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Why Canadian co-investors and fund managers structuring Italian acquisitions through holding companies still face capital gains risk — even after DL 38/2026 restored the participation exemption
A Canadian pension co-investor holds a 3.2% stake in a mid-market Italian manufacturer. The stake was acquired through a Luxembourg special purpose vehicle for €350,000. The co-investor's general counsel received a briefing in January 2026 warning that Italy had just closed off the participation exemption (partecipazione esente, the PEX regime under Article 87 of the Italian Tax Code, known as the TUIR) for holdings below 5% of share capital or below €500,000 in tax value. Neither threshold was met. The exit gain — expected at roughly €1.2 million — looked fully taxable in Italy at 24% IRES, wiping out a material portion of the fund's net return.
Then, in late March 2026, the Italian government reversed the thresholds. Decree-Law No. 38 of 27 March 2026 (DL 38/2026), in force from 28 March 2026, restored the pre-existing PEX framework with retroactive effect from 1 January 2026. The briefing had been overtaken by events within eleven weeks.
The general counsel filed the memo and moved on. That was the mistake.
Italy's 2026 Budget Law (Law No. 199 of 30 December 2025) introduced new minimum-participation thresholds for accessing the participation exemption (PEX) and dividend-exemption regimes — thresholds that were then partially rolled back by Decree-Law No. 38/2026. Article 11 of DL 38/2026 abolished / removed the dual threshold — the 5% minimum stake and the €500,000 tax value requirement — and restored the prior PEX framework retroactively from 1 January 2026. That restoration reinstated the 95% IRES exemption on qualifying capital gains, as confirmed by the conversion law (Law No. 88/2026), restoring the regime regardless of the size of the holding.
So the Canadian co-investor above can, once again, structure for a 95% exempt exit gain — in theory. The effective Italian IRES rate on a PEX-qualifying gain is approximately 1.2% (5% of the gain taxed at the 24% IRES rate). The PEX regime under Article 87 TUIR applies to IRES taxpayers — essentially Italian corporate entities and permanent establishments of non-resident companies — for whom qualifying capital gains are 95% exempt, leaving an effective rate of roughly 1.2%.
But the eleven-week crisis exposed something the DL 38/2026 repeal did not fix: the Luxembourg holding vehicle sitting between the Canadian fund and the Italian target is only as good as its substance. the Italian Revenue Agency had been challenging exactly that structure long before Law 199/2025 was drafted. The crisis simply focused attention on where the real risk has always sat.
Yes — for now, and subject to the four conditions that Article 87 TUIR has always required: continuous ownership from at least the first day of the twelfth month before disposal; classification of the shareholding as a fixed financial asset in the first balance sheet after acquisition; the target must not be resident in a preferential low-tax jurisdiction; and the target must carry on a commercial activity. Italian Revenue Agency Ruling No. 97/2026 clarifies the boundaries of the "commercial activity" requirement under Article 87, paragraph 1, letter d) of the TUIR for the participation exemption regime. In that ruling, a holding company sold shares in three SPVs established just over a year prior for developing battery energy storage systems; the SPVs had reached "ready to build" status at the time of sale, and the Agency denied the PEX benefit, finding the commercial activity requirement unfulfilled.
That ruling signals something important for infrastructure and early-stage industrial co-investments: the look-through approach applies for shareholdings indirectly held through group entities under de jure control. Revenue is not examining only the immediate seller. It is examining whether the underlying target genuinely conducts business, and it will look through holding layers to verify that.
For the Canadian co-investor holding the 3.2% stake, this creates a two-layer question. First, does the Italian target qualify? Second, does the Luxembourg SPV qualify as the entity actually disposing of the stake?
Article 87 of the TUIR, governing the exemption of capital gains (PEX), was amended by the 2026 Budget Law to make the exemption conditional upon holding a direct participation in the capital of the issuing company of at least 5%, or a participation with a tax value of at least €500,000, in addition to the requirements already provided by Article 87(1) of the TUIR. For the purposes of calculating the 5% threshold, indirect shareholdings within the same group were also to be taken into account, as provided by Article 2359, paragraph 1 of the Italian Civil Code.
The regime of partial exclusion or exemption was restricted to direct shareholdings of not less than 5%, or alternatively, with a tax value of not less than €500,000; where shareholdings fell below this threshold, realised capital gains would have been fully subject to IRES and IRPEF.
That rule is now repealed — but two effects linger. First, the repeal was legislative: it offers no protection against a Revenue audit that re-characterises a gain on other grounds, such as abusive avoidance or interposition of a fictitious holding. Second, any structure assembled during the January-to-March 2026 window solely to meet the now-abolished thresholds may draw scrutiny on its own terms.
Unlike the treatment of minority stakes in most common-law jurisdictions, where a capital gains exemption for corporate sellers either exists or does not depending on a simple residency or holding-period test, Italy's PEX has always carried substantive conditions that run to the target, to the seller, and — critically — to any intermediate holding entity. A Canadian fund relying on a domestic Capital Dividend Account strategy or a Canadian-controlled private corporation capital gains exemption will find no analogue in Italian law. The Italian regime rewards corporate substance in the chain, not simply corporate form.
The Luxembourg holding vehicle is both the solution and the problem. Under the Italy-Luxembourg Double Taxation Treaty (signed 3 June 1981), capital gains on the disposal of shares are, as a general rule, taxable only in the state of residence of the seller — Luxembourg. If the gain arises in the Luxembourg SPV and Luxembourg imposes no capital gains tax on a qualifying holding (which, under Luxembourg's own participation exemption, it typically does not for holdings above 10%), the economic result is close to a fully tax-free exit.
But Italian Revenue has been testing that chain consistently. On 5 September 2025, the Milan First Instance Tax Court issued Decision No. 3525, providing guidance on the Italian tax treatment of capital gains arising from indirect disposals of Italian companies held through foreign holding structures; the case concerned an international private equity investment in an Italian company operating in the pet care sector, held through a two-tier Luxembourg holding structure, carried out through the disposal of an intermediate Luxembourg entity resulting in an indirect transfer of the Italian target.
The Italian Revenue Agency argued that the Luxembourg entities were mere conduits, invoking Article 37(3) of Presidential Decree No. 600/1973, which addresses interposed entities. The First Instance Tax Court of Milan ruled in favour of the international private equity fund, rejecting the Revenue Agency's attempt to tax the capital gain; the court emphasised that the Luxembourg holding companies were genuine entities with their own offices, staff, and independent decision-making processes, countering the Revenue Agency's claims that they were mere conduits for tax avoidance purposes.
The fund won. But note why it won: it had offices. It had staff. It had independent decision-making. A lean Luxembourg SPV set up solely to hold a 3.2% co-investment stake, with no employees and a sole corporate director acting on instructions from the Canadian fund manager, will not produce the same evidence.
Entities utilising holding companies for investments should consider Decision No. 3525 as a precedent, reinforcing the importance of maintaining genuine operational substance in their corporate structures to defend against potential tax challenges.
The Milan Tax Court's reasoning, read alongside Revenue Agency Circular No. 97/2026 and the look-through posture it signals, produces a practical substance checklist for any Luxembourg vehicle holding an Italian stake:
Resident directors with authority. Board members must have the actual authority to approve the investment, monitor it, and decide on disposal. Rubber-stamp approval of decisions already made in Toronto or Montreal is not authority.
A physical registered office with documentary presence. A shared registered address used by dozens of funds is insufficient. The ruling reinforces the principle that the mere presence of a light corporate structure — a small office with one or two employees — does not automatically imply interposition, but the reverse is equally true: the complete absence of operational footprint will.
Independent investment decision-making. The SPV must be shown to have evaluated, approved, and monitored the Italian stake on its own terms, not as a passive conduit for the parent fund's decisions. Board minutes, investment committee records, and risk reports must show genuine deliberation.
Tax residency defensible in Luxembourg. The entity must be managed and controlled in Luxembourg, not in Canada, and must file Luxembourg corporate returns reflecting its genuine economic position.
No automatic pass-through of proceeds. A vehicle that receives disposal proceeds and immediately distributes them upstream without any treasury or reinvestment function is commercially indistinguishable from a conduit.
The cost of building this substance into a Luxembourg SPV varies by structure, but as a practical benchmark, a Luxembourg holding with a local substance package — resident director fees, registered office, fiduciary services, and annual compliance — runs between approximately €15,000 and €40,000 per year. That cost is negligible against an exit gain of €1.2 million and a potential Italian tax exposure of up to €288,000 at a 24% IRES rate on the full gain.
If the substance question is unresolved, three restructuring paths are available before a sale process begins. Each carries its own timeline and cost. None is available the week before signing.
The first path is a top-up of the stake to cross the 5% threshold of the target's capital. This can be done by acquiring additional shares or converting shareholder loans into equity. It requires a counterparty willing to sell, a valuation agreed, and — if the target is an S.r.l. — notarial intervention for the transfer. Timeline: typically 60 to 120 days. The benefit: once the 5% threshold is met, the look-through risk on the Luxembourg SPV also diminishes, because the PEX would apply even without reliance on the double tax treaty. Note that the 12-month holding clock runs from the date of the top-up acquisition, not from the original entry date, for the new tranche.
The second path is a merger of the SPV into an Italian holding company that itself meets the PEX conditions. This eliminates the Luxembourg interposition entirely, brings the gain into the Italian tax perimeter, and allows the 95% PEX exemption to be claimed at the Italian level. Timeline: Italian cross-border mergers take 4 to 6 months at minimum. Tax neutrality conditions under the Italian Civil Code and Legislative Decree No. 108/2024 (implementing the EU Cross-Border Conversions Directive) must be satisfied.
The third path — and the least recommended — is a re-characterisation of the gain as business income of the Luxembourg vehicle, relying entirely on the double tax treaty. This works only if the substance test is met. If Revenue successfully argues interposition, treaty protection falls away entirely and the gain is taxed in Italy as if earned by the Canadian fund directly, at 26% for non-residents without a permanent establishment.
Actori incumbit probatio — the burden of proof lies on the claimant. In a Revenue audit of a Luxembourg holding structure, the burden of demonstrating genuine substance lies with the taxpayer, not with the Revenue Agency. A fund that waits for the audit notice to begin assembling its substance evidence will lose.
As John Kenneth Galbraith observed, the modern corporation is an organisation in which the effective power of decision is concentrated at a level quite removed from those who formally hold authority. Italian Revenue has read the same book. It will ask who actually decided to invest in the Italian target, who monitored it, and who authorised the exit — and it will expect the answer to be a board sitting in Luxembourg, not a committee in Toronto.
In our files, the most common mistake on Luxembourg-held Italian co-investments is that the substance review is treated as a closing condition rather than an investment condition. By the time the exit SPA is being drafted, the vehicle has been in place for four or five years with minimal governance records. The decision to acquire, the annual business reviews, the monitoring calls with management — none of it was documented at the SPV level. Reconstructing that record retrospectively, even from authentic underlying materials, creates a credibility problem in any audit. The substance review should happen at the time the co-investment structure is first set up, and it should be repeated annually.
The next concrete step in your transaction is not engaging a tax adviser at exit. It is commissioning a substance audit of your Luxembourg vehicle now, while the holding period is still running and while restructuring options remain open. If the audit reveals gaps, you have time to address them. If you wait until the buyer's tax counsel raises the question in due diligence, the only option left is a price reduction.
For most purposes, yes. DL 38/2026 restored the pre-Budget Law PEX framework retroactively from 1 January 2026, removing the 5% and €500,000 thresholds. The standard Article 87 TUIR conditions — 12-month holding, financial fixed asset classification, non-privileged-regime target, commercial activity of the target — continue to apply unchanged. However, the Revenue Agency's look-through posture on intermediate holding companies, confirmed by Circular 97/2026 and illustrated by the September 2025 Milan Tax Court ruling, adds a substantive layer that has nothing to do with the thresholds.
A Canadian fund cannot directly claim Italy's PEX, which applies to IRES taxpayers. The Luxembourg holding company, if it is an IRES-equivalent corporate entity subject to genuine corporate tax in Luxembourg, can claim PEX on a qualifying Italian stake — or can rely on the Italy-Luxembourg Double Taxation Treaty to exclude the gain from Italian tax altogether. Either route requires the Luxembourg entity to have genuine economic substance, as confirmed by Milan Tax Court Decision No. 3525 of 5 September 2025. Without substance, Revenue will disregard the interposed vehicle and tax the gain in Italy as if earned directly.
Revenue will apply Article 37(3) of Presidential Decree No. 600/1973, the interposition rule. It will examine whether the Luxembourg entity had its own offices, staff, and independent decision-making, or whether it was a pass-through for the foreign parent fund. If it determines interposition, the capital gain is re-attributed to the fund as if it earned it directly, and taxed at 26% — with interest and potential penalties added. Under Italian law the assessment period for undeclared income is generally five years from the year the return should have been filed, or eight years if no return was filed at all.
HREFLANG BLOCK:
Editorial Team — Panato Law Firm Staff
