M&A and BUSINESS COMBINATIONS (class 4/2)

M&A: generally refers to business combinations  extraordinary transactions according to which

a business activity is transferred to another legal entity.
Reason for M&A transactions can be different: operate in another business, sell a business unit,
increase dimensions and/or market power etc.

M&A identifies a wide range of transactions in which the ownership of a business activity is
transferred from a legal entity to another (business combination), either for external growth or
corporate restructuring purposes.
The business activity can be °incorporated in a legal entity or °transferred as standalone subject

Under Italian law, the company is a legal entity, different and separate from its shareholders. The
company runs a certain entrepreneurial activity (business) with the aim of making profits, to be
distributed to its shareholders.
The company has assets and incurs in liabilities. The difference between the total value of the
assets and the total value of the liabilities is the net worth of the company.

The single person who runs an individual entrepreneurial activity is liable for the obligations
incurred in business activity with all its assets, while if the entrepreneur establishes a corporation
which carries out business activity it is the corporation to be liable with its assets  the general
rule is that the company pays its debts/liabilities with all its assets and exclusively with its assets.

As an exception to this rule, it is possible to set up "segregated assets" (patrimoni destinati) for a
specific area of business or to guarantee specific financings; in such case the assets are segregated
and cannot be used to pay the debts of the company pertaining to other areas of business.

In principle only the company is liable for its obligations, and the shareholders are not liable for
the company's obligations ("autonomia patrimoniale perfetta"). As an exception to this rule, under
certain circumstances it is possible to "pierce the corporate veil" and the shareholders can be held
liable for the obligations of the company.

Shareholders are never liable unless in fact they abuse of their powers and run the business
playing a managerial role.
Directors run the business and are liable if they breach their duties or in case of mismanagement.

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M&A transactions can be motivated by two main orders of objectives:

Often extraordinary transactions are part of a wider acquisition and/or reorganisation process,
which may comprise, by way of example:
> acquisition of the shares of a target company → merger between the buyer and the target
company
> partial demerger of a company → merger of the demerged company with the target company
> transfer of a business in a new company (“newco”) → transfer of the shares of newco ù

When the transaction is functional to the achievement of (intra-group) reorganisation objectives:

> to simplify the group structure and chain of control → merger
> to separate a business division → demerger / transfer or contribution of a business division
> to refinance the existing indebtedness and/or to optimise the financial structure → each
extraordinary transaction may be part of a more complex restructuring of the existing debt

Main criteria to decide how to structure the transaction:

- Underlying business reasons for implementing the transaction
- Tax driven analysis
- Civil law effects
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 - Accounting effects
- Third party consent requirements
- Employment law concerns
- Contingent and unknown liabilities issues

SALE OF SHARES  shares of company A are sold for a certain amount of money to company B,
which becomes shareholder of company A -> company B doesn’t run directly the business activity
but indirectly through the rights it can exercise in company A as a shareholder: vote in sh
meetings, appoint directors etc.

It’s also possible to perform a sale of shares through the creation of a Newco: the buyer
establishes a Newco which acquires the target’s shares in exchange for money (through debt
raised from banks) and in this way the buyer – who controls the Newco – becomes shareholder of
the target.

Share deal = acquisition by Buyer of all or part of Target’s shares (100% vs controlling stake vs
minority stake)
Depending on the nature of the transaction, it might be advisable that the acquisition is made not
directly by Buyer but by a special purpose vehicle (“Newco”) incorporated by Buyer:
° not necessary, if Buyer is an industrial corporation
° always, when Buyer is a financial institution
° "debt ring-fencing"

ADVANTAGES of Share Deals

V The purchaser is not liable for target’s liabilities (indeed, as a rule, the shareholder is never
liable for the company’s obligations, except when “piercing the corporate veil”)
V Perimeter. A share deal is more straight forward than an asset deal because the purchaser
only needs to acquire from seller the target’s shares in order to (indirectly) acquire the
entire target’s business
V A transfer of shares does not constitute a transfer of the target’s business → thus the rules
governing transfer of business (e.g., third party consent for the transfer of contracts,
receivables, etc.) do not apply
V Tax implications  in a business transfer through asset deal, there is a 3% registration tax
on the value of the net assets, 0.5% on receivables and 9% on real estate assets.
Sale of shares: 1.2% tax on capital gain (+0.2% transfer tax for shares, 0% for quotas of Srl),
spinoff = contribution in kind has no taxes 0%.
Moreover, deferred tax assets can’t be transferred via transfer of the business, they remain
with the legal entity

DISADVANTAGES of Share Deals

X Target company will continue to have all the liabilities generated during its previous
ownership
X Target company may have un-desirable assets, such as obsolete machineries or
inventories, and legal or business problems, such as unfavourable contracts or pending
litigation → importance of the due diligence investigation and determine the transaction
perimeter
X Unless buyer acquires 100% of the target’s shares:
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 ° the existence of minority shareholders has some legal implications
° if target is listed risk of triggering the obligation to launch a mandatory tender offer

SALE OF ASSETS  company A directly transfers the business to company B, which acquires and
runs the business in a direct way.

Asset deal = purchase and sale of selected, specifically identified assets of the seller and/or
assumption by buyer of the relevant liabilities

Sale of shares and sale of assets have similar results: company B running the business originally
run by company A. The main difference is that in the first case company B runs the business
through the ownership of shares in company A (which becomes a subsidiary) so it’s an indirect
control of the business, while in asset sale it is direct.

Advantages:
V Buyer purchases only certain assets (i.e., those agreed by way of negotiation) Cherry picking
V Buyer assumes only certain liabilities (i.e., those agreed by way of negotiation)
However, when the assets are organised as a “going concern” (business – “azienda”) then specific rules
apply: certain liabilities of the transferor are “transferred” by operation of law to the transferee, even
though the parties have expressly excluded those liabilities from the transfer (thus the third party creditors
have a course of action against the purchaser and, if the purchaser pays the relevant debt, then it has a
course of action against the seller)

Disadvantages:
X As the legal entity operating the business changes (from the Seller to the Buyer), the
transaction is usually more complicated
° identify each assets / liabilities
° properly document and transfer title to each of such assets
X Third party’s consent (regulatory?)
X For transferring contracts and agreements to Buyer it may be necessary to obtain the
consent from the other party thereto (unless the contract or agreement permits such
assignment)  if a single contract is transferred you need the consent of the third party
involved in the contract, while if there is a whole business transfer then contracts are
transferred automatically without need for third party consent (unless the contract
states..)
X The seller is not released from pre-existing liabilities  in a share deal, new shareholders
bear no risk for liabilities incurred by the company, while in asset deals it’s different...
X Tax implications  registration tax

In the context of a transfer, the business is defined as = group of assets, contracts, rights,
obligations owned and assumed by an entrepreneur in order to run a certain activity  going
concern.
According to Italian law, business = “a combination of assets (tangible and intangible) organised by
the entrepreneur as a going-concern to run and manage a business activity”.

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The concept of business comprises not only assets, but also the various relationships pertaining to
the running of the relevant business activity:
• contracts
• relationships with employees
• accounts receivable
• accounts payable...

Business transfer:
It’s possible to pick and choose certain assets and liabilities, but there are exceptions ->
employment relationships are always protected so it’s not possible to transfer only part of these
contracts.
Employees are protected: employment relationships must be entirely transferred and, moreover,
if there are liabilities incurred in the past before the transfer (e.g., social security contribution)
then the acquiring company is responsible for those liabilities.
General rule: excluded liabilities and unknown liabilities are not transferred, but if they
are related to employment contracts then they’re transferred.
(Then if the contract clearly states which liabilities are transferred, company B can appeal against
company A but that is a contractual relationship between A and B; the third party, the employee,
has a course of action vis a vis the new employer)
In general, excluded and unknown liabilities are not transferred to the buyer together with the
business, but there are some relevant exceptions:
a) Employment relationship
Transferred irrespective of contractual provisions,
b) Environmental obligations
even if expressly excluded from the transfer
c) Taxes (unless a tax certificate...)
d) Sanctions for crimes committed in the interest of the company

Certain liabilities incurred by the seller in running the business are, by operation of law,
“transferred” to the purchaser together with the business, even though the parties have expressly
excluded such liabilities from the transferred business, or they were unknown by the parties.
 the third-party creditor, has a course of action both against the seller, and the purchaser.
If the purchaser pays to the third-party creditor the debt which under the agreement had not to
be transferred (e.g., unknown liability belonging to one of the categories indicated above), then it
has recourse against the seller.

Apart from these exceptions, buyer and seller can agree in the contractual specifications the
assets and liabilities they want to transfer (pick and choose).

Moreover, in any business transfer, irrespective of any provision in the contract (valid between the
two parties) wrt to third parties the seller remains liable for the debts incurred by the business
before the transfer  the seller cannot transfer its debts unless the creditor accepts.
In the contractual relationship between seller and acquirer the two parties can determine
whatever they want but these contractual provisions are subordinated to legal ones (whose
objective is to protect third parties’ interests).

If a liability (arisen before the transfer of the business) is transferred but the buyer doesn’t fulfil its
obligation, the 3rd party creditor can act against the seller who in turns will likely pay and act
against the buyer (because the contractual agreement stated that the liability was transferred
from the seller to the acquirer).
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In general, the seller of the business is not free from the debts arisen before the business transfer
unless the creditors agree.

Liabilities relating to assets that are not transferred they’re not transferred as well (e.g., liabilities
related to a real estate asset not transferred to the buyer).

SPIN OFF  transaction according to which a company contributes an asset (usually a business) to
another company in exchange for shares in transferee company.
Company A transfers a business to company B and subscribes shares of company B.

To subscribe the share capital of a company means to acquire shares in the company in exchange
for money, assets, receivables etc.
 The spinoff is in fact a “contribution in kind”: the subscription of the corporate capital of
the subsidiary by way of transferring assets.

Through a “spin-off” a company transfers part of its assets and liabilities (normally, a “business”)
to another company, either pre-existing of newly incorporate upon the spin-off, in exchange of
shares of such transferee company
 The spin-off is different from the sale of business, because the consideration is made by
newly issued shares of the transferee company (instead of money)
 The spin-off is a contribution in kind, and it requires an evaluation process – because the
contributed business forms part of the corporate capital of the company receiving such
assets, specific rules regarding the formation of the capital apply
 The spin-off is different from the de-merger, because in a spin-off the company itself (and
not its shareholders) receives the shares in the transferee company.
 No taxable transaction

MERGER
Transaction according to which (at least) 2 legal entities are combined into a single legal entity ->
shareholders of the legal entities become shareholders of the surviving legal entity.
Different classifications:
- Forward, reverse, consolidation
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 - Horizontal, vertical, conglomerate
Merger = “combination of two or more companies into one absorbing company”.
 The absorbing comp. assumes all of the existing rights and obligations of the absorbed
comp.
 Creditors of the absorbed comp. may rely on the corporate assets of the absorbing
company
 The original shareholders of the absorbed company become shareholder of the surviving
entity → the number of shares granted to them depends on the exchange ratio →
negotiation, but the basic rule is that the overall economic value of the shares owned prior
and after the merger should not change
 Neutrality  neutral transaction from a tax perspective: zero taxes

DEMERGER
Through a de-merger, a company (the “de-merged” entity) transfers all of its assets and liabilities
to two or more companies (the “beneficiary” entity/ies), pre-existent or newly incorporated, or
part of its assets and liabilities, in such case also to one beneficiary only, and the related shares or
quotas to its shareholders
Total demerger: all the assets of a company are transferred to more than one new or existing
companies; the demerging company ceases to exist without undergoing any liquidation procedure
Partial demerger: part of a company’s assets are transferred to one or more new or existing
companies; the demerging company continues to exist.

The shareholders of the demerged company receive shares or quotas of the beneficiary company,
in exchange for the reduced value of the shares they own.
 Proportional demerger: the shareholders of the demerging company receive an amount of
stock in the beneficiary company proportional to their participation in the demerging
company
 Non-proportional demerger: the shareholders of the demerging company receive an
amount of stock in the beneficiary company not proportional to their participation in the
demerging company

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Demerger is a trilateral transaction:
° Demerged company  transfers the business
° Beneficiary company  receives the assets + issues shares increasing the capital
° Shareholders (of demerged company)  receive shares of the beneficiary

Also in the case of a demerger we have:

- Economic valuation -> principle: final value for demerged company’s shareholders must be
equal to the initial value
- Neutrality rule -> both from an economic and tax perspective

Rights provided by shares: economic (dividends), voting (in shareholders meetings), but do not
provide the right to run the business, which is a peculiarity of directors, appointed by
shareholders. Shareholders have the right to vote in crucial decisions such as: directors
appointment, approval of financial statements, distribution of dividends, capital increases,
changes in the bylaws, mergers demergers and other extraordinary transactions.

Usually, the principle applied to decisions is the majority: of course it there is only one controlling
shareholder holding 100% or, alternatively, at least 51%.

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SPA: Sale and Purchase Agreement (class 7/2 and ...)
Whenever there is a sale of shares, there is a contract regulating that sale.
The SPA is a contract for the transfer of the full title to:
 Shares in SpA (i.e., securities representing a contractual position)
 Quotas in Srl (i.e., the contractual position of the quotaholder of the company)
in exchange for consideration.

While the transactions we previously saw were corporate transactions, the transfer of shares and
quotas is a contractual transaction (and the rights and obligations of the parties involved are set
on a case-by-case basis and are negotiated).
If there is a demerger, there must be an expert determining the exchange ratio, because the
demerger must be a neutral transaction.
In a sale of shares, any company can decide the amount and the price of the shares of the
subsidiary, there is no provision of law determining neutrality and other mandatory conditions.

The decision to sell the shares is made by directors (it’s a management decision) while the amount
and price are the result of a negotiation process.

The contract is in fact the place where everything is determined and SPA contracts are sort of
“standardized” even though they might be very complex, because the beyond the simple sale of
shares in exchange for a price there are many features and obligations to take into consideration.
Determining the purchase price might be very complex as well.
For all these reasons, SPA contracts have sections which regulate parties’ obligations:
o Sale and purchase (and determination of purchase price)
o Representations and warranties (and related indemnity obligations)
o Other ancillary covenants (e.g., interim management, non-compete undertaking)
o Other ancillary agreements (e.g., escrow, transitional services agreement)

Shareholders are never liable for company’s obligations, but they make their own valuations of the
balance sheet, business model, projections etc. in order to understand the convenience of the
deal, the value of the company and the consequent fair purchase price...
However, there might be unknown liabilities (e.g., environmental clean-up) and in this case the
buyer is not liable for those liabilities but he has already become shareholder paying a certain
price which might become not fair anymore -> as a rule, the buyer is not protected for the
liabilities (or the absence of future revenues): he is not liable but he’s not protected neither.
The contract will provide protection to the buyer for those cases, in the representations and
warranties and indemnity section.

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Class 11/2
In case of a SPA, the Italian law provides protection to the buyer with respect to potential liabilities
of the company -> and this protection is the same for a big multinational and a small company; the
difference is then in the body of the SPA.
In general, Italian law protects the buyer of a good in the case the product acquired doesn’t satisfy
the agreed features, it doesn’t have the qualities that the seller has promised.
In case of sale of shares, the subject matter is the ownership of shares, irrespective of the nature
of the business whose shares are transferred.
The buyer is protected (representations, warranties and indemnities) but the law only provides
protection for the object of the transaction (the shares) not for liabilities, fraudulent financial
statements etc. relating to the business
 it is a matter of negotiation for the buyer to be protected against liabilities and other risks.
There is no law requirement that obliges SPA to contemplate a set of representation and
warranties and indemnity clauses, so it’s up to the buyer to protect himself with negotiation
implementing reps, warranties, indemnity clauses etc.

The law gives protection in case of fraud but only if the fraud concerns the subject matter of the
sale (shares), not other elements pertaining the business.
Moreover, we can’t say it’s fraud if the buyer doesn’t ask for information.
(e.g., I buy Juventus’ shares at a certain price believing C. Ronaldo is still playing for Juventus but I
don’t pay attention to the fact that Ronaldo has changed team and the spa contract doesn’t clarify
anything about this matter -> I do not have protection).

Presupposizione  the implicit assumption that a certain aspect was crucial for the completion of
the transaction is difficult to demonstrate -> and that’s why the parties should be exhaustive in
defining the conditions of the contract, determined through negotiation.
The historical origin of this problematic was: rent of a window on the place where there was the
queen’s parade the following day; it was well known and evident to anybody that the price of the
contract was affected by the queen’s parade. If at the end the parade wasn’t made, the buyer
would be protected by the law.

In Italian law, every agreement shall be negotiated, structured and signed in good faith (buona
fede), but this is a relative concept, sometimes difficult to prove.
Identifying what good faith means on a case-by-case basis is not easy at all.
In theory, each party should consider what is the best interest for itself and the other party.
What happens if the authorities make a control of a company and find out irregularities made by
the previous management? The buyer is not protected, there is fraud but it’s not made by the
shareholder (the seller, previous owner) but the managers.
The fraud of the shareholder incurs if he knows there is a certain liability and he tries to hide it.
If the purchaser asks to the seller if he knows about the existence of any liability and – despite the
knowledge of that – the seller puts in place artifizi e raggiri (proof of bad faith) to hide this liability
then the buyer is somehow protected against this fraud, but it’s still a grey area
(and that’s why parties should agree on the terms, conditions, reps and warranties etc. in the
contract, in order to avoid doubtful situations)

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START OF NEGOTIATION – SIGNING: non-binding phase
In most cases, the execution of the contract is not the date when the actual sale and purchase of
shares occurs, because in many cases there might be actions between signing and closing.
For instance, any time there is an antitrust issue (revenues of the target are above a certain
amount), the buyer needs to obtain the approval from antitrust authorities.
Or any time the company belongs to special categories such as insurance, bank etc. the buyer
needs the approval or regulatory authorities.

Two main items are negotiated in any SPA:

1) Price
2) Representations, warranties

Assume a producer of labels which has one main client Coca-Cola and the revenues mainly come
from this supply relationship.
The buyer of the company determines its value based for instance on future revenues, therefore
it’s crucial for the buyer to review that supply relationship and contract with Coca-Cola before
performing the acquisition of shares -> this can be done through DUE DILIGENCE.

In such a case, representations (e.g., the seller didn’t breach any supplying contract) are crucial:
without the representation, if after the purchase the buyer discovers that the supply relationship
with Coca-Cola was not long-lasting as the seller stated, he isn’t protected by the law and it would
become a matter of demonstrating bad faith, presupposizione etc. which is not easy.

The purchaser is normally not protected from potential liabilities of the target company.
Representations are statements of the seller related to the business (financial statements are
correct and truthful, employment relationships are correctly regulated and salaries are paid,
contracts do not have changes in control etc.).

Representations give the buyer protection under the contract: reps are crucial also to indemnify
the buyer in case of “breach of reps and warranties” = factual situation different from the one
disclosed and presented by the seller.

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SIGNING – CLOSING: binding phase
Assume between the signing and closing, Coca-Cola breaches the contractual relationship with the
seller of the Spa (or Cristiano goes away) before the closing.
If the agreement says nothing, the purchaser is not protected, unless:
if between the date of execution of an agreement and date of the performance, there are
unforeseeable events that change the valuation of the company and make the agreement
excessively onerous (eccessiva oneserosità soprravennuta) then the agreement can be
terminated. But once again it’s difficult to define terms such as unforeseeable events and
excessively onerous.

The closing of an agreement is subordinated to:

- Closing condition
- Price

One example of closing condition may be: absence of “material adverse change MAC” (e.g.,
erroneous valuation of the target firm): there might be a MAC provision that allows to terminate
the contract if some material changes occur.
Some events (e.g., heavy change in EBITDA) occurring between signing and closing may be
captured by the formula defining the price.
Seller is interested in:
° releasing no reps and warranties
° releasing the minimum amount of representation and warranties
° releasing reps and warranties based on already known events and conditions (i.e., the reference
date of reps and warranties: signing date)

“Bring down”: repetition of reps and warranties on the closing date, with an obligation of the
seller to indemnify any events that occur between signing and closing that would represent on
closing date a breach of reps and warranties.

“Anti-sandbagging provision”: provision that sellers in M&A transactions often try to include in the
merger or purchase agreement to ensure the buyer cannot bring an indemnification claim based
on an inaccuracy or breach of a representation or warranty that the buyer knew about before the
closing if the buyer chooses to proceed and close the transaction despite the inaccuracy or breach
of the representation.

PRE-CONTRACTUAL DOCUMENTS:
The non-disclosure agreement ("NDA", also referred to as "confidentiality agreement") is a
contract having binding nature that offers protection where two or more parties will be disclosing
confidential information to each other, whilst they need to preserve confidentiality when
exchanging commercially sensitive information.
Under the NDA the party receiving confidential information undertakes to keep it confidential, not
to use it for any purpose other than the negotiation of the transaction and not to disclose it to any
third party. The NDA allows the parties to get to know each other better so they can decide
whether to enter into a deal.

The undertakings of an NDA can be:

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“mutual”  each party provides confidential information to the other party, and each receiving
party undertakes to keep confidential the received information
“one-way” 1 party provides confidential info to the other which undertakes to keep it
confidential
Main issues in NDA:
» How to define the "confidential information"
» How to identify the breach of the confidentiality undertaking
» For how long the confidentiality undertaking shall survive
» How to determine the damages in case of breach

Letter of intent: preliminary document, typically used to introduce a transaction and to ensure
that the parties involved in the negotiation understand and express their respective interests.
The LOI is normally intended to be non-binding upon the parties, as they:
 make their interests and objectives reciprocally known
 agree to continue negotiations in good faith for a certain period and
 outline the key topics of the transaction and the key steps of the negotiation.

Historical case: Segrate battle between Berlusconi and De Benedetti, when Berlusconi wanted to
acquire Mondadori.

The letter is non-binding in the sense that it’s not mandatory to enter into the agreement, but the
more the negotiation goes on the more the principle of good faith provides that the counterparty
always can decide until the very end not to enter the contract unless it has created the certainty
on the other party that the agreement was to be executed.
Without good faith, the party terminating the contract is usually obliged to restore damages.

Usually, there is a section which is binding: the exclusivity agreement  an exclusivity agreement
is a binding agreement, or sometimes a provision inserted in a document having a wider scope,
which lays out the terms and conditions upon which the parties undertake to negotiate a certain
transaction exclusively with each other and to discontinue negotiations with third parties, for a
specified period of time. The purpose is to define the relationship between the parties and to
confirm that they are dealing only with each other to the exclusion of everyone else.

Core "steps" of the negotiation

a) Financial statements  "picture" of the company that forms the basis of the agreement
b) Representations and Warranties  primarily aimed at the company's assets and liabilities
c) Signing of the Agreement - Purchase Price
d) Interim management  buyer protection for any changes, due to extraordinary activities
carried out by the target in the interim period between signing and closing
e) Date of Closing  transfer of title and payment of the (provisional) purchase price
f) Price adjustment  new financial statements as at closing date -> contractual provision that
allows for increases or decreases in price depending on certain condition

Price adjustment clause gives an idea of how much SPAs are dynamic in their process

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DETERMINATION OF THE PRICE
3 main price determination criteria
1. Fixed price  “locked-box”, based on historical data. It’s typical in PE transactions.
The transaction is structured as if the company was purchased at the reference date of
financial statements; everything that happens in the middle is on the buyer and the buyer
pays an interest in the interim period.
No leakages provision: leakages are payments for extraordinary events (e.g., dividends paid
to the seller) between the reference date and the closing date.
The buyer acquires the company with whatever profit, cash, losses generated or incurred
between reference date and closing date, except for payments made to the seller.
The price is fixed minus leakages.
2. Fixed but determinable after closing  price is determined on the basis of financial data as
of the closing date (e.g., agreed EBITDA x multiplier +/- Net Financial Position at closing +/-
changes in Working Capital).
The adjustment of working capital is useful in order to avoid opportunistic accounting tools
to hide financial debt under the veil of commercial debt.
3. Variable  i.e., a portion is fixed (paid at closing) and a potential additional portion is
subject to "earn-out" on the basis of the performance after the closing date (e.g. € 1,000 +
x% of the revenues for the following two financial years

In all cases where the price is not determined, the sale and purchase agreement will contain
mechanisms for determining the variable elements of the price (price adjustment clauses).
The purchase price will also depend on the contractual strength of the parties and other
circumstances of the specific case.

Earnout -> variable additional element of the purchase price depending on future financial results.
This provision requires lots of negotiations and has a very relevant issue: the seller finds it difficult
to forecast how the business will be managed by the new buyer and managers appointed by him
so it’s difficult to forecast future financial results.

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Class 14/2
Conditions to closing  Normally there exists a “time gap” between signing of the SPA and closing
of the transaction. This is due to various reasons, e.g. regulatory approvals and/or financing
and/or corporate restructuring.
In some cases the obligation to perform the closing is subject to certain conditions precedent:
ü anti-trust authorisation*  especially if the business combination exceeds determined
thresholds in terms of size, revenues
ü other regulatory approvals (foreign direct investment – FDI; Bank of Italy; IVASS; etc.)
ü third party approval (e.g., in case of contracts containing change in control clauses)
ü corporate restructurings (demergers; transfer of assets)
ü no material adverse change ("MAC“).

*Usually, the competence in giving the authorization depends on the location of the parties
involved and also on the dimensions: if certain thresholds are exceeded, it’s the EU antitrust
commission to have the competence to give or not the authorization.
Italy is one of the unique countries in which, if the thresholds are exceeded, the parties can close
the deal even without the explicit authorization of the authority but just notifying the authority
(however, parts are exposed to the risk of subsequent reject from the authority)

REPRESENTATIONS AND WARRANTIES

Sale and purchase agreements generally contain a very extensive set of representations and
warranties released by the seller in favour of the buyer.
This is because in a sale and purchase agreement, although it falls within the contractual type of
the "sale" (provided for in the Civil Code), the subject matter of the contract is the sale of the
shares or quotas of the target company and not the target company’s business.
When the agreement is silent, if after closing the company incurs in liabilities deriving out of the
running of the business prior to closing, the purchaser is not protected by operation of law.
The warranties provided for by law in favour of the purchaser (Articles 1490 and 1497 of the Civil
Code) relate to the “subject matter" of the sale and purchase.
According to the majority of case law, the “subject matter" of the SPA is represented by the shares
or quotas, and not the assets or the business of the target company.
The purchaser may not rely on the "legal" warranties provided by the Civil Code in relation to
defects or liabilities affecting the goods or assets of the company being sold.
Other remedies under the law (mistake, fraud, assumption, etc.) are unlikely to be available to the
buyer. In this situation, contractual representations and warranties are normally negotiated in
favour of the buyer with respect to the business or assets of the target company (so-called
business warranties).

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Different theories have been proposed concerning the legal nature of the representations and
warranties contained in SPAs, which, broadly speaking, can be divided into two main categories:
§ According to a first (minority) theory, reps and warranties are "promised qualities" of the
shares/quotas under Art. 1497 of the Civil Code;
§ according to another (majority) doctrine, reps and warranties are not "promised qualities"
of the shares/quotas under Art. 1497 of the Italian Civil Code.

Adhering to one or the other opinion means considering whether or not Article 1495 of the Civil
Code applies to warranties
Article 1495 of the Civil Code provides that warranties are barred by the (mandatory) term of one
year after closing, whilst normally the reps and warranties under SPAs have a longer term (3 to 5
years, up to 10 and beyond).

§ Legal Warranties: somehow duplicate mandatory provisions of Italian law. Thus, even
though they were not included in the SPA the purchaser would be in any event protected
by operation of law; (-> fundamental warranties)
§ Business Warranties: are required to be included in the SPA for the purchaser’s protection
as to their subject matter.
Legal Warranties are normally referred to as “fundamental warranties” in respect of which the
limitations of the indemnity obligations (as to time and amount – see next slides) do not apply.

Example: the buyer B purchases 100% shares of a company from the seller S. In the meantime, the
target company has performed a capital increase -> without reps and warranties, the buyer is not
protected from this event.

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The "Disclosure Schedule" may be of two types:
a) "Affirmative": contain a list of certain circumstances relating to the target's assets: e.g.
"Annex [x] contains a complete list of all trademarks, patents or patent applications for industrial invention,
trademark or ornamental or utility model held or used by the Companies (...)"

b) "Negative": contain a list of the "exceptions" contractually recognised to the relevant

warranties: e.g. "Except as set forth in Annex [x], there are no pending or threatened third party
disputes of any nature whatsoever, whether judicial or extrajudicial, concerning, in any respect, the
intellectual property rights".

If the seller doesn’t give the representation related to FINANCIAL STATEMENTS: if after the
acquisition the buyer discovers the financials were false, fraudulent...the buyer doesn’t have any
course of action against the seller but - becoming a shareholder - he has course of action against
the directors for mismanagement.
In case of directors’ liability, there must be two triggering events for litigation:
° mismanagement (i.e., breaching a provision of law)
° damage  this is quite tricky, because it refers to a damage for the company

Normally, when there is the transfer of ownership of a majority stake, the new buyer appoints a
new board of directors. Nevertheless, the old directors are potentially liable for 5 years after the
termination of their contract.

The rep on financial statements at a certain date also implicitly guarantees that there are no other
liabilities relating to events prior to the reference date that should have been recorded in the
Statement of Financial Position according to the accounting principles and were not recorded (e.g.,
provision for bad debts after solvency investigation).

UNDISCLOSED LIABILITIES  An additional protection for the buyer is to require a warranty as to

the “absence of undisclosed liabilities":
"As at [31 Dec. 2021], the Company had no current or contingent liabilities of any kind arising from acts
and/or transactions entered into by the Company on or before [31 December 2021] and/or from
circumstances or situations of fact existing on that date and not resulting from the Reference Financial
Statements".

17
Thus, the buyer is also protected against liabilities (known or unknown; actual or contingent) that
should not have been recorded on the basis of the Accounting Principles; e.g. provision for bad
debts without having carried out a solvency investigation or full provision for litigation.

Financial statements are drafted at a certain reference date which is performed few months
before the signing: accounting principles require to record liabilities according to certain rules.
Example: litigation involving the target company -> during the litigation, each year end, the
directors should disclose the risk deriving from that litigation. There is an analysis made by the
directors to determine the risk of losing the litigation: if the risk is only remote it can be ignored
and not included in the financial statements.
A similar case was referred to the Segrate battle, when Mediaset was sued 500m for corrupting a
judge during the litigation between Berlusconi and Formenton family. However, Mediaset
directors decided not to record any potential liability, because they were sure to win the case in
the end.

"Catch-all" warranties are those that summarise the presence or absence of certain circumstances
or the observance of certain rules; a typical example is the repres. on "compliance with laws":

How Reps and Warranties work:

Before the acquisition of shares, the buyer (or its lawyers, advisors etc.) perform a due diligence of
the target company.
The due diligence analyses in deepen the target company under many aspects (financial, legal,
competitive etc.) and gives a picture of the company and outlines.
Due diligence has a twofold importance
- allows the buyer to identify potential liabilities (-> understand risks and ask for protection)
- allows the seller to be aware of those liabilities and tailor the reps&w accordingly
Representations are statements made by the seller (as a result of a negotiation process) which
guarantee the buyer against potential risks arising from the acquisition of shares.
If the representations made by the seller reveal to be fraudulent, untrue (reps are breached) then
the buyer is protected by the law; without those representations the buyer wouldn’t be protected
and wouldn’t have course of action against the seller.

INDEMNIFICATION
Two conditions must occur to have the indemnification:
1. Breach of reps and warranties
2. The damage -> the negative consequence for the company
Indemnification is a crucial form of protection for the buyer: the seller is obliged to indemnify the
buyer for any breach of warranties, i.e., for any inaccurate or untrue representation.

The typical function of the indemnity obligation in an SPA is to indemnify and hold the buyer
and/or the target company harmless from the negative consequences (“cost, damages and
expenses”) deriving out of the discrepancy between what is stated by the seller in the

18
representations and warranties section of the SPA and what actually exists in the business of the
target company as at the reference date of the reps (so called “breach of rep”).

(Special indemnity: for instance, the buyer is aware of a litigation in which the target is involved
and therefore he may °offer a lower purchase price or °pay the same price including a special
indemnity which allows to receive an indemnification in the case of losing the suit and being
obliged to pay a certain compensation)
Example with taxes: the buyer performs the due diligence and discovers there are issues in VAT
payment concerning the target company which may imply future tax issues and litigations.
However, the seller believes and represents that there are no tax-related liabilities according to its
estimates, policies and considerations.
The issue comes to the relevance of the due diligence and the knowledge by the buyer of potential
liabilities arising from breaches of reps and warranties.
The question is whether the buyer – which knows the representation is wrong – can seek for
indemnification if after the closing of the deal it comes out there actually were tax issues.
 Good faith  the seller may claim that the buyer entered the agreement on purpose and
in bad faith because he knew about that potential tax liability
 Pro/anti sandbagging clause  in the anti-sandbagging clause, the buyer represents he’s
not aware (before closing the deal) about any breach of reps and warranties -> the buyer
won’t be entitled to seek indemnification if he was aware of the risk.
Again, it’s a matter of negotiation whether to include these clauses in the contract or not.

Two aspects are always negotiated:

1. Amount of indemnification  determination of a cap and a threshold (max and min) and
also a negligible amount for which the seller is not liable (e.g., 500 euros)*
2. Time limit  until when the buyer is protected (until when he’s right to have recourse
against the seller in case he discovers previously unknown liabilities)

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 *
The above limits do not apply in case of fraud of the seller (i.e., when the seller has fraudulently
hidden a known liability to the purchaser). Doubts whether they would apply in case of gross
negligence (i.e., when the seller “should have known” the existence of an undisclosed and
unknown liability by using professional diligence).
The above limits normally do not apply for breach of fundamental warranties

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Example:
Tax representation covers a period of 5 years. If in this period tax authorities make an inspection
and reach the conclusion that taxes were not correctly determined before the closing or the
signing, then there is a tax claim. It doesn’t immediately involve a liability which will occur after
the 5y time limit of the indemnification.
In a case like this, the buyer is entitled to raise a claim against the seller for tax misrepresentation,
because the issue was discovered within the 5y time limit; he will be protected as long as he has
sent a claim to the seller due to the potential breach of reps&w within the 5y term.
If tax authorities or the buyer discover the misrepresentation after the time limit, then he won’t
have any recourse of action against the seller (except for the case of fraud).

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Normally there is a third party (tax authority in this case) claiming vis a vis the target company that
something was wrong.
The potential liability of the seller under SPA depends on the outcome of a litigation between the
target company and a third party, so another material issue which is discussed and negotiated is
the handling of claims: how the target company will handle the claim, who would lead the
litigation, who would pay the costs, who would appoint the lawyers and who will decide the
settlement (the buyer will want full power and authority to negotiate with the third party because
in the end he will pay the seller and the seller will want to control the claim because he will be
obliged to pay).

TAKEOVER (Acquisition of Listed companies). 18/2

Under Italian laws, takeover (or tender offer) means any offer, invitation to tender or promotional
message, in whatever form, involving the purchase or exchange of financial products:
 addressed to a number of persons exceeding 150 and
 relating to financial products for a total consideration of at least Euro 100,000.
Normally, the takeover is a proposal to enter into a sale and purchase agreement SPA of securities,
made by the potential purchaser to an indefinite number of addressees, under certain formalities.
It applies to listed and non-listed companies.
The owners of the target company’s securities are entitled to accept the offer (i.e., tender the
securities) or not. If they accept the offer, the sale and purchase of the relevant securities is
performed upon the terms and conditions of the relevant offer.

It is possible to buy shares in a listed company without using a tender offer (through private SPA)
-> the tender offer is made to at least 150 shareholders for a consideration of at least 100k euros.
If below those thresholds, the purchase of shares can be performed through private negotiation
and the SPA (sell purchase agreement).
The tender offer is a mandatory process to buy shares of a listed companies whenever it is
directed to at least 150 shareholders for at least 100k euros. Then the tender offer can be vol. or
mandat.

The takeover can be:

 "voluntary" (i.e., based on the discretional decision of the offeror to launch the takeover)
or
 "mandatory" (i.e., mandated by the law, as a consequence of certain triggering events) 
under Italian law, if the bidder passes the threshold of 30% stake in the company as a
consequence of private SPAs, then the bidder is obliged to launch a mandatory tender
offer; current shareholders are not obliged to accept. The price is not freely determinable,
but it must be at least the one paid by the bidder to acquire firm’s shares in the previous
12 months; moreover, the mandatory tender offer cannot be subordinate to any condition
From a procedure perspective, the provisions applying to voluntary offers are also generally
applicable to mandatory offers.
However, there are two main differences between voluntary and mandatory offers:
(1) Price
The Price in voluntary takeovers is freely determined by the bidder and can be made in cash or
securities (“exchange offer”).

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The Price in mandatory takeovers cannot be lower than the highest price paid by the bidder (or by
persons acting in concert with it) for the same securities in the 12 months before the offer is
announced, and (except when the offeror has acquired all the shares in the target company by
way of exchange of securities) shall be made in cash or, if made in securities, there shall be a cash
alternative.

2) Conditions
- Voluntary takeovers can be made conditional upon events which do not depend upon the mere
will of the offeror.
- Mandatory takeovers cannot be subject to any conditions.

Recommended vs. Hostile takeover

Hostile takeover is an offer which is not agreed with neither °incumbent shareholders nor
°directors of the company.
Since the offer is made to shareholders and since in Italian law we have “passivity rule” (directors
of target company cannot put in place frustrating actions -> aimed at complicating the offer and its
completion) there is not so much difference.
 There is no real difference between a "recommended" or a "hostile" takeover: the offer is made
to the shareholders, not to the management body.

The management body of the target company may not engage in any act or conduct aimed at
opposing the success of the takeover, unless expressly authorized by the shareholders' meeting
(the so-called “passivity rule” – see below).

Listed companies are subject to much higher regulation, disclosure requirements (of any price
sensitive information) etc. and for this reason in some cases the purchaser wants to delist the
target.

2 main ways to take control of a company:

1. Private purchase of shares through SPAs -> reach the 30% threshold -> launch a mandatory
tender offer to purchase the remaining shares if the shareholders accept
2. Voluntary tender offer  it allows higher degree of freedom in determining the price and
conditions of the offer;
However, there is lower protection in terms of indemnities against potential liabilities of
the target company because there are no privately negotiated Spas
Due diligence and takeover
There are no statutory rules expressly requiring that due diligence can or cannot be carried out in
the context of a takeover.

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Once the notice of the decision to launch a voluntary takeover is filed with Consob, the offer is
irrevocable and cannot be withdrawn by the bidder.
Accordingly, to the extent possible, any due diligence exercise should be conducted before the
launch of the offer, to assess in advance whether and under which conditions investment in the
target is desirable.
This is similar to what happened few months ago with KKR announcing TIM’s board of directors to
launch a voluntary tender offer (it’s non mandatory, it’s just an expression of interest) subject to
due diligence.
As a general rule, bidders must be treated equally. It is argued, though, if the target, which
provides information to one bidder, is obliged to provide the same information to the other
bidders who have asked to obtain such information. Because directors are responsible for
protecting the interests of the company, they will grant the bidder access to confidential
information only to the extent that the potential offer is deemed to be in the interest of target and
its shareholders.
In principle, the target should not disclose to selected bidder information which is clearly "price
sensitive" and is not in the public domain. This may constitute a breach of Italian insider trading
rules by both the directors of the target and the bidder. The only way to provide any price
sensitive information to the bidder should be to disclose it to the market at the same time.
In due diligence there should be a section in which the bidder states whether he has received or
not information which is still not available to the market and which materially affects the price ->
in this way, current shareholders can make a rational decision whether to tender their shares or
not, based on the same information available to the offeror.
Whenever there is the possibility for a competing offer (higher price offered from another bidder), directors
are in a sort of trade off:
° on the one hand, they have the duty to act in company and shareholders’ interest, so their objective
should be to increase the competition for the acquisition of firm’s shares in order to increase the price
° on the other, directors want to protect price sensitive information
So, the question is: allow the due diligence or not?

CONDITIONS
Once launched, takeovers are irrevocable but voluntary offers can be conditional upon certain
specified events, which cannot be dependent solely on the "pure discretion" of the bidder.

(under Italian law, a company cannot be delisted unless a bidder has offered to acquire at least
90% of its shares and declares that he won’t restore a minimum floating -> in this case, if the
tender offer succeeds, minority shareholders will have the opportunity to sell their shares)

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(remember that conditions are allowed only in case of voluntary tender offers, while mandatory
tender offers are unconditional by nature)

FINANCING of the takeover

The takeover can be financed by way of third-party loan, but it cannot be subject to financing 
the price paid to shareholder can be made of cash and/or shares but it cannot derive from
financing.
To the contrary the takeover can be launched only when the bidder has certainty of funds for the
entire consideration of the offer (assuming 100% acceptances). The bidder may only make its
notification to Consob once it is in a position to fully fund the offer.
In case of exchange offer, before launching the offer the bidder’s shareholder meeting must have
approved the issuance of the bidder’s shares to be offered in exchange for the target shares.

If, as a consequence of a merger, the shareholder receives shares of a non-listed company, then he has the right
to withdraw (walkaway rule).
Moreover, neutrality rule applies: the value of the shares must remain equal .

SELL-OUT RIGHT
The majority shareholder of a listed company is required to allow all the remaining minority
holders of voting shares who request exercise their right to sell-out if it comes to hold:
 95% or more of the target’s voting shares as a result of a takeover aimed at acquiring the
entire share capital (mandatory sell-out); or
 90% or more of the target’s voting shares and does not reinstate sufficient floating stock to
ensure the regular trading within 90 days (voluntary sell-out).
The price shall be the same price of the prior takeover. In certain cases, the sell-out price is determined by
Consob taking into account: a) the previous offer price; b) the weighted average market price for the target
shares in the 6 months prior to notification of the offer; c) the value allocated to the shares by any existing
independent valuation reports, dated no earlier than 6 months prior to the purchase obligation arising; d)
any other acquisitions of securities during the last 12 months by the person subject to the purchase
obligation or by persons acting in concert with it.
If the sell-out obligation did not arise as a result of a previous takeover, the price will be established by
Consob based on the higher of: i) the highest price paid for the purchase of securities of the same class over
the last twelve months by the person subject to the purchase obligation or by persons acting in concert
with it; and ii) the weighted average market price for the six months prior to the obligation arising.

25
PRELIMINARY NOTICE
It must be made available when the shareholder has decided to launch a tender offer, because in
any case it is price sensitive information.
Anyone who is required or intends to launch a takeover must give a preliminary notice thereof to
CONSOB, to the target issuer and to the market, indicating (if it is the case) that:
i. any notice which is required to be made to any regulatory authority for the acquisition of
the relevant stake in the target company has been filed; and
ii. the shareholders meeting of the offeror to resolve upon the increase of capital of the
offeror (if such capital is needed as consideration of the offer) has already been called.
For takeovers that concern securities conferring the right to vote on resolutions concerning the
appointment or removal of directors or members of the supervisory board, there is an obligation
on the part of the respective boards of directors of the issuer and of the bidder to inform the
respective employees’ representatives or, where there are no employee representatives, the
employees themselves, as soon as the takeover is made public.

Within 20 days from the date of the preliminary notice, the buyer shall promote the offer by filing
with Consob a draft of the offer (“offer document”).
The Offer Document must contain all the information that is necessary for a complete evaluation
of the offer by the public, such as the terms and conditions of the offer, as well as information on
the offeror and the Target company.
CONSOB has the power to ask the offeror to make any amendments to the document and may
impose special requirements for the publication of the Offer Document, or request that special
guarantees be provided. Once CONSOB has issued its approval of the Offer Document (nulla osta)
or a 15-day term has elapsed with no requests by CONSOB, the Offer Document can be published.
If specific regulations require clearance from other authorities, Consob shall approve the offer
document within 5 days of that clearance being given.

MANDATORY TAKEVOER (21/2)

The takeover is mandatory when the bidder has acquired certain shareholdings of the target
company and is then obliged to offer the purchase of all the shares of the target company from all
other shareholders.
The mandatory takeover may concern only securities representing the target’s share capital that
confer voting rights in shareholders' meeting resolutions on the appointment or removal of
directors or of the supervisory board.
Consob may expressly include in the notion of relevant shareholding classes of securities that
confer voting rights on different matters, taking into account the nature and type of influence that
their joint exercise may have on the management of the company.

Any person who, as a result of acquisitions or increased voting rights, holds an interest exceeding
the threshold by 30% or has voting rights exceeding 30% of the same, shall launch a takeover
addressed to all holders of securities on all securities admitted to trading on a regulated market in
their possession. In companies other than SMEs, the threshold might be only 25% in absence of
another shareholder holding a larger interest.
The articles of association of SMEs may provide for a threshold other than 30%, but no less than
25% or more than 40%.

26
The takeover is a "full" takeover because the bid is addressed to all the holders of securities and
concerns all the securities in their possession.

The offer is irrevocable and cannot be subject to CONDITIONS.

PRICE  the price at which the mandatory offer is made may not be lower than the highest price
paid by the bidder, and by persons acting "in concert" with the bidder, in the 12 months preceding
the notice of the takeover obligation, for purchases of securities of the same class.
If no purchases for consideration of securities of the same class have been made in the 12-month
period, the offer shall be launched, for that class of securities, at a price not lower than the
weighted average market price of the last 12 months or the lowest available period.
The consideration for the bid may consist in cash or wholly or partly of securities. In the event
that: (a) the securities offered as consideration are not admitted to trading on a regulated market
of an EU Member State; or (b) the bidder (or a person acting in concert with the bidder) has, in the
12 months preceding the announcement of the offer, purchased for cash 5% or more of the voting
shares of the target, then, the bidder must propose a cash consideration as an alternative to the
non-cash consideration.

INDIRECT TAKEOVER
The purchase of a controlling shareholding in a non-listed company entails a mandatory takeover
when the purchaser indirectly holds an interest exceeding the relevant thresholds in a listed
company.
An indirect interest is deemed to exist when the assets of the holding company in respect of which
securities are held consist “mainly" of interests in listed companies.
A prevalence is deemed to exist when at least one of the following conditions is met:
a) the book value of interests represents more than one third of the assets and is higher than
any other fixed asset recorded in the financial statements of the holding company;
b) the value ascribed to the interests represents more than one third and is the main
component of the purchase price of the participating company’s securities.
Where the company's assets mainly consist of interests in several listed companies, the takeover
bid obligation shall apply only to the securities of companies with a value that represents at least
30% of the total value of those interests.

Mandatory takeovers could occur even after some events different from the purchase of shares by
the bidder, such as an increase in the voting rights performed by the company.
In indirect takeovers, the rule concerning the price (at least highest price paid to purchase shares
in the last 12 months) is not applicable.

Therefore, the obligation to launch a takeover exists even if the threshold of a 30% interest in a
listed company does not derive from the direct purchase of shares in that firm but from the
purchase of shares in another company which has an interest in the company, constituting its main
asset.
Due to an indirect purchase (or both direct and indirect purchases), a person comes to control
more than 30% of shares with voting rights of the listed company at the top of the chain.
This has the purpose of enabling the shareholders of subsidiaries to sell their shares in anticipation
of a change in control of the parent company.
27
In this case, it does not matter whether the company through which control is directly or indirectly
acquired is itself listed.
The obligation to launch a takeover arises for shareholders of the target company who already
own more than 30% but less than 50% of the share capital and purchase more than 5% of the total
number of voting rights, or of the capital represented by securities carrying voting rights in general
meeting resolutions that concern the appointment or removal of directors or of the supervisory
board, within a period of 12 months.

EXEMPTIONS:
Exceeding the 30% interest, whether directly or indirectly, does not trigger any obligation to
launch a bid in the following cases:

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(no mandatory tender offer if the threshold is exceeded as a result of the exercise of options)

There is no obligation to launch a bid if the 30% stake is held following a public takeover (voluntary
takeover) or exchange bid addressed to all security holders in respect of all securities held.
The threshold is exceeded as a result of a prior takeover (offerta preventiva totalitaria) aimed at
acquiring all securities, therefore all shareholders have the opportunity of selling their stake upon
the same terms and conditions.

There is no obligation to launch a bid if the 30% stake is held following a voluntary, preventive
takeover (offerta preventiva) involving at least 60% of the target company’s shares, if the following
three conditions are jointly met:
a) the bidder and the parties acting jointly with the bidder must not have acquired
shareholdings amounting to more than 1%, including by means of forward contracts with a
later expiry, in the 12 months prior to the takeover notice to Consob, or during the bid;
b) the effectiveness of the bid has been subject to the approval of as many security holders as
holding the majority of the securities, excluding from the calculation the securities held by
the bidder, by the majority shareholder, including in the event of relative majority, if the
stake exceeds ten percent, and by persons acting jointly with the majority shareholder;

29
 c) Consob grants the exemption, subject to assessing the existence of the conditions set out
in a) and b) above.

PERSONS ACTING IN “CONCERT”

Persons acting "in concert" shall mean:
a) persons who have signed a shareholders agreement, even if null and void;
b) a party, its parent company, and its subsidiaries;
c) companies subject to joint control;
d) a company and its directors, members of the management board or general managers;
e) persons who cooperate with each other in order to obtain control of the company.
The persons acting jointly are jointly obliged to launch a takeover when, following purchases made
even by one of them alone, they hold a total stake exceeding the relevant percentages (30-90-
95%).
The mere signing of a shareholders' agreement that combines a stake higher than the relevant
thresholds does not trigger any obligation to launch a takeover, provided that the relevant
thresholds have not been exceeded in the 12 months prior to execution of the agreement.

 PASSIVITY RULE
The target company shall refrain from putting in place actions aimed at frustrating the takeover,
unless such actions are authorized by the shareholders, with the favourable vote of a majority of
shareholders representing at least 30%* of the company’s share capital.
The passivity rule applies from the date the offer is firstly announced until the end of the offer
period or the date on which the offer ceases to have effect.
The most common "frustrating actions" are: (i) actions which increase the costs of the transaction
(such as increases of capital; conversion of bonds or saving shares into ordinary shares; buy-back
of shares); (ii) actions aimed at changing the financial situation of the company (such as sales of
subsidiaries; sales of business; mergers/de-mergers); (iii) actions making the success of the offer
more difficult (such as the launching of a takeover against the offeror; the acquisition of
businesses which may create anti-trust problems to the offer made by the offeror).
* On the contrary, there is no need of a specific approval by the shareholders for actions which
may frustrate the offer only indirectly (such as advertisements against the offer, or legal actions
against the offeror, or the research of a possible "white knight").
Firms may expressly derogate from the passivity rule by including specific provisions in their
bylaws.

 BREAKTHROUGH RULE
Under the breakthrough rule, upon the launch of a takeover:
(i) any transfer restrictions on the target’s shares set forth in the target’s by-laws will not
apply to the bidder;
(ii) any restrictions on voting rights set out in shareholders’ agreements or in the target’s
by-laws will not apply at shareholders’ meetings called to authorize defensive measures
against the takeover bid. Furthermore, shareholders willing to accept a takeover aiming

30
 at acquiring control of the target may terminate at will any existing shareholders’
agreements, with effect from settlement of the offer.
Further, at the first shareholders’ meeting to be held after the takeover has been completed,
called to amend the by-laws or to replace the directors, the bidder who has at least 75% of the
voting shares will not be subject to any voting restriction in any shareholders’ agreement or in the
company’s by-laws nor subject to special voting rights.
If the takeover is successful, the bidder shall indemnify the holder of those voting rights for any
economic damage suffered as a result of the breakthrough rule.
The breakthrough rule is optional and applies only if set out in the by-laws of the Target.
 RECIPROCITY RULE
The passivity rule and/or the breakthrough rule (if the latter is provided for in the by-laws of the
target) shall not apply in the event that a takeover is made by an entity which is not subject to the
same or equivalent rules in its state of incorporation.
Consob is competent to establish whether the rules applicable to the bidder are equivalent or
different to the rules applicable to the target.
However, the above rule only applies to any defensive measures that have been authorised in
advance by the shareholders’ meeting of the target, not earlier than 18 months prior to the
launching of the takeover.

JOINT VENTURES – SHARES / CLASSES OF SHARES

Joint venture agreement = business agreement by which two or more parties agree to pool their
resources together for the purpose of accomplishing a specific goal. This may be a new project
being entered into together or some other joint business activity.
Under Italian law a joint venture has no specific meaning and the arrangement between the
parties can take different forms depending on what the parties are trying to achieve.
Sometimes a joint corporate vehicle will be formed with the parties being the shareholders; other
form of joint ventures might be made through a mere commercial arrangement.
Whenever a joint corporate vehicle is formed by the venturers, a shareholders’ agreement is
executed between the parties as shareholders of the company. Shareholders’ agreement is within
a joint venture agreement and determines how to vote, how to distribute dividends, rights and
obligations of the parties involved in the j.v. agreement etc. it’s also possible to determine that a
third party will do something.
Key drivers of a joint venture agreements are: (i) the joint business purpose; (ii) the governance;
(iii) the exit rules.

Suppose to enter a joint venture agreement and shareholders agreement provides the obligation
for me (shareholder) to appoint Mr. X (another shareholder) as a director.
The agreement is valid between the parties, not vis a vis third parties and the company
represents a third party to that contract.
If I breach the agreement and vote to appoint another director, my vote is valid and Mr. X
has a course of action against me.
The parties can give “efficacia reale” (actual force) to the contractual provisions by
including those provisions in the articles of association. If the resolution breaches what
stated in articles of association, then the vote is not valid.

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(Articles of association are publicly available documents -> and that’s why they have actual force
and can be opposed to third parties, and the company)

Whenever the joint venture encompasses a company of which the parties to the agreement are
shareholders, most of the provisions of a joint venture/shareholders agreement can:
- remain at the level of the agreement;
- be incorporated in the articles of association of the legal entity.

Two main differences:

A. Consequences of the breach;
B. Disclosure
A. Consequences of the breach
A valid joint venture/shareholders agreement “has the force of law between the parties”: i.e., it is
valid, binding and effective between the parties thereto, which must abide by its provisions.
However, each party to any agreement might breach the relevant undertakings. In case of breach,
the non-breaching party has course of action in Court against the breaching party, with the aim of
seeking for: (i) the due performance of the agreement, if possible; and (ii) the recovery of damages
suffered as a consequence of the breach.
But the agreement has no effect °vis-à-vis the company (therefore, resolutions adopted in breach
of the JVA are valid and effective) nor °vis-à-vis third parties (therefore, sale of shares made in
breach of the JVA are valid and effective).
Provisions included in the articles of association of a company cannot be breached:
Any resolution adopted conflicting with the provisions of the articles of association is invalid and
ineffective vis-à-vis the company;
Sales of shares made in breach of the articles of association are invalid and ineffective vis-à-vis the
company and third parties.

B. Disclosure  agreement: private, no publicity vs. articles of association: public, deposited...

The joint venture/shareholders agreement is a private agreement with no publicity: thus, no third
party is aware of the existence and/or of the terms of the relevant agreement (exception made for
shareholders agreement relating to listed companies).
Articles of association of Italian companies are deposited with the relevant companies’ register:
thus, anyone is entitled to review and know the terms and conditions of any relevant provisions.

SHARES
GENERAL PRINCIPLES
In exchange for the contribution of cash/assets/receivables to the company, the shareholders
receive shares.
Article 2346 states that: “The corporate participation is represented by shares”.
The concept of “share” is twofold, it represents:
(i) from a substantial perspective, the contractual relationship between the company and
the shareholders
(ii) a type of securities (titolo di credito) which embeds rights and obligations deriving from
the corporate contract

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The person or the entity that subscribes a portion of share capital becomes shareholder and
receives shares in exchange for a contribution of at least the same value.
Shares incorporate the rights attributed to any shareholder (voting rights, economic rights, other
rights such as the preemption right) and usually these rights are the same for any share, unless
there are different classes or other provisions.

Unless otherwise provided for by the by-laws, each shareholder is granted a number of shares
proportional to the share capital he/she subscribes for a value not exceeding the value of the
contribution made by the relevant shareholder to the corporate capital.
The principle above can be derogated, subject to agreement of all the shareholders: shares can be
allocated among shareholders on a non-proportional way, provided that in no event can the
aggregate value of all contributions be lower than the full amount of the corporate capital.
Need to determine the value of the assets or receivables contributed by the shareholder:
valuation made by an independent expert.
Shareholders can contribute cash/assets/receivables for a value greater than the par value of the
shares they subscribe for: such greater value is referred to as “share premium” and it does not
concur to form the corporate capital (but a reserve).

Exceptions to (some of) the above-mentioned general principles are possible, by way of
amendment to the by-laws (resolution of the shareholders meeting).

RIGHTS of shareholders
Shares do carry equal rights but shareholders do not have equal rights.
The rights of shareholders can be classified in three categories:
a) rights granted to all shareholders, regardless of the number of shares owned  example:
attend shareholders’ meeting
b) rights granted only to shareholders that own a minimum percentage of the share capital
(which usually differs between listed and unlisted companies)  example: request a call of
the general meeting (10%), challenge invalid general meeting’s resolutions (5%)
c) rights that are granted proportionally to the number of shares owned  example: voting.

Moreover, the rights that shares confer to their holders can be classified as follows:
i) economic rights  such as the right to dividends or to a portion of the company’s assets upon
liquidation of the same;
ii) voice rights  such as the right to vote in the general meeting of shareholders, to inspect
certain books and records of the company or to challenge invalid resolutions of the general
meeting; and
iii) other rights  such as pre-emption right in capital increases, the right to receive new shares
for free in a nominal capital increase or the right to withdraw from the company.
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FEATURES of ordinary shares (class 25/2)
The two main features of ordinary shares are:
 they grant voting rights on all matters on which the (ordinary and extraord.) shareholders’
meeting may resolve according to the law and the by-laws of the company; and
 they participate equally in the profits/losses of the company, so that their value is affected
by the economic results of the same.
More generally, ordinary shares are those shares that confer on their holders (all of and only) the
entire set of rights provided for by the law to the shares proportionally to the percentage of the
corporate capital the shares represent.

It is possible that the company issues shares with different rights, i.e., it is possible to tail the rights
attached to a class of shares depending on the will of the parties (company, shareholders), of
course within some limits defined by the law.
When a special class of shares is created, ordinary shares are treated as a class themselves and are
subject to the same regime.
Although only ordinary shares are issued by a company unless otherwise provided in the by-laws,
theoretically a company’s share capital may be composed only by special classes of shares.

CLASSES OF SHARES
“Which are the limits imposed by the law that companies face in creating special shares classes?”

(The first limit of the third point has been deleted in the last years, now companies can issue
classes of shares with multiple voting rights).

“Patto leonino”:
As we said, companies are free to issue classes of shares with different rights but always remaining
within the limits set by law.
One of these limits is the prohibition for companies to issue classes of shares that completely and
permanently exclude shareholders from profits and/or losses of the company.

Within the above-mentioned limits the company can freely determine the contents of the various
classes of shares.
For instance, the company can issue “atypical” classes of shares, which have peculiarities as to:

34
 - Economic rights (e.g., right to dividends);
- Voice rights (e.g., voting right);
- Other management rights (e.g., withdrawal right).
Furthermore, the law expressly contemplates some special classes of shares (“typical”).

The aim of this high degree of freedom is to allow companies to identify potential investors and
satisfy their different needs.

Classes of shares and VOTING RIGHTS

“Except as provided for by special laws, the by-laws may provide for the creation of shares:
° without voting rights
° with voting rights limited to specific matters
° with voting rights subordinated to the occurrence of certain conditions (not merely dependent
on the will of any individual)
The value of such shares cannot be greater in aggregate than one half 1/2 of the corporate
capital!!”
(at least 1/2 of total corporate capital must composed by shares with full voting rightzs)

Multiple voting rights  “except as provided by special laws, the by-laws may provide for the
creation of shares with multiple voting rights

Since 1973, Italian listed companies have been allowed to issue shares without voting rights (called
“saving shares”, azioni di risparmio) with the obligation to include preferred economic rights.
In 2003, this possibility was extended to all companies, without any need to mandatorily include
preferred economic shares (in case of atypical non-voting shares).
The obligation of preferred economic rights is still applied for saving shares, but without – as in the
past – a minimum of 5% profits.

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Example of conditional: vote limited or full conditional on certain events (objective), for example a
financial investor who doesn’t want to exercise voting rights until he receives dividends.
Or the case of shares without voting rights unless the case of a tender offer.

The different possibilities are negotiated on a case-by-case basis by the company and new
investors.
Special classes of shares can be issued at °incorporation or °at any time during life of the company;
issuing shares is a resolution of shareholders which must be adopted by at least the majority.
All existing shares have the pre-emption right to subscribe newly issued shares (unless the right is
specifically excluded, only if it is in the best interest of the company -> very difficult to exclude).
Especially if the capital increase is subscribed by contributing cash, it’s very difficult to justify the
exclusion of the pre-emption right (in the best interest of the company). °
If instead the subscription is made with the contribution of specific assets, it’s easier to exclude
the pre-emption right and in this case it is excluded by operation of law.

°however, also in this case there are some possibilities to prove that the subscription by cash
made by only one or some investors (and therefore the exclusion of the pre-emption right for
incumbent shareholders) is in the best interest of the company (for instance, the investor – which
may be an entity – becomes a business partner of the firm).

If the exclusion of the pre-emption right and the issuance of the new class of shares somehow
affects existing shareholders in their rights (i.e., the new class has preferred economic benefits
that may damage incumbent shareholders in receiving payments), then exist. shareholders can
exercise the withdrawal right.

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Non-listed companies only can issue 1 class of shares with multiple voting rights.

The maximum of multiple voting rights is always set at 3, not more.

How does the issuance of shares with multiple voting rights affects majorities, quorums?

Voting and meeting quorum must be recalculated, but in any case, the introduction of shares with
multiple voting rights cannot affect the rights given to minority shareholders.

Increase in voting rights (different from issuance of shares with multiple voting rights -> shares
with increased voting rights do not constitute a special class of shares)
It is possible only for listed companies.
Italian listed companies may amend their by-laws by including the possibility to increase the voting
right of shares (voto maggiorato):
- up to a maximum of 2 votes per share
- for those shareholders who have continuously held their shares for at least 2 years*
- provided that such shareholders had previously requested the registration of their shares
in a special register
Purpose: to promote long-term investment and therefore the presence of stable investors with
deeper monitoring powers and less oriented to short-term investment, also in order to reduce the
volatility of stock prices and encourage a more efficient process of price making.

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* This benefit is granted to the shareholder according to the time for which each share has been
owned by the same person. This implies that:
° a shareholder may be entitled to the increase of voting rights only with respect to some of the
shares owned (those held for more than two years) and not with respect to some others
° this benefit ceases in case of transfer of the shares to third parties (this rule does not apply in
case of succession to the estate of deceased person – mortis causa – merger or demerger of the
owner, unless the by-laws provide otherwise)

NB Even though listed companies cannot issue classes of shares with multiple voting rights,
however non-listed firms can maintain one class of shares with multiple voting rights once they get
listed.

Waving the increase in voting rights  such right can be waived by the single shareholder.
In case of transfer of the shares before the 2-year period or the direct or indirect transfer of
controlling participation in companies which hold shares with an increase in their voting rights of
more than 2% of the share capital of the company, the shareholder will lose its increase in the
voting right for the relevant share transferred.

Tender offer  in 2014 law has been changed, providing the obligation to launch a tender offer is
also in the event that a shareholder owns more than 30% of the voting rights as a consequence of
the increase in voting rights of its shares (before 2014, the obligation to launch a tender offer was
triggered only in the event the 30% threshold was surpassed due to acquisition of shares)

Table: we have a listed company in to with three shareholders owning 18, 10 and 3% of share
capital while the market owns 69%.
a) all the three shareholders enjoy double voting rights
b) only the first shareholder enjoys the double voting right while the other two shareholders sell
part of their shares to waive the right -> is he obliged to launch a mandatory tender offer?*
c) only the second shareholder enjoys the double voting etc.
depending on the fact that all the shareholders or only two of them or only one of them enjoy the
increase in voting rights, we have different configurations of the voting rights -> it’s very difficult to
predict the total number of votes that companies with this rule would have at a certain date,
because that depends on how many shareholders keep their shares for the period required in
order to increase their voting rights
 even though the corporate capital is the same, the number of voting rights changes daily.
* Issue: does the obligation to launch a tender offer arise in case of merely passive exceeding of
the material thresholds (for example, as a consequence of the reduction of the overall number of
voting rights due to the waiver by other shareholders of the increase in voting rights or due to the
sale of the shares which granted the increased voting rights)? NO
According to new art. 49, paragraph 1, lett. d)-bis of the Issuers Regulation, the passive exceeding
of material thresholds due to the reduction of the overall number of voting rights shall be
exempted from the obligation to launch a tender offer, unless the shareholder has purchased a
shareholding which grants voting rights above the thresholds.

Other Issue: as to companies which have introduced the increase in voting rights, does the
obligation to launch a tender offer arise when the shareholder, although it owns more than 30% of

38
the shares with voting rights of the issuer, does not own voting rights above 30% of the voting
rights?
According to new art. 44-bis of the Issuers Regulation, in the companies which have introduced
the increase of voting rights or which have provided for the issuance of multiple voting shares, the
obligation to launch a tender offer is triggered when the percentage thresholds, calculated in
relation to the overall number of the voting rights (rather than in relation to the corporate capital),
are exceeded

OTHER RIGHTS
 Drag Along right
The right of any shareholder, conditional upon the sale of its shares to a third party, to cause the
other shareholders to sell their shares to the same third-party purchaser, at the same terms and
conditions  the majority shareholder can force minority shareholders to sell their shares at the
same price, terms and conditions as him.
Usually: (i) on a pro-rata basis; (ii) right given to the majority shareholder to "force" the sale of the
minority shareholders (entire stake).
Special protection provided by the law to the shareholder who suffers the expropriation of shares
as to the “value” of his/her shares.

(The law provides protection for minority shareholders in certain cases – such as delisting,
becoming a foreign company, a Spa becoming a srl etc. – where they aren’t entitled to block the
resolution but - if they vote against - they have the withdrawal right, selling their shares to the
company at the fair market value.
In case of dragalong right, Italian law provides protection in terms of terms and conditions,
ensuring minority shareholders to obtain a price at least equal to the price that would be applied
in case of withdrawal right)

 Tag Along right

The right of any shareholder, in the case of sale by other shareholders of their shares to a third
party, to cause the third-party purchaser to acquire also its own shares, at the same terms and
conditions  minority shareholders have the right to force the third-party purchaser to acquire
also their shares, at the same price, terms and conditions.
Usually: (i) relating to the entire stake of the relevant shareholder; (ii) right given to the minority
shareholder to protect its participation in case of sale by the majority shareholder.

 Call option
The right of a shareholder (or of the company/certain third parties) to purchase the shares of a
different class of shares on a specific date (or when specific events occur) at pre-determined terms
and conditions.
Special protection provided by the law to the shareholder who suffers the expropriation of shares
as to the “value” of his shares.

 Put option
The right of a shareholder to sell its shares to other shareholders (or to the company/certain third
parties) on a specific date (or when specific events occur) at pre-determined terms and conditions.
39
Both options usually:
- relate to the entire stake of the relevant shareholder
- establish certain criteria to determine the transfer price
- are granted as "way out" from the company

Call and put option can be incorporated in the by-laws and/or in some special classes of shares.

Highly debated the issue whether put option at fixed price may represent a breach of the
prohibition of patto leonino, because if today I decide to invest in the company but I’m not so sure
and I want to protect my investment and agree that I have the right to sell in three-year time at
the same price, then it would imply that I’m not really bearing the risk of being a shareholder. (no
details)

Class 28/2
TEMPORARY shares
(Brand new feature of Italian law and as a matter of fact it’s not even contemplated in Italian law).
As we know, the resolution about the issuance of new classes of shares is voted by shareholders
and adopted by a notary, who has the duty to control that the resolution is valid (previously the
control was performed by courts).
The council of notaries periodically issues rulings about provisions relating to firms’ bylaws.
In 2020, the council issued a ruling stating that any company can issue a class of shares which will
automatically extinguish upon fulfilment of certain condition or elapsing of a certain period of time
-> “temporary shares”.

Rationale: since it is possible to issue shares which have a call option (which is exercised by some
shareholders and suffered by others, forced to walk away), it’s also possible that this exit occurs
automatically upon certain conditions or time periods.

3 relevant questions:
1) Which are the triggering events?  the triggering event must be objective, i.e., clearly set
in the bylaws of the company, so that the subscriber or purchaser of this class of shares
knows exactly when, how and upon which conditions the extinguishment will occur
(e.g., after 3 years or once the shareholder has received a certain amount of dividends)
2) What happens to the corporate capital?  reduction of corporate capital
3) What happens to shareholders?  for the exiting shareholder it is possible to contemplate
that, upon extinguishment, he will receive the liquidation amount of the shares or not (it’s
also possible that the extinguishment occurs without consideration given) *
* The general principle on the basis of which a shareholder who is forced to exit from the company
must be compensated in exchange for the liquidation of the shares (by applying the “fair value”
rule applicable to the withdrawal) does not apply in this case.
This is because, in the case of temporary shares, the shareholder has already accepted – at the
subscription/purchase of such shares – the “temporary” nature of its shareholding, i.e., that, upon
elapsing of time or occurrence of the relevant triggering event, it will cease to be a shareholder

40
In case of payment to the exiting shareholder of a consideration in exchange for the
extinguishment of its shares, the rules relating to the distribution of dividends shall apply.
Therefore, there must be profits or available reserves for the relevant payment by the company to
the exiting shareholder.
In the absence, the rules relating to the voluntary reduction of the corporate capital shall apply.
Therefore:
- it must be resolved by the extraordinary shareholder meeting;
- it can be performed only 90 days after the relevant resolution, assuming there is no
objection from the company’s creditors.

Who would subscribe this type of (temporary) shares?

These features assume a negotiation between the company and the shareholder: shares with
particular features are issued on a sort of negotiated basis -> it is possible to structure and tailor
the economic rights attached to the shares.
It is possible that the parties agree that the investor subscribes shares with particular economic
rights that will expire upon certain conditions, such as the receival of a certain return.
For instance, the investor could agree to subscribe temporary shares which give him a preference
in dividends distribution, but which extinguish once a certain return is obtained.

ECONOMIC RIGHTS and classes of shares

No shareholder has an absolute right to receive dividends.

Normally, shareholders have the right to receive distributions on a pro rata basis. Distributions
depend on 2 triggering events:
i) Presence of profits / distributable reserves
ii) Resolution of shareholders meeting

The share capital is seen as the last resort for creditors and it’s a fixed item -> at the beginning of
the bylaws (publicly available) the company states the amount of its share capital, which at least
represents the amount of the contributions made by shareholders.

The share capital remains fixed (unless particular increases or decreases) while the net worth –
comprehending also reserves, retained earnings etc. – changes on a yearly basis.

41
The net worth must be at least equal to the share capital, in order to give protection to creditors
and other subjects economically interacting with the company.

Within the limit of patto leonino (complete exclusion from any profit or loss), companies can issue
classes of shares with particular economic rights.
The economic right attached to ordinary shares is to receive dividends – if the two triggering
events occur – on a pro rata basis.

If there are different classes of shares, whenever there is a distribution of dividends, priority
shares or other classes with particular economic rights cannot receive an amount that completely
excludes other shareholders from the distribution, otherwise it would be a breach of patto
leonino.

The last two classes of shares are priority shares and it is provided that they receive 60 if profit is
equal to 100. The remaining 40 can be allocated to ordinary shareholders only or proportionally
between ordinary and preferred shares.
You can have a super minority shareholder receiving the majority of profits (but within limits).

(if it’s not truthful and reliable that the company will ever manage to have an amount of
distributable dividends above the 60 promised to preferred shareholders, then we would have a
breach of the prohibition of patto leonino)

Consider a share capital equal to 50 subscribed by 5 shareholders, how is it allocated?

The immediate answer would be 10 to each shareholder, but law allows for flexibility in
° non proportional allocation of shares
° non proportional economic rights
° non equal voting rights (for single share)
Everything is set according to the needs of the parties involved in negotiation, always within the
limits of patto leonino and other provisions of law.

42
(In no way it is possible to guarantee a certain shareholder to receive every year a certain payment
-> preferential rights can be granted but the certainty to always receive payments despite losses
and/or no approval of shareholders meeting is not possible)

43
Article 2348:
Different economic rights can be applied also with reference to losses, which may be allocated in a
non-proportional way.
Example: “deferred shares”  typical deferment clause: «the decrease in the share capital due to
losses does not entail a reduction of the value of the deferred shares but for the portion of the
loss exceeding [95%] of the aggregate value of all other shares»
Deferment of losses may be partial (e.g., no reduction of the value of deferred shares for losses up
to a certain percentage of the share capital) and then losses exceeding the specified threshold can
be allocated pari passu or on a staggered basis between deferred shares and other shares.
A company may also issue several classes of deferred shares, thereby creating a real “ranking” in
the allocation of losses.
Deferred shares may also grant priority rights over distribution of the share capital upon
liquidation of the company.

Example: corporate capital of 100 and losses equal to -50. Assume B shares are deferred shares
and would not be affected by losses for the first 2 years (not forever, otherwise it would be a
breach of patto leonino). Other typical provision: not affected if the loss doesn’t exceed a certain
% of c. capital

TRACKING SHARES (azioni correlate)

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For instance, if Fiat issued separate shares for cars business and trucks business unit.
Limit of tracking shares: even though they benefit of the economic results of one of the different
business units and sectors of the company, they remain shares issued by the company -> if there
are no available profits and/or distributable reserves at the overall company level, tracking shares
will not receive any dividends even though the specific business was profitable.

REDEEMABLE SHARES

SPECIAL MEETING of classes of shares

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Any time a resolution of general shareholders’ meeting prejudices the rights of a class of shares,
that resolution has to be approved also by the majority of the affected shareholders -> special
meeting of those shareholders.
This is not an individual veto right given to any individual shareholder owning shares of a particular
class but to the majority of shareholders of that class.

For instance, this could happen in case of approval of a resolution to issue a new class of shares
which has a priority in economic rights over another class of shares.

CASE STUDY on classes of shares

500 class A shares -> full economic and voting rights
500 class B shares -> certain economic privilege in the distribution of dividends; they have no
voting rights in the ordinary shareholders meeting, but they have double voting rights in the
extraordinary shareholders meeting.

The extraordinary shareholders meeting wants to resolve an increase of capital by issuing 1,000
new Class A shares to be offered in pre-emption to all shareholders.

1)
Ordinary meeting Extraordinary meeting
John (300 A) 300 300
Paul (200 A, 300 B) 200 600
George (200 B) - 400
500 1500

Additional shares with the capital increase through issuance of 1000 class A shares:
John +300, Paul +500, George +200.
After the capital increase:
Ordinary meeting Extraordinary meeting
John (300 A) 600 600
Paul (200 A, 300 B) 700 1300
George (200 B) 200 600

46
 1500 2500

2) John (majority owner of class A shares) is affected in its rights by the capital increase.
Class B shares don’t seem to be affected in their economic rights by the resolution.

3) After the resolution, Paul still controls the extraordinary shareholders meeting but John does no
longer have the majority of the ordinary shareholders meeting.
The ordinary meeting is the one which appoints directors, approves the financial statements,
approves the distribution of dividends etc. so it’s crucial in the functioning of the company.

This is what in fact occurred back in the 90s in the Segrate battle: there was a resolution of a
capital increase, before the resolution De Benedetti had the control of Mondadori while after the
resolution the control passed to Berlusconi.

The question is: is this valid?

We previously saw that when there are different classes of shares, resolutions which affect the
rights related to a class of shares must be approved also by the majority of the shareholders
belonging to that affected class.

4) there is an objective prejudice to John’s rights but as a consequence of how shares allocated
without specifically affecting one class of shares.
There is no specific answer, also in Segrate case there was a harsh debate with different positions:
- It’s not the right of one class of shares to be affected by the right
- Art. 2376 should apply -> class A shareholders are affected and the resolution should be
approved by shareholders belonging to that class
In the case at issue, the increase of capital concerns ordinary shares, offered in subscription to all
shareholders as a consequence of the pre-emption right.
The ruling of the pre-emption right has the main aim to avoid modifications in the proportions and
the majorities.
Maybe here the issue is that the pre-emption right was offered to all shareholders and not only to
shareholders belonging to the same class. (rewatch)

MERGERS (Lecture 9)
Merger = combination of two or more companies into one absorbing company.

47
One (or both) of the two legal entities will cease to exist, because incorporated into the other one,
otherwise there will be the creation of a Newco and both companies will cease to exist.

The absorbing company assumes all of the existing rights and obligations of the absorbed
companies (article 2504-bis).

Creditors of the absorbed companies may rely on the corporate assets of the absorbing company.
Companies into liquidation that have started distributing the assets may not be party to a merger
(article 2501).

EXCHANGE RATIO
Shareholders of the absorbed company become shareholders of the absorbing company → the
number of shares granted to them depends on the comparison between the economic value of
the absorbed company and of the absorbing company (exchange ratio) → negotiation factor
among shareholders/companies.
The exchange ratio derives from the ratio between the economic value of the absorbed company
compared to the economic value of the absorbing company and, on the basis of the total number
of shares of the absorbing company and of the absorbed company, it determines the number of
new shares of the absorbing company to be given to the shareholders of the absorbed company in
exchange for their original shares of the absorbed company.

Company A will resolve upon an increase of capital and company B shareholders will have their
shares cancelled and will become shareholders of company A.
This is one of the cases in which there is no pre-emption right: the increase of capital is exclusively
aimed at providing shares of the absorbing company to shareholders of the absorbed firm.
From a tax perspective, merger is a neutral transaction -> there is no transfer of value (and in fact
there is no tax payable).

There must be a valuation of the surviving (and absorbed) company, performed by an expert,
which has to confirm the validity (and the correctness) of the exchange ratio = number of shares
offered to shareholder of the absorbed entity.
The exchange ratio is °proposed by directors, °approved by shareholders and °confirmed by
expert.
Minority shareholders don’t have the right to block the merger but they’re protected by the
neutrality rule.
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Exchange ratio formula:
MV a /na
ER=
MV b /nb
Where a is the absorbed company and b the absorbing entity.

Example:

Company Y shares is absorbed by

company X, its shares will be
cancelled and the question is:
How many shares will be obtained
by its shareholder c?

Assume the value of the two companies correspond to the accounting value (200 X, 100 Y).
Company X has 200 shares in total, while company Y only 100.
 ER = (100/100) / (200/200) = 1.
(And the increase of capital will be equal to 100)

If the fair market value is 300 for both companies, then the ER is equal to 2 (and the capital
increase will be equal to 200).
If we look at shareholders, we need to increase the corporate capital by 200.
However, there is an accounting issue: the net worth of the absorbing company becomes only 300
(not 600), so there is a mismatch -> there is an increase of capital -> increase of net worth, which
is not possible. How to tackle this issue?
i) directors should consider whether it is possible to increase the historical value of the
absorbed company’s Assets
ii) consider Goodwill = difference between the price paid and the net asset value, related
to a higher ability of the company to produce earnings

MERGER DEFICIT
Merger deficit is an accounting concept used to record the (positive) difference between:
(x) the increase of capital of the absorbing entity (in order to give its shares to the shareholders of
the absorbed entity in exchange for the cancellation of the latter’s shares)
(y) the net asset value of the absorbed entity to be recorded in the accounts of the absorbing
entity (in case of exchange of shares)
OR

49
(x) the accounting value of the absorbed entity as recorded in the accounts of the absorbing
entity,
(y) the net asset value of the absorbed entity to be recorded in the accounts of the absorbing
entity (in case of cancellation of shares)

 Merger deficit shall be recorded either as increased value of the assets of the merged entity
when recorded in the accounts of the surviving entity, or as goodwill, i.e. an asset that represents
the difference between a purchase price/fair market value of a company and the net asset value of
its net identifiable assets (here, goodwill is recorded as an asset on the balance sheet of the
surviving entity after completion of the merger), or, if this is not sustainable, merger deficit is
recorded in the shareholders' equity section as a negative number (loss).

MERGER SURPLUS (avanzo)

In this case we have: y > x.
Merger surplus shall be recorded as surplus reserve (i.e., share premium), corresponding to the
positive difference between the (greater) net asset value of the identifiable assets of the merged
entity and the (lower) purchase price/fair market value of the same.

Example: same companies as before but with FMW Y = 100 and FMW X = 400.
ER = (100/100) / (400/200) = 0.5. (And the capital increase will be 50)
However, the capital increase is lower than the incremental net worth of 100.

(first company x acquired shares of company y, then there

was the merger between the two companies).
There is a gap because the shares were recorded at 100
while the net asset value is 50 -> this difference is reflected
in the net worth of the company.
This is the merger deficit due to cancellation of shares.
How to deal with it?
1. assess the value of individual Assets
2. consider the presence of Goodwill
3. record a Loss
(deficit from cancellation = disavanzo da annullamento)

Also the opposite case is possible: shares record at 50, while the net worth of the absorbed
company results being 100  surplus from cancellation.

MERGER PROCESS

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1) Preliminary phase  preparation of Merger documents
- Merger Plan (article 2501-ter)
- Merger Financial Statements (article 2501-quater)
- Board of Directors’ Report (article 2501-quinquies)
- Expert’s Report (article 2501-sexies)

1) Preliminary phase  Merger plan

The directors of each company prepare and approve one Merger Plan, specifying, inter alia:
» the form of incorporation, the corporate name and the registered office of both
companies;
» newco’s articles of association after the Merger;
» the exchange ratio between the companies’ shares and possible compensation in cash, if
any (maximum 10% of nominal value of newly issued shares);
» the method chosen to allocate the newly issued shares among the absorbed company’s
shareholders;
» the rights, if any, reserved to the holders of securities different from ordinary shares (e.g.
saving shares, bonds);
After approval by the board of the two companies, the Merger Plan, with its attachments, must be
registered in the companies’ register at least 30 days (15 days for s.r.l.s) prior to the approval of
the merger by the shareholders

1) Preliminary phase  Merger financial statements

The directors of each company prepare the Merger Financial Statements (which include balance
sheet, profit and loss account and explanatory note of the directors), as at the date not earlier
than 120 days prior to the date on which the Merger Plan is filed with the registered offices of the
respective company.
The term is of 180 days, if the Merger Financial Statements are the yearly financial statements of
the company duly approved by the relevant corporate bodies.

...

Minority shareholders of Spa don’t have the right to block the resolution nor to withdraw, while
shareholders of srl have the right to withdraw.
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PRIVATE EQUITY and LBOs (class 7/3)
The PE has subject matter to perform M&A transactions in order to create value for the investors
and then exit from investments in 5-10 years time repaying the investors.

The PE fund is managed by its partners (general partners) and uses the funds of its investors
(limited partners) to fund its acquisitions.
The “normal” private equity investment is structured in three steps:
(i) acquiring the target company, using third-party debt;
(ii) hiring management for the restructuring of the target company, by reducing costs,
reorganizing the business, enlarging the business (through “adds-on”), etc.,
(iii) divesting (by way of IPO or private sale) the target company at a higher value, aiming
for a high return on equity in the shortest timeframe possible.

PE funds typically carry out acquisitions performing LBOs = buyouts (acquisitions) carried out
mainly through third-party debt, by leveraging against the ability of the target company to repay
that debt through its future cash flows.
The goal is usually reached by way of a merger between the purchaser and the target company,
carried out after the acquisition of the relevant shares. As a consequence of the merger, all assets
and liabilities are combined, therefore the debt incurred by the purchaser to pay the purchase
price becomes, in the end, a debt of the target company (“merger leveraged buy-out” - MLBO).

In the traditional KKR method, a NewCo is created by the PE fund (or the purchaser in general)
and financed for a minority part with equity (provided by sponsors and partners) and for the
majority part with debt (borrowed from banks).
The financing of the Newco allows it to have enough financial resources to acquire the target
company and, after, merge with it.
The debt will then be repaid through the cash flows of the target company, whose assets are often
pledged against the debt.

The very distinguishing element is the presence of debt in the liability side of the balance sheet of
the target company.

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PROHIBITION OF FINANCIAL ASSISTANCE
In the past, there has been an intensive debate on the lawfulness of MLBO in Italy and Europe.
The debate was grounded on the fact that the end-result of a MLBO was considered similar to
what would happen if target made a loan or provided guarantee to acquire its own treasury stock.
According to law, one company cannot provide financial assistance for the acquisition (and
subscription) of its own shares.
For instance, in line with this principle. it wouldn’t possible for the (target) company to reimburse
the debt incurred by a shareholder (newco) to acquire the shares, because that would be financial
assistance. Moreover, it could not guarantee that debt through the pledge of its assets or the use
of future cash flows.

Some legal authors and court cases held that the MLBO scheme would allow to circumvent certain
provisions of Italian law regarding the prohibition of financial assistance: under this theory, MLBOs
regarded as an instrument permitting to achieve (indirectly) the result prohibited by art. 2358.

So, is the MLBO a breach? Two main arguments:

 formal  target is not providing financial assistance because in the first step it is acquired
(not an active player in the acquisition) and then becomes a subsidiary of the Newco which
is a third party.
The merger is not per se financial assistance and after that target shares are cancelled and
it does no longer exist as a separate legal entity.
 substantial  the prohibition of financial assistance is a prohibition that has to consider
the actual aim of the ruling -> a company cannot repay the debt incurred for the
acquisition of its own shares

The debate was developed in the 90s during a period of boom in M&A and LBO transactions.

One possible solution was found in a new structure of the Newco.

Newco 1 borrows money from the bank and

creates Newco 2, which has no liabilities and a
substantial share premium account used to pay
dividend to newco 1.

Newco 2 has 100 assets, 0 liabilities, 1 share

capital and 99 share premium.
Newco 2 pays 100 so in the assets we will have
target shares instead of cash, acquires target and
then merges with it.

Share premium is per se a net worth item available to shareholders, it’s the share capital which
should be fixed as a guarantee to shareholders, creditors etc.
Share premium and reserves are normally available for distributions.

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2-Newxo structure steps:
1. Sponsor sets up Newco 1
2. Newco 1 incurs debt (loan 1) to create and capitalize Newco 2, which has no debt and a net
worth mainly composed by share premium
3. Newco 2 acquires and merges with target company
4. If the target does not have cash to pay dividends, it incurs additional debt (loan 2) to repay
the share premium in the form of dividends

At the end, we will have the target with 99 of debt, as if it was a normal LBO.
Which is the difference? As we said, the doubtful step of the MLBO is the merger between the
target and the shareholder newco which has raised debt to acquire target’s shares.
In this case, however, when target merges with newco 2 the latter has no debt -> in no way target
deals with the shareholder which has incurred debt, which is newco 1.

Whenever there are minority shareholders, it is in the interest of the sponsor to create the 2
Newco structure. Why? Let’s assume that instead of acquiring 100%, the sponsor acquires 60%, so
we have 40% minorities in the target share capital.
Neutrality -> after the merger, minorities have to receive a number of shares in the newco with
the same value of the preceding stake owned.
If before the merger minorities hold 40% of a company with no debt, it is clear that in any case the
merger will imply a dilution of newco’s stake and an increase in minorities’ one, because the
newco will be made of target + debt, resulting in a lower value.
Instead, if you have the 2 newco structure, the merger of target into newco 2 will not have any
dilutive effect.

However, there is a problem here (for target): how much is it the debt incurred by newco 1 to set
up newco 2 and acquire target’s shares?
In our example 100 and newco 1 will be 60% shareholder, so if the company will distribute
dividend of 100 then it will be split between newco and minorities and a portion of the debt won’t
be repaid
-> in this case, the dilution is in terms of distributions rather than shareholdings.

54
The surviving entity (newco + target) will have to incur more debt (e.g., 120 instead of 100) to
ensure that newco 1 will receive enough distributions to repay the debt initially incurred.

1999 leading case (Trenno)

The MLBO is not a breach of the prohibition of article 2358 as long as it is made for business
purposes and not with the unique aim of repaying the debt (because otherwise it would be a
breach of the prohibition to provide financial assistance).

In 2001 the Italian Parliament specifically requested the Government to enact rules according to
which the merger between two companies, one of which had incurred debts for the acquisition of
the other, was not to be considered in breach of article 2357 and 2358.
With the 2003 company law reform, MLBOs were legal subject to the fulfilment of specific
additional information disclosure requirements: the legislative decree has introduced more
cautious provisions than those contemplated in the delegating law.

Article 2501-bis:
“In case of merger between companies, one of which incurred debt to acquire control of the other
company, when as a consequence of the merger the assets of such latter company constitute
security or source of repayment of the indebtedness, the provisions of this article apply”.
2 main requirements for this article to apply:
1. The purchaser has incurred debt to acquire the control of the other company
2. As a consequence of the merger the assets of such latter company constitute security or
source of repayment of the indebtedness*
* this is more a feature of the merger because after that the b/s of the target will show more debt
in the liability side; the implicit requirement is that the merger must be carried out in order to
allow the repayment of debt so that the newco wouldn’t be in the position to repay the debt
without performing the merger.
(So, for example, the case of Luxottica acquiring a small glasses shop with a Lbo doesn’t fall within
the scope of the article because L. would be in the position to repay the debt also without a
merger)

This article specifically applies in case of LBO performed through a merger (MLBO).

55
Any type of debt – whether preexisting or incurred for the purpose of the acquisition and also a
vendor loan (a portion of the purchase price is paid at a later stage with interest) – what is
important is the fact that the price is paid out of the sources coming out from that debt.

The amount of indebtedness is irrelevant, it’s not important whether it is a small or large portion
of total price paid.

Without going into detail, we need to remember that when art. 2501 bis applies, the law requires
additional disclosure requirements
 MERGER PLAN
In addition to the information that must be provided pursuant to article 2501-ter, the Merger Plan
shall expressly indicate the financial resources that will be available to pay the liabilities of the
post-merger company (e.g., any combination of equity, business revenues or disposals).
The basic issue is the sustainability of the overall debt that the target company will have to repay
after the merger.

 BOD’S REPORT
In addition to the information that must be provided pursuant to article 2501-quinquies, the Board
of Directors Report must:
i) indicate the reasons underlying the transaction
ii) include a business and financial plan specifying the source of the financial means and
the economic objectives of the transaction

 EXPERT’S REPORT
In addition to the information that must be provided pursuant to article 2501-sexies, the Expert’s
Report must certify the reasonableness of the information contained in the Merger Plan.
this is different from the assessment of the soundness of the provision of the Merger Plan
regarding the exchange ratio (article 2501-sexies).

 AUDITOR’S REPORT
A report of the auditor entrusted with the legal accounting review (soggetto incaricato della
revisione legale dei conti) of target or of the acquiring company must be attached to the Merger
Plan (this report should merely confirm that the accounting information used as a basis of the
Merger Plan is true and accurate)

https://elibrary.fondazionenotariato.it/articolo.asp?art=08/0808&mn=3

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DEMERGER
The demerger is the opposite of the merger: we have one entity (demerged entity) which transfers
all/part of its assets and liabilities to:
- At least two beneficiary companies (in the first case: all a/l)
- At least one beneficiary company (second case: part)

The transfer of assets and liabilities is made for NO consideration (-> reduces the value of the
demerged entity)  a demerger is different from a spin-off (scorporo), because in a spin-off the
company itself (and not its shareholders) receives the consideration for the transferred assets (i.e.,
stock in the receiving company).
There is no consideration, but shareholders of the demerged company receive shares of
beneficiary company(ies).
The spinoff is a transaction according to which one company transfers a portion of its assets and
liabilities to another company in exchange for shares of the company receiving those assets and
liabilities -> the spinoff is a “normal” transaction for the transferring entity, it’s not determinantal
for the transferring entity and it does not affect its shareholders.
In the demerger, instead, the demerged entity transfers assets and liabilities but doesn’t receive
anything, so its net worth is reduced (and, normally, as a consequence, the corporate capital),
while the beneficiary company (which can be newly created or existing) increases its net worth.
If the beneficiary company is an already existing one, its shareholders will have to resolve upon a
capital increase with the aim of assigning new shares to the shareholders of the demerged entity.

Demerger shall be a neutral transaction because it is not taxable, for this reason it’s needed an
analysis (appraisal) of the transferred assets and liabilities in order to determine the decrease (or
increase for the bc) of the net worth, the allocation of new shares to shareholders of demerged
ent. and - if the beneficiary company is an existing company – there must be also a parallel
valuation of the beneficiary company to understand the increase in the value of the bc after the
demerger in order to determine how many shares should be allocated.
In certain cases a capital increase is not necessary for giving shares to the new shareholders (e.g.
treasury stock).

If the beneficiary company is a newly incorporated company, its shareholders are the same
shareholders of the demerged company.

As a rule (but, as we will see, there are exceptions):

 the demerged company reduces the corporate capital (as a consequence of the transfer –
with no consideration* – of the assets and liabilities to the beneficiary company)
 the beneficiary company increases the corporate capital (as a consequence of the receipt –
at no price – of the assets and liabilities from the demerged company), and the relevant
newly issued shares/quotas are attributed to the shareholders of the demerged company

For the shareholders of the companies involved, the demerger is a value-neutral transaction.
57
* A cash payment (but not exceeding 10% of the nominal value of the assigned shares or quotas) is
however permitted.

A demerger may be structured in different ways:

A. Total demerger  ALL of the demerged entity’s assets and liabilities are transferred to (at
least two) beneficiary companies.
As a consequence, the demerged entity ceases to exist as an automatic consequence
without going through the liquidation process, and its activity is continued by the benef.
company.
B. Partial demerger  PART of the demerged entity’s assets and liabilities are transferred to
(at least one) beneficiary company.
As a consequence, the demerged entity is not wound up and it continues its business
operations, except for the assets and liabilities transferred to the beneficiary company.

A company’s shareholders can decide at any point in time to put the company in liquidation
process, appoint liquidators who take the direction of the company with the aim of selling its
assets and repaying its creditors; it’s a very long and complex process.
In total demerger, liquidation is not transferred because assets and liabilities are not sold buy
simply transferred to beneficiary companies.

Other possible classification (provided that the neutrality rule should always apply):
1. Proportional demerger  shares or quotas of the beneficiary company are distributed to
the shareholders of the demerged entity is a way which is proportional to their stake in the
demerged company (e.g., I’m 10% shareholders of demerged entity i will receive 10% of
the corporate capital of the beneficiary company – if it’s preexisting – or 10% of the newly
issued shares if it’s a newly incorporated one).
2. Non-proportional demerger  in this case, shareholders who do not approve the
demerger have the withdrawal right from the company.

Example of non-proportional: there are 2 shareholders A (70%) and B (30%) in the demerged
entity, which has a total value of 2bn and makes a total demerger, transferring 1.4bn to
beneficiary 1 and 600m to beneficiary 2.
Before the demerger, the value of A’s stake was 1.4bn and B’s was 600m.
Beneficiary company 1 increases its capital (or issue new shares if it is newly incorporated) and
allocate 90% of the increased corporate capital (1.26 bn) to A and 10% (0.14 bn) to B, while
beneficiary company 2 allocates 0.14 bn (23.3%) to A and 0.46 bn (76.7%) to B.
 shareholders A and B don’t receive exactly 70% and 30% in the two beneficiary companies but
the value of their shares is not affected.

PECULIAR CASES of demerger

[ Demerger without reduction of the corporate capital of the demerged entity
The demerger has, as a natural consequence, the transfer of assets and liabilities from the
demerged company to the beneficiary company. As a rule, the demerged company reduces the
net worth.

58
Usually, the demerged company reduces the corporate capital – but this is not an essential
element of the demerger -> it’s not a requirement of law that the company reduces the corporate
capital.
If there are available reserves, the shareholders of the demerged company can resolve that the
demerger does not reduce the corporate capital, but only the reserves.

[ Demerger with increase of the net worth of the demerged company

Is it possible that the net asset value of the assets and liabilities transferred from the demerged
company to the beneficiary company is negative?
There are 3 main interpretations:
a) According to certain scholars, this would not be possible, as it is essential for a demerger
that "part of the net worth" is transferred from the demerged company to the beneficiary
– therefore, the net asset value of the assets transferred could only be positive (and,
accordingly, the demerged company would reduce the net worth/corporate capital and the
beneficiary company would increase the net worth/corporate capital)
b) According to certain scholars, this is possible, if, not only from an accounting perspective,
but also from a valuation perspective, the economic value of the transferred assets would
be negative, provided that the shareholders of the beneficiary receive shares/quota of the
demerged entity
c) According to certain scholars this is possible provided that the economic value of the
transferred assets is positive. In such case: (i) demerged company increases the net worth;
(ii) the beneficiary company: (A) reduces the net worth (reserves or capital); and (B) issues
new capital (disavanzo da concambio), by using pre-existing available reserves.

It’s not 100% certain whether a negative net worth can be transferred (goodwill?) while it’s almost
sure that a negative net worth with negative economic value cannot be the subject matter of the
transfer in the context of a demerger.

[ Demerger without increase of the corporate capital of the beneficiary company

Normally, the transfer of the assets to the beneficiary company by way of demerger implies the
increase of the net worth and a parallel increase of capital of the beneficiary company and the
shareholders of the demerged company are provided with newly issued shares/quotas of the
beneficiary company. But this is not an essential element of the demerger.
Indeed, shareholders of the demerged company can be provided with shares already existing of
the beneficiary company (e.g. treasury stock or splitting of shares owned by the other
shareholders of the beneficiary company).
What counts is the "weight" of the shareholders of the demerged company in the corporate
capital of the beneficiary company (determined by the exchange ratio ER on the basis of the
comparison of the value of the assets transferred by way of demerger and the value of the
beneficiary company); to this end there could be no need to have an increase of capital of the
beneficiary company.

Remember: in the merger, we can have avanzo or disavanzo because of the difference between
accounting and economic value. In the case of a merger/demerger it’s almost the normality to

59
have different values, it would be a very peculiar and special case if the accounting change in
worth was exactly equal to the economic value of new shares.

If the reduction of net worth corresponds to a negative economic value, demerged entity’s
shareholders shouldn’t be entitled to receive any share from the beneficiary company.

[ Demerger without assignment of capital of the beneficiary company to the shareholders of

the demerged company
Essential element of the demerger is the transfer of assets from the demerged company to the
beneficiary company; consequential element of the demerger is (normally) the assignment of
(newly issued or pre-existing) shares/quota of the beneficiary company to the shareholders of the
demerged company, with the aim of "compensating" them for the reduced value of the shares
they own in the demerged entity.
According to some scholars, however, in certain exceptional cases the beneficiary company might
not need to assign shares/quota to the shareholders of the demerged entity.
Indeed, the essential element of the demerger is that the shareholders of the demerged company
are somehow "compensated" of the reduced value of their shares/quota in the demerged
company (which has transferred assets with no consideration), as the demerger shall be neutral in
terms of value for the shareholders.

Example: I’m 100% shareholder of two companies and resolve to transfer a business from the
demerged entity to the beneficiary company -> the beneficiary increases capital and issues new
shares to be assigned to demerged entity’s shareholders, but in this case I don’t really mind
whether I receive additional shares on a company I already fully own.

The assignment of shares/quota of the beneficiary company to the shareholders of the demerged
entity is the normal way to compensate them for the reduced value of the capital of the demerged
company, but this is not an essential element of the demerger, in the cases where the
shareholders of the demerged entity are differently compensated.

 Partial demerger in favour of the 100% controlling shareholder (assuming it’s a company)
 Partial demerger in favour of a beneficiary company, when the demerged and the
beneficiary companies have a sole shareholder (or the same shareholders in the same
percentages)

(Also in this case of the demerger there are procedural steps and rules similar to the merger:
demerger plan, directors and expert report, shareholders’ approval and creditors have 60 days
from the last registration in the business register RdI to object to the demerger -> in this case the
demerger cannot happen unless the company has paid the opposing creditors or has deposited
the amount as a security.

60
Moreover, there is further protection for all creditors of the companies participating in the
demerger: any of the companies participating in the demerger is liable for the obligations and the
debts preexisting before the demerger which have not been transferred, within the limit of the
assets transferred in the demerger).

Art. 2506-quarter: «ciascuna società è solidamente responsabile, nei limiti del valore effettivo del
patrimonio netto ad essa assegnato o rimasto, dei debiti della società scissa non soddisfatti dalla
società cui fanno carico».

[ Demerger with exclusion of some of the shareholders of the demerged company from the
distribution of shares/quota of the beneficiary company and assignment thereto of
shares/capital of the demerged entity (“asymmetric demerger”)
Article 2506: with shareholders’ unanimous consent, it’s also permitted that to some of the
shareholders of the demerged entity, the shares of the demerged company are distributed instead
of the shares of one of the beneficiary companies.
 it may be possible to decided, by unanimous consent, that some shareholders of the demerged
company do not receive shares/quota of the beneficiary company, but they receive shares/quota
of the demerged company.

The provision of law is unclear: it is a case of "extreme" non-proportional demerger – i.e. the "non-
proportionality" is so that some shareholders of the demerged company do not receive
shares/quota of the beneficiary company: they are excluded from the beneficiary company. It is a
fundamental derogation from the normal scheme of the demerger. This is why the "unanimous
consent" of all shareholders is required.
The shareholders of the demerged company which do not receive shares/quota of the beneficiary
company shall be "compensated" of the reduced value of the demerged company by an increase
of their shareholding in the demerged company (rule of neutrality in terms of value for the
shareholders of the demerger).
According to some scholars, the fact that they receive new shares of the demerged company is a
possibility (depending on the practical circumstances; i.e. the value of the assets transferred; the
existence of reserves; the amount of the reduction of capital of the demerged company, etc.) but
not a requirement.

CASE STUDY: Enel –Enel green power non proportional demerger

Before the transaction, the main shareholder of Enel was “Ministero dell’Economia e delle
Finanze” which held 25.5% of the share capital.
After the transaction, the shareholding of MEF was diluted: the percentage of ownership dropped
to 23,57%.
Enel, before the demerger, owned 68.3% of the EGP’s share capital, however, after the transaction
it became the sole shareholder of EGP while all the EGP shareholders other than Enel were
excluded from EGP and became Enel’s shareholders.

61
Other shareholders of the demerged entity receive shares in the beneficiary company in exchange
for the reduced value of their shares in the demerged entity.
This has been a non-proportional demerger, in the sense that the reduced value has been
allocated in a non-proportional way and all minority shares of Enel Green Power have been
cancelled in exchange for newly issued shares of the beneficiary company Enel.

Here we have an extreme non proportionality because some shareholders of Enel Green Power
have seen all their shares cancelled and they have received shares in the beneficiary company
having the same economic value.

Is this an asymmetric demerger (where some shareholders of the demerged entity do not receive
shares of the beneficiary company)? No.

(rewatch)
What happened here is that some shareholders of the demerged entity have seen their shares
cancelled in exchange for shares in the beneficiary company.
The real question is: is this legal?
You can end up to this result by having
i) merger of Enel Green power into Enel  minority shareholders of e.g.p. receive shares
of Enel – surviving entity – in exchange for their cancelled shares, the surviving entity
(result of the merger) will have the shareholding of EGP among others.
ii) splitting of all assets and liabilities which were of Enel green power  split through a
contribution in kind (spinoff), recreating a new Enel green power.

In the end you obtain Enel surviving entity controlling at 100% the two subsidiaries Enel green
power and EGP international.
This 2-step transaction (merger, spinoff) can be certainly performed without unanimous consent
of the shareholders because it is not an asymmetric demerger.

Majority of scholars believe that the case of asymmetric demerger only applies in the
circumstances described by law.
In our example that 2-step transaction had the same result of an asymmetric demerger without
requiring the unanimous shareholders’ approval, however it’s not to be considered illegal because
it’s not exactly the case of asymmetric demerger described by law.

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FDA GROUP (guest speaker 22/3)
Forno d’Asolo is active in bakery and pastry industry, especially for Horeca channel, and has
managed to grow very rapidly in the last years, performing also a significant acquisition in 2016,
acquiring La Donatella and increasing is revenus from 76m in 2014 to 133m in 2014 (and EBITDA
from 13m to 24m).

Why did BC Partners decide to perform the acquisition?

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In 2019 acquired one of the most relevant players in the Italian bakery industry, Bindi, and in 2020
it unified Forno d’Asolo and Bindi creating FDA group. Now BC expects a turnover > 360m for
2022.
Key elements to drive successful M&As

The PE investor is a short-medium term investor who seeks profitable opportunities to invest in
private companies, restructuring/making them grow -> obtain higher profitability (key measure:
Ebitda) and exit the company once the target profitability of the investment has been achieved.

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 SECOND PART: INTERNATIONAL TAX LAW
What is a tax?
It is one of the instruments used by governments to get the necessary funds for public
expenditures.
• It is applied on a specific manifestation of "ability to pay”  constitutional feature, taxes are
based on the ability to pay
• It has an authoritative character and is narrowly linked to the territorial dimension of a State
("jurisdiction")  tax authorities have coercive power to collect taxes in their jurisdiction, they can
impose penalties if taxes are not paid

Example of taxes: property tax, VAT, capital gain tax, excise duties, custom duties (import
duties) ...

International tax law = body of legal provisions of different countries that covers the aspects of
cross-border transactions. It includes:
- Domestic provisions dealing with international business
- International treaties

In general, we can distinguish between °domestic legislation and °international law, which can be
furtherly divided into -customary law and -treaties.
In case of conflict, international law prevails over domestic legislation.
EU law belongs to international law but somehow prevails for European countries and the
application of that law is performed through courts, parliament etc. which are not present for
international law, for which we only have treaties.

RULES of international tax law (in treaties):

 Are influenced by policy considerations of governments
 Are a form of exercise of State sovereignty
 Might depend on a balance with national wealth maximization and the return of
investment of investors
 Are often influenced by international organizations

International investment
° Can be influenced by the level of taxation, the compliance and administrative costs, the certainty
of law, the approach of authorities, and other factors.
° Has to face different legal and tax systems;
° Can take advantage of existing "tax gaps" in domestic laws  in order to minimize the tax
burden and maximize return on investments

Taxation of inward and outward investment

1. Tax neutrality  tax systems should not affect the choices of investments to taxpayers
(while the level of taxation does actually affect investment behaviors in reality)
2. Capital-import neutrality (CIN)  A tax regime is neutral in the way that it taxes income
derived by suppliers of investment capital.
It treats nationals and foreign investors investing in the country equally. It is regarded from
the perspective of the State where the investment is made.

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 It is typically achieved when the State of residence of the foreign investors exempts income
produced abroad.

Example: imagine two states A and B and two investors, one resident in A and the other in B, both
investing in B. As a general rule, a resident and a foreign investor should be treated equally when
investing in a country. This system is usually achieved through exemption.

Other example:

CEN is usually achieved through tax credit -> a resident investor investing domestically should be
treated equally as a resident investor investing abroad.
Imagine for example two Milanese entrepreneurs, one with a real estate property in Milan and the
other with a real estate property in Nice. According to CEN, they should be treated equally.
Taxes shouldn’t encourage or discourage tax payers to invest domestically or abroad, because of
the general principle of tax neutrality.

3. Capital-export neutrality (CEN)  A tax regime is neutral in taxing income derived from
exported capital like income from capital invested domestically.
It treats nationals investing domestically and nationals investing abroad equally.
It is regarded from the perspective of the State of residence of the investor.
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 It is typically achieved when the State of residence of the investors grants a tax credit for
income produced abroad. (not a tax exemption but a tax credit)

CONNECTING FACTORS
A person is subject to tax by a certain State if some “reasonable” connection exists between that
person (i.e., the taxpayer) and the State considered. Lacking this connection, a State cannot
exercise its taxing powers over that taxpayer or over a specific transaction.
With a view to levying a tax, each State establishes under its own domestic legislation the
connecting factors between its tax jurisdiction and:
 The taxable person (“taxpayer” or “tax subject”) and
 The taxable event (“tax object”).

Connecting factors are usually based on taxpayer’s:

a) Residence
b) Nationality
c) Domicile

Tax objects are determined under some specific rules established by domestic legislations and can
vary from country to country; some typical examples: production of income, purchases (VAT),
inheritances, real estate, contract in a state...

The existence of any connecting factor between a tax subject or a tax object and a given
jurisdiction determines the right to tax. To that purpose it is possible to distinguish between two
tax systems: “worldwide tax systems” and “territorial tax systems”.
Worldwide  looks at the existence of subjective connecting factors and levies income taxes upon
taxpayers meeting such a subjective requirement on their worldwide income. By contrast,
taxpayers not meeting such a subj. requirement are taxed by a State on income derived from its
territory only.
Territorial  taxation on income produced in the territory, while income which is produced
abroad is disregarded for tax purposes

The majority of countries apply the “worldwide tax system”, which taxes income produced both
internally and abroad. (And this system can create double taxation)

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There might be problems of double taxation in the worldwide tax system: the individual (resident
in State A -> personal connecting factor) pays taxes on dividends from Fiat according to the
taxation of its State of residence, but he also has to pay taxes on Nestlé dividends (income
produced abroad). Therefore, dividends on Nestlé are double-taxes, both domestically and abroad
where it’s produced.
“Which is the amount of tax due?” The amount of tax due by the taxpayer depends on 2
items:
1) TAXABLE BASE
+ Sum of all gross assessable income produced in a given tax period
– Allowed related expenses
– Past years' losses
Deduction of costs / Inclusion of profits do not always match accounting criteria

2) TAX RATE
Tax rates depend on policy considerations and are very different among States.
High tax rates can aim at discouraging some activities or at facing high public expenditures.
Low tax rates can favour certain investments (e.g., in some areas) or attract capital inflows.
 A State should not set its tax rates at a level so high as to deter foreign investment in the
country and to distort the cost of capital structure in the country’s economy.

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(Progressive tax rate is usually applied for individuals not for companies; one of the only countries
to use progressive rates for companies is Netherlands)
“How to pay taxes?”
Domestic laws of countries also identify how taxpayers are required to pay the tax due.
Two are the main ways to collect taxes in the international scenario:
Filing a tax return (usually annually) dichiarazione dei redditi by a certain date, in which they
have to calculate the tax due considering the net income produced within the tax period
considered (i.e. the difference between gross income and deductible expenses for tax purposes)
and pay the amount due within some deadline.
This method normally applies to resident taxpayers, who are more familiar with the language of
the tax return and the tax law provisions existing in their home country. Tax return usually follows
a specific format established by the tax authorities and is the document through which the
taxpayer might also claim the deduction of certain costs, other charges and tax credits.
Bearing a withholding tax at source under this method, the tax due is directly deducted from
the income paid by the payer. The withholding tax can be either “in advance” or “final”. The
application of withholding taxes is very common in the case of payment of the so-called “passive
income”, i.e. income that does not involve productive activity, such as dividends, interest and
royalties, and it is applied to non-resident taxpayers. In this way, foreign investors bearing a final
tax on the income sourced in the State of source are not obliged to file any tax return

Advantages of withholding taxes:

• Less compliance costs associated with the obligation to file an annual tax return;
• No problem with "language" or domestic rules;
• Government collects the tax earlier;
• The paying party failing to withhold the tax is exposed to penalty (rather than the foreign
investor).
WHT generally apply to non-resident taxpayers, who cannot benefit from deductions.

CONFLICTS of tax jurisdictions: JURIDICAL DOUBLE TAXATION

Resident or non-resident taxpayers engaged in cross-border income earning activities are exposed
to the tax jurisdictions of more than one country.

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Methods of relief from juridical double taxation:
Since double taxation represents a constraint to cross-border activities, States normally provide
some mechanisms of relief through:
- Domestic legislation
- International tax conventions (DTTs: double tax treaties)
DTTs, which are negotiated under public international law, are normally drafted on the grounds of
the Model Tax Convention elaborated by the OECD or the UN.
DTTS establish international obligations upon sovereign States, they do not create new taxing
powers but limit the existing ones.
DTTS not only allocate taxing powers of the Contracting States in order to reduce double taxation
but also establish the method to be adopted by the State of residence to grant relief from the
issue of juridical double taxation.

3 most common reliefs from double taxation:

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On the 10k portion of income you end up paying taxes twice.
Possible solutions:
a) Exemption  country of residence exempts the taxpayer from paying 20% tax on 10k, so
the taxpayer will pay 20%*30k = 6000 in state R (and 1500 in state S)
b) Tax credit  income produced abroad is included in tax calculation but then the taxpayer
can benefit from a credit equal to the tax paid abroad (15%*10k = 1500)  8000-1500 paid
in State R and 1500 in state S
c) Tax deduction  reduction of the taxable base -> 20%*(30k+10k-1500) in State R
2 forms of tax exemption (a):
 Full exemption. Under this method, the State of residence simply disregards the full
amount of income produced abroad.
 Exemption with progression. Under this method, the State of residence includes foreign-
source income in the tax base of the taxpayer, but only with a view to determining the
overall tax rate and the amount of tax, as that income is not subject to taxation again.
Usually, the exemption with progression is applied to individuals.

3 forms of tax credit (b):

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1) Ordinary or partial credit. The State of residence allows, as a deduction from its own tax on the
income of its resident taxpayer, an amount equal to the tax that would be due on equivalent
income, as computed under its domestic rules, if it was produced domestically. This system fully
eliminates double taxation only in those situations where the first tax to be grossed up is lower
than the second tax. This is also the most frequent method adopted by States that use the tax
credit, as a full credit (as it will be shown below) risks resulting in a tax refund from one State to
another.
2) Full credit. The State of residence grants its resident taxpayers a credit equal to the full amount
of tax that has been already paid abroad. This system fully eliminates double taxation, but in those
situations where the first tax to be credited is higher than the second tax, it may result in a “tax
refund”, which actually never happens.
3) Tax sparing or matching credit. The tax sparing credit is a form of tax incentive granted by some
States to attract foreign investors. It is normally provided for in some bilateral DTTs between
industrialised countries and developing countries in order to favour

Class 28/3
Normally the relief is granted by the State of residence of the individual.

In case of tax credit, it’s indifferent for the investor whether to pay taxes in the state of residence
or state of source.

Ordinary tax credit  the amount of the credit is up to the amount of taxes you would have paid
domestically without tax credit. (2000 in our example)

Full credit  the State of residence grants its resident taxpayers a credit equal to the full amount
of tax that has been already paid abroad. (Never applied in practice)

Matching credit  usually provided between a rich and a developing country; the tax of the
foreign investment is 0 (tax incentive) but, when the investor pays taxes in his state of residence,
he can deduct a fictitious credit corresponding to the tax he would have paid to the state of
source, based on the foreign country’s tax rate.
(it’s a way to incentivize investments in developing countries)

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DOUBLE TAX TREATIES
DTT (which are also often referred to as “double tax agreements”, “double tax conventions”, or
more simply “tax treaties”) are international agreements concluded bilaterally (or hardly ever
multilaterally) by States, in order to:
V Eliminate (/reduce) cross-border juridical double taxation
V Prevent tax avoidance and evasion
V Solve tax disputes

Exchange of information  very crucial provision of DTTs, aimed at allowing States to have
complete information and exchange it.

The OECD Model Tax Convention is the most common model, being a model it’s not enforceable
and there is also a commentary (=non-binding tool which contains interpretations and
clarifications of the provisions embedded in the model).

Objective: the aim of the Model is to provide some guidance to countries wishing to enter into a
bilateral or multilateral DTT and, ideally, to minimise the complexity and compliance costs of tax
law

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UN model  provisions are similar, but UN considers more rich developed countries.

FORMATION of DDTs
Six are the stages of the life of an international agreement, which normally follow a well-
established procedure:
1. Negotiation  the initial negotiation of a DTT is usually carried out by representatives of the
ministries of finance, treasuries or revenue authorities of the two State concerned.
2. Initialing  once the negotiators agree the terms of the DTT, this latter is initialed and
submitted for approval at the political level in each State (i.e. by each country’s Minister of
finance, Cabinet or Council of Ministers).
3. Signature  once both governments approve the DTT, this latter is formally signed by the
respective Ministers of finance or their representatives (i.e. an ambassador).
4. Ratification and exchange of ratification instruments  ratification completes the formal
process of approval. It embodies the DTT into each country’s domestic law by way of
parliamentary approval or the passing of an empowering regulation. After one State has
successfully completed the ratification procedure domestically, the other State must be informed.
Therefore, both States exchange their respective ratification instruments
5. Entry into force and effective date  a DTT enters in to force on the date on which it becomes a
legal obligation binding both States. The act of ratification does not normally bring a DTT into force
immediately. A DTT often comes into force automatically at the end of a specified numbers of days
after the last notice of ratification has been received by a Contracting State. Even after the DTT
enters into force, it may not yet be effective. The date on which the DTT takes effect can also be
different, and it is often the beginning of a Contracting State’s tax year immediately following the
date of entry into force of the DTT. It is also possible that the effective date can be the date of
entry into force of the DTT.
6. Termination  formal act to end a DTT. This may be a consequence of different factors, e.g.,
subsequent the conclusion of the DTT the other State has unilaterally introduced measures in its
domestic law that override the provision of the DTT, without the agreement of the other State, or
because the other State simply wants to terminate its obligations under that treaty. If a country
intends to terminate a DTT, it must give notice to the other country of a certain period in advance
of the termination date. The date on which a DTT no longer has any effect is also specified in the
DTT.
INTERPRETATION of DDTs
Rules governing interpretation of treaties are contained in Articles 31 and 32 of the Vienna
Convention. DTTs must be interpreted accordingly.

Under Article 31(1), a DTT “shall be interpreted in good faith in accordance with the ordinary
meaning to be given to the terms of the treaty in their context and in the light of its object and
purpose”  interpretation *in good faith, *ordinary meaning.

According to Article 31 (2), the context is inclusive of: (text of treaty, agreements, any
instrument...)
• The text of the treaty, including its preamble and annexes;
• Agreements between parties made in connection with the conclusion of the treaty;
• Any instrument made by one party in connection with the conclusion of the treaty, which is
accepted by the other party (i.e., explanatory memoranda)

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Vienna convention contains customary law (which is at the top level, like Constitution prevails on
ordinary law) and then DTTs are a rank below.
International treaties are binding only for those parties (States) being directly involved in the
negotiation, while Vienna convention is binding also for countries not part of Vienna convention.

Under Article 31(3), together with the context above highlighted, some additional elements might
be relevant as follows:
- Subsequent agreements between the Contracting States regarding the interpretation of
the DTT or the application of its provisions
- Subsequent practice in the application of the DTT, which establishes agreement between
the Contracting States with respect to the interpretation of the DTT
- Rules of international law applicable in the relations between the Contracting States.

Articles 31(1) and 31(3) establish the “ordinary” meaning of a term in its rather narrowly defined
context and are likely to exclude the recourse to extraneous supplementary material, such as the
OECD Commentary.
The OECD Commentary is not in connection with the treaty, it’s just something that OECD
proposes and therefore many countries think it’s not binding.

However, Articles 31(4) and 32 of the Vienna Convention extend the scope of Articles 31(1) and
31(3), by allowing the recourse to other material, such as supplementary means of interpretation
(i.e., preparatory work), but only:
• To confirm the meaning of a term established under Article 31; or
• To determine the meaning when the interpretation according to Article 31 produces ambiguous,
obscure, manifestly absurd or unreasonable results.

The OECD Model sets out a series of general autonomous definitions of the terms that are used in
the DTT (such as “person”, “company”, “enterprise of a Contracting State”, ““international traffic”,
“competent authority” ...) and operates a cross-reference to the domestic legislation of the State
that applies the DTT (i.e., State of source).
When there is no interpretation, the final word is to the state of source.

Role of the COMMENTARY

It’s out of doubt the importance of the Commentary, however the OECD Commentary does not fall
within the notion of “context” contemplated by Article 31(2) of the Vienna Convention. It might be
considered as a supplementary means of interpretation contemplated by Article 32, but it can only
be used to confirm a meaning already ascertained or to establish a meaning in the rather
restricted circumstances of ambiguity, obscurity, or manifest absurdity or unreasonableness.
Despite the difficulties of reconciliation of the Commentary with the Vienna Convention, it is
actually taken into account!
- The OECD Model is the basis of hundreds of DTTs and its Commentary is often the only
available material to shed light on the meaning of the provisions of DTTs
- It helps develop a common body of international tax rules
- It gives a certain degree of certainty to taxpayers and tax authorities

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The Commentary is often updated and this raises the issue of the application of:
a) Static interpretation  the term object of interpretation has the meaning that domestic
law attributes to it at the time that the DTT was concluded
b) Ambulatory interpretation  the term takes the meaning that it has under the country’s
domestic law as amended from time to time

STRUCTURE of DTTs
 Application rule

 Distribution rules

- Active income is income which you normally derive when performing some activities,
business or employment activties (for instance: business profits, transports, independent
personal services, income from employment etc.)
- Passive income refers to income deriving from investments

 Methods of elimination of double taxation

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  Rules on prevention of tax avoidance and tax evasion

 Miscellaneous matter

RESIDENT TAXPAYERS
The definition of tax residence in a given country is contained in its domestic legislation.
As far as companies are concerned, the general rules setting the tax residence normally look at
different criteria, such as:

The place of incorporation or registration or where the legal seat of the company is located is
generally provided for in the civil or commercial law of the country. A company can be
incorporated in a State but be effectively managed in another country.
The criteria to identify the place of effective management can vary widely under the domestic
legislation, practices and case law of the different countries.
The place of effective management is the most common criterion used by countries to identify the
tax residence of companies, as it is more substantial than the place of incorporation or the legal
seat, which are more formal.
In Italy we don’t consider the place of incorporation (while for instance UK does).

Residence-residence conflict
As every country has its own tax rules, due to the variety of criteria to establish the tax residence
of a company, legislation of States in respect of definition of tax residence might not only be
different, but also conflict. In this latter situation, a taxpayer can be considered as “dual resident”,
i.e., resident for tax purposes in more than one jurisdiction. In such a case (i.e., residence-
residence conflict), this taxpayer is liable to worldwide taxation in each State considered and
double taxation might arise.

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In respect of companies, till November 2017 Article 4 (3) of the OECD Model Tax Convention
provided that where a company is resident in both Contracting States, then it had to be deemed to
be a resident only of the State in which its place of effective management is situated.
DTTs concluded and entered into force before 2017 still have this place of effective mgmt clause.

Following to 2017 update, Article 4(e) now provides that the competent authorities of the
Contracting States shall endeavor to determine by mutual agreement the Contracting State of
which such person shall be deemed to be a resident for purposes of the Conventions, considering:
(i) its place of effective management
(ii) the place where it is incorporated or otherwise constituted, and
(iii) any other relevant factors
In the absence of such agreement, such person shall not be entitled to any relief or exemption
from tax provided by the Convention except to the extent and in such manner as may be agreed
upon by the competent authorities of the Contracting States.

Advantages: new rule, takes into account the new way of doing business
Disadvantages: higher uncertainty

Place of effective management  place where the key management decisions that are necessary
for the conduct of the business are in substance made. This is normally the place where the most
senior person or group of persons (directors) makes its decisions.
States wishing to deal with cases of dual resident entities through the rule of the «place of
effective management» can still do so.

Example: company based in Italy with one director in Italy, one in Belgium and one in Spain
-> what is the place of effective management? In order to determine, I should check which is the
place where the board of directors meats and where key managerial decisions are taken.

Other example: company with legal seat in UK, place of management in Belgium and place of
business in Italy.
Under previous Article 4, the company should be considered resident in Belgium.

(rewatch)

Example: company based in Spain (Zara) with 100% participation in Zara Italy and Zara France -> in
this case, I have 3 different entities subject to the taxation of their countries.
If instead of Zara Ita we considered Zara Slovenia which is assumed to have a store in Italy, then
the entity may be deemed to pay taxes in Italy because Italian tax authorities could claim that it is
a resident entity considering the criterion of place of business. In order to avoid double taxation,
contracting states (Italy and Slovenia in this case) should find an agreement.
If for instance the same managers of Zara Esp were appointed as managers of Zara Slovenia then
Spanish tax authorities may claim that Zara Slovenia pays taxes in Spain according to the criterion
of place of effective management.

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Factors to solve the conflict:
According to para. 24.1 of the OECD Commentary on Article 4 the competent authorities would be
expected to take account of various factors, such as where the meetings of the person’s board of
directors or equivalent body are usually held, where the chief executive officer and other senior
executives usually carry on their activities, where the senior day-to-day management of the
person is carried on, where the person’s headquarters are located, which country’s laws govern
the legal status of the person, where its accounting records are kept, whether determining that
the legal person is a resident of one of the Contracting States but not of the other for the purpose
of the Convention would carry the risk of an improper use of the Convention etc.
 tax authorities should look at how the business is actually carry on, who does what, which are
the people in charge of making decisions etc.

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NON-RESIDENT TAXPAYERS
A non-resident company is defined “a contrario” and it is taxed in the source State for income
produced therein only. A non-resident taxpayer is one which doesn’t qualify for being defined as a
resident taxpayer; usually there are lists for each State of qualifying objective links.
The taxation of a non-resident company depends on the existence of a Permanent Establishment
(PE) in the territory of the State of source.  when a non-resident company has a PE in the State
of source, then it can be subject to tax in that State.

According to Article 7 of the OECD Model Tax Convention, profits of an enterprise of a State shall
be taxable only in that State unless the enterprise carries on business in the foreign State through
a PE situated therein  an enterprise is subject to taxation only in the country where it is resident.
If it performs some business activity abroad, then it will be liable to taxation in such a foreign
jurisdiction if and to the extent to which foreign profits can be attributable to a PE situated in this
foreign State (the State of source).

Example: even if in State 3 the company has only one shop which qualifies as a PE, than the
company (resident in State 1) can be exposed to taxation in state of source 3, even if it doesn’t
have a wholly owned subsidiary but simply a shop.

Material PE:
PE is an “existing place of business* through which the non-resident enterprise carries on in part
or totally a business activity in the state of the source.” (*fixed + at disposal)
This place of business must be fixed, i.e., established at a distinct place with a certain degree of
permanence.
Moreover, this place must be at the disposal of the non-resident company.

Example: vending machines  the company owning vending machines carries through them part
of its business abroad, generates income through them in a fixed place at disposal of n-r company,
even if it has no employees in that State -> vending machines qualify as a PE -> the n-r company
can be subject to taxation in the State of source where those vending machines are located.

Example: Italian company produces products in Italy and sells them – among others – in Greece,
where it has a shop (not a separate entity like a subsidiary, but just a branch).
Italian company has a physical presence in Greece. Profits produced from Greek sales are subject
to Greek income tax because the shop qualifies as a PE (even if the shop doesn’t qualify as a
separate entity from the Italian company) but at the same time they’re also subject to Italian tax,
because profits from Greece come from a branch, not a separate entity.
Interest of the State of source is to provide evidence of the PE in order to be legitimated to apply
its tax rate to the income produced.

Article 5(2) of the OECD Model Convention contains a positive and non- exhaustive list of
examples of PE. It establishes that the term PE includes: a) place of management, b) branch, c)
office, d) factory, e) workshop, f) a mine, an oil or gas well, a quarry or any other place of
extraction...

Construction projects  article 5(3) of the OECD Model Convention establishes that “a building
site
or construction or installation project constitutes a PE only if it lasts more than twelve 12 months.”
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Example: non-resident company wants to build a house or a road in a State -> if the construction
projects lasts less than twelve months then it cannot be taxed.
Exceptions to PEs  refer to cases in which the business activity has preparatory/auxiliary
function.
Article 5(4) of the OECD Model contains a “negative” list of activities, which do not qualify as a PE.
In particular, the PE shall be deemed not to include:
A. The use of facilities solely for the purpose of storage, display or delivery of goods or
merchandise belonging to the enterprise;
B. The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the
purpose of storage, display or delivery (e.g., exhibition in a fiera)
C. The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the
purpose of processing by another enterprise;
D. The maintenance of a fixed place of business solely for the purpose of purchasing goods or
merchandise or of collecting information, for the enterprise;
E. The maintenance of a fixed place of business solely for the purpose of carrying on, for the
enterprise, any other activity;
F. The maintenance of a fixed place of business solely for any combination of activities mentioned
in subparagraphs a) to e).

In all these cases (exceptions), the non-resident company cannot be taxed by the State of source.
(Because there is no PE).
When the activity mentioned in the list of exception is carried out through a fixed place of
business, no PE is deemed to exist.
These activities do not involve sufficient economic activity and they are not deemed to qualify as
relevant connecting factors between the non-resident enterprise and the State of the source.
However, if the activity goes beyond the purpose of the list, a PE might be deemed to exist.

According to para. 59 of the OECD Commentary to Article 5(4), it is often difficult to distinguish
between activities which have a preparatory or auxiliary character and those which have not.
The decisive criterion is whether or not the activity of the fixed place of business in itself from an
essential and significant part of the activity of the enterprise as a whole  Essential? Significant?
(in the activity of the enterprise as a whole)
Each individual case will have to be determined on its own merits.
According to para. 60 of the OECD Commentary, an activity that has a “preparatory character” is
one that is carried on in contemplation of the carrying on of what constitutes the essential and
significant part of the activity of the enterprise as a whole  (Preparatory = in contemplation...)
Since a preparatory activity precedes another activity, it will often be carried on during a relatively
short period, the duration of that period being determined by the nature of the core activities of
the enterprise.

Anti-fragmentation rule
The anti-fragmentation rule is anti-avoidance rule introduced in 2017.
The purpose of this paragraph, which was inserted in 2017, is to prevent an enterprise or a group
of closely related enterprises from fragmenting a cohesive business operation into several small
operations in order to argue that each is merely engaged in a preparatory or auxiliary activity.

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For instance, coming back to our example of the Italian company which sells also in Greece, the
company may want to open many stores and carry on a significant part of its business in Greece
through many branches trying to make tax authorities believe that none of these shops solves an
essential function for the business of the company but only a preparatory/auxiliary activity.
According to Article 5(4.1.), para. 4 shall not apply to a fixed place of business that is used or
maintained by an enterprise if the same enterprise or a closely related enterprise carries on
business activities at the same place or at another place in the same Contracting State and
a) that place or other place constitutes a permanent establishment for the enterprise or the
closely related enterprise under the provisions of this Article, or
b) the overall activity resulting from the combination of the activities carried on by the two
enterprises at the same place, or by the same enterprise or closely related enterprises at
the two places, is not of a preparatory or auxiliary character,
provided that the business activities carried on by the two enterprises at the same place, or by the
same enterprise or closely related enterprises at the two places, constitute complementary
functions that are part of a cohesive business operation.

(Always remember that PE is only a tax concept, it is a non-resident taxation by the State of
source.
It is just a place of business, not an entity)

Example (?): Ikea, resident in State A, has a shop and produces in State A and decides to open a
new shop in State B. There are 2 possibilities of investment in B:
° incorporating a company in B  resident company in B (wholly controlled subsidiary) is exposed
to B’s income tax (then company in State A can be exposed to taxes in B for dividend distributions)
° creating just a branch in B  profits produced in B are taxable in B according to its tax rate
(because the shop qualifies as PE) and are also included in the taxable amount of company in State
A; then a tax credit will be recognised in order to avoid double taxation

Dependent agent  A person (case of personal PE), who:

• Acts in a Contracting State on behalf of an enterprise;
• Habitually concludes contracts; or
• Habitually plays the principal role leading to the conclusion of contracts that are routinely
concluded without material modification by the enterprise; and
These contracts are either: (in the name, for transfer of property ownership, for service provision)
a) In the name of the enterprise; or
b) For the transfer of the ownership of, or for the granting of the right to use, property owned by
that enterprise or that the enterprise has the right to use, or
c) For the provision of services by that enterprise.

The dependent agent represents the company in the State of the source.
Where a Dependent Agent exists, then the enterprise shall be deemed to have a PE in that State in
respect of any activities which that person undertakes for the enterprise, unless these latter have
preparatory or auxiliary character  dependent agent -> PE (unless: preparatory/auxiliary).

Independent agents  where an enterprise of a Contract. State carries on business dealing

through an independent agent carrying on business as such, it cannot be taxed in the other
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Contracting State in respect of those dealings if the agent is acting in the ordinary course of that
business.
The activities of such an agent, who represents a separate and independent enterprise, should not
result in the finding of a PE of the foreign enterprise.
There is an exception: only applies where a person acts on behalf of only 1 enterprise in the course
of carrying on a business as an independent agent. (When the agent acts on behalf of one single
company it is less likely to prove he’s independent).
It is sometimes difficult to determine whether the services rendered by an individual constitute
employment services or services rendered by a separate enterprise.
The independent status is less likely if the activities of that individual are performed exclusively or
almost exclusively on behalf of one 1 enterprise or closely related enterprises.
An independent agent will typically be responsible to his principal for the results of his work but
not subject to significant control with respect to the manner in which that work is carried out.
He will not be subject to detailed instructions from the principal as to the conduct of the work.
Another key factor to determine the independent status is the number of principals represented
by the agent. Independent status is less likely if the activities of the agent are performed wholly or
almost wholly on behalf of only one enterprise over the lifetime of the business or a long period.
All the facts and circumstances must be taken into account to determine whether the agent’s
activities constitute an autonomous business conducted by him in which he bears risk and receives
reward through the use of his entrepreneurial skills and knowledge.

Subsidiary company  the fact that a company controls or is controlled by a company which is a
resident of the other State, or which carries on business in that other State (whether through a PE
or otherwise), shall not of itself constitute either company a PE of the other.

Example: Philip Morris, American company, with a Dutch subsidiary and also a subsidiary in Italy; it
came out that the Italian subsidiary – besides its own business purpose – also performed some
activities for the Dutch subsidiary -> the Italian subsidiary can be deemed to be considered a PE in
Italy of the Dutch subsidiary.
You have a company in Netherlands with a participation in an Italian subsidiary. A portion of the
subsidiary’s profit relates to the activity of the Dutch company carried on in Italy.
For that portion, the Dutch company has a PE in Italy and Italian tax authorities can claim taxes
from the Dutch company. (Quite contradicting wrt what OECD says) -> if a part of the subsidiary’s
activity is a fixed place of business for the controlling company.
OECD says in general that being a subsidiary doesn’t necessarily imply a PE. Nevertheless, a
subsidiary company can be a PE of its parent if it is a dependent agent of its parent, and habitually
exercises authority to conclude contracts in the name of its parent company.

Closely related enterprise  Article 5(8), inserted in 2017, explains the meaning of the concept of
a person or enterprise “closely related to an enterprise” for the purpose of Article 5 and in
particular or Article 5(4.1.) and Article 5(6).
A person or enterprise is closely related to an enterprise if, based on all the relevant
circumstances, one has control of the other or both are under the control of the same
persons or enterprises.
In any case, a person or enterprise shall be considered to be closely related to an enterprise if:

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a) one possesses directly or indirectly more than 50 per cent of the beneficial interest in the other
(or, in the case of a company, more than 50 per cent of the aggregate vote and value of the
company’s shares or of the beneficial equity interest in the company) or if
b) another person or enterprise possesses directly or indirectly more than 50 per cent of the
beneficial interest (or, in the case of a company, more than 50 per cent of the aggregate vote and
value of the company’s share or of the beneficial equity interest in the company) in the person
and the enterprise or in the two enterprises.

OECD is trying to establish new rules related to e-commerce because traditional rules of PE are not
suitable anymore and end up in many cases in lower taxation of companies such as Amazon.
TAX IMPLICATIONS OF E-COMMERCE
Modern digital economy and the widespread use of the Internet have raised new challenging
issues for international tax law. A company resident in one country can in fact easily reach
customers located worldwide without the need of having a physical presence in another State.
Under a strict interpretation of the definition of PE contained in Article 5 of the OECD Model, it
would therefore be easy for companies to escape from taxation in some States, as they can make
profits in their territory without establishing a fixed place of business.

The OECD deals with the challenges of e-commerce and in the Commentary to Article 5 it
discusses about whether a PE can be deemed to exist.
To that purpose, it is possible to identify the following scenarios:
a) Internet website. An Internet website is an intangible combination of software and data, which
cannot qualify as facility such as premises or, machinery or equipment within the meaning of
Article 5(1) of the OECD Model Convention. As the website does not have a location, it cannot be
considered as a “place of business” enabling the State of source to levy its taxes  No PE.
b) Use of server (hosting arrangements). A company can enter into a website hosting contract
with an Internet service provider and normally pays some fees for the use of the Internet service
provider’s disk space. According to the OECD, in this case the server and its location are not “at the
disposal of the enterprise” under the typical contractual arrangements between the service
provider and the company. As a result, a hosting contract does not give rise to a place of business.
 No PE (because server not at disposal)
c) Use of own server. A different scenario, however, appears if a company has a server at its own
disposal, which hosts the website through which the transactions with the customers take place.
Irrespective of the legal title under which this server is at disposal of the enterprise, if it is “fixed”
and the activity of the company wholly or partly is carried on through such a server, then this
server can constitute a PE. To that purpose, it is necessary to verify on a case- by-case basis what
business functions are performed at the location of the server, bearing in mind the nature of the
business and the activity performed by the server (such as conclusions of the contract, processing
of the payments, automatic online delivery and so on). Therefore, if the operations carried out
through the server are merely preparatory or auxiliary activities (such as merely communicating
with customers, advertising, supplying information, gathering data, etc.), there will be no PE. As it
has already been mentioned above, the exclusions set forth in Article 5(4) do not apply if the
activities carried out via the server are an essential and significant part of the business of the
enterprise.
 if the company has its own server located in another State, it can be considered as fixed place
and fall within the definition of PE (if the business activity performed through it is essential and
does not have an auxiliary/preparatory character)
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d) Internet service providers. A server is an essential part of the business of the Internet service
provider. Therefore, if the server of an Internet service provider is located in a country different
from that where it is resident, such a server might easily be considered as a PE of the Internet
server provider in the foreign country. (Example: eBay server in Switzerland)

Example (unrelated): UK company with a branch in Switzerland. The BoD is in UK (and nothing
else), but the activity and the production are performed in Switzerland generating 1 million per
year. It’s the UK company which has to pay taxes for that 1 million to Swiss tax authorities, but
also to UK authorities because the branch is not a separate entity -> it pays according to Swiss tax
rate and then is granted tax credit / exemption by the Uk tax authority.
(It’s a way to elude more onerous taxes in the State of residence)

From a legal point of view, a PE and headquarters are the same entity so they can’t even conclude
contracts with each other.
However, from a tax perspective, it’s always important to treat them as if they were two separate
entities for the correct allocation of costs and profits among them.

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TAXATION OF BUSINESS PROFITS
In general, a business entity is an organisation formed under the legislation of a given country and
its purpose is to carry on a business activity.
From a tax perspective, a main distinction exists between two forms of business entities, which
have a different tax liability, i.e., “companies” and “partnerships”.

One big difference: companies have “legal personality”  companies are considered as an entity
different from its shareholders -> companies are subject to tax (corporate income tax) differently
from their shareholders. Moreover, a company can repay shareholders only through dividends.

“Economic double taxation”  income generated by the company and distributed to

shareholders (remember: they’re separate entities), is taxed twice both on a corporate and
personal level.
The difference from the juridical double taxation is that in this second case we have same income
taxed twice but by the same taxpayer.

In case of companies we have

economic double taxation:
the same income is taxed twice
on two separarate entities
1) CIT on corporate income
2) PIT on dividend distributions

If then some of the shareholders

were foreigners, then we would
also have a problem of juridical
double taxation.

Companies have a problem of economic double taxation, partnerships don’t.

Partnerships usually do not benefit from tax treaties -> a MNE would never use a partnership to
make investments, but they’re often used for asset management.

Partnerships usually don’t have legal personality (-> no subject to tax; “fiscally transparent
entities”).
Income produced by partnerships is considered as an aggregate of income produced by partners.
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They need to file a tax return but then income is attributed to partners, which are the only ones
which have to pay taxes on that income.
Before, States recognised tax credits to give relief from economic double taxation.
Then Luxembourg introduced participation exemption for capital gains and dividends  income
deriving from shareholding is tax exempt.
That’s why Luxembourg became the State of holding companies. Now this model has been
adopted by the majority of European countries.
Dividends are taxed only in the state of residence of the company.

Class 8/4
Class 8/4
Business profits are normally an aggregation of revenues derived in a given tax year, less the
deduction of the costs and past losses.
Rules governing such computation vary a lot among States.
Normally, tax rules on computation of profits do not follow the same criteria determined by
accounting principles.

Normally the rules of computation of profits of a PE follow those of a resident company.

Article 7 of the OECD Model establishes that if a PE exists in the State of source, this State is
allowed to tax the profits attributable to such a PE. The term profits if defined under domestic law.
A PE defines “if” and “to what extent” the State of source can tax a non-resident company  a
company needs to have in the State of source an existing place of business (fixed + at disposal)
through which it carries on partly or totally its business activity. The PE can be taxed in the State of
source only if (and to the extent of) the profits are attributable to the PE.

Example: a company based in Spain with a PE in Italy and France. Profit respectively 2000, 500,
1000.
The company has to declare 3500 profits in Spain where it is resident, then 500 in Italy and 1000 in
France, and there will be DTTs to avoid double taxation (Article 23 a or b), for example granting tax
credit or exemption in the state of source.
In Italy and France, the taxable profit is limited to the extent of profits produced by the PE there
(500 and 100 in this example).

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If France PE had a loss, no taxes would be paid in France, while taxable profit in the resident State
(Spain) would be 1500. Then tax law usually allows to bring forward the loss, reducing taxable
income in the following period(s).
If the headquarter in Spain incurred 200 marketing expenses, a proportional part should be
allocated to PEs because those expenses contribute in generating revenues in foreign branches.

Tax exemption assuming profit in Spain 2000, in Italy 500 and in France loss of -1000. Taxes:
- Spain  CIT (E) x 2000 -> other profits/losses are disregarded
- Italy  CIT (I) x 500
- France  0 (because there is a loss)

Tax credit
- Spain  CIT (E) x (2500) – tax credit
- Italy  //
- France  //

 Article 7(1) OECD Model

Profits of an enterprise of one Contracting State (i.e., State R) shall be taxed only in this State
unless the enterprise carries on business in the other Contracting State (State S) through a PE
situated in this latter Contracting State (i.e. State S). If the enterprise carries on business as
aforesaid, the profits that are attributable to the PE in accordance with the provisions of
paragraph 2 may be taxed in that other State.

4. Article 7(2) OECD Model

For the purposes of Article 23A or 23B, the profits that are attributable in each Contracting State
to the PE are the profits it might be expected to make, its dealing with other parts of the
enterprise, if it were a separate and independent enterprise engaged in the same or similar
activities under the same or similar conditions.
 a PE is not legally a separate entity but from a tax perspective it should be taxed as if it was
independent from other parts of the non-resident company.

Example: suppose the Spanish headquarters request a loan of 1000 € with 2% interest -> this
clearly entails a cost of financing. Legally, the debtor is the Spanish company which has requested
the loan and it also has to pay interests. However, part of the cost of financing can be allocated to
the PE because it contributes to the creation of its profits.
Then, for tax purposes, the PE should be considered independent. (rewatch)

5. Article 7(3) OECD Model

Where a State adjusts the profits attributable to a PE and taxes accordingly the profits, the other
State shall make appropriate adjustment to the amount of tax charged on those profits in order to
eliminate double taxation.  adjustments
In determining such adjustment, the competent authorities of the Contracting State shall consult
each other, if necessary.
This rule only applies with respect to differences in the determination of the profits attributed to a
PE that result in the same part of the profits being attributed to different part of the enterprise
according to Article 7.

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It does not deal with the computation of taxable income, but rather with the attribution of profits
for the allocation of the taxing rights between the Contracting States and to the extent necessary
to eliminate the double taxation resulting from the adjustment.

Definition of PROFITS
There is no definition in DTTs, it’s established by the legislation of contracting States.
For instance, Italy considers business profit as all profits (revenues minus costs) produced by a
company in a specific year.
This means that if a company receives royalties, rents, dividends...all these income items are
included in the definition of corporate profit.
Broad meaning is: income derived from carrying out a business enterprise according to the
meaning established in the domestic laws of the Contracting States.
Under Article 7(4), where profits include items of income which are delt with separately in other
articles of the DTT, then the provisions of these articles prevail.
Examples of separately-delt income items are: Article 6(4) (Income from immovable property),
Article 10(4) (Dividends), Article 11(4), Article 12(3) (Royalties), Article 17(1) and (2) (Entertainers
and sportspersons), and Article 21(2) (Other income)

Article 8:
Until 2017, the profits from the operation of ships or aircraft in international traffic, as well as
profits from the operation of boats engaged in inland waterways transport, were taxable only in
the Contracting State in which the place of effective management of the enterprise is situated.
 if Lufthansa, based in Germany, had a base also in the US, it could be taxed only in Germany
(State of source), independently from the presence of a PE.
Following the 2017 OECD Model amendments, Article 8(1) now provides that profits of an
enterprise of a Contracting State from the operation of ships or aircraft in international traffic shall
be taxable only in that State  the principle is still to apply taxation only in 1 State: the
Contracting State of the enterprise. It’s eliminated the reference to the place of effective
management.
Usually, Contracting State refers to the State in which the company was established, but
competent authorities can apply their criteria, provided that an agreement is found.
Article 8(2) sets forth that the provisions of paragraph 1 shall also apply to profits from the
participation in a pool, a joint business or an international operating agency.

ASSOCIATED ENTERPRISES (article 9)

Multination enterprises often abuse of this article -> artificial manipulation of profits to minimise
the level of taxation, because MNEs are divided in many entities spread worldwide and each one
has its tax obligations.
The idea is to share costs and profits in order to obtain the lowest possible tax burden:
concentrate costs in high-tax countries (-> deductions) and concentrate profits in low-tax
countries.

Inter-company transactions can occur at values that do not reflect the true market value.

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This practice can occur between entities of the same group, as well as between companies and
PEs.
Anti-avoidance measures to hinder phenomenon of "transfer price" (should be: arm-length price)

Example: imagine an Italian company with an asset in its balance sheet (e.g., trademark D&G).
The company has other companies in other countries, the use of the brand in those countries
should be remunerated paying a royalty to the Italian company.
Sell the trademark to another company in a State where the taxation of royalties is more
favourable than Italy, such as Luxembourg -> in this way, Italy could be taxed only for the sale of
the trademark (capital gain) while royalties would be taxed in Luxembourg with a more favorable
tax rate.
In this case you have a tax advantage: companies paying royalties can deduct costs (in high-tax
countries) and royalty revenue is taxed at a more favourable rate.
The sale price for the trademark was also manipulated downwards (below its arm-length price, its
fair value) in order to reduce taxes on capital gains.

According to article 9, tax authorities of contracting state are allowed to adjust profits of PEs and
companies and subsidiaries based in their territories when they think or have evidence that the
price applied in intragroup transactions was not arm-length (i.e., was artificial, manipulated).
Article 9 applies in both cases showed in slide 12.
Moreover, the fact that DTTs apply in a bilateral way, doesn’t limit the power of tax authorities of
State 1 and 2 to apply article 9 in case the companies are controlled by another company which is
resident in a non-contracting State.

Article 9 apply when the value of the transaction between the company 1 and company 2 differs
from that between independent (unrelated) enterprises in a competitive market (the fair value).
The profits determined by the market price is to be substituted (and taxed in the place of) the
profits from the transaction agreed upon by 1 and 2;
Tax authorities are allowed to re-write the accounts and tax the profits accordingly.
In order to avoid double taxation resulting from the adjustments operated by the tax authorities of
one State, the tax authorities of the other State must make a corresponding adjustment.

TAXATION OF IMMOVABLE PROPERTY

Taxes on immovable property, which is also known as real property, can vary a lot from country to
country. It normally applies to both resident and non-resident -> normally, the taxing powers of a
given country include both the income derived by a resident from immovable property situated
abroad and the income derived by a non-resident from immovable property situated within its
territory. This residence-source conflict therefore results in a double taxation.
In general, income deriving from immovable property refers to the rent that is paid by a tenant
(i.e., the user of the real property) to a property owner (i.e. the owner or supplier of the real
property).

Article 6(1) establishes that income derived by a resident of a Contracting State (i.e. State R) from
immovable property (including income from agriculture and forestry) situated in the other
Contracting State (i.e. State S) may be taxed in this latter Contracting State (i.e. State S).

If OECD model doesn’t specify “only State of residence” (as in the case of airways), then it’s
possible that both countries, resident and source, can tax.
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The double taxation is usually solved through tax credit or tax exemption.

Immovable property  the term "immovable property" shall have the meaning, which it has
under the law of the Contracting State in which the property in question is situated.
The term shall in any case include property accessory to immovable property, livestock and
equipment used in agriculture and forestry, rights to which the provisions of general law
respecting landed property apply, usufruct of immovable property and rights to variable or fixed
payments as consideration for the working of, or right to work, mineral deposits, sources and
other...
Ships and aircraft shall not be regarded as immovable property.

Extension of the provision: the provisions contained in Article 6(1) shall apply to income derived
from the direct use, letting or use in any other form of immovable property.
Article 6(4): articles 6(1) and (3) also apply to the income from immovable property of an
enterprise.
This means that for income deriving from immovable property, a company is taxed under Article 6
and not under Article 7 and the principle of PE.

TAXATION OF CAPITAL GAINS

There are different systems of taxation among countries and also different meanings of term
“gain”.
The issue is a source-residence conflict when the asset is located in the State of source  taxation
of the gain occurs both upon the resident taxpayers for gains realised domestically and abroad,
and upon non-resident taxpayers for gains derived from the disposal of property located within
the territory of the State of source.

Participation exemption  these provisions also apply to capital gains on participations. Bear in
mind that in the majority of EU countries there is participation exemption: a company having a
substantial participation in another company (10-20%) which sells the related shares can benefit
from 0 taxation.
PEX means you’re not taxed on dividend distributions nor on capital gains on sale of shares.

Article 13(1) deals with the alienation of immovable property and establishes that gains derived by
a resident of a Contracting State (i.e. State R) from the alienation of immovable property referred
to in Article 6 and situated in the other Contracting State (i.e. State S) may be taxed in that other
State (i.e. State S)  both states can tax on capital gains from alienation of immovable property.

Article 13(2) of the OECD Model Convention deals with the taxation of gains from the alienation of
movable property forming part of the business property of a PE. It establishes that gains from the
alienation of movable property forming part of the business property of a PE, which an enterprise
of a Contracting State (i.e. State R) has in the other Contracting State (i.e. State S), including such
gains from the alienation of such a PE (alone or with the whole enterprise), may be taxed in that
other State (i.e. State S)  both states can tax on capital gains from alienation of movable
property

Article 13(3) OECD Model

Gains that an enterprise of a Contracting State that operates ships or aircraft in international
traffic derives from the alienation of such ships or aircraft, shall be taxable only in that State
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 only the contracting state of the enterprise can tax capital gains on alienation of ships/aircraft

Article 13(5) OECD Model

Gains from the alienation of any property, which has not been specifically addressed in the other
paragraphs of Article 13, are taxable only in the State of residence of the alienator.
 this provision is important in the case of sale of shares: only the State of residence can tax gains
from the sale of shares.

Article 13(4) OECD Model

Gains derived by a resident of a Contracting State from the alienation of shares or comparable
interests, such as interests in a partnership or trust, may be taxed in the other Contracting State if,
at any time during the 365 days preceding the alienation, these shares or comparable interests
derived more than 50% of their value directly or indirectly from immovable property, as defined in
Article 6, situated in that other Contracting State.

Example:
Luxembourg based holding sells a house (immovable property) in Spain, realizing a capital gain of
3m -> this cg will be taxed in both States according to 13(1), immovable property.
Then of course, in order to avoid double taxation, Luxembourg (State of residence) has to grant
some relief through tax credit or tax exemption.
How to do to reduce taxes? Transfer the property of the real estate into a Spanish company, so
that the Luxembourg company which wants to sell the real estate actually sells the shares of the
Spanish company, whose value is equal to the value of the house.
But if you sell the shares, then article 13(5) applies and only the State of residence can tax for
capital gains on alienation of any property -> only Luxembourg can tax, thus avoiding Spanish
taxation.

OECD tried to solve this issue with 13(4):

Gains derived by a resident of a Contracting State from the alienation of shares or comparable
interests, such as interests in a partnership or trust, may be taxed in the other Contracting State if,
at any time during the 365 days preceding the alienation, these shares or comparable interests
derived more than 50% of their value directly or indirectly from immovable property, as defined in
Article 6, situated in that other Contracting State

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TAXATION OF SHAREHOLDERS
Main issue when dealing with the taxation of shareholders: Economic Double Taxation EDT, which
arises when income is taxed twice upon two different taxpayers (while in juridical double taxation
income is taxed twice upon the same taxpayer in two different jurisdictions).
Economic double taxation can be either:
6. Domestic  the double tax is levied by the same State (e.g., domestic dividend
distributions)
7. International  the double tax is levied by two different States (e.g., cross-border dividend
distributions)

Starting from 2000, at the international level there has been a widespread use of the system of
“participation exemption” -> exemption on income related to participations (capital gains and
dividend distributions), introduced by Luxembourg and then copied by many countries because it
managed to attract many holding companies.
PEX has broadly replaced the credit method, which normally works in a purely domestic situation.

SYSTEMS OF TAXATION of corporate profits

1. CLASSICAL system  the company is regarded as a separate entity and pays its own taxes.
Profits are then taxed upon the shareholders as dividend distribution.
(-> company and shareholders are separate entities, each one with its own taxes to pay)
Double taxation arises, as taxation of corporate profits has no impact on the calculation of
the tax upon the shareholders.

2. FULL INTEGRATION system  the company is not considered as a separate taxpayer but as
a tax accounting entity (like partnerships).
The taxable profits of the company, irrespective of whether actually distributed to the
shareholders, are included in the taxable base of the shareholders.
In this way, double taxation is avoided, because taxes are levied only upon shareholders.

3. SPLIT RATE system  taxes are levied upon the company at different rates, depending on
whether it distributes dividends.
In the case of dividend distribution, the tax rate is lower.

4. DIVIDEND IMPUTATION system  the company is regarded as a separate taxpayer.

The company pays taxes at the corporate tax rate, while dividend distributions to
shareholders can benefit from a tax credit.

It works as long as the company has a lower tax rate than the individual shareholder.

5. DIVIDEND EXEMPTION system  the company is regarded as a separate taxpayer.

Dividend distribution is exempt from tax upon the shareholders. (EU system).

6. DIVIDEND DEDUCTION system  the company is regarded as a separate taxpayer.

Dividends paid to shareholders are deducted from the taxable base when corporate
taxable income is calculated.

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DIVIDEND TAXATION
 Domestic dividend
Dividend payments = distributions of corporate profits by a company to its shareholders in respect
of their shareholding. Dividends are normally paid in cash, but distributions can also occur in kind.
The definition of dividend is provided by each State, but in general it is “ any distribution by a
company to its shareholders, in cash or in kind”.
(Example of dividend in kind for tax purposes: paying a dinner with company’s credit card)
From a tax standpoint, the treatment does not change. The tax legislation might also consider as
dividends certain repayments of share capital, certain interest payments (e.g., exceeding certain
thresholds), as well as non-arm’s length payments between associated companies*.

*Example: two companies, A and B, belonging to the same group. One sells to the other a
computer with a value of 1000 for 2500 -> tax authorities may consider 1000 as revenue (subject
to corporate income tax) while the remaining 1500 as dividend (subject to withholding tax).

Regimes of taxation of dividends can vary widely among different States, both in terms of amount
of °tax to be paid (i.e., different rates in respect of domestic and cross-border dividends) and in
terms of °collection of the tax (i.e., withholding tax or inclusion in the annual tax return)

 Cross-border dividend
Cross-border dividend distributions refer both to dividend payments from resident companies to
non-resident shareholders and to dividend payments from non-resident companies to resident
shareholders. 2 categories:
o Outbound dividends  dividends paid by a resident company to a non-resident
shareholder
o Inbound dividends  dividends paid by a non-resident company to a resident shareholder

Tax authorities can either impose the shareholder to file a tax return or oblige the distributing
company to withhold a tax upon the shareholder.
States usually prefer WHT because it’s easier, faster, safer from the perspective of the government
(easier to be collected), and also because the non-resident shareholder doesn’t need to be familiar
with the legislation of the State where the distributing company is based.

Dividend payments from resident companies to non-resident shareholders are usually subject to a
withholding tax in the source State.

Cross-border dividend is exposed to the problem of both economic and juridical double taxation.

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 Juridical double taxation is dealt in
DTTS and it’s usually solved through
Article 23 A or B.

Economic double taxation is not dealt in

DTTs but in domestic law through a tax
credit or exemption (in Europe we have
participation exemption)

If you want to grant some relief through tax credit according to Article 23 A, the tax credit should
take into account the withholding tax.

If instead the State of residence has an imputation system and wants to grant relief through a tax
credit according to domestic law, it should consider foreign corporate income tax (but it would be
such a mess to consider cit of each country); and that’s why we have participation exemption
instead of tax credit to avoid economic double taxation.

State A grants relief from economic

double taxation through PEX, while
we still have juridical double
taxation in State B, which applies
taxes on corporate profit as well as
a withholding tax on dividends.

Often, dividends paid by companies resident in low-tax jurisdictions do not benefit from any
double taxation relief, but are fully liable to tax upon the taxpayer in the State of residence of this
latter.
Nowadays we don’t have anymore black lists of low-tax countries (if dividends came from
companies located in these countries, PEX didn’t apply) but now tax authorities look at the CIT of
these low-tax countries -> the majority of the anti-avoidance legislation applies if the cit of the
foreign State is lower by a certain percentage.

Article 10(1) OECD Model  Dividends paid by a company resident in a contracting State to a
resident of the other contracting State, may be taxed in that other State.
(In this provision there is not the term “only”, so this means that both States can tax)

Article 10(2) OECD Model  if the beneficial owner is a resident of this other contracting State,
the WHT should not exceed:

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• 5% of the gross amount of the dividends if the beneficial owner is a company which holds
directly at least 25% of the capital of the company paying the dividends throughout a 365 day
period that includes the day of the payment of the dividend (for the purpose of computing that
period, no account shall be taken of changes of ownership that would directly result from a
corporate reorganization, such as a merger or divisive reorganization, of the company that holds
the shares or that pays the dividend); or
• 15% of the gross amount in all other cases.
The competent authorities shall by mutual agreement settle the mode of application of these
limitations. This paragraph shall not affect the taxation of the company in respect of the profits
out of which the dividends are paid.

(More favourable WHT in case of controlling companies)

Example: Company in State 1 distributes a dividend to its 100% controlling company resident in
State 2. According to domestic law of State 1, the withholding tax is 10%. According to DTT
between State 1 and 2, the tax rate should be in line with OECD model (5 or 15%).
The applicable tax rate is 5% (because the controlling company has at least 25%).
If domestic law provided for a withholding tax rate of 2% -> in this case, the shareholder resident
in State 2 shall pay 2%, because DTTs cannot create new taxing rights of the States.

Article 10 deals with the issue of juridical double taxation.

Double taxation is not actually eliminated, it’s just reduced: it reduces the taxing right of the State
of source but doesn’t annihilate it; then the State of residence will have to grant some relief.

Concept of BENEFICIAL OWNER

Example: two States 1 and 2. Domestic law provides for 25% WHT while the DTT only 10%.
In the past, in order to avoid the withholding tax, transferred its participation in the non-resident
company to a fully owned subsidiary. In this way, when company in State 1 distributed dividends,
you didn’t have to apply DTT between 1 and 2 but between 1 and the State in which the subsidiary
was incorporated (a favourable tax regime State). That’s why the concept of beneficial owner was
introduced -> if the owner of the company distributing dividends is just an empty box without any
offices, employees etc. then it’s not a beneficial owner and the application of the DTT can be

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denied (and usually the WHT tax defined in the treaty is more favourable than the one of domestic
law)
Beneficial owner (common law concept) = a person who is free to decide
(i) whether or not the capital or other assets should be used or made available for use by
others (i.e., the right over capital), or
(ii) how the yields from them should be used (i.e., the right over income), or
(iii) both

By providing for the “beneficial ownership” clause, the Model Convention aims at avoiding that
the State of source is obliged to give up its taxing rights under the DTT merely because dividends
are immediately received by a resident of the other Contracting State. The “beneficial owner”
clause has an anti-avoidance purpose, as it prevents a resident of one State acting in the capacity
of an intermediary, such as an agent or nominee, to claim the advantages of the DTT, without
being the actual owner of the income for tax purposes.
DEFINITION of Dividends (Article 10(3))
Due to the risk of different definitions of dividends in the States involved, Article 10(3) sets an
autonomous definition:
“The term dividend means income from shares, “juissance” shares or “juissance” rights, mining
shares, founders’ shares or other rights, not being debt-claims, participating in profits, as well as
income from other corporate rights which is subjected to the same taxation treatment as income
from shares by the laws of the State of source”.
 everything which is considered remunerated by equity or connected to the profits of the
company should be considered as dividend.
This is just a proposal, then Contracting States can restrict or enlarge this definition.
The distribution of profits of partnerships? Usually, partnerships don’t pay dividends.

PE CLAUSE (Article 10(4))

Article 10(4) establishes that if the B.O. carries on business in the State of source through a PE
situated therein and the holding in respect of which the dividends are paid are effectively
connected with such PE, the dividends received by the PE are taxable as part of the profits of the
PE.
Example: domestic law 20% WHT, 5% under DTT. If the parent company has a PE in State S and the
shareholding is effectively connected with the activity of the PE in State S, the WHT of Article 10(2)
shall not apply -> it’s like dividends are paid not to the parent company in State R but to the PE.
 State S doesn’t apply a WHT but applies Article 7.
This is valid not because of the presence of a PE itself, but only if the shareholding has economic
relevance and it’s strictly connected with the activity of the PE.
In such a situation, the dividends received by the PE are taxable as part of the profits of the PE,
belonging to the company resident in the other Contracting State. (Watch example)

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Other example: we have a parent company IKEA in Sweden with a PE in Norway and receives
dividends from France. In this case, we can’t apply PE clause because the PE is not resident in the
State of source -> Article 10(4) only applies if the PE is resident in the State of source.

EXTRATERRITORIAL TAXATION OF DIVIDENDS (Article 10(5))

Article 10(5) establishes that where a company resides in the State of residence and derives profits
or income from the State of source, the State of source may not impose any tax on the dividends
paid by the company, except insofar as such dividends are paid to a taxpayer resident in its
territory.
The State of source can impose a tax on the dividends insofar as the holding in respect of which
the dividends are paid is effectively connected with a PE situated in its territory.

The rule aims at avoiding the practice by which States tax dividends distributed by a non-resident
company solely because the corporate profits from which the distributions are made originated in
their territory (for example, realized through a PE situated therein).
This rule prevents the State of source from taxing dividends distributed by a non-resident
company simply because the profits of that company generated from activities or investment
undertaken by its PE situated in its territory. Usually, in fact, the State of source would have
already taxed the profits upon the PE when derived by the non-resident company.
(rewatch examples)

PARENT-SUBISIDIARY DIRECTIVE
(One of the very few EU directives about tax law which doesn’t concern VAT tax. Directives impose
objectives to member States which they have to implement through domestic law).
The directive also left to member states the choice between tax credit and exemption, but if they
opted for tax credit then they had to grant full credit.
Enacted in 1990 and emended in 2004, it provides for the most favourable dividends tax
treatment when specific requirements are met  0% WHT in the State of source and tax
credit/exemption in the State of residence.

When the company meets certain requirements, you check between domestic legislation, DTT (5
or 15) and EU directive (0), which prevails because it’s the most favorable.

Second point means they need to be two different member states of the EU (not valid for instance
between Italy and Egypt)

The third point means that the State of the source or the State of the shareholder doesn’t have to
exempt the company from taxes, in order to avoid double tax advantages.

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In respect of the minimum holding period, it must be pointed out that Member States (almost all)
may opt for a minimum holding period between zero and 2 years and some Member States
require a 1-year holding period only.

(see cases)

Class 15/4
INTEREST TAXATION
Normally, for tax purpose, interest is any remuneration of money which is lent. However, the
definition of “interest” varies widely among different States and legislations.
Differently from dividends, interest usually doesn’t suffer from economic double taxation -> we
have taxation and deduction, one taxpayer has to pay tax (lender) the other can deduct
(borrower).
If lender and borrower are in the same State, what is deducted in the hands of the borrower is
taxed in the hands of the lender. In a cross-border, this changes: you as a borrower may be
tempted to pay high interests in a high-tax country (because you can benefit from higher
deduction) while you as a lender may be tempted to be established in a low-tax country (lower tax
rate).

Interest can be taxed through inclusion in the tax return or through WHT
- final  if the debtor applies the wht and the lender has already fulfilled its tax obligation
towards the State of the source (usually applied for non-resident taxpayers)
- in advance  the taxpayer has to include the interest in the taxable income, subject to
normal tax rated, and then deduct the advance payment of wht

As in the case of dividends, we can have:

o Outbound interest  interest paid to a debtor resident in the State of residence to a
creditor resident in the State of source
o Inbound interest  interest paid to a debtor resident in the State of source to a creditor
resident in the State of residence

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The State of source normally applies a WHT. Although domestic legislations of States can define
the relevant connecting factors to determine the source of interest payments, quite often the
State of source of interest is the State where the debtor is resident. Also the State of the debtor
wants to tax the interest -> problem of international juridical double taxation (solved through
article 23A, 23B or domestic legislation).

Article 11(1)  interest arising in a Contracting State and paid to a resident of the other
Contracting State may be taxed in that other State.
(Since, as in the case of dividends, the article doesn’t contain the word “only”, both States can tax)

Article 11(2)  interest arising in a Contracting State may also be taxed in that State according to
the laws of that State, but if the beneficial owner of the interest is a resident of the other
Contracting state, the tax so charged shall not exceed 10% of the gross amount of the interest. The
competent authorities shall by mutual agreement settle the mode of application of this limitation.
(Remember 5 and 15 for dividends)

Also in Article 11(2) there is the Beneficial Owner clause, with an anti-avoidance function, in order
to avoid that the State of source applies a more favourable tax rate just because interest is paid to
someone resident in the other State.

Example: State of source domestic legislation provides for 30% wht, the DTT between State S and
State 1 provides for 20%. The creditor resident in State 1 may be tempted to divert the interest
payment to a subsidiary company in State 2 where there is a more favourable tax rate provided by
DTT between S and 2. The BO clause aims at avoiding such fraudulent practices.
Article 11(3)  “interest” = income from debt claims of every kind, whether or not secured by
mortgage and whether or not carrying a right to participate in the debtor’s profits, and in
particular, income from government securities and income from bonds or debentures, including
premiums and prizes attaching to such securities, bonds or debentures.
(This is an autonomous definition of interest contained in the treaty which can be changed by
domestic legislations or in the negotiation of dtts)
Penalty charges for late payment shall not be regarded as interest for the purpose of this article.

Article 11(4)  provisions of Article 11(1) and Article 11(2) shall not apply if the beneficial owner
of the interest, being a resident of a Contracting State, carries on business in the other Contracting
State in which the interest arises through a PE situated therein and the debt-claim in respect of
which the interest is paid is effectively connected with such PE.
In such a case, the provisions of Article 7 shall apply.

Interest is legally paid to

the creditor while from
an economic point view
interest is paid to the PE
resident in State S and
interest is included in the
profits of the PE.

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Can the State of residence R tax? If there was no PE, the State of residence can tax (and grant
some relief through...); instead, if there is a PE, the State of source can’t apply a withholding tax
but taxation on business profits (article 7) while State of residence can tax according to the
principle of worldwide taxation (because profits of the PE – which is not a separate entity – belong
to the creditor) and then grant some relief.
The creditor is taxed in both cases but we need to keep in mind that corporate income tax rate is
usually higher than withholding tax rate.

Article 11(5)  (which should be considered the State of source?)

Interest shall be deemed to arise in a contracting State when the payer is resident of that State.
Where, however, the person paying the interest, whether he is a resident of a contracting State or
not, has in a contracting State a PE in connection with which the indebtedness on which the
interest is paid was incurred, and such interest is borne by such PE, then such interest shall be
deemed to arise in the State in which the PE is situated.
-> if the debtor has a PE in a contracting state and the debt refers to the PE, even if the debtor is
not resident in the State, I can consider that State as State of source.

Example: Zara Spain decides to open a shop in Milan and to get a loan from an Italian bank to
finance the opening and other costs. Legally, the debtor is Zara Spain, while from an economic
perspective the interest is paid by the shop PE. The State of source is not Spain where the legal
debtor is resident but Italy where the PE is located.
If Italy is the State of residence of the creditor (the bank) and it’s also the State of source of the
interest, I won’t apply the withholding tax but domestic legislation.

Article 11(6)  where, by reason of a special relationship between the payer and the beneficial
owner or between both of them and some other person, the amount of the interest, having regard
to the debt- claim for which it is paid, exceeds the amount which would have been agreed upon by
the payer and the beneficial owner in the absence of such relationship, the provisions of this
article shall apply only to the last- mentioned amount.
In such case, the excess part of the payment shall remain taxable according to the laws of each
contracting State, due regard being had to the other provisions of this Convention.
-> If there is a special relationship (e.g., control) between the debtor and the beneficial owner and
the interest is not fair, arm-length, then the taxation of interest according to Article 11 (10%) shall
only occur on the portion of this payment which is considered interest.

INTEREST & ROYALTIES DIRECTIVE

This 2003 Directive has the main purpose to ensure that interest and royalty payments are subject
to tax once in a member State, thus avoiding juridical double taxation.
It provides for 0% WHT in the EU Member State of source in respect of interest and royalties
payments within a group of companies based in the EU and/or their PE
 0% WHT, tax in State of R.
Why not 0-0 as for dividends? Because for interest and royalties there is no problem of economic
double taxation.

Requirements for application:

• The State of source must be a EU Member State;
• The interest/royalty must be paid to a beneficial owner resident in a different Member State.
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• The payment must take place between two associated companies and/or their PE located in an
EU Member State.

The Directive also provides for a definition of beneficial owner BO:

The company is the BO if it receives the payment for its own benefit and not as an intermediary.
A PE is the BO if:
- The debt-claim, right or use of information in respect of which interest or royalty payments
arise is effectively connected with that PE; and
- The interest or royalty payments represent income in respect of which that PE is subject in
the Member State in which it is situated to CIT.
Where a PE is treated as the payer or the BO, no other part of the company can be treated as the
payer or the BO.

Example: if Zara Spain controls 100% Zara Italy and the latter has a PE in France. If the PE is
considered as BO, even if juridically the interest goes from Zara E to Zara I, economically the
interest goes to the PE in France -> we don’t apply 10% but 0% WHT in Spain and only France can
tax.

If instead it’s the PE which pays the interest to the parent Zara E, we will have 0% WHT in France
and France (not Italy) is considered the State of source and only Spain can tax.
Zara Italy however can deduct the interest and it can tax profits (not interests) according to Art. 7.

Going back to the Directive, the term “company of a Member State” means any company:
- The companies must take one of the forms listed in the Annex to the Directive;
- They must be considered to be resident in two different Member States (no third State
under a DTT);
- They must be subject to CIT
- There must be a minimum direct participation of 25% in the capital of one company or a
third company must have a minimum direct participation of 25% in the two companies
- Minimum holding period: 2 years

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 In order for the directive to apply, it
has to be an interest payment
between companies which have one
a direct participation in the capital of
the other (not indirect).

State of source  It is the EU Member State of residence of the paying company or of

establishment of the PE, provided that such payment is deductible upon it.

Interest  Income from debt-claims of every kind, whether or not secured by mortgage and
whether or not carrying a right to participate in the debtor’s profits, and in particular income from
securities and income from bonds or debentures, including premiums and prizes attaching to such
securities, bonds or debentures.
Penalty charges for late payment shall not be regarded as interest.
No application in the case of “dividend reclassification”.

Example: if company 2 wants to have remuneration from company 3 then it can have it through
dividend or interest. In the second case, interest can be deducted by the payer (company 3,
resident in State of S which can apply withholding rate, if not 0 according to directive) and taxed
upon the lender which receives the interest.
If the interest rate paid is 20% but tax authorities believe the appropriate and fair interest rate
should be 5%, then the remaining 15% is considered as dividend or other income.
Interest can be deducted by the payer (upon which the State S applies 0 wht) and taxed in the
State of the lender while dividend is not deductible (and 0 wht) and State of the shareholder
receiving the dividend grants exemption.
In our case, State 2 and State 3 want the first that it is interest so it can tax, the second a dividend
so there can’t be any deduction.

If company 2 distributed interest to company 3, then the remaining 15% couldn’t be dividend
(because the parent doesn’t pay dividends to subsidiaries) but it rather could be capital increase, a
capital contribution.
That’s why some countries apply an equity tax.

Even if the European law prevails over domestic legislation, it does not preclude the application of
domestic law or DTT when they aim at avoiding fraud or abuse.
The 0% WHT in the State of Source does not apply in the following cases:
• Payments which are treated as distribution of profits or as a repayment of capital under the law
of the source State;
• Payments from debt-claims which carry a right to participate in the debtor’s profits;
• Payments from debt-claims, which entitle the creditor to exchange its right to interest for a right
to participate in the debtor’s profits;
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• Payments from debt-claims, which contain no provision for repayment of the principal amount
or where the repayment is due more than 50 years after the date of issue.

If interest/royalty payment is subject to WHT at source, a claim for a refund can be submitted to
the competent authorities of the source country.
Such request should be submitted within the period as laid down by the source country, but it
should last for at least 2 years.
The source country must repay the tax withheld within 1 year after receipt of the application and
the requested supporting information.
 this procedural rule states that the Directive has 2 ways to be implemented:
- the debtor applies the wht and then the creditor has to claim for a refund to its own tax
authorities
- file a specific form to obtain the immediate application of the directive

ROYALTIES TAXATION
Royalties usually refer to payments for the use of intangible property (i.e., intellectual property IP)
which benefits from protection under domestical law.
The definition of IP can vary a lot among States, but can be transferred and/or the owner can
grant the use of such property.
The definition of “royalties” can also be very different.
Normally, royalties involve deduction upon the payor, and taxation or exemption upon the
recipient. (As in interests) -> countries which want to favour R&D should provide for “patent box
system”, patent boxes are companies which only have IP and receive royalties because they grant
the use of the IP to other companies of the group. It happens in many countries such as Italy,
Switzerland, Luxembourg etc.

As dividends and interests, we can have outbound and inbound royalties.

The problem is juridical double taxation, not economic, and the State of source normally applies a
withholding tax WHT.

Article 12(1)  royalties arising in a Contracting State (i.e. State S) and beneficially owned by a
resident of the other Contracting State (i.e. State R) shall be taxable only in that other State.
-> royalties are taxed only in the State of R of the recipient.

Italy reserves the right to tax royalties when it is the State of source -> Italy always applies a
withholding tax at source, even if the OECD model suggests 0 wht at source and taxation only in
the State of R of the recipient.

(This fact of 0 WHT at Source created some criticism, especially by developing countries who
cannot tax when their companies pay royalties to parent companies in developed countries. In the
UN Model, developing countries can apply a wht at source on royalties)

Article 12(2)  the term “royalties” as used in this article means payments of any kind received as
a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific
work including cinematograph films, any patent, trade mark, design or model, plan, secret formula
or process, or for information concerning industrial, commercial or scientific experience.
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Software  Software is a program containing computer instructions for the operational processes
of the computer itself or for the accomplishment of other tasks.
It can be transferred through different media and it may be standardised or tailor-made.
The correct qualification of the payment for the transfer of software depends on the nature of the
rights that the transferee receives.
• If the right covers the use and exploitation of the software in the computer programs, this right if
a form of IP (i.e., royalty)
• In other types of transactions, the transferee receives a right over the software limited to what is
necessary to operate the program. These payments would fall within Article 7 (i.e., business
profits)

Example: I buy the Microsoft Office package and I have to pay a fee to Microsoft. This is not a
royalty but a business profit so Italy can apply the withholding tax at source if Microsoft has a PE in
Italy.

Article 12(3)  The provisions of paragraph 1 shall not apply if the B.O. of the royalties, being a
resident of a contracting State (i.e. State R), carries on business in the other contracting State (i.e.
State S) in which the royalties arise through a PE situated therein, and the right or property in
respect of which the royalties are paid is effectively connected with such PE.
In such a case, the provisions of article 7 shall apply.
-> if the royalty is paid by the PE located in State of S, article 12(1) doesn’t apply.

Article 12(4)  where, by reason of a special relationship between the payer and the B.O. of
between both of them and some other person, the amount of royalties, having regard to the use,
right or information for which they are paid, exceeds the amount which would have been agreed
upon by the payer and the B.O. in the absence of such relationship, the provisions of this article
shall apply only to the last-mentioned amount.
In such case, the excess part of the payment shall remain taxable according to the laws of each
contracting State, due regard being had to the other provisions of this Convention.

Article 12(4) deals with the issue of transfer prices and it is anti-avoidance provision.

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Another example of avoidance may be the following: USA broadcasting company transfers IP to an
Italian company. The latter decides to incorporate a Cayman Islands subsidiary which receives the
IP and transfers it to the Italian company in exchange for a much higher royalty than its fair value
-> in doing so, Italian company can deduct the royalty payment in Italy and pay a much lower tax
(actually zero) in Cayman Islands.

AGREEEMENT EU – CH
Even if Switzerland is not part of EU, in 2004 the EU and the Helvetic Confederation signed a
bilateral agreement whereby Switzerland obtained from the European Union a system of taxation
similar to that contained in the Parent-Subsidiary Directive and in the Interest & Royalties
Directive.
This was granted in exchange of automatic exchange of information on interest payments sourced
in Switzerland to individuals resident in EU Member States.
 it was like an exchange of favour: exchange of info (instead of secrecy) in exchange for the
regime provided in the Directives.

DVIDEND (0% WHT in S and exemption in R)

Dividends paid by Swiss or European subsidiary companies to European or Swiss parent companies
shall not be subject to taxation in the source State where:
• The parent company has a direct minimum holding of 25 % of the capital of such a subsidiary for
at least 2 years, and,
• One company is resident for tax purposes in a Member State and the other company is resident
for tax purposes in Switzerland, and,
• Under any double tax agreements with any third States neither company is resident for tax
purposes in that third State, and,
• Both companies are subject to CIT without being exempted and both adopt the form of a limited
liability company.
(Same requirements but we don’t have 10% minimum participation but 25% as for interests)

INTEREST & ROYALTIES

Interest and royalty payments made between associated companies or their PEs shall not be
subject to taxation in the source State, where:
• Such companies are affiliated by a direct minimum holding of 25 % for at least 2 years or are
both held by a third company which has directly a minimum holding of 25 % both in the capital of
the first company and in the capital of the second company for at least two years; and
• Where a company is resident for tax purposes or a PE is located in a Member State and the other
company is resident for tax purposes or other PE situated in Switzerland; and
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• Under any double tax agreements with any third States none of the companies is resident for tax
purposes in that third State and none of the PEs is situated in that third State; and
• All companies are subject to corporation tax without being exempted in particular on interest
and royalty payments and each adopts the form of a limited liability company.

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INTERNATIONAL TAX PLANNING
International taxation deals with the different rules provided for by both domestic legislation and
DTTs applicable to cross-border transactions in various tax jurisdictions.
International tax planning is the “art” of arranging cross-border transactions with the knowledge
of international taxation in order to achieve a tax effective and lawful routing of business activities
and capital flows  objective: minimize tax burden.
• Tax planning strategies of MNEs look at different factors and balance the costs/risks and
present/future benefits of a given structure.
• Tax structures should be kept as simple as possible.
• One tax strategy can be legitimate in one country, but unacceptable in another.

TAX AVOIDANCE
= Technique of combining several transactions which °separately are legitimate, but °all together
aim at avoiding a tax  formal compliance, but against the spirit of the law.
Tax evasion is a direct violation of the law.
The definition and the approach to tax avoidance are different from country to country.
Acceptable tax avoidance is legitimate tax planning.
Unacceptable tax avoidance consists of an indirect violation or improper use of tax laws and
treaties.

Anti-avoidance tax rules:

Example:
In order to avoid paying taxes, company A
may perform a merger with the two
controlled companies.
In this way, it would have a loss for 40k and
of course it wouldn’t have to pay taxes on
that loss.

However, tax authorities may challenge the

merger and the company would have to
prove that avoiding taxes was not the main
goal of the transaction.

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SAARs are anti-avoidance rules which are targeted to specific behaviours of taxpayers.
Sometimes they’re contained in domestic law, sometimes in DTTs and they want to prevent a
specific gap in tax law.
They aim at denying tax benefits associated with specific forms of transactions.
(Example: beneficial owner clause)

EXAMPLES OF SAARs:
A. Controlled Foreign Companies legislation (CFC rule)
B. Treaty Shopping
C. Thin capitalisation
D. Transfer pricing

A. CFC rules
Set of rules introduced by US in 1980s, then adopted by most of developed countries.
These rules aim at avoiding tax deferral = technique implemented by a resident taxpayer to avoid
current taxation on foreign income in the State of residence.

Example: US company producing phones, it sells in South Africa without a PE -> profits are taxed in
the State of Residence.
If the company doesn’t want to pay all the taxes in US, it can incorporate a subsidiary company in
Luxembourg which performs the sales in South Africa.
Suppose CIT US 30% vs. CIT LX 10%.
US can tax the profit only if the Luxembourg company distributes dividends, otherwise not.

CFC rules aim at avoiding cases of tax deferral like the one above, by extending the tax jurisdiction
of the State of R to income produced in specific low-tax countries (e.g., Dubai, Singapore etc.)
(In our example, tax authorities would consider those profits as belonging to the US company and
therefore apply US CIT)

CFC rules normally apply to income earned and accumulated in foreign entities located in certain
specified or low-tax jurisdictions. These countries can either be defined under a white list or a
black list (or even a grey list), or be identified under a comparison between the effective foreign
tax rate and their own effective rate.
In addition, the CFC rules require that the resident taxpayer control the foreign entity.

According to the type of income that under the CFC rules is taxed in the hands of the resident
taxpayer, it is possible to distinguish between:
1) The jurisdictional approach  looking at the country
2) The transactional approach  looking at the tainted income (e.g., passive income)

The main methods to tax income produced by the foreign entity in the hands of the resident
taxpayer are the following two:
• Piercing the veil  the foreign controlled entity is considered fiscally transparent -> its income is
taxed upon the resident shareholder irrespective of any actual distribution (the following
distribution of dividends, if any, will not be subject to double taxation)
• Deemed distribution of dividends  income produced by the controlled foreign company is
deemed for tax purposes as a dividend distribution, irrespective of an actual payment.
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With very few exceptions, most countries grant exemptions from the CFC rules, provided that the
resident taxpayer gives evidence to one or more of the following criteria:
1) The CFC distributed a certain percentage of its income annually;
2) The CFC earns most active income from genuine business
activities and has a business presence in the country;
3) The CFC is not established with the purpose to avoid or defer tax that would otherwise be
payable in the country of residence of the shareholder;
4) The shares of the CFC are listed on a recognised stock exchange;
5) The total or attributed income of the CFC is below a minimum amount (“de minimis” rule), or
the pro rata share of such income does not exceed a certain percentage of the total income of the
CFC.

B. Treaty shopping
= routing income arising in one country to a person in another country through an intermediary
country to obtain the tax advantage of a more favourable tax treaty.
Examples include the use of conduit companies in so-called “treaty havens” (e.g., Netherlands), triangular
situations in which a low or nil taxed branch of a company in a treaty country receives income from a third
country, as well as the use of hybrid entities that are characterized differently in two Contracting States.
Individuals can also “treaty shop” by transferring their tax residence to another treaty country.
Typical clause against treaty shopping: beneficial owner clause.

Several countries provide for specific anti- treaty shopping measures, which can be distinguished
into the following four main categories:
• Measures aimed at preventing treaty shopping through a combination of domestic and tax
treaty provisions;
• Specific measures that deny benefits to entities, which are not subject to tax in their State of
residence;
• Purpose-based measures that deny certain tax treaty benefits to entities set up only for claiming
such benefits;
• Comprehensive measures imposed under the domestic legislation or treaties.

C. Thin capitalisation
Business investment can be financed either through equity or loan capital (or, usually, both).
Besides economic or commercial considerations, the choice can also be affected by tax reasons.
Quite often, the use of debt is preferred to the use of equity for the following reasons:
- Interest can be tax-deducted;
- Interest is not exposed to economic double taxation  interest is taxed upon the creditor,
deducted by the debtor
- Equity can be subject to wealth taxes, net worth taxes and other capital duties;
- Debt can provide greater flexibility, as it can be converted into equity, but not the reverse;
- Often the withholding tax on interest payments is lower than that on dividends.

“Thin capitalisation” is used to describe “hidden equity capitalisation” through excessive loans,
which implies excessive use of debt over equity capital
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 tax authorities have the right to requalify for tax purposes this loan into contribution capital
and the remuneration is not considered as interest but dividend.

Rules:
• Target loan capital provided by non-resident lenders*
• Substantial shareholders able to influence the financing decisions and the debt-equity ratio
• The rules disallow the deductibility of the excess interest payments over a given debt/equity
ratio and often reclassify the interest as dividend and the loan as equity.

*(In a purely domestic situation, with the controlling company A and the subsidiary B resident in
the same State, tax authorities don’t lose any revenue: interest deducted by the debtor B can be
taxed upon the creditor A. If instead they’re from different countries, State of B can only apply a
wht while taxation is imposed by State of A)

Thin capitalisation rules usually follow one or more of the following tax treatments:
1. The expenses deduction for either the interest payment or the excess interest is denied.
2. The interest payment or the excess payment is treated as a constructive dividend payment.
3. The loan is wholly or partly reclassified as equity capital.
The interest income of the lender may remain interest for WHT and treaty purposes.
Sometimes countries re-classify the excess interest as a deemed dividend for treaty purposes.
If the loan is re-classified as equity, additional taxes may be imposed as capital duties.

Other approaches:
Countries that have no thin capitalisation rule often curb such phenomenon under their GAAR rule
or under the judicial doctrine of substance over form.
Some other countries apply the general principles of transfer pricing.
These approaches are subjective and create uncertainties for taxpayers.

D. Transfer pricing
Transfer pricing refers to the value of transactions between related companies.
Charging improper prices to transfers of goods or provisions of services might result in an artificial
and unjustified shift of profits from one country to another.
MNEs operating in more than one country might be tempted to avoid tax liability in intra-group
transactions, trying to concentrate profits in l-t countries and costs in h-t countries.

Arm’s length price  the price of cross-border intra-group transactions is different from that
normally charged between unrelated entities (not on an “arm’s length basis”).
OECD Reports: price that would have been agreed upon between unrelated parties engaged in the
same or similar transactions under the same or similar conditions in the open market.
Price between related parties should be the same as if the parties were independent acting in the
same or similar circumstances.

Arm’s length price is based on some main features:

 Based on transactional analysis  established wrt a single identified transaction

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  Must consider the private law obligation entered into by the contracting parties  it
should consider risks, guarantees and other conditions and obligations which may affect
the price
 Must be based on open market conditions (and reflect ordinary business practices)
 Must consider the particular circumstances that characterize the transaction

3 main computation methods:

No hierarchy exists. The comparability analysis should examine the functions performed by each
party, the contractual terms, the risks borne, the transfer of tangible and intangible assets, and the
business strategies employed.

1. CUP
It compares the price charged for property or services transferred in a controlled transaction to
the price charged for property or services transferred in a comparable uncontrolled transaction in
similar circumstances.
• Internal transaction vs. external transaction
• This method requires a high degree of comparability, but some adjustments are reasonably
allowed to compensate the differences existing between the controlled and the uncontrolled
transactions.
• It is the best indicator of the arm’s length price for transfer of both tangible and intangible assets
and provisions of services.

2. RPM
The price is based on the uncontrolled price at which a trader (as purchaser) would normally
expect to resell the goods, less a mark-up adequate to compensate him for his services in reselling
goods.
• The mark-up should be adjusted for material differences that exist between the related
transaction and the comparable unrelated transactions due to different factors.
• The final price is reduced by the other operating expenses and an appropriate profit margin.
• This method is appropriate when there are no comparable products, and the reseller does not
add any significant value to the product itself (i.e. distribution company).
• It relies on the price at which a product that is purchased from an associated enterprise is resold
to an independent enterprise.

3. CPP
This method relies on the direct and indirect production costs incurred by the supplier plus an
appropriate mark-up to give the arm’s length price.
• The arm’s length price is the cost of producing the product plus a gross profit percentage earned
on uncontrolled sales.
• The mark-up should reflect the differences in the functions performed and the operating (e.g.
marketing) and non-operating expenses (e.g. risks).

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• This method is useful at the end of the supply chain and is adequate when both parties to the
transaction add value (e.g. semi-finished goods sold between related parties under a joint facility
agreement or long-term buy- and-supply agreement, contract manufacture, provisions of group
services).

The OECD provides for some other methods, which are profit-based and rely on net profits earned
by the parties from the transaction, and not on the price (transactional net margin, profit split...)
They are alternative methods, which should be used where there is no satisfactory evidence of a
CUP and where it is not possible to apply the RPM or CPP.
OECD Guidelines are recommendations that can be used by tax authorities to apply a uniform
approach in case of transfer pricing.
Otherwise, tax authorities can curb this phenomenon with GAAR rule (whenever the transaction is
formally compliant with law but in substance something is wrong).

Tax authorities are allowed to make different types of adjustments to the prices charged in intra-
group transactions if they differ from the arm’s length value.
They can charge domestic tax on the portion of the price that has been altered.

Several countries also provide for procedures to grant unilateral ruling on transfer pricing issues
under an “advance pricing arrangement” (APA), which however may imply double taxation issues
if the tax authorities adopt conflicting tax treatment of an affected transaction.

(In the last few years, OECD suggested to member States to enact some legislation at domestic
level in order to have MNEs filing a transfer pricing documentation, in which they describe intra-
group transactions also making reference to external transactions)

OECD Base Erosion and Profit Shifting (BEPS)

Aggressive tax planning strategies, aimed at artificially shifting taxable base from high-tax
jurisdictions to low-tax ones, are broadly considered as a form of tax base erosion. MNEs are often
accused of dodging taxes worldwide and in particular in developing countries, where tax revenue
is critical to foster long-term development.

It is common view that BEPS causes damages in different ways:

x. Government revenue
x. Faith in taxation system
x. Inequality
x. Competition
x. Inefficient allocation of resources
x. Burden of individual taxpayers

In order to avoid this phenomenon, OECD published the BEPS Report, calling for cooperation from
countries and for immediate action by tax administrations to improve compliance.
Action plan  OECD identified 15 actions to tackle BEPS (i.e. “Action Plan”), assigned each action
to concrete working parties and task forces, and set deadlines for the delivery of the expected
outputs.
The Action Plan contains 15 actions that are grouped under four headings, as follows:

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1. Establishing international coherence of corporate income taxation.
2. Restoring the full effects and benefits of international standards.
3. Ensuring transparency while promoting increased certainty and predictability.
4. From agreed policies to tax rules: the need for a swift implementation of the measures.

(Read details on slides)

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EU Council Directive 2016/1164
EU somehow participated in anti-BEPS action, enacting this “anti-tax avoidance directive”, which
lays down rules against tax avoidance practices in order to protect the internal market.
It is framed within the OECD BEPS initiative and supports the introduction within the EU of the
anti-BEPS measures  objectives: prevent tax avoidance + protect int. mkt from aggressive tax
planning

The rules apply to all taxpayers which are subject to corporate tax in a Member State (i.e., PE are
included, but individuals and transparent entities are not).
The Directive does not preclude the application of domestic or agreement-based provisions aimed
at safeguarding a higher level of protection for domestic corporate tax bases.

 Interest limitation rule (Article 4)

Exceeding borrowing costs shall be deductible in the tax period in which they are incurred only up
to 30% of the taxpayer’s earnings before interest, tax depreciation and amortisation (EBITDA).
Exempt income shall be excluded from the EBITDA of a taxpayer. (Read the rest)

 Exit taxation (Article 5)

A taxpayer shall be subject to tax at an amount equal to the market value of the transferred
assets, at the time of exit of the assets, less their value for tax purposes.

 General Anti-abuse rule (Article 6)

For the purposes of calculating the corporate tax liability, a Member State shall ignore an
arrangement or a series of arrangements which, having been put into place for the main purpose
or one of the main purposes of obtaining a tax advantage that defeats the object or purpose of the
applicable tax law, are not genuine having regard to all relevant facts and circumstances. An
arrangement may comprise more than one step or part.
An arrangement or a series thereof shall be regarded as non-genuine to the extent that they are
not put into place for valid commercial reasons which reflect economic reality.

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Where arrangements or a series thereof are ignored, the tax liability shall be calculated in
accordance with national law.

 Controlled foreign company rule (Article 7)

The Member State of a taxpayer shall treat an entity, or a PE of which the profits are not subject to
tax or are exempt from tax in that Member State, as a controlled foreign company where the
following conditions are met:
a) In the case of an entity, the taxpayer by itself, or together with its associated enterprises holds a
direct or indirect participation of more than 50% of the voting rights, or owns directly or indirectly
more than 50% of capital or is entitled to receive more than 50% of the profits of that entity; and
b) the actual corporate tax paid on its profits by the entity or PE is lower than the difference
between the corporate tax that would have been charged on the entity or PE under the applicable
corporate tax system in the Member State of the taxpayer and the actual corporate tax paid on its
profits by the entity or PE.

GUCCI case
Italian company (Guccio Gucci SpA) transferred the trademark to LGI SA (Suisse), granting the right
to be the worldwide exclusive Gucci trader.
Italian Police made an investigation and noticed the huge discrepancy in CIT between Italy and
Suisse (over 30% vs. 9% only). Italian tac authority claimed that the Suisse company had to pay
taxes in Italy because it had a “hidden PE” in Italy through a Milan branch where the majority of
trading activity was carried on.

o Who and where had to pay taxes? The Suisse company, in Italy
o On what ground can the Italian tax authorities claim the payment of Italian taxes? On the
basis of the presence of a hidden PE
o What kind of taxes had to be paid? IRES and IRAP (corporate income and regional taxes)

Tax consequences:
- Tax evasion on undeclared profits for €1.4bn
- Criminal tax consequences (imprisonment up to 3-5 years for similar cases) upon the CEO
Marco Bizzarri and the former Patrizio di Marco
- Agreement with Italian tax authorities -> settlement for €1.25bn

Remuneration of the CEO:

Mr. Di Marco was resident in Paradiso (Canton Ticino), where he benefited from a forfeit taxation.
He received, besides his salary, a hidden remuneration of €24m paid to a Panama company on a
Singapore bank account as consultant.
Mr. Bizzarri was also resident in Canton Ticino and received a salary of €40m.
In both cases, there was an issue of fictitious residence.

Conclusions:

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  A MNE cannot pay taxes where it wants, but where “added value” is actually created and
where key managers work
 Complex analysis of functions performed by the single entities of the MNE in order to
allocate each of them to correct share of taxable profits
 Strong international cooperation between tax authorities nowadays

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