The “arm’s length range”: clarifications for a proper interpretation provided by the Italian Revenue Agency. Approaches and tools to be adopted during the audit

On May 24th 2022, the Italian Revenue Agency published Circular Letter n.16/E aimed at providing operational instructions on transfer pricing with respect to the ”arm's length interquartile range”.

With this Circular Letter, the Italian Revenue Agency provides operational instructions to the Offices on the interpretation of the "arm's length range principle", provided for by Article 6 of the Decree issued on May 14, 2018 (hereinafter “Decree”) when applying the provisions set forth in Article 110 (7), of the

Italian Tax Code, i.e. the provisions contained in the Double Tax Treaties entered into by Italy that comply with Art. 9 of the OECD Model Tax Convention.

The legislation defines as consistent with the arm's length principle the range of values resulting from the financial indicator selected in applying the most appropriate method, if these values are referable to a number of transactions carried out between two independent parties (non-controlled transactions), each of which is equally comparable to the controlled transaction. 

Article 3 of the Decree provides that a non-controlled transaction is deemed comparable to a controlled transaction if: 

(i) there are no significant differences that materially affect the financial indicator that can be used in applying the most appropriate method; or if, 

(ii) in the presence of the differences referred to in (i), comparability adjustments can be made that eliminate or significantly reduce the effects of those differences for the purposes of comparison.

These conditions constitute the essential element for the application of the “full range” and prefigure an optimal situation not always easy to achieve.

In view of the fact that, despite the efforts made to make transactions homogeneous, also by means of adjustments aimed at eliminating or narrowing differences in comparability, there may still be comparability flaws that cannot be identified or quantified and, therefore, adjusted, the possibility of using "statistical tools" is accepted. The purpose of such tools is to narrow the range of values by strengthening their reliability, especially when a significant number of transactions are involved. 

Whether one decides to adopt the 'full range' or to identify a narrower range based on statistical tools, all values contained within the range must be considered to comply with the arm's length principle.

Should the financial indicator fall within this range (either full or narrow range), no adjustment will be necessary. Conversely, should the financial indicator fall outside the range, the company will have to provide, in order to avoid corrections, appropriate documentation demonstrating the compliance of the indicator used with the arm's length principle. 

Should the company fail to provide any evidence, or should the evidence provided be inadequate, the tax administration will have to make an adjustment by identifying the point that most closely satisfies the arm's length principle within the range. In such cases, the Italian Revenue Agency recommends that the Offices provide evidence of the adjustments involving the identification of the point that most closely satisfies the arm's length range principle.

The Circular provides instructions on how to search for a possible point of contact between the taxpayer's position and that of the Tax Administration in the presence of non-overlapping arm's length intervals, suggesting that the financial indicator identified by the company should be set at the 'minimum' or 'maximum' value of the arm's length range that first intersects that identified by the tax auditors.

Worthy of note is the in-depth analysis of the approach to be taken with respect to 'extreme' values consisting of subjects that realise particularly high profits or losses. In these cases, the selection criterion should be oriented towards the assessment of the causes and thus to the facts and circumstances affecting the subject examined, without referring to financial results alone. 

Therefore, in addition to the inherent functional comparability of the entity, extraordinary situations affecting the parameters considered will also be analysed. A specific paragraph of the instructions issued to the Offices is devoted to the subject of loss-making transactions, which should not be rejected a priori, but assessed, again, on the basis of the specific facts and circumstances. 

Such transactions require investigation precisely because, in general terms, an independent company could not continue to operate without concrete expectations of generating profits. They should be excluded where the losses are not attributable to normal market conditions or do not reflect a level of risk other than that assumed by the examined company. 

In conclusion, Circular Letter16/E, from the Revenue Agency's perspective, should prefigure a scenario characterised by less discretion and the issuance of broader and deeper reasoning regarding the adjustments made.

From our point of view, i.e. professionals in  Transfer Pricing, this is a useful document to reflect once again on the approach adopted by each taxpayer in the definition of the value ranges and in the choice of its positioning, re-evaluating it or better circumstantiating it. 

Edited by Matteo Coppola and Kristian Bresciani

 

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