according to the specific characteristics of the data) although allowing the risk to be minimized error, is limited to cases where the range does not include figures with a sufficient degree of comparability; a specific motivation of the underlying reasons must be provided.
More importantly, the Italian Revenue Agency recognizes the validity of all figures in the range. Thus, in the presence of a complete range, the tax authorities will position the financial indicator identified by the company by considering the “lower” or “higher” arm’s length value which intersects with the first identified one. If instead statistical tools are used, figures within the restricted range can be used.
On the other hand, the reference to a central figure within the range must be expressly reasoned and limited to cases where the range does not contain sufficiently comparable figures.
The complexity of the analysis leading to the application of a reliable transfer pricing method is not limited to the definition of an arm’s length range. On the contrary, it assumes a series of steps recently set out by the Italian Supreme Court in judgment n. 15668. In the specific case examined by the Court, the transactional net margin method was applied.
The Supreme Court summarized the relevant steps as follows (i) choice of the tested party; (ii) determination of the financial results of the transaction; (iii) selection of the target period; (iv) identification of comparable entities; (v) accounting adjustments related to different accounting practices; (vi) assessment of any adjustments necessary to account for differences in terms of risks assumed or functions performed; (vii) selection of a reliable profit indicator.
It follows that in the event of a dispute between the tax administration and the taxpayer regarding the aforementioned process (in the case examined by the Supreme Court, the standards of comparability), the validity of the decision of the lower court is affected when the taxpayer’s claims are not properly assessed. A new examination on the merits of the controversy concerning the standards of comparability was therefore referred to the high court.
The guidelines issued by the Italian Revenue Agency and the Supreme Court undoubtedly represent an important step with regard to the proper application of transfer pricing principles.