Narrow base companies: a step backwards?

In its judgment no. 2752 of 2024, published on 30 January 2024, the Supreme Court once again ruled on the issue of assessment notices sent to shareholders of narrow-based companies. In this respect, the Court, recalling a legal precedent from the year 2020, confirmed the principle according to which tax benefit of partial exemption of corporate profits, provided for in Article 47 of the Italian Income Tax Code (TUIR), should not be applied in the case of narrow-based companies.

The case

The Italian Tax Police of Chiari (ITP) carried out a fiscal audit of Luma Plastic Srl, which resulted in two tax assessment for the financial years 2003 and 2004, relating to VAT and income tax. Due to the narrow shareholder base, Italian Tax Office (ITO) has presumed the distribution of hidden profits and applied the tax recovery also against partner L.L. 

The taxpayer has filed separate appeals mainly challenging:
•    the unlawfulness of the tax assessment, since there was no basis for assuming the distribution of the company’s increased profits to the shareholders;

•    the unlawful imputation to the taxpayer of the entire amount of the hidden profits, assessed in proportion to the shareholding in the share capital (95% and 100% respectively), without complying with the percentage limit (40%) provided for in Article 47 of the of the Italian Income Tax Act (TUIR).

The legality of the contested acts was confirmed both at first and second instance. Consequently, the taxpayer lodged an appeal in cassation.

The taxpayer claimed violation and misapplication of Article 38 of the Italian Presidential Decree No 600/1973, Articles 115 and 116 of the Italian Code of Civil Procedure and Articles 2697, 2727 and 2729 of the Italian Civil Code. In particular, the taxpayer challenged the pro-rata attribution of the company's additional income to the shareholders, because the narrow shareholder base alone, in the absence of other reliable evidence, is not sufficient to prove the actual distribution among the shareholders of the increased profits recorded in the company’s name.

In a separate ground of appeal, he challenged the judgment because the second-instance court had not explained on what assumptions those profits could be considered effectively allocated to the shareholder.

The taxpayer also challenged the attribution to the shareholder of the increased undeclared profits taxed to the company in proportion to the shareholding, without taking into account the 40% limit provided for in Article 47 of the of the Italian Income Tax Act (TUIR).

The judgment

The Supreme Court rejected the taxpayer's appeal, considering in the first place that the assumption of attribution to the shareholders of the extra-accounting profits is not contrary to the prohibition of second-degree presumption, since the known fact is not the existence of a higher income assessed against the company, but rather the limited company structure, which implies a bond of solidarity and mutual control of the shareholders in the management of the company". Therefore, once this presumption is deemed to be operating, 'it is up to the taxpayer to provide proof to the contrary.

Regarding the application of the 40% limit, the Supreme Court confirmed that in the case of a narrow base company, this limit should not be applied because the off-balance sheet profits were obtained by tax evasion, as they were never reported in the company's accounts. In essence, there would be no double taxation as the company had never declared them.

In this regard, the Supreme Court stated that the company was transparent as a partnership, with the consequence that the distribution of the increased tax evaded profit justifies the loss of the benefit of Article 47 of the TUIR, a provision that applies only to the accounting profit. 

It is therefore possible to conclude that failure to declare such income would legitimise double taxation, with the same economic substance being taxed first in the hands of the company and then in the hands of the shareholders.

However, it should be noted that article 163 of the TUIR, in establishing the prohibition of double taxation, both legal and economic, does not make its effectiveness conditional on the prior declaration of the income, but rather establishes a general and immanent principle about income tax. This principle has no limits and is confirmed by the double taxation treaties signed by the Italian State with many foreign countries. The prohibition of double taxation therefore applies to all income, both that which is subject to declaration and that which is subject to assessment by the tax authorities.

From another point of view, if one were to equate off-balance-sheet profits with those of partnerships, with the latter being taxed 'in full' in the hands of the partners, then it cannot be ignored that the same 'transparent' companies are not taxed at all, and it must therefore be concluded that the current income taxation system does not provide for the possibility of the same income being taxed in full twice: in the hands of the company and then in the hands of the partners.

Then there is the 'practical effect' of taxing the same income first in the hands of the company and then in full in the hands of the shareholders: the latter would be nullified, meaning that almost all of their economic substance would be transformed into a debt to the tax authorities.