Leveraged cash-outs: is the tax saving legitimate?

A leverage cash-out is a transaction whereby:

• the original shareholder steps up the tax base in the participation of the target company by paying a reduced (currently 11 per cent) substitute tax on the fair value of the participation;
• the original shareholder sells such participation for a price equal to the stepped-up value, so that no or minimal gain is realised; and
• the purchaser (either a third party or a vehicle controlled by the original shareholder) pays the price (or the debt borrowed to pay the price) with proceeds derived from dividend payments of the target company.

The tax saving for the original shareholder is to pay the 11 per cent substitute tax on the value reflecting retained earnings as opposed to cash in dividends suffering a 26 per cent withholding tax.

Audits of the Italian tax authorities

The Italian tax authorities often recharacterise the transaction as a withdrawal of the original shareholder from the target company. The price paid to the original shareholder is regarded as dividend income (hence subject to 26 per cent withholding tax). 

Sometimes the audit is brought against the target company (acting as withholding tax agent in respect of dividend income realised by shareholders). In such cases, the target company is exposed to higher tax liabilities (for taxes, interest and penalties ranging from 110 per cent to 200 per cent of higher taxes).

The position of the Italian Supreme Court

In its decision no.24839/2020, the Italian Supreme Court stated that:

• leveraged cash-out transactions are not unlawful if the transaction meets the rational of the favourable tax regime (ie the transfer of participation); and
• the tax saving realised by the original shareholder (ie 26 per cent withholding tax - 11 per cent substitute tax) is accordingly legitimate.

Brief remarks

Leveraged cash-out transactions should be legitimate if the shares are transferred by the original shareholder to third parties (ie there is an actual disposal of the participation). No higher tax liabilities should accordingly be claimed from the original shareholder or the target company. 

The above remarks should also be extended to cases (sometimes implemented in private-equity deals) where the original shareholder transfers the entire participation in the target company to a third party and reinvests the proceeds in a minority stake