Italian Tax Issues in Consensual Debt Restructurings*

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1 Vittorio Salvadori is a Partner in the Milan office of Freshfields Bruckhaus Deringer LLP. He can be contacted at vittorio.salvadori@freshfields.com. Roberto Egori is a Senior Associate in the Milan office of Freshfields Bruckhaus Deringer LLP. He can be contacted at roberto.egori@freshfields.com V. Salvadori and R. Egori Volume 10 Issue Italian Tax Issues in Consensual Debt Restructurings* By Vittorio Salvadori di Wiesenhoff and Roberto Egori Vittorio Salvadori di Wiesenhoff and Roberto Egori review the income tax treatment usually applied to consensual debt restructurings in Italy. In some circumstances, those transactions could imply the recognition of gains in the income statement of the borrower, which could trigger potential tax consequences. 1. Introduction In simple situations, debt restructurings are generally negotiated and agreed on a pure consensual basis between the debtor and its creditors. When companies are in more serious operational and financial difficulties, agreement with creditors is often reached in the context of certain light debt restructuring procedures governed by Royal Decree no. 267 of March 16, 1942, as subsequently amended (the Italian Bankruptcy Law, or IBL). The two most important procedures in that respect are the debt restructuring agreement ( accordo di ristrutturazione dei debiti ) governed by Article 182-bis of the IBL and the certified restructuring plan ( piano attestato di risanamento ) governed by Article 67(3)(d) of the IBL. Such procedures emphasise the freedom of the parties to negotiate the agreement, and the role of the Bankruptcy Court is limited. If no consensual agreement is found, even under the above mentioned light judicial procedures, the companies in distress may undergo other forms of judicial restructuring procedures, in which the freedom of debtor and creditors to contract the restructuring is limited, and subject to the influential role of the Bankruptcy Court. This article addresses the main accounting and Italian income tax consequences of consensual debt restructurings for corporate debtors (i.e., debtors other than banks, insurance companies and other financial intermediaries), even in the context of the light judicial procedures mentioned. The implications of such transactions from the perspective of the credi- Before the financial crisis, a large number of Italian corporations, including subsidiaries of foreign multinational groups or private equity houses, had incurred massive amounts of debt to carry out acquisitions of assets in Italy. These e leveraged era issuers are now suffering the combined deffects of the economic downturn and the credit crunch: declining earnings, fallen asset values, and inability to raise further capital or to refinance existing debt. In addition, many of them are also facing the nearing maturity of their debt obligations. As a result, corporations are frequently compelled to try to restructure their debt positions. A consensual corporate debt restructuring normally occurs when a company is suffering a financial and/or operational crisis and, as a consequence, is no longer able to meet its obligations towards creditors. In such a case, that company looks for ways to reach agreements with its creditors, spreading out its obligations with smaller repayment amounts and a longer time within which to pay off its obligations. If an agreement is reached with its creditors, and in particular its lenders, a consensual corporate debt restructuring takes place. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 9

2 Italian Tax Issues in Consensual Debt Restructurings tors, as well as the relevant indirect tax treatment, are outside the scope of this article. 2. Debt Restructuring in General 2.1 General Italian Tax Law Principles Applicable to Italian Corporates Italian companies are normally liable to both corporate income tax (IRES, currently levied at the rate of 27.5 percent, subject to possible industry-based surcharges) 1 and regional tax (IRAP, currently levied at the base rate of 3.9 percent, subject to possible regional and industry based surcharges). IRES and IRAP are governed by different law provisions and, as a result, are levied on different tax bases. Under the Italian Income Tax Code (IITC), 2 the IRES taxable income of an Italian corporate is determined starting from the (pre-tax) accounting profit (or loss) as shown in its separate income statements, to be adjusted in light of a number of specific tax provisions. As a result, the IRES taxable income is dependent upon accounting; this is even more true for adopters of the International Accounting Standards and International Financial Reporting Standards (the IAS/ IFRS). 3 The dependency of the tax base on accounting book ok income is even closer with respect to IRAP. When addressing the tax treatment for an Italian corporation of a given transaction, it is therefore crucial to investigate the relevant accounting treatment as discussed in paragraph 2.4 below. The IRAP taxable income of an Italian corporation corresponds, in broad terms, to EBITDA (with some limited adjustments required), which does not in principle include financial items of income and extraordinary items of income. Accordingly, consensual debt restructuring transactions do not normally imply material IRAP consequences for a corporate debtor. In the following paragraphs, we will therefore only focus on the Italian corporate income tax aspects of such transactions. 2.2 What Is Debt for Tax Purposes? Generally speaking, funding that is provided in the form of a debt instrument from a civil law perspective is considered debt from a tax perspective, except in specific circumstances. These specific circumstances normally affect corporate bonds, other securitised debt instruments and other specific agreements ( associazione in partecipazione and cointeressenza ), should the relevant remuneration fully or partially imply a participation in the profit/loss realised by the relevant issuer. 4 Certain issues may also arise in related-party situations, in which an independent party would not have entered into the same debt instrument under the same circumstances. In these specific circumstances, a debt instrument may be wholly or partially re-characterised for tax purposes as equity. This would lead to the full or partial denial of interest deduction for the debtor. Moreover, some specific considerations are required when a restructuring transaction involves an adopter of IAS/IFRS, whose taxable income is strongly dependent upon accounting. The Italian income tax laws 5 clarify that the characterisation of shares, equity instruments similar to shares, bonds and debt instruments similar to bonds must be defined in accordance with the tax laws, irrespective of the relevant accounting treatment under IAS/IFRS. In other cases, however, the accounting characterisation of an instrument under IAS/IFRS may not reflect the relevant legal characterisation, possibly with income tax ramifications to be considered on a case by case basis. A key issue in restructuring indebtedness is therefore to establish whether and to what extent a certain debt instrument qualifies as a debt instrument also for tax purposes (which would normally be the case), and if the proposed restructuring could change such qualification. 2.3 Limits to Deduction of Interest Expenses and Debt Restructuring Under the IITC, in broad terms, interest expenses recognised in the income statement of an Italian corporation are deductible for IRES purposes subject to the following limitations 6 : i. net interest expenses (i.e., interest expenses net of interest revenues) are normally deductible up to 30 percent of the EBITDA of the relevant company; ii. net interest expenses exceeding 30 percent of the EBITDA may be carried forward for an unlimited period of time, becoming deductible if and when there is sufficient EBITDA capacity; iii. the deduction of interest expenses due on debt securities issued by a nonlisted corporation are also subject, in certain circumstances, to a specific cap established by an ad hoc tax provision. 7 The general rules under points (i) CCH. All Rights Reserved.

3 Volume 10 Issue and (ii) above apply to the portion of interest expenses within the mentioned cap (any such excess remaining entirely nondeductible). However, on the basis of the changes recently enacted by the Decree Law, that are still subject to conversion into law by Parliament, interest expenses due on bonds subscribed by qualifying intermediaries would not be subject to the cap 8 ; iv. as mentioned above, no tax deduction is in principle granted in respect of profit participating debts. 9 A corporate debtor that is in a distressed position is likely to have low or even nil EBITDA capacity so that, on the basis of the set of rules described above, its interest expenses are partially or entirely nondeductible in the year of accrual (albeit being eligible for carry forward). 2.4 Accounting Issues The accounting treatment of debt restructuring by an Italian debtor is an important aspect of the transaction to be reviewed, since this can influence the tax treatment of the restructuring in the hands of the debtor. The accounting treatment of debt restructuring may vary, depending upon the accounting principles adopted d by the debtor in preparing its separate finan- cial lstatements, 10 as discussed in more detail in the following paragraphs. In this article we will consider the accounting treatment of debt restructuring for adopters of IAS/ IFRS, and for adopters of the accounting principles provided for by the Italian civil code, as further implemented by the Organismo Italiano di Contabilità (the Italian GAAP ). 3. Amendments to the Terms and Conditions 3.1 Legal Framework In general terms, in order to modify the features of an existing debt instrument, the parties may: amend certain terms and conditions of the existing debt (such as interest rates, payment dates, final maturity, security package, etc.); or decide to extinguish the existing instrument and replace it with a new one at different conditions by way of novation; or issue new debt at different conditions, which is used to repay the outstanding debt. In this section 3, the focus is on the amendments of terms and conditions of an existing debt instrument. As a general remark, no particular legal limits or constraints apply to such transactions. 3.2 Accounting and Income Tax Treatment for Adopters of Italian GAAP Under Italian GAAP, 11 amendments to the terms and conditions (deferral of interest and/or principal payments, adding additional security, extension of the maturity term, etc.) generally do not require any changes in the book value of the restructured debt, nor any recognition of gains in the income statement. The same applies in case of novation or issue of new debt to repay outstanding debt. This assumes of course that the restructuring does not entail any reduction of the outstanding principal amount or of any accrued but unpaid interest. 12 These transactions do not have any particular income tax implications for the debtor. In particular: Deferral of interest payments should, in principle, not negatively affect deductibility, because interest is normally deducted on an accrual basis. Deferral of principal repayments should not also trigger corporate tax consequences. Adding additional security cover should not of itself affect the tax position of the debt instrument. Moreover, if a third party loan to a distressed debtor would, as a result of the renegotiations, be guaranteed by a party related to the debtor, this should not trigger corporate tax consequences for the debtor. 13 Indeed, Italian tax laws do not provide for thin capitalization rules. An extension of the maturity term should not also, of itself, affect the tax position of the debt instrument; however, in certain cases, the extension of the maturity above 50 years may have an effect in the hands of the creditor in terms of applicable withholding taxes. 14 Change of the interest rate should not trigger any corporate tax implications to the extent that no retrospective effect is provided (otherwise a taxable event for the debtor may arise). However, if the parties agree that, instead of a floating or fixed interest rate, the restructured debt shall entitle the creditor to participate in the future profits of the debtor, then in principle such remuneration should not be tax deductible. 15 Also, the following tax provisions should in any event be carefully JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 11

4 Italian Tax Issues in Consensual Debt Restructurings considered: (a) transfer pricing rules; and (b) the provision capping, in certain circumstances, the deductible interest expenses due on bonds. 16 Usury law aspects should also be considered. 3.3 Accounting and Income Tax Treatment for Adopters of IAS/IFRS Pursuant to IAS/IFRS, 17 when a debt restructuring entails amendments to the terms and conditions of an existing liability, the accounting treatment depends on whether the modified terms are substantially different from the previous terms. A substantial modification of the terms (whether or not attributable to the financial difficulty of the debtor) shall be accounted for as an extinguishment (i.e., derecognition) of the original liability and the recognition of a new liability (so-called extinguishment accounting ). The terms are considered to be substantially different if the discounted present value of the cash flows on the new instruments (including net fees paid or received) differs by at least 10 percent from the discounted present value of the remaining cash flows on the original instruments. 18 This calculation should be carried out using the effective interest rate used in the amortisation of the original debt. inc The difference between the carrying amount of the extinguished liability and the fair value of the new liability assumed shall be recognised in the income statement. Any incremental costs or fees incurred, and any consideration paid or received, are also included in the calculation of the gain or loss. IAS/IFRS do not prohibit an entity to adopt extinguishment accounting in case of modifications which do not meet the 10 per cent test. Indeed, there may be situations where the modification of the debt is so fundamental that immediate derecognition is appropriate, whether or not the 10-percent test is satisfied. 19 If extinguishment accounting is not adopted, the debt is not re-measured at fair value and, generally, any costs or fees incurred adjust the carrying amount of the liability and are amortised over the remaining term of the modified liability. The accounting treatment of the aforementioned transactions in the hands of the debtor should be Before the financial crisis, a large number of Italian corporations, including subsidiaries of foreign multinational groups or private equity houses, had incurred massive amounts of debt to carry out acquisitions of assets in Italy CCH. All Rights Reserved. respected for income tax purposes as well. Accordingly, any gains or expenses recognised in the income statement should generally be taxable or deductible. 4. Debt Buy-Backs, Debt-for-Debt Transactions and Debt-for-Equity Swaps 4.1 Debt Buy-Backs Legal Framework. In the Italian market, debt buy-back transactions normally involve debt securities. On the other hand, buy-backs of nonsecuritized debt instruments, such as loans, are not normally executed in Italy. The buy-back of bonds or debt securities is not subject to specific legal limits or constraints Accounting and Income Tax Treatment for Adopters of Italian GAAP. Under Italian GAAP, 20 buy-backs of debt securities are normally treated as any other purchase of third party securities. The securities are recognised in the asset side of the financial statement of the debtor at the relevant purchase price. As a consequence, the liability existing in the financial statement of the debtor is not derecognised upon buy-back. Under such transactions, debtors do not normally recognize capital gains or losses in their income statements upon buy-back, 21 except if the securities are boughtback to be extinguished. Assuming that the securities are acquired at a discounted price, a gain on the instruments is in any event recognized when the securities are extinguished after the buy-back. 22 A gain (or loss) on the securities could be realized if, after buy-back, the instruments are sold, or otherwise transferred, at a price which differs from the purchase price. Italian GAAP 23 also include a nonbinding recommendation whereby debt securities that have been purchased to be extinguished (or to be held until maturity) should be shown on the liability side of the financial statement, as a reduction of the relevant liability (the amount of the reduction being equal to the par value of the relevant securities). Given that, in normal circumstances, an issuer would repurchase the securities only if the price is lower than the par

5 Volume 10 Issue value, the recommendation is that a gain should be recognised in the income statement when the securities are purchased to be extinguished. The buy-back of debt securities should not of itself be treated as a taxable event. However, any gain (or loss) that is recognized in the income statement on the basis of the appropriate accounting treatment should be taken into account to determine the taxable income of the debtor Accounting and Income Tax Treatment for Adopters of IAS/IFRS. The buy-back of bonds is regarded, under IAS/IFRS, 24 as a redemption of the underlying instruments, notwithstanding that the instruments are not extinguished from a legal perspective. In particular, according to IAS/IFRS, if an adopter acquires its own bonds, it should derecognise the relevant liability from the liability side of its balance sheet. Any difference between the price paid upon buy-back and the carrying value of the liability should be recognised in the income statement. Accordingly, owned bonds are not recognised on the asset side of the balance sheet of the issuer after buy-back. 25 The accounting characterization of these transactions in the hands of the issuer as, respectively, a cancellation and a new issue of bonds should be respected for tax purposes. Accordingly, the buyback of own bonds normally triggers the realisation of a taxable gain (or a deductible loss) in the hands of the issuer Debt Buy-Back by a Party Related to the Debtor Acquisition of debt instruments by a related party does not constitute per itself a taxable event for an Italian tax resident debtor. Unlike other countries, the Italian tax laws do not characterize as a taxable event in the hands of the debtor a transaction where the debt is bought back by a related party. However, where the new creditor is an Italian tax resident, any sums received by the creditor as a repayment of the debt in excess of its acquisition price (probably at a discount) should become taxable for the creditor. Alternatively, if the new creditor is a direct shareholder of the debtor, and the liability is waived, no such tax consequence should, in principle, arise. 27 If the new creditor is non-italian resident, the Italian tax characterization as capital gain or interest income of the sums received by the creditor, as a repayment of the debt, in excess of its discounted purchase price should be carefully considered in light of the specific features of the transaction. Whilst interest income derived by a non-italian resident would be in principle taxable in Italy, a capital gain should not be taxable in Italy if the new creditor is resident in a jurisdiction allowing an adequate exchange of information with Italy, or is protected by a tax treaty that does not allow Italy to tax. 4.3 Debt-for-Debt Transactions Legal Framework. A debt-for-debt transaction normally involves the early termination of existing debt instruments and the concurrent issuance of new debt instruments. A debt-for-debt transaction that is commonly considered in the Italian market in debt restructuring transactions is the extinguishment of existing financial liabilities through the issuance of convertible debt instruments, such as convertible bonds or bonds cum warrant. Such transaction allows the creditors to retain their positions of creditors and to defer the conversion of debt into equity while pre-establishing the relevant terms of the possible debt-for-equity swap. Debt-for-debt transactions are not subject to specific legal limits or constraints. However, the issue of debt securities, including convertible bonds, is subject to legal limits that may impact the viability of transactions potentially involving the issue of convertible securities Accounting and Income Tax Treatment for Adopters of Italian GAAP. Under Italian GAAP, 29 in situations where there are differences between the carrying value of the liability extinguished and the initial book value of the new debt instruments, a corresponding item of income should be recognised in the income statement. The Italian tax laws do not include any specific provisions addressing refinancing of debt by new debt granting a roll-over relief to the debtor. It is normally believed that this transaction should be treated as a taxable event, with the resulting gain consequently being taxable. 30 However, if the creditor is a shareholder of the debtor, any gain potentially realised by the latter should be treated as an equity contribution under Italian tax laws, which is not taxable for the debtor. 31 If the parties agree that, instead of a floating or fixed interest rate, the new debt shall entitle the creditor to participate in the future profits of the debtor, then in principle such remuneration may not be tax deductible Accounting and Income Tax Treatment for Adopters of IAS/IFRS. Pursuant to IAS/IFRS, 33 a debtfor-debt transaction should imply the extinguishment JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 13

6 Italian Tax Issues in Consensual Debt Restructurings of the original financial liability and the recognition of a new financial liability. The difference between the carrying amount of a financial liability extinguished and the new liability recognised, if any, shall be recognised in the income statement. The accounting treatment of the above mentioned transactions in the hands of the debtor should be respected for income tax purposes as well. Accordingly, any gain possibly recognised in the income statement should generally be taxable, unless the creditor is a shareholder of the debtor. 34 The same remarks in paragraph regarding the profit participating feature of the new debt apply in principle. 4.4 Debt-for-Equity Swaps Legal Framework. Debt-for-equity swaps can take place either as a conversion of debt into new equity instruments of the debtor, or as an exchange of debt instrument and treasury shares of the latter. In the Italian market debt-for-equity swaps are normally executed following the first route, i.e., conversion of debt into new equity instruments. This is inter alia due to the fact that Italian corporate laws provide for limits to the ownership of treasury shares. A conversion of debt into equity is characterized as a transformation rma by the creditors of their debtor receivables ei es into debtor equity instruments, under a share capital increase that is underwritten through an offset of such receivables. The equity instruments issued by the debtor to its creditors in such transactions could be ordinary shares, or special classes of shares, or profit participating financial instruments that do not attribute to the holder the status and the rights of a shareholder but could have enhanced economic rights Accounting and Income Tax Treatment for Adopters of Italian GAAP. Under Italian GAAP, 35 debt-for-equity swaps are treated as neutral events, whereby the carrying value of the debt converted into equity (normally equal to par value) is derecognised from the liability side of the balance sheet, against the recognition of items in the net equity of the borrower (e.g., share capital, share premium) for a corresponding amount. Under such transactions, debtors do not recognise capital gains or losses in their income statements. 36 These considerations apply also to debt-for-equity swaps arising upon conversion of convertible bonds. Even though the Italian tax laws do not include any provisions addressing this transaction from the perspective of the debtor, it is normally believed that a debt-for-equity swap should not be treated as a taxable event, since it merely implies a share capital increase in the hands of the debtor Accounting and Income Tax Treatment for Adopters of IAS/IFRS. IAS/IFRS do not specifically address the accounting treatment of debt-for-equity swaps for the debtors. Different accounting policies were followed by adopters of IAS/IFRS on the matter in the past. In November 2009, the IASB issued an interpretation on this matter, the IFRIC 19, in order to harmonise the different practices followed by adopters of IAS/IFRS when accounting for debt-for-equity swaps in their balance sheets. IFRIC 19 addresses the accounting treatment by a debtor when the terms of the financial liability are renegotiated and result in the debtor issuing equity instruments to a creditor to extinguish all or part of a financial liability. 38 According to IFRIC 19, following a debt-for-equity swap: the borrower shall remove the financial liability swapped from the liability side of the financial statement; the equity instruments issued to the creditor to extinguish the liability shall be recognised at their fair value (unless the fair value cannot be reliably measured, in which case the equity instruments shall be measured to reflect the fair value of the liability extinguished); any difference between the carrying amount of the liability (or part of it) extinguished, and the fair value of the equity instruments issued, shall be recognised in profit and loss. As a matter of fact, the fair value of the equity instruments issued by debtors that are subject to debt restructuring procedures is normally lower than the par value of the financial liability extinguished. As a result, the transaction normally triggers the recognition of gain in the income statement of the debtor. The Italian income tax laws do not specifically address the treatment of such possible gain. The matter has never been considered by the Italian tax authorities in a ruling available to the public. No precedents exist in the tax court. Different commentators have expressed conflicting views on this topic. Some commentators have expressed the view that the gain, if any, should be taken into account to determine the taxable income of the debtor. 39 In the opinion of other commentators, there should be good arguments to conclude that any such gain should not be taxable in the hands of the debtor since inter alia the tax relief CCH. All Rights Reserved.

7 applicable to gains arising upon debt waivers by a shareholder should apply. 40 In the authors opinion, the latter interpretation is preferable, on a matter which is, however, subject to a significant degree of subjective interpretation Accounting and Income Tax Treatment for Adopters of IAS/IFRS of Debt-for-Equity Swaps in the Context of Convertible Bonds. Upon maturity of a convertible bond, or similar convertible securities, the embedded call option may be out of the money or in the money and this could have varying consequences. Should the call option be out of the money, the bond is normally re-paid in cash. On the other hand, should the call option be in the money, the bondholder generally requires the bond to be converted into shares and therefore a debt-for-equity swap would take place. IFRIC 19 does not apply to debt-for-equity swaps arising upon conversion of convertible bonds, since this implies the extinguishment of a financial liability by issuing equity instruments in accordance with the original terms of the debt instrument. 41 Rather, under IAS/IFRS, 42 the accounting treatment of the conversion at stake should be as follows: the issuer derecognises the financial liability component and recognises a corresponding amount in net equity; the equity component recognised in the net equity upon issuance of the convertible securities remains in equity (although it may be reclassified from one line item of equity to another); no gain or loss is recognised upon conversion of the bond at maturity. As confirmed by a specific income tax provision 43 and by the commentators, 44 the conversion of convertible bonds is not to be treated as a taxable event, since it merely implies a share capital increase from the perspective of the debtor. 5. Debt Waivers 5.1 Legal Framework Debt waivers can involve the outstanding principal amount of a debt under restructuring, and/or any accrued but unpaid interest. Such transactions are not subject to ad hoc legal limits or constraints. In simple situations, debt restructurings are generally negotiated and agreed on a pure consensual basis between the debtor and its creditors. Volume 10 Issue Accounting and Income Tax Treatment for Adopters of Italian GAAP Under Italian GAAP, 45 a partial or full waiver of the principal amount of a financial debt instrument and/ or of any accrued interest implies the cancellation of the liability and, if the lender is unrelated to the debtor, a profit recognition in the income statement (amongst the extraordinary items). Such profit is generally liable to corporate income tax. 46 However, on the basis of changes recently enacted by the Decree Law (albeit that such changes are still subject to conversion into law by the Parliament), if certain conditions are met, any profits recognised in the income statement in connection with debt waivers agreed under the light restructuring procedures governed by Article 182-bis or Article 67(3)(d) of the IBL (respectively, the debt restructuring agreement and the certified restructuring plan ) are tax exempted for the amount which is in excess of any tax losses available to the debtor (whether carried forward from the past or accrued in the tax year of the restructuring). This (partial) exemption does not apply if the debt restructuring agreement is not concluded under those procedures (i.e., it is executed on a purely consensual basis by the parties with no involvement of the Bankruptcy Court). If the lender is also a direct shareholder of the debtor, in the books of the latter the waiver is not treated as a gain reported in the profit and loss but rather as an equity contribution. 47 Appropriate disclosure shall be given in the notes to the financial statements. Similarly, Italian tax law states that partial or full debt waivers are not treated as taxable events when made by a direct shareholder of the debtor 48 ; however, this relief does not apply to waivers granted by other related parties (e.g., indirect shareholder, another subsidiary of the common shareholder, etc.). This rule applies not only to financial debts but also to trade debts. The availability of such an exemption in connection with transactions having certain extreme features has been challenged by the Italian tax authorities in the past in light of the Italian anti- JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 15

8 Italian Tax Issues in Consensual Debt Restructurings abuse provisions, and the abuse of law doctrine elaborated by the Italian Supreme Court. As a final remark, the waiver of accrued but unpaid interest does not affect the deductibility for the debtor. However, such a waiver could trigger the application of an Italian withholding tax, according to the approach adopted by the Italian tax authorities in certain precedents (so-called incasso giuridico doctrine), which the authors do not share. 5.3 Accounting and Income Tax Treatment for Adopters of IAS/IFRS IAS/IFRS require the derecognition of liabilities when the underlying obligations are cancelled or discharged. 49 Consistently with Italian GAAP, a debt waiver entails a gain recognition in the income statement, except when the creditor is also a shareholder of the debtor. Even absent a formal statement in the IAS/ IFRS, debt waivers by certain related parties (e.g., direct shareholder, another subsidiary of the common shareholder, etc.) are normally treated as equity contributions from the debtor perspective. 50 The same income tax implications as for an adopter of Italian GAAP arise. In particular, gains realised upon debt waivers should not be treated as taxable events only when made by a direct shareholder of the debtor. In principle, gains realized upon debt waivers byo other related parties may trigger taxable items of income, even if such gains are accounted as equity contributions under IAS/IFRS. 6. Particular Subjects 6.1 Italian Notional Interest Deduction Regime (ACE) and Debt Restructurings The so-called Aiuto alla Crescita Economica (ACE), enacted as of fiscal year 2011, is a notional interest deduction regime which enables taxpayers to deduct from their corporate income tax base a fictitious interest amount. The main purpose of this regime is to reduce the tax discrimination between debt financing and equity financing. The deduction equals to the notional yield of any adjusted net equity increases, compared to the equity resulting from the balance sheet as at December 31, In very broad terms, the items which are taken into account in determining the adjusted net equity increase are cash equity injections (new share capital and share premium) and retained profits, net of any distributions to the shareholders (save for distribution of the annual profits) or capital repayments. Issuances of profit participating financial instruments which do not attribute to the holder the status and the rights of a shareholder are disregarded for ACE purposes, even where such instruments are fully or partly recognised in equity. For the first three years ( ), the notional yield is fixed at three percent. From 2014 onwards, a decree of the Ministry of Finance will establish the yield on a yearly basis, taking into account the yield on State bonds plus a premium risk. Certain debt restructuring transactions may imply, amongst other things, a benefit for the debtor in terms of notional interest deduction. This may apply in the case of debt waivers, when the debtor recognises a profit in the income statement (if this is then retained), or books the waiver directly in equity. 51 Debt-for-equity swaps may also increase the ACE basis, provided that the liability swapped is a financial liability and the debtor issues new shares to the creditor. In this case, the transaction should generate a qualifying net equity increase for an amount equal to the book value of the new shares (including share premium). 52 On the other hand, if the transaction involves a commercial debt, or entails the conversion of debt into profit participating financial instruments (which do not attribute to the holder the status and the rights of a shareholder), the ACE benefit would be limited to the amount of any gain recognized by the debtor in the income statement (if the resulting profit is then retained). 6.2 Impact of debt restructuring on Italian fiscal unity When the debtor is part of an Italian fiscal unity as subsidiary ( società controllata ), any issue of new shares in the context of a debt restructuring transaction must be carefully considered. Indeed, if the number of new shares issued is such that the control over the restructured debtor and/or the entitlement to more than 50 percent of its profits is transferred to a third party, this would entail the termination of the fiscal unity. In these circumstances, one may consider whether to issue different instruments which do not entail those adverse effects, such as profit participating financial instruments (but caution should be placed on the profit entitlement issue), convertible bonds or bonds cum warrant CCH. All Rights Reserved.

9 Volume 10 Issue Impact of Tax Losses in Debt Restructuring Some of the transactions described above as part of a debt restructuring may trigger the recognition of a taxable gain by the Italian tax resident debtor. As a matter of principle, such gain is included in the taxable income of the debtor (subject to Italian corporate income tax at standard rate). However, available tax losses may be used to shelter any taxable income, making the debt restructuring easier for the debtor. A recent change in Italian tax law has reduced the possibility for a distressed debtor to avoid any cash tax payments from a debt restructuring by using its pre-existing tax loss carry forward. Indeed, in 2011, the Italian legislators have capped the amount of tax loss carry forward which may be used against the taxable income realised in a given financial year to 80 percent of such taxable income. 53 The new provision does not provide for any kind of exception regarding extraordinary items of income (such as gains resulting from a debt restructuring). This new development will result in significantly increasing the effective cash cost for the debtor in transactions that imply the realisation of taxable gains and should lead the parties to prefer to structure their transaction in a way thatd does not affect the taxable income of the debtor. 6.4 Restructuring of Tax and Social Security Liabilities Debt restructuring procedures may involve also certain tax and social security liabilities of taxpayers in distress. The restructuring of these debts is governed by Article 183-bis of the IBL and can occur exclusively in the context of a composition with creditors ( concordato preventivo ) under Article 160 of the IBL or in the context of a consensual debt restructuring agreement ( accordo di ristrutturazione dei debiti ) governed by Article 182-bis of the IBL. In very broad terms, the restructuring may entail a partial waiver of the outstanding liabilities (including penalties and interest) 54 and/or a deferral of payment terms. The debt restructuring should not generate any taxable profits for the debtor insofar as the waiver involves taxes which are not deductible (this is the case of income taxes and penalties). 6.5 Other Issues: Derivatives, Transaction Costs and Transfer Taxes Other issues that should normally be considered in connection with debt restructuring transactions include: the accounting and tax implications resulting from the derivative instruments potentially associated with the debt which is to be restructured. Consequences may indeed arise from either the restructuring of such derivatives, and/or the possible discontinuing of the existing hedge accounting relationships; the accounting and tax treatment of transaction costs; and transfer tax implications arising from the debt restructuring. * This article is based on the article, Vittorio Salvadori di Wiesenhoff and Roberto Egori, Italian Tax Issues in Consensual Debt Restructurings, Derivatives & Financial Instruments, 2012, IBFD, cited with the permission of IBFD, see This article is based on Italian tax law in force as of August 3, In this respect, we note that on June 15, the Italian Government approved urgent measures aimed at stimulating growth. Such measures have been enacted with the Decree Law June 22, 2012 no. 83 (the Decree Law ), published in the Official Gazette of June 26. The Decree Law amends, inter alia, certain provisions of Royal Decree no. 267 of March 16, 1942 (i.e., the Italian Bankruptcy Law) governing debt restructurings, with a view to facilitating access to such procedures. In connection with this, the Decree Law also enacts favourable tax changes concerning certain light debt restructuring procedures governed by Italian ENDNOTES Bankruptcy Law, and some other changes to the tax regime of debt securities. The Decree Law entered into force as of its publication in the Official Gazette, which occurred on June 26, and was converted into law (with amendments, not affecting however the provisions mentioned in this article) by the Parliament on August 3, An IRES surcharge also applies to the socalled nonoperating companies ( società di comodo ). 2 Presidential Decree, December 22, 1986 no Since 2008, Italian adopters of IAS/IFRS are subject to a specific income tax provision whereby the criteria as to the characterisation, timing of accrual and classification in the financial statement provided by the mentioned accounting principles [i.e., IAS/IFRS] are respected [also for income tax purposes] and prevail over the [income tax] provisions [ ] (see the last sentence of Article 83 of IITC, that has been further implemented by two ministerial decrees). 4 It should be noted that, by way of derogation to the general principles, Article 32(24) of the Decree Law introduces a special rule on subordinated profit participating notes, allowing the deduction of the profit-linked portion of the remuneration due thereon, subject to compliance with certain specific conditions. 5 See Article 5(1) of Ministerial Decree of June 8, See Article 96 of the IITC. Please note that specific rules apply to companies belonging to an Italian fiscal unity in respect of deduction of interest expenses. 7 See Article 3(115) of Law, December 28, 1995 no. 549, as amended by Articles 12(10) and 14(2) of Decree, November 21, 1997 no Indeed, Article 32(8) of the Decree Law states that the limitations under Article JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 17

10 Italian Tax Issues in Consensual Debt Restructurings 3(115) of Law, December 28, 1995 no. 549 shall no longer apply insofar as the securities are held by qualified investors that are not direct or indirect shareholders of the issuer, including through fiduciary companies or interposed persons. 9 Article 32(24) of the Decree Law introduces a special rule on subordinated profit participating notes, allowing the deduction of the profit-linked portion of the remuneration due thereon, subject to compliance with certain specific conditions. 10 The accounting treatment of the restructuring in the consolidated financial statement does not influence the tax treatment of the transaction. 11 See the paper OIC 6 Ristrutturazione del debito e informativa di bilancio, issued by the Organismo Italiano di Contabilità on July 2011 and addressing the accounting treatment of debt restructuring (the OIC 6). 12 Should the transaction result in a full or partial waiver of the principal amount of the original debt and/or of any accrued but unpaid interest, this may in some cases lead to profit recognition for accounting and tax purposes by the debtor, as further considered in paragraphs 5.1 and 5.2 below. 13 Impact of the claw-back provisions applicable under bankruptcy law ( azione revocatoria ), which may imply that the new guarantees obtained are disregarded, should be carefully considered. 14 This may be the case when the creditor is a direct shareholder h of the debtor and is eligible for the withholding tax relief under Directive 2003/49/EC (so-called Interest and Royalty Directive). Indeed, the relief is not applicable when interest is paid on debts with no final maturity or with maturity in excess of 50 years. 15 Article 32(24) of the Decree Law introduces a special rule on subordinated profit participating notes, allowing the deduction of the profit-linked portion of the remuneration due thereon, subject to compliance with certain specific conditions. 16 See the tax provision mentioned in paragraph 2.3 point (iii) above. 17 See IAS 39(40). The new IFRS 9, which is expected to replace IAS 39 as of 2015, is consistent with the present wording of IAS See IAS 39(AG62). 19 Ernst & Young, International GAAP 2008, Wiley, at See paragraph I.4 of the Italian GAAP no The fact that the fair value (and the purchase price) of the bought-back debt instruments may differ from par value does not imply the recognition of any gain or loss in the income statement. 22 Although the extinguishment might result in an increased tax liability, all in all the ENDNOTES balance sheet might be strengthened. 23 See paragraph I.4 of the Italian GAAP no See IAS 39(39,41,42,AG58). The new IFRS 9, which is expected to replace IAS 39 as of 2015, is consistent with the present wording of IAS The magnitude of the differential to be recognised on the income statement of the issuer upon buy-back may vary depending upon whether the liability reflecting the bonds is carried at fair value or at amortised cost. Should the bonds be carried at fair value, the differential arising upon buyback should reflect the change in fair value experienced by the instrument since the last balance sheet date while, if the bonds are carried at amortised cost, it should reflect the change in fair value experienced since the issue date. 26 According to certain commentators, this differential could be characterised as interest income, rather than capital gain or loss. See L. Rossi, Treatment of purchase of own shares and bonds under amendments introduced by Finance Act 2008, DERIVATIVES & FINANCIAL INSTRUMENTS, July-August 2008, at This transaction should however be considered in light of the Italian anti-abusive provisions, as discussed in paragraph Article 32(26) of the Decree Law lessens such legal limits. 29 See paragraph of the OIC A. Magliocco, Tax consequences of restructuring of indebtedness, BRANCH REPORT: ITALY, IFA CAHIERS 2006, at See Article 88(4) of the IITC. 32 Article 32(24) of the Decree Law introduces a special rule on subordinated profit participating notes, allowing the deduction of the profit-linked portion of the remuneration due thereon, subject to compliance with certain specific conditions. 33 See IAS 39(39-41). The new IFRS 9, which is expected to replace IAS 39 as of 2015, is consistent with the present wording of IAS See Article 88(4) of the IITC. 35 See paragraph of the OIC The fact that the fair value of the equity instruments issued may differ from the par value of the liability derecognised does not imply the recognition of any gain or loss in the income statement. 37 See Article 91(1)(d) of the IITC, whereby a share capital increase is not treated as a taxable event in the hands of the issuer for Italian income tax purposes. 38 However, IFRIC 19 does not apply to situations where: (a) the creditor is also a direct or indirect shareholder and is acting in its capacity as a direct or indirect existing shareholder; (b) the creditor and the entity are controlled by the same party or parties before and after the transaction and the substance of the transaction includes an equity distribution by, or contribution to, the entity; (c) extinguishing the financial liability by issuing equity shares is in accordance with the original terms of the financial liability (see IFRIC 19(3)). 39 F. Dezzani L. Dezzani, Ifric 19 - Swap di debito contro capitale azionario: il trattamento contabile secondo i principi IAS/ IFRS, il fisco, no. 40, 2011, at According to Article 88(4) of the IITC partial or full debt waivers by a shareholder should not be treated as taxable events. See Assonime, Guida all applicazione dell IRES e dell IRAP per le imprese IAS adopter, Documento 1, May 2011, at 81, footnote See IFRIC 19(3)(c). 42 See IAS 32(AG39). 43 See Article 5(4) of Ministerial Decree 8 June See G. Tardio in AA.VV., La fiscalità degli IAS, Il Sole 24 Ore, at 118. Before the enactment of Article 5(4) of Ministerial Decree 8 June 2011, see R. Egori, Tax Treatment of Italian Company Treasury Shares or Bonds Buy-Backs, and Convertible Bond Issues After the Adoption of IAS/ IFRS, J. TAX'N FIN'L PRODS., Vol. 8, Issue 3, at 43 (2009). 45 See paragraph of the OIC See Article 88 of the IITC. 47 See the Italian GAAP no See Article 88(4) of the IITC. 49 See IAS 39(39). The new IFRS 9, which is expected to replace IAS 39 as of 2015, is consistent with the present wording of IAS See BDO, Financial Reporting Bullettin, Issue 7, 2010, at 4. As a matter of principle, reference is normally made to the general principle originally stated in paragraph 70 of the IASB s Framework for the Preparation and Presentation of Financial Statements issued in 1989 (now paragraph 4.25(a) of The Conceptual Framework for Financial Reporting issued by the IASB in 2010) whereby income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increase in equity, other than those relating to contributions from equity participants. Reference to this principle is made, inter alia, by Assirevi (the Italian Association of Auditors) in the paper OPI no. 9 that states that the day one profit arising upon initial recognition of an interest bearing loan granted by a shareholder should be booked in the net equity of the debtor as an equity contribution. 51 Waivers recognised as equity contributions in the net equity increase the ACE basis only if related to financial liabilities and granted by a direct shareholder CCH. All Rights Reserved.

11 Volume 10 Issue Also, any gain recognised in the income statement upon debt-for-equity swap by an adopter of IAS/IFRS may in principle increase the ACE basis (if the resulting profit is then retained). Indeed, for adopters of IAS/IFRS, a debt-for-equity swap normally ENDNOTES entails a gain recognition since the fair value of the new equity instruments issued by the borrower is normally lower than the par value of the financial liability extinguished under the transaction. 53 According to Article 84(2) of the IITC the 80 percent cap does not apply to tax losses suffered in the first three tax years since the incorporation of the company. See paragraph 1.3 of the Circular Letter no. 53 of 6 December 2011 of the Italian Tax Authorities. 54 No waiver of VAT liabilities is allowed. This article is reprinted with the publisher s permission from the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS, a quarterly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher s permission is prohibited. To subscribe to the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS or other CCH Journals please call or visit All views expressed in the articles and columns are those of the author and not necessarily those of CCH. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 19