Economic soundness principle and challenges by the Italian Tax Authority

by Alberto Allegra | Jun 8, 2021 | Blog

The recent judgment of the Court of Cassation No. 11932/2021 provides an opportunity to briefly discuss the concept of “economic soundness” of entrepreneurial choices; this type of dispute allows the Italian Tax Authority (i) to deny the tax deductibility of those expenses deemed contrary to the business logic (because they are deemed “not inherent”), or (ii) to redetermine the taxable income on the basis of presumptions, when the inconsistency relates to the conduct of the entire business activity. The burden to prove that the uneconomic behaviour is justified by reasons other than tax avoidance or evasion, is on the taxpayer.

The Supreme Court, reaffirming its well-established position, has recognised that “the administration may disallow costs also because of their excessiveness, i.e. the uneconomic nature of the expenditure, thus requiring the taxpayer to prove that it is justified, according to the analytical inductive mechanism […]. Therefore, from this perspective, the unquestionability of entrepreneurial choices certainly cannot serve to relieve the taxpayer of the duty to clarify the economic reasons for a choice otherwise incomprehensible, because of an apparently total lack of inherent economic commitment compared to the importance of the company”.

 

What does economic soundness principle consist of?

Basically, an uneconomic behaviour is characterised by being unreasonable and not congruous with respect to the business activity, the magnitude of the cost incurred, the type of expense, the selected counterpart, etc.; this discordance leads to the presumption that behind such conduct, although formally irreproachable (e.g. because the passive invoices are punctually recorded and the payments are demonstrated by the bank accounts), there may be avoidance or evasion phenomena.

By way of example, case law has qualified the following conducts as uneconomic:

  1. the incurring of expenses, for goods that to be freely donated to customers (information brochures), for an “enormous” amount, equal to about 13% of the entire amount of annual revenues, moreover at a unit cost just as disproportionate and without producing any “study or business plan from which it could emerge the usefulness in the future of the purchase of brochures” (Civil Cassation sentence no. 2224/2021);
  2. recourse to financing of such a high amount as to entail operating losses, such as to make the whole company business as unprofitable (Comm. Trib. Reg. Lazio sentence no. 534/2021);
  3. the presence of significant losses for four consecutive years, without the taxpayer having provided the reasons that had negatively affected its business and causing an anti-economic management, but limiting itself, instead, to merely listing the costs incurred (thus Civil Cassation order no. 1282/2021);
  4. the use of mark-up rates lower than the average for the sector combined with a persistent operating loss in the years under scrutiny, a negative operating income which is not suitable for remunerating the work of the partners, with a very high cost of labour, which has, moreover, progressively increased in inverse proportion to the trend in profits, which tended to fall (see Civil Cassation Order no. 22185/2020);
  5. the disproportionate gap existing between the mark-up percentage applied by the taxpayer company (3.3%) and that applied by the Office (20%); in such a case the uneconomic nature of the conduct was deduced from a single presumptive element, provided that it was precise and serious (Civil Cassation order no. 20068/2020);
  6. the presence of derisory operating profits for five consecutive years accompanied by a mark-up on sales equal to one-fifth of the mark-up normally applied, but at the same time followed by the opening of as many as six sales stores in prestigious areas of the city of Rome (Civil Cassation Order No. 9901/2020);
  7. a clear disproportion between the economic result of the business and the cost of the factors of production (employees), since it cannot be justified to run the business at break-even for reasons extraneous to the conduct of a business (Supreme Court order no. 8925/2020).

 

Effects on the tax assessment

If the Office qualifies a conduct as “uneconomic” (in the terms indicated above), it may proceed to redetermine the taxable income of the taxpayer through an inductive assessment, i.e. based on presumptions and without the need to provide “certain” evidence of an actual and proven tax evasion.

The basic assumption is that the entrepreneur tends to maximise his profit: clearly uneconomic behaviours (and in open contrast with this principle) allow the Office to presume the existence of fictitiously inflated costs or hidden revenues. In order to support the tax assessment, the circumstantial framework may also be based on simple presumptions provided that they are serious, precise and consistent.

 

Burden of proof on the taxpayer

In order to defend itself against such assessments, the taxpayer must prove the reasons why it engaged in the apparently uneconomic conduct, demonstrating that it is not the effect of underlying tax violations. For example,

  1. the sale of unfinished (rather than finished) real estate has been considered as a valid justification for the lower sale prices applied and, therefore, for the apparent uneconomic nature of such transactions, suitable to preclude the inductive tax assessment (Civil Cassation order n 13839/2020);
  2. the evidence of significant (multi-year) research, development and advertising expenses, which had borne fruit in the years subsequent to those under assessment, refuted the alleged unprofitability of the financial years closed at a loss and characterized by such expenses (Civil Cassation order no. 14468/2015);
  3. evidence that the overvaluation of used vehicles, sold in exchange by the purchasers of the new vehicles, was intended to encourage sales of the new vehicles, thus justifying the apparent uneconomic nature of the overvaluation, which was applied instead of a direct discount (Civil Cassation order no. 14468/2015).

In such a situation, the accounting records, although formally correct, are of no use whatsoever; in fact, they are considered unreliable precisely because they reveal a contrast with the criteria of reasonableness and business logic, due to the uneconomic nature of the taxpayer’s conduct.

 

Conclusions on economic soundness principle

In a tax system that facilitates the Italian Tax Authority in the formation of evidence and in the issuance of notices of assessment based on presumptions, it is absolutely advisable for the taxpayer to keep track of the reasons that prompted him to make those choices, which appear not to be supported by a strict economic logic. This can be done through keeping e-mail exchanges, minutes of specifically held boards of directors, minutes of extraordinary meetings, strategic studies, business plans, etc.; in fact, as seen, the mere evidence of expenses incurred (invoices payable, bank accounts) is not sufficient for this purpose. Only in this way will the taxpayer be able to validly oppose to the Authority the reasons for his choices and, sometimes, for his entrepreneurial failure.

 

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