New Italian Administrative Guidelines on Taxation of Trusts

Introduction

On 20 October 2022, the Italian Revenue issued the Circular Letter No. 34/E setting out new guidelines on the taxation of trusts (the “Circular Letter”). The Circular Letter provides clarifications but also raises some uncertainties due to inconsistencies with previous rulings (for example in relation to disregarded trusts) and to some ambiguous wording (for example, in relation to reporting obligations of resident discretionary beneficiaries). Trustees, settlors and beneficiaries of existing trusts with a potential exposure to Italian taxes should take advice on the impact of the guidelines.

Inheritance and gift tax (“IGT”)

In the Circular Letter, the Revenue withdraws its past approach of applying IGT on trust additions and accepts the interpretation that IGT is due only on distributions to beneficiaries. The Revenue further clarifies that IGT is due on distributions of capital only and that the applicable rate and exempt amount depends on the family relationship, at the time of the distribution, between the settlor and the beneficiary of the distribution. The new position of the tax authorities will allow for a deferral of the payment of IGT but could expose the trust assets to the application of higher IGT rates in the case of their future increase.

The Circular Letter states that the above general principle is not valid if a trust is to be considered as disregarded vis-à-vis its settlor for income tax purposes. In such a case, upon the demise of the settlor, IGT should be applied on the trust assets as if they were part of the estate of the settlor and the trust did not exist. Furthermore, during the lifetime of the settlor, distributions made by the trustee to the settlor should not be in the scope of IGT while distributions made to the beneficiaries (other than the settlor) should be subject to IGT for their entire amount (that is, not just for the component that qualifies as distribution of the trust capital) as if they were gifts made by the settlor. This position from the Revenue is rather surprising as it is inconsistent with its previous precedents where it stated that the disregarded characterisation of a trust for income tax purposes did not impact its IGT treatment. Based on the new approach, the IGT consequences of the demise of the settlor of a disregarded trust will depend on the impact of such demise on the characterisation of the trust. In such an event, a trust could become either (i) disregarded vis-à-vis a beneficiary or (ii) non-disregarded. In the case (i), IGT should be levied on the taxable value of the trust assets determined at the time of demise with rates and exempt amounts based on the family relationship between the settlor and the beneficiary as if such beneficiary had inherited the trust assets from the settlor. The case (ii) should be treated like an addition of assets to a trust upon the demise of its settlor and, therefore, under the new approach of the Revenue, no IGT should be due on addition as any IGT liability could arise only upon distribution to the beneficiaries. The Circular Letter only addresses the IGT treatment of trusts that are disregarded vis-à-vis their settlors, but the same consequences should materialise when the trust is disregarded vis-à-vis a beneficiary. So that, if a settlor settles a trust that characterises as disregarded vis-à-vis a beneficiary, IGT should be due on settlement as if the settlor had made a gift to such beneficiary.

Moreover, the Circular Letter:

• Clarifies that the territoriality rules of IGT should be applied in relation to trust distributions making reference to the residence of the settlor and to the situs of the assets at the time of settlement of the trust. Under this rule, if the settlor was not resident in Italy at the time of settlement and if he did not settle into the trust any Italian situs asset, no IGT should be due on trust distributions even if, upon distribution, the settlor had relocated to Italy and the distributed assets were to include Italian situs assets;
• Suggests that distributions made to the settlor should not be subject to IGT (this is stated in relation to trusts settled for the satisfaction of the settlor’s creditors, but should apply to any trusts);
• Clarifies how to deal with trusts that were funded through settlements already subjected to inheritance and gift tax according to the past approach. Depending on the circumstances, the taxpayer may claim a refund of the IGT paid on trust additions, be exempt from IGT on trust distributions or benefit from a credit, for the IGT paid on additions, against the IGT on distributions.

Income tax

The Circular Letter provides guidance on several important aspects concerning the income tax treatment of trusts.

When a trust is disregarded – typically vis-à-vis its settlor or a beneficiary – the income and gains from the trust assets are treated as income and gains of the settlor or beneficiary and subject to income tax in his/her hands as if the trust did not exist and the said settlor or beneficiary had realised the income and gains directly. An implicit consequence of the disregarded characterisation of a trust was that a distribution from a disregarded trust was to be treated like a gift from an income tax perspective and, as such, would be outside the scope of income tax. In the Circular Letter, the Revenue takes the view that trust distributions made by a disregarded trust do not qualify as taxable income for the recipient on condition that the distributions are made out of trust income that, due to the disregarded characterisation of the trust, had been previously imputed to a resident person and subject to tax. This condition required by the Revenue is highly debatable.

In relation to trusts that are not disregarded, the Circular Letter comments on the 2019 provisions that stipulate that (i) distributions of “income” from trusts established in “low-tax jurisdictions” are taxable income for the recipient, and (ii) trust distributions qualify as distributions of income, unless there is adequate evidence that capital is being distributed. On this point, the Revenue:

Takes the view that these provisions are interpretative, rather than innovative, so that trust distributions to resident beneficiaries may have been subject to income tax even prior to the change in law. The position of the Revenue is highly disputable;

• Provides clarifications on the notion of “low tax jurisdiction”. A trust should be considered as established in a “low-tax jurisdiction” if the income of the trust is subject to an income tax in its jurisdiction of establishment that is lower than 50% of the nominal tax rate applicable in Italy (either 26% or 24%, depending on the circumstances). The nominal tax rate of the foreign jurisdiction should be determined taking into account any special tax regime applicable in the foreign jurisdiction. Unfortunately, the Circular Letter does not clarify how this test should be applied if, in the jurisdiction of establishment of the trust, the income of the trust is imputed and taxed in the hands of the settlor and/or beneficiaries as it accrues at trust level. Based on the precedents of the Revenue in relation to Italian CFC legislation, the tax rate applicable on the settlor or beneficiaries in relation to the trust income should be taken into account;
• States that income consists of income and gains (even if accumulated) while capital consists of the original settlement and subsequent additions, and that income must be computed on the basis of Italian tax rules;
• Confirms that the trustee may freely decide whether to distribute income or capital from an Italian tax standpoint. However, to this purpose, the trustee must keep adequate supporting evidence on the computation of income and capital and must properly formalise the distribution resolutions.

Reporting obligations

In the Ruling no. 693 of 8 October 2021, the Revenue took the view that all resident beneficiaries, including discretionary beneficiaries, have reporting obligations – in their capacity of beneficial owners of the trust – on trust assets. This position of the Revenue was widely criticised by practitioners. The Revenue seems to have reviewed such approach stating that while non-discretionary beneficiaries should always fulfil reporting obligations in relation to the trust assets, discretionary beneficiaries have reporting obligations only on the basis of the information available to them such as when the trustee communicates to the beneficiary the decision to distribute in his/her favour a certain trust income or capital. Unfortunately, the wording of the statement of the Revenue leaves it unclear whether reporting obligations of discretionary beneficiaries are triggered by the mere availability of information (e.g., if the trustee makes an annual reporting on the value of the assets in trust and sends it out to all the discretionary beneficiaries) or by the existence of a right of the beneficiary over the assets held in trust.

The Circular Letter takes the view that no reporting obligations on the trust assets apply to individuals that have a second tier interest (“titolari di interessi successivi”) on the condition that no clauses in the trust deed nor in any other governing document of the trust allow them to receive any distribution until the demise of another individual.

This article is has been published on ThoughtLeaders4 Private Client Magazine Issue 9.