A series of corporate scandals in Italy have driven an update to the rules for related party transactions in a bid to protect minority shareholders. Gianfranco Veneziano and Stefano Simontacchi report

On 3 August 2009, Consob (the Italian securities market regulator) issued a new consultation document to regulate related party transactions carried out by listed companies and companies that issue financial instruments widely distributed among the public. The expiry date for public comment was 31 October 2009. Even though final rules might differ from those proposed, companies may wish to become familiar with the new regulations so as to plan future implementation appropriately.

The need for a comprehensive set of rules on related party transactions has been increasingly recognised by the market, particularly following certain corporate scandals in Italy and worldwide, as a way to protect minority shareholders from abuses by managers and majority shareholders.

Related party transactions are, in fact, regarded as one of the most typical examples of conflicts of interest among corporate constituencies. These conflicts are labelled by economists as 'agency problems'. Every relationship in which one party (the agent) promises to perform certain duties for another party (the principal) may present agency problems.

The problem is mainly that the agent is encouraged to operate in an opportunistic way, decreasing the features of the agent's performance or even diverting, to the agent's benefit, some of the wealth that the agent is supposed to generate for the principal. In large corporations, this problem is essentially driven by the conflict between the shareholders who only retain property of the company (the minority shareholders) and the persons who have control over the company (managers and majority shareholders).

With specific regard to related party transactions, the problem is therefore how to allow advantageous transactions (not all related party transactions have negative effects on the company's wealth), while simultaneously ensuring that minority shareholders are not expropriated by the management/majority shareholders through self-dealing transactions.

Solutions adopted by foreign countries vary significantly. The principles underlying Consob's proposal seem to reflect the approach taken in the US. In the US, securities regulations impose transparency requirements for related party transactions (in documents such as registration statements, proxy statements, financial statements) and impose disclosure of the company's policies and procedures for reviewing, approving or ratifying related party transactions.

The procedural rules required to 'clear' conflicted transactions are derived instead from statutory provisions and case law. The Model Business Corporation Act, for instance, provides a safe harbour for transactions entered into by interested directors, so long as proper disclosure of the relevant conditions is given and the transaction is approved by a majority of disinterested directors, a committee of disinterested directors or a majority of disinterested shareholders. Transactions with majority shareholders are disciplined by case law, and the approval by a majority of disinterested shareholders shifts the burden of proving that the transaction was unfair from the controlling shareholder to the challenging shareholders.

Consob's current proposal is aimed at curbing the risk of expropriation of minority shareholders by setting forth a comprehensive set of rules on related party transactions. Those rules provide for transparency requirements as well as procedural principles to be adopted by companies to ensure fairness within related party transactions.

With regard to transparency requirements, Consob's current regulations already set forth disclosure obligations (to be performed after the conclusion of the transaction), for business deals "that, in view of the financial instruments involved, the consideration or the manner or time of their conclusion, may affect the security of the company's assets or the completeness and correctness of information on the issuer, including that of an accounting nature".

In the new proposal, the disclosure obligations are triggered whenever a related party transaction crosses certain specific thresholds, and thus falls within the definition of a 'material transaction'. In that case, companies have to prepare a document describing the terms of the transaction, the economic drivers behind it, and the elements taken into account in determining the relevant consideration.

The document must be made public after the approval of the transaction by the competent corporate body, or after the signing of an agreement (even a preliminary one). The new regulations therefore give companies less room for discretionary application, affect a wider range of transactions and operate at an earlier stage.

With regard to the procedural rules, Consob's new proposal enhances the role of independent directors in the approval of both 'material transactions' and 'non-material transactions'. For non-material transactions, a non-binding approval by a committee of independent directors is required.

Conversely, for material transactions independent directors must actively participate in the negotiations, and the board of directors may only approve the transaction after having received a favourable opinion from a committee of independent directors. Companies may allow the board to carry out a material transaction even when the opinion rendered by the independent directors committee is negative. In this case, though, the transaction requires approval by a majority of disinterested shareholders (a so-called 'whitewash mechanism').

The whitewash mechanism is also required whenever a material transaction requires shareholders' approval pursuant to the law, or the company's by-laws, and where the independent directors give a negative opinion on the transaction when it is approved at the board level.

Related party transactions are relevant also from a tax perspective, in that these affect the profit allocation between the companies involved. Governments are thus particularly concerned when such transactions occur between related companies resident in different countries.

The solution commonly endorsed from a tax perspective relies on the arm's length principle; for instance, transactions between related parties must be carried out at the same conditions that would be imposed between independent parties. The arm's length principle is embodied in paragraph 1 of Article 9 of the OECD Model. Italy adopts the arm's length principle both in its domestic law and in its bilateral tax treaties.

The OECD Transfer Pricing Guidelines provide support for the application of the arm's length principle by also identifying five methods to determine an arm's length range of prices. The preferred method (CUP) consists in the comparison of the price of the transaction under review with prices of similar transactions occurred between unrelated parties. Where such method is not applicable (as this is frequently the case) other methods are considered, which are based on the comparison of gross margins (cost plus and RPM) or of operating margins (profit split and TNMM). The adopted transfer pricing policy must be disclosed and supported by a proper set of documentation.

European tax authorities (following the path traced by the IRS) are more and more aware of the key role of transfer pricing in the determination of the taxable income of multinational enterprises and are increasing audits on this issue. In this respect, transfer pricing is key not only for ordinary transactions but also for the exam of all types of business reorganisations, for example, IP management, supply chain restructuring and commercial restructuring. Transfer pricing will certainly be the main object for tax litigations in the years to come.

In light of the above, the same OECD has increased the efforts devoted to such a topic by recently issuing several discussion drafts that also include a draft entirely focused on the transfer pricing aspects of business restructurings.

A particular hot topic relates to the impact of the current economic downturn on transfer pricing. In fact, where the CUP method is not applicable, arm's length gross margins or operating margins can only be determined on the basis of historical data of comparables. In an era of recession, using historical comparables data (related to years not affected by the economic downturn) may lead to an over attribution of profits to one of the parties involved. A departure from the generally accepted standards seems thus to be justified (or even due), but no express guidance is provided and each case needs to be addressed specifically.

A recent circular letter issued by the Italian Ministry of Finance identifies transfer pricing investigations on multinational enterprises as a primary target for the Italian tax authorities for the years 2009-11. It is important that multinational enterprises with Italian companies (or with Italian permanent establishments) be ready to support their transfer pricing policy on the basis of a proper set of documentation.

In addition, it is worth mentioning the recently introduced Advanced Pricing Arrangement procedure on the basis of which taxpayers may reach an agreement with the Italian tax authorities on a certain transfer pricing policy (the agreement applies for three years and is renewable). The procedure is managed by a special team of the tax authorities (Ruling Office) that has a great expertise on the matter. The adoption of such a procedure may allow the company to avoid a tax exposure that is linked to the particular characteristic of transfer pricing. This is a grey area that requires both tax and economic expertise which ordinary tax auditors and tax courts rarely have.

One of the challenges for the years to come will also be to address in a consistent way transfer pricing from corporate governance, accounting standards and tax perspectives.

Gianfranco Veneziano and Stefano Simontacchi are partners at Bonelli Erede Pappalardo.