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Italy Issues Guidance On Tax Consequences Of Corrections Of Prior Years' Accrual Errors

13 November 2013   (0 Comments)
Posted by: Author: Ernst & Young
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Author: Ernst & Young

On 24 September 2013, the Italian Revenue Agency (Revenue) issued Circular Letter no. 31 (Circular) which contains important clarifications with respect to the tax treatment of prior years’ accounting errors.

The Revenue explained the procedures through which a taxpayer may or shall amend under certain conditions the taxable base of one or more fiscal years that were incorrectly determined as a result of accrual mistakes in prior years’ financials.

Among other things, this procedure represents an opportunity for taxpayers to deduct costs that were not deducted in the year of accrual.

Clarifications provided by the Revenue

With Circular Letter no. 23 of May 2010 (Circular 23/2010) the Revenue had already clarified that, when as a result of tax audits, the deduction of a cost is disallowed because the cost was accrued in a different period (Accrual Period), in order to avoid double taxation the taxpayer has the right to either (i) file an amended tax return for the Accrual Period (provided it is still timely under the relevant rules) or (ii) claim a tax refund for the excess of tax paid with reference to the Accrual Period.

The Revenue has now extended the principle expressed with Circular 23/2010 to the cases in which the taxpayer voluntarily corrects accrual errors made in previous years’ financials. Corrections should be made in accordance with the relevant accounting standard provisions.

The Revenue focused its analysis on the cases where the taxpayer:

  • Has not recognized a given cost in the financials related to the Accrual Period and has subsequently disclosed the error by recognizing such cost in the financials of any of the following years;
  • Has not recognized revenue in the financials related to the Accrual Period and has subsequently disclosed the error by recognizing such revenue in the financials of any of the following years.

The above-mentioned corrections affect the computation of the taxable base of the period in which they take place. As a result, the Revenue explained how the effects of such accounting corrections should be dealt with for tax purposes.

Tax treatment of costs recognized in a FY different from the Accrual Period

The procedure to follow for the deduction of a cost which was not recognized in the Accrual Period depends on the timing of the accounting correction, i.e., whether or not the tax return of the Accrual Period can still be amended or not.

The tax return of the Accrual Period can still be amended

If the correction is made in the financials related to the year which immediately follows the Accrual Period, an amending return in favor of the taxpayer (dichiarazione integrativa a favore) can be filed with reference to the Accrual Period by imputing the cost in the amending tax return. This is because an amending tax return can only be filed if the terms to file the tax return of the following year have not expired yet.

The Circular provides an example that can be restated as follows.

Example: if in FY13 a company finds out that a cost accrued in FY12 was not recognized in the relevant financials, the company may correct the error by imputing the cost to the FY13 accounts. However under the tax accrual principle the company will not be allowed to take the related deduction in the FY13 return (because the cost is related to FY12). Therefore, by following the instructions of Circular 31/2013, it will have the possibility to amend the tax return for FY12 (by including the corresponding deduction therein) provided that the terms to file the tax return for FY13 (generally the end of September of 2014 for calendar year companies) have not expired yet.

The tax return of the Accrual Period can no longer be amended

If the correction is made when the terms to file an amending tax return for the Accrual Period have already expired, the taxpayer can internally re-determine the taxable base of the Accrual Period by considering the deduction of the cost as well as the taxable base of the subsequent years up to the period for which the terms to file an amending return have not yet expired. The taxpayer will then file an amending return only for the latter period which takes into account the effects of all the redeterminations done starting from the Accrual Period.

The Circular provides an example that can be restated as follows.

Example: in FY13 a company finds out that a cost accrued in FY10 was not recognized in the relevant financials and imputes the cost to the FY13 accounts. Under the tax accrual principle the company will not be allowed to take the related deduction in the FY13 return (because the cost is related to FY10). Therefore, the company will have the possibility to re-compute internally the taxable basis for each of the FYs from 2010 through 2012 and file an amending return for FY12 which will include the overall effects of the mentioned re-computations.

Tax treatment of revenue recognized in a FY different from the Accrual Period

Taxpayers who did not recognize certain revenue in the due period of accrual, and imputed the revenue to the financials of any subsequent FY, will need to file an amending tax return with reference to the Accrual Period. If the re-determination of the taxable base of the Accrual Period affects the taxable base of the following periods, the taxpayer should file an amending tax return for each of the affected periods.

In this respect, it is important to note that while amending returns in favor of taxpayers are only allowed within the deadline for the filing of the following year’s return, amending returns not in their favor (dichiarazione integrativa a sfavore) can be filed for any FY for which the statutes of limitation have not yet expired (i.e., by 31 December of the fourth year following the one in which the tax return was filed). For instance, in case of calendar year companies, the only FY for which an amending return could be currently filed in favor of the taxpayer would be FY12 (before the deadline for the filing of the FY13 return which is 30 September 2014); in contrast, FYs for which an amending return could be currently filed not in the favor of the taxpayer would be from FY08 (by 31 December 2013) through FY12 included.

In the case of amending returns not in favor of the taxpayer, additional taxes may be due as well as penalties and interest for delayed payment. If particular timing terms and conditions are met, the taxpayer may benefit from reduced penalties under self-disclosure procedures.

The Circular provides an example that can be restated as follows.

Example: In FY13 a company finds out that some proceeds accrued in FY10 were not recognized in the relevant financials and imputes such items to the FY13 accounts. The company will have to file an amending return not in its favor for FY10 by including the mentioned proceeds and will need to pay the related additional taxes (plus penalties and interest). By following the said procedure the proceeds recognized in FY13 accounts will be taxed with reference to FY10. Depending on the case the company will also have to amend the FYs from 2011 through 2012.

Other cases

The Revenue addresses other specific and more complex cases such as where a company corrects accrual errors in respect of both costs and revenue at the same time, either with reference to the same FY or to different FYs. Depending on the overall net position resulting from the corrections, amending returns in favor (with possible internal re-computations for old FYs) or not in favor of the taxpayers will be needed on the basis of the principles addressed above. The Circular also explains how taxpayers should behave if in the past years they have amended a mistake by imputing a cost in a FY other than the Accrual Period and have taken the relevant tax deduction in the year of the correction.

Regional Tax on Productive Activities (IRAP)

The correction of a prior period accounting error should first of all affect the computation of the Corporate Income Tax (IRES). In addition, the Revenue clarified that to the extent that the correction of the errors is made in accordance with the relevant accounting provisions, the explained procedures may also affect the computation of IRAP.

Effects of the correction procedures on audit activities

The Revenue clarified that as a consequence of the described procedures the statute of limitation will revive for the given period when an amending return is filed. In particular, it is mentioned that the statute of limitation should revive only in respect of the specific items of the tax return that were affected by the correction procedure.

In this respect, the Circular addresses the key importance for taxpayers to create and keep detailed back-up files on the re-determination of the taxable base for the relevant FYs affected by any accounting correction. The tax authorities will ask for such information and will require it for a complete reconciliation between the old returns and the reinstated ones. Though the preparation of such files might not be significantly complex in the case of a correction affecting a single fiscal year, the relevant documentation should be carefully prepared where the corrections involve several fiscal years.

This article first appeared in ey.com.


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