Executive summary

In Resolution No. 1 published on 3 January 2022, the Italian Revenue Agency (ITA) has clarified that the net cash settlement payments made upon the execution of derivative contracts are exempt from Value Added Tax (VAT) under Article 10.1.4 of the Italian VAT Law, implementing Article 135.1b-f of the European Union (EU) VAT Directive.

The Resolution supersedes the former ITA's official interpretation, provided in Resolution 77 of 16 July 1998, which stated that the net cash settlement payments were to be considered out of the VAT scope.

The new ITA interpretation may have a significant impact on Italian taxpayers that apply the pro rata calculation to recover input VAT.

Detailed discussion

Background

In Resolution 1/2022, the ITA addresses the case of an Italian company (the Buyer) that has signed a Power Purchase Agreement (PPA) with an Electric Energy producer (the Seller) established in a non-EU country, to purchase a pre-determined amount of electricity at a fixed price for a certain period, in order to be hedged from the risk of possible changes in the electricity prices.

According to the PPA, each party undertakes to pay to the other one:

• The positive difference between the PUN (National Reference Energy Price) and the fixed price that the Seller has to pay to the Buyer.
• The negative difference between the PUN and the fixed price that the Buyer has to pay to the Seller.

In order to define the VAT treatment of the above cash settlement payments between the Seller and the Buyer, the ITA first pointed out the following:

• When an agreement concerns the purchase/sale of Electric Energy with the commitment of the buyer and the seller to make cash settlement payments for the purposes of being covered by the risk of changes in the energy prices, it shall be considered a financial derivative, and namely a swap.
• With regard to swaps, in Judgement 8770 of 12 May 2020, the Italian Supreme Court clarified that the payment obligations arising from a financial derivative cannot be considered as a mere obligation to exchange cash flows but shall be regarded as an agreement on how to manage a risk on the basis of parameters previously agreed by the parties.

Based on the above considerations, the ITA asserts that:

• From a VAT perspective, transactions concerning financial derivatives are exempt according to Article 10.4 of the Italian VAT Law¹ implementing Article 135.1 (letters from b to f) of the Council Directive 2006/112/EC.
• The exempt base is the amount of the net cash settlement payments due upon the execution of the derivative contract, also considering Article 4 of Law 133/199. This law provision defines the VAT treatment of Repurchase Agreements on securities or currencies, and states that for VAT purposes the sale and repurchase agreements shall be regarded a single loan transaction whose VAT base is the difference between the forward price and the spot price.

According to the ITA, the same rule can be applied to determine the VAT base of derivatives.

Implications

The interpretation provided by the ITA Resolution 1/2022 may have a significant impact on VAT taxpayers who deduct input VAT in proportion to the ratio between the total amount of turnover attributable to transactions with right of deduction and the total amount of turnover including exempt transactions (the so-called "pro-rata").

For these VAT taxpayers, the characterization of the net cash settlement payments as exempt considerations may cause a reduction of the pro-rata amount and consequently a decrease of the VAT input recovery rate, in so far the financial derivatives are not incidental supplies.²

However, it is worthwhile mentioning that some authoritative scholars and most market operators have strongly criticized the new ITA position.

In particular, these individuals have pointed out that the extension of the VAT rules provided for Repo to financial derivatives appears to be inappropriate, because it does not take into account the substantial difference between these two financial contracts from a legal perspective. Indeed a Repo is actually a loan agreement where the difference between the forward and the spot price is the consideration for the loan; conversely a derivative is an aleatory contract where the cash settlement is not due as a remuneration, as it has no direct link with any supplies, but it is a mere payment of money calculated by reference to a random or uncertain variable. Accordingly, lacking a direct link between a supply and the payment, the latter cannot be considered as consideration from a VAT perspective.

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For additional information with respect to this Alert, please contact the following:

Studio Legale Tributario, FSO Indirect Tax

• Gabriella Cammarota | Gabriella.Cammarota@it.ey.com

Studio Legale Tributario, FSO Global Compliance and Reporting - Wealth Asset Management

• Paolo Zucca | Paolo.Zucca@it.ey.com

Studio Legale Tributario, FSO International Tax Services, Milan

• Giuseppe Marco Ragusa | Marco.Ragusa@it.ey.com

Studio Legale Tributario, FSO Tax Controversy

• Alberto Giorgi | Alberto.Giorgi@it.ey.com

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ENDNOTES

¹ DPR 633/1972.

² Incidental supplies mean supplies not forming part of the usual business activity of the taxable person. According to Article 19-bis, Paragraph 2, of the Italian VAT law, the turnover attributable to incidental supplies shall be excluded from the pro-rata calculation but any input VAT incurred on purchases directly allocable to such supplies is not deductible.