Legal update (Italy): 22% VAT on all settlements agreed by insurance companies

Background: Italian VAT regime

VAT is a general tax that applies, in principle, to all commercial transactions between VAT-Registered Entities, involving the sale of goods and/or the provision of services in exchange for a consideration, in cash or in kind (the “Relevant Consideration”). As a general rule, a seller/service provider must issue an invoice to the buyer/client, charging VAT (usually at the standard 22% rate or – in specific cases – at a reduced 10%, 4% or even 0% rate) on the Relevant Consideration. The VAT collected must then be paid by the seller/service provider to ITA.

Under the provisions of Articles 1 and 3, paragraph 1, of the Italian VAT Decree (Presidential Decree no. 633/1972), VAT applies to the Relevant Consideration due in respect of a service performed pursuant to an obligation to do, not do or to permit something (“obbligazioni di fare, non fare o permettere”), as confirmed by the Italian Supreme Court in its judgment no. 20233 of July 31, 2018¹.

Ordinarily, VAT-Registered Entities may offset VAT charged on the supplies they make (output transactions)] (“fatture attive”) and due to ITA against any VAT charged on supplies made to them (input transactions) (“fatture passive”). This mechanism ensures that VAT is ordinarily neutral between VAT-Registered Entities engaged in fully VAT-able activities (principle of neutrality) and it is ultimately borne by the final consumers at the end of a supply chain (who is not a VAT-Registered Entity).

However, VAT-Registered Entities that carry on exempt transactions, such as insurance companies and banks and which, therefore, do not charge VAT on their supplies are prevented from recovering input VAT incurred by them. Accordingly, for such businesses, any VAT paid on invoices only represents a deductible cost for income tax purposes.

VAT on settlement agreements prior position of the ITA

The previous position taken by the ITA meant that a distinction had to be made between a settlement under which new legal obligations would arise and a “declarative” settlement agreement.

Under the former, the amount paid in connection with a new or varied obligation could qualify as Relevant Consideration and, therefore, be subject to VAT.

For “declarative” settlement agreements (where no new legal obligations arise):

1. the applicable VAT treatment would  be based on the underlying existing legal relationship; and
2. where the agreement only concerns the amount of loss suffered by one party (as is typically the case with indemnities under an insurance policy), payment under the settlement would qualify as compensation for damages, falling outside scope of VAT.

VAT on settlement agreements: what’s new

In a move away from the previously established position, following rulings in 2021, ITA has now taken the position that any amount paid in connection with a settlement agreement between VAT-Registered Entities will qualify as Relevant Consideration and be subject to VAT at 22%, regardless of whether the new legal obligations arise under the settlement agreement. This is because, according to ITA, any payment from one party of an amount in exchange for the counterparty’s agreement not to pursue legal action, will meet the requirement of the above-mentioned Italian Supreme Court judgment. In other words, the ITA argument is that an obligation not to do something” in a settlement agreement is de facto a supply of services, and therefore qualifies as Relevant Consideration for VAT purposes.

As a result of this line of argument, any time a VAT-Registered Entity receives a claim settlement it must issue an invoice to the insurer that includes an additional 22% VAT charge. Such VAT will not be give rise to an input VAT deduction for the insurer although it is likely to be a deductible cost for income tax purposes.

The position on settlements taken by ITA has been criticised by commentators and even by the courts. Indeed, in a recent case, the Italian Supreme Court (Judgment no. 20316/2021) although not explicitly referring to the ITA’s position, confirmed that:

1. in order to determine whether an amount paid in connection with a settlement agreement is subject to VAT, the underlying claim should be taken into account (i.e. the reason why the settlement sum was paid), holding that in the specific case VAT was not due;
2. should any settlement agreement in which a party agrees not to pursue a claim qualify as a contract whereby a party renders a “service”, any settlement agreement will necessarily qualify as a “novation” (i.e. as a contract that replaces a previous contract and discharges the parties of any previous contractual obligations). This approach, however, is not consistent with the fact that many settlement agreements clearly do not qualify as novations.

Conclusions

Based on the position taken by the ITA, there may be a number of negative effects for insurance companies:

• There is likely to be an increase in loss ratios for all types of insurance products, including W&I policies issued alongside M&A transactions, since the insured (if a VAT-Registered Entity) will be obliged to issue a VAT invoice to the insurer.
• Failure to do so may expose (i) the insured to a claim by ITA for not having issued the correct (VAT-inclusive) invoice to the insurer; and (ii) the insurer to a claim by ITA for not having issued the missing invoice to the insured, pursuant to Article 6, paragraph 8, of Legislative Decree no. 471/199.
• Accordingly, there is likely to be an impact on settlement negotiations, since the payment of the VAT may discourage settlements (or lower the threshold at which such settlements are acceptable, compared to the risk of an adverse judgment).

Even if the new ITA position with respect to VAT due on insurance claims settlements has yet to be tested in the Italian courts, in the meantime, a prudent approach is for insurers to account for the payment of the VAT on settlements and take this into account in their reserves.