Budget Law 2017 (in force from Jan. 1, 2017), has introduced a special forfait tax regime for individuals who transfer their tax residence to Italy. In a nutshell, the regime provides for the payment of a substitute tax of 100,000 euro per year in lieu of ordinary taxation on (almost) all foreign source income and assets.
In order to be eligible for the regime, an individual must move his tax residence to Italy without having been resident therein for the previous nine out of 10 years. There is no limitation based on citizenship so that the regime is available also for Italian citizens. For income tax purposes, an individual is considered resident in Italy if at least one of the following conditions is fulfilled for most part of the year: (i) registration with the Italian Official Register of the resident population; or (ii) habitual abode in Italy (i.e. residence according to the Italian civil code); or (iii) center of one’s main business and interests in Italy (i.e. domicile according to the civil code).
The regime is available for a maximum of 15 years. During the period of validity, no income tax, wealth tax and inheritance tax would be due on foreign assets and income (Italian source income remains subject to ordinary taxation). Differently from the (very similar) U.K. resident but not domiciled regime, income tax remains not due even if the income is remitted to Italy, so there is no limitation on bringing one’s income to Italy as long as it is foreign sourced, according to Italia law. Moreover, reporting obligations do not apply on such foreign assets and income, so that the regime can be considered appealing also from a privacy perspective .
There are two exceptions to the general rule whereby the forfait tax covers all obligations. The first is that capital gains on substantial shareholdings realized in the first five years of effect of the option are excluded from the scope of the substitute tax and are subject to income tax under general rules. The rationale behind this is to avoid so called “tax holidays” whereby the transfer of residence is exclusively finalized (and limited) to the realization of latent capital gains. In other words, one must reside in Italy at least six years under this optional regime in order to avoid ordinary taxation on such capital gains.
The second exception is optional. The individual can opt for all income and gains sourced in one or more states to be subject to income tax under ordinary rules. The rationale behind this exclusion is to permit the application of certain double taxation conventions which would otherwise not be applicable due to the forfeit regime (see below).
The regime can be extended also to one or more qualifying family members, provided that they also fulfill the nine out of 10 years non-residence condition, against the payment of a further annual tax of 25,000 euro (rather than 100,000 Euro) per each family member benefiting from the regime. If the individual subject to the 100,000 euro substitute tax revokes the option, the substitute tax regime automatically ceases to apply also to the qualifying family members. However, in such cases, the qualifying family member is entitled to exercise an autonomous option by paying the 100,000 euro tax with effects for the remaining tax years up to a total of 15 years. On the other hand, the extension of the substitute tax regime to qualifying family members can be revoked without affecting the application of the substitute tax regime to the main applicant.
The regime, which is in force as of January 2017, is proving very appealing for individuals whose income is exclusively or mostly sourced outside of Italy, and already quite a large number of applicants have come forward.
The issue raises the question of whether double taxation conventions on income and capital based on the OECD Model concluded by Italy will be applicable to individuals who will be resident in Italy under the flat tax regime. The issue is relevant mainly in two cases: (i) claim of residence by both contracting states (double residence) ; and (ii) application of the so-called allocation rules by the source state.
Article 1 of double taxation conventions provides that the Convention applies to persons who are resident of one or both of the contracting states. According to Article 4, paragraph 1, the term resident “means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence” or similar criterion and that “the term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.” Prima facie, based on the wording of this provision, one would conclude that the treaty is not applicable to Italian residents under the flat regime, since one could argue that the flat tax is not an analytical tax on foreign items of income so that the condition of Article 4 of being liable to tax is not met. The issue is not completely new to international tax practitioners, since other countries have either territorial taxation (Hong Kong) or alternative tax regimes for foreign income (U.K., Switzerland, Portugal). The scope of this article does not allow an in-depth analysis of this technical issue, but the main arguments and conclusions can nonetheless be summarized.
There are a number of elements that would lead to conclude that the treaty remains applicable. First, there are indications within the OECD Commentary to the Model that suggest that the intention of that provision is not to exclude the application of the treaty to individuals who are resident under forfait regimes. Paragraph 8.3 of the commentary, indeed, expressly states that that sentence is “clearly not intended” to exclude from the scope of the Convention residents of countries adopting a territorial principle of taxation. A territorial system of taxation occurs when one country taxes its own resident only on income sourced therein with the exclusion of foreign income. As a consequence, one should conclude that DTCs are a fortiori applicable if, as in the case of Italy, foreign income is subject to a substitute form of taxation, albeit flat. Another indication is given by paragraph 26.1 of the Commentary to Article 1 which – under the section on remittance based taxation (e.g., U.K. system) – affirms that contracting states wishing to restrict the application of the Convention to income that is effectively taxed in the hands of those persons may do so, adding a specific provision to the Convention, thus suggesting that treaties not departing from the OECD Model do remain applicable also to persons who are resident under these specific type of regimes.
Moving to treaty practice, the conclusions do not seem to differ. Many countries that have wished to expressly specify that the treaty was not applicable to persons who were resident under forfait regimes have specified so in an ad hoc provision, thus suggesting that the standard wording of the Model did not suffice to this purpose. Similarly, other treaties – without departing from the wording of the Model – contain interpretative clarifications in their Protocols to clarify that the last sentence of Art. 4, paragraph 1, “does not preclude a person from being treated as a resident of a contracting party by reason of a territorial source principle.” Others (especially with the U.K.) contain (in line with para. 26.1 of the Commentary to Art. 1 discussed above) clauses specifying that treaty relief is granted only to so much of the income taxed/remitted in the other state. There are nonetheless some treaties concluded by countries that have a similar system (Switzerland and Portugal) that may cast some doubts on the interpretation of that provision, namely those that (though subsequent to 1977) do not contain the second sentence of Art. 4, paragraph 1, thus suggesting the argument that treaty application would have otherwise been precluded (although one can argue that the sentence was deleted only for the avoidance of doubts).
Finally, the Italian tax authorities have expressly taken the view that Italy will regard persons who are resident under this regime as resident for treaty purposes due to the fact that foreign income is taxed with the 100,000 euro. Though important, treaty application is a bilateral exercise and much is left to the other countries, especially the source country who must apply relief clauses (exclusive taxation in the country of residence or reduced withholding taxes). And it is within this very context that the above-mentioned provision of the new regime, whereby one person may elect to subject to ordinary taxation items of income sourced in one or more specific countries (see above), could prove useful for those countries that will take the view that the second sentence of Art. 4, paragraph 1 restricts treaty application.