The effectiveness of financial strategies is traditionally measured, before tax, based on the gross cash flows of the enterprise.
However, in France, experience has shown that the effectiveness of a strategy, particularly a hedging strategy, can be profoundly affected by disadvantageous taxation, or by taxation poorly adapted to the economic reality of transactions.
Given the tax rules currently in force in our country, it has therefore become necessary to include tax factors in the choice of adequate treasury instruments.
Furthermore, derivatives have been used not only to support the financial strategy of companies, but also as part of their tax optimisation strategies.
2. Significant distinctions regarding French tax law
France, unlike other countries such as Belgium and Germany, has progressively introduced a specific tax regime for financial instruments largely inspired by the American rules. This regime has gradually become more and more complex as the legislation and rules have been refined.
Mastering the French tax rules comes from the understanding of the following distinctions:
distinction between instruments valued at their market value at year end, and those which are not;
distinction between speculative transactions and hedging transactions. Within the latter, distinction between the rules relating to the deferral of the taxation of gains and the rules relating to the deferral of deduction of losses;
distinction between industrial and commercial enterprises on the one hand, and credit institutions on the other.
It is interesting to note, in this respect, that some of the greatest distinctions operating abroad, particularly in Anglo Saxon jurisdictions, do not exist in France.
For example, the distinction between revenue and capital gains is of considerable importance when the revenue / capital gains categories are not fungible or when the methods of taxing the income are not the same (this is the case in the United States, the United kingdom and Australia);
By contrast, in France, profits and gains, whatever their nature, realised on financial instruments are traditionally treated as ordinary income, and do not to benefit from the reduced tax rate applicable to long term gains.
The domestic legislation of some countries (Australia, UK) similarly distinguishes between "trading" and "non trading" profits, and between trading and investment companies : such distinctions are not relevant from a French perspective.
3. Valuation at market value at the accounting period end
The first step in mastering the French tax rules consists of distinguishing, amongst the various instruments:
Australia, the United States, and proposed UK regulations also operate this distinction .
- those valued at their market value at each year end;
- from those which escape the obligation to be valued.
The instruments marked to market at year end are those which are traded on the market or by reference to a market.
Other instruments, such as over-the-counter instruments (swaps, FRAS, caps, floors, collars, etc.) remain subject to normal French rules (latent losses only are taken into account by way of a provision).
According to the Tax Administration, the fact that an instrument relates to foreign currency (independently of its characteristics or liquidity) is nevertheless sufficient for it to be included amongst the instruments evaluated at their market value at each period end.
4. Speculative or hedging ?
In the same way as the American legislation, the second distinction made for tax purposes relates to the speculative or hedging nature of the transaction.
In France, the distinction between a hedging position and a speculative position is, in fact, essential since:
- it determines whether a company can benefit from the option to defer the taxation of latent gains;
- it prevents the enterprise from definitively losing the right to deduct the losses suffered on one side of the position.
5. Optional deferral of gains
Considering the deferral of the taxation of gains in more detail, there are two distinct sets of tax rules, which only apply when the hedged transaction is a future transaction.
Firstly, the law provides for the limited deferral, for a maximum of two years, of the taxation of latent gains on hedging contracts in force at year end. This deferral applies to contracts whose sole objective is to compensate the risk of a transaction which will take place in one of the two following accounting periods. Tax neutrality can not therefore be reached where the hedged transaction produces effects over several years.
The legislature has, however, introduced a specific provision for foreign currency instruments whose sole purpose is to cover exchange risks of future transactions, whatever the period during which they will be realised or will produce effects.
The law provides that the latent gains on the hedging transactions are taxed symmetrically to the losses suffered on the position hedged.
The hedged transaction must be identified by a clear and measurable agreement in respect of a third party (i.e. long term contracts with customers or suppliers). This excludes the possibility of benefiting from a deferral of taxation for the traditional hedging against estimated budgets.
Each of the two deferrals is conditional upon providing specific declarations annexed to the tax return.
6. Compulsory deferral of losses
Moving on now to the rules relating to the treatment of losses suffered by an enterprise on one side of a hedging strategy.
Tax law provides that the loss incurred on one side of a position, whether latent or realised, is deductible from taxable results only for the fraction that exceeds the as yet untaxed gain on the other side of the position. That is, losses corresponding to an untaxed gain are deferred, losses exceeding the untaxed gain are immediately deductible. If the gain is taxable, all losses are deductible.
Such a deferral of losses, directly inspired by the American legislation relating to the "straddle rules", is obligatory.
In order to be able to deduct the losses, the company has to respect the declaration obligations required by tax law.
If not respected, the penalty is the absolute loss of the right to deduct the loss suffered.
The application of this rule is not related to the intention of the company but to the objective symmetrical character of the position held.
7. Specifics relating to the status of the taxpayer
French credit institutions are, in principle, subject to the same tax provisions previously described, except:
there are specific rules applicable to interest rate and currency swaps and FRA contracts; swaps and FRA contracts entered into by a credit institution with the aim of hedging instruments subject to the mark to market rule are also marked to market at year end (i.e. latent gains are included in the taxable result whereas latent losses are deductible for corporate tax purposes).
Furthermore as opposed to commercial and industrial companies, credit institutions are not entitled to deduct latent losses on speculative swaps and FRA contracts at year end ;
there are lighter declaration obligations in respect of symmetrical positions since credit institutions are entitled to produce declarations prepared for regulatory purposes.
8. Non corporate tax aspects
The preceding discussion has largely been devoted to analysing the corporation tax rules applicable to financial instruments. But derivatives used by French enterprises are also likely to have withholding tax and VAT consequences.
Regarding the possible liability to withholding tax on payments made overseas, we can summarise the situation by saying that the flows, in practice, escape withholding tax even though the theoretical basis of this exemption is debatable (in particular, in non treaty circumstances).
The situation is essentially similar in respect of VAT (exemption without option). The issue is more a matter of the input VAT consequences of using financial instruments rather than the output VAT consequences, i.e. the consequences on the company's right to deductions (inclusion in the prorata) rather than on the liability to VAT.
9. Tax consequences
To conclude on the principal French tax mechanisms, when the rules are correctly applied, the enterprise will not suffer any additional absolute tax cost from adopting a financial strategy.
But the strict application of French tax principles can lead to the enterprise paying tax before the transaction economically gives rise to a gain.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. For additional information contact Claire Acard on +33 (1) 55 61 10 10. The members of ARCHIBALD ANDERSEN Association d'Avocats (S.G. Archibald and Arthur Andersen International) are registered with the Hauts-de-Seine Bar.
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