In this French Tax Update, we will catch up on the recent developments pertaining to two generally hot topics under French tax law: the controlled foreign companies ("CFC") rules, and the abuse of law (abus de droit, "AoL") procedure. More specifically, we will focus on recent case law affecting the CFC safe harbor rules, and on the advisory opinions issued during the last few months by the Committee in charge of AoL matters (Comité de l'Abus de Droit Fiscal, "AoL Committee"), inter alia with respect to management packages and certain financing transactions.
Recent Case Law Affecting French CFC Rules
During the last 15 months or so, French tax courts have issued various decisions that have, potentially, a significant impact on the application of the French CFC rules (article 209 B of the French tax code (Code général des impôts, "FTC")).
Basic Operation Of The French CFC Rules
The French corporate tax rules are on a strict territoriality basis, i.e., only profits generated in France are liable to tax.
Article 209 B introduces an exception to the above territoriality principle, and it may be summarized as follows:
- if a French corporate taxpayer owns, directly or indirectly, more than a certain threshold (currently 50 percent) of the share capital or voting rights or financial rights of a non-French entity; and
- such non-French entity benefits from a so-called "privileged tax regime" in the jurisdiction where it is located (i.e., its effective tax rate in such jurisdiction is more than 50 percent lower than the effective French tax rate which would have been applicable in similar circumstances); then
- the French corporate taxpayer would be deemed to receive fully taxable dividends, from such non-French entity, in proportion to its participation in the latter.
When the non-French entity is located within the European Union, a specific safe harbor rule applies whereby article 209 B is applicable only if the participation of the French corporate taxpayer, in the above entity, is an artificial scheme targeting the avoidance of French tax legislation.
When the non-French entity is located outside of the EU, article 209 B is disapplied if the French taxpayer can evidence that the principal purpose and effect of the operations, effected by the above entity, do not consist of a transfer of profits to a tax-privileged jurisdiction ("General Safe Harbor"). Article 209 B provides that, inter alia, such evidence is deemed to be provided when the non-French entity has, principally, an effective industrial or commercial activity in the jurisdiction where it is located ("Deemed Safe Harbor")
Case Law Interpretation Of The Safe Harbor Rules
The case law referred to, at the beginning of this section, concerns the interpretation of the above safe harbor rules, and although they relate to a period where the wording of article 209 B of the FTC was a bit different, the resulting principles are valid under the current version.
The case law refers to two different situations, both involving a French bank:
- In one case, the potential CFC subsidiary, based in Guernsey, had a private banking activity; the local effective rate of taxation was about 4 percent, and, accordingly, article 209 B would have been applicable unless the safe harbor rule could protect the French bank.
- In the other case, the potential CFC subsidiary, based in Hong Kong, was active in the currency markets of the surrounding region; the effective taxation rate in Hong Kong was de minimis, i.e., as with the Guernsey entity, article 209 B would have been applicable if the safe harbor rule was not an effective defense.
Without going into the procedural details, the cases were first decided by the lower courts, and afterward, the Supreme Court (Conseil d'Etat) voided these decisions and referred them back to the lower courts. They were finally decided in summer of 2013.
In both cases, the initial query was whether, for the purposes of the safe harbor rule, one should refer to the "purpose" or to the "effect" of incorporating the non-French entity in a tax privileged jurisdiction.
The position of the French tax authorities was that only the "effect" should be taken into consideration, i.e., if the presence in the non-French jurisdiction enabled a reduction in tax liability (as defined by article 209 B), then any question about the motivation or "purpose" of such presence would be irrelevant. Actually, the position of the French tax authorities seemed correct on the basis of the then-current version of article 209 B, which was indeed only referring to the effect (NB: the current version refers to the object and the effect). However, the Conseil d'Etat decided that, despite the wording of article 209 B, one should refer to the motivation of the taxpayer for the purpose of the safe harbor rule.
Indeed, the Conseil d'Etat took the view that, from a constitutional perspective, the taxpayer should be in a position, when challenged on the basis of an anti-abuse legislation (such as article 209 B), to provide the evidence that its operations were not principally tax motivated despite the local low effective rate of taxation. In other words, if only the effect was taken into account (i.e., the low tax rate), it would have been extremely difficult for the taxpayer to be protected under the safe harbor rule. Once this principle was established by the Conseil d'Etat, the lower court decided as follows:
- In the case of the Guernsey subsidiary of the French bank, the lower court took the view that the subsidiary was targeting international individual clients who were attracted by the banking and tax legislations applicable in Guernsey; in other words, these international clients, given their specific needs, would not have been attracted by the French bank acting from France. Interestingly, the lower court added that even if some of these clients were French, and they used French-sourced funds, the above reasoning should not be modified given that article 209 B targets the motivation of the French bank and not the motivation of its clients.
- In the case of the Hong Kong subsidiary of the French bank, the lower court took the view that the subsidiary was managing the Asian currency position of the banks' affiliates in the region (specifically by investing in the Korean market), and that such an activity could not have been effected from France given the time difference and the required expertise that may only be found locally. As with the Guernsey situation, the French tax authorities were arguing that some of the clients and funds available to the subsidiary were potentially of a French origin, and the court decided that even if these allegations were true, they would be irrelevant for the purposes of the application of the safe harbor rule.
While it is too early to decide whether there has been a definitive change in terms of application of article 209 B (from a safe harbor rule perspective), one can expect certain tendencies:
- contrary to the position of the French tax authorities, the courts would take into account the motivation of the French taxpayer (and not only the effect of being located in a low tax jurisdiction); and
- the Deemed Safe Harbor would be less used in the future as it would imply that the relevant activity is performed in the jurisdiction where the entity is located; typically, in the Guernsey situation discussed above, the General Safe Harbor was more efficient given the bank's international clients (who are obviously not located in Guernsey).
AOL Committee Opinions
Pursuant to the AoL procedure, the French tax authorities may, under certain conditions, recharacterize a given transaction if they can prove that it is either fictitious or exclusively tax motivated. If the tax authorities attempt to recharacterize a given transaction under the AoL procedure, the dispute may be forwarded (either by the taxpayer or the tax authorities) to the AoL Committee.
While the AoL Committee is an independent body whose object is to issue nonbinding advisory opinions, such opinions are in practice closely followed as they (i) shift the burden of the proof, for any subsequent litigation, to the party with which the AoL Committee did not agree, and (ii) are generally viewed as influential on practitioners and tax courts (inter alia because of the qualifications of the AoL Committee members: three judges from the administrative supreme court, a tax lawyer, a public notary, a chartered accountant, and a university professor).
We develop below two of the most noteworthy topics covered by the opinions issued by the AoL Committee from October through December 2013 ("Q4 Opinions").
Management Packages In LBO Transactions
In various Q4 Opinions, the AoL Committee has once again addressed the income tax treatment applicable to the capital gains realized by managers who are transferring shares carrying attached warrants (actions à bons de souscription d'actions, "ABSA") received as part of a management package within the context of a given LBO transaction.
In several of the cases reviewed by the AoL Committee, the managers of a company about to be bought out had subscribed ABSAs in the holding company that was to carry the buyout. The number of shares that a given warrant could give right to was inter alia contingent upon the internal rate of return of certain other financial investors in such holding company.
As in many other similar cases, the French tax authorities have challenged the capital gains subsequently realized upon the transfer of the ABSAs, on the basis that the managers were actually benefitting from a profit-sharing scheme rather than capital gains realized by an actual investor, and that the income derived from such scheme was to be subject to personal income tax as employment income (in the cases at hand, the ABSAs had further been assigned to the plans d'épargne en actions of the managers, i.e., a type of shares savings plan entitled to a favorable capital gains tax regime).
Unlike certain opinions issued earlier in 2013, the Q4 Opinions sided with the French tax authorities.
The AoL Committee indeed found that while (i) the managers had funded the ABSAs on their own and (ii) such funding was substantial compared to their global income, certain features of the management package should lead to the characterization of employment income: (a) the provisions of the ABSAs were such that the exercise conditions of the warrants amounted to an allocation among the managers of a pre-determined sum, and (b) the managers had a de facto guarantee of recovering their initial investment, with the additional opportunity of realizing a substantial gain.
Interestingly, the AoL Committee disregarded the fact that the managers were not effectively guaranteed against the loss of their investment, and that the sale price always reflected the market value of the relevant warrants.
Allegedly Tax-Optimized Structured Financings
The Q4 Opinions have also addressed two allegedly tax-optimized structured financings.
Facts. The features of the first financing ("Transaction 1") may be summarized as follows (steps 2 through 8 all took place on the same day, that is, the day after step 1 took place):
- A French company X ("Company X") successfully completed a takeover bid over a US company Y ("Company Y"), the holding entity of several US operating companies;
- A US Company Z ("Company Z") was subsequently set up in order to modify the financing of such takeover bid and issued three types of shares: preferred shares carrying increased voting rights ("A PShares"), preferred shares carrying no voting rights but entitled to cumulative priority dividend rights that may be carried forward ("B PShares"); and ordinary shares ("C Shares");
- Company Y contributed certain US operating companies to Company Z and received the A PShares ("Contribution");
- Company Z and Company Y, respectively, undertook to issue and subscribe the B PShares ("B PShares Subscription Right");
- A French Company TP ("Company TP") and Company Y entered into an assignment and assumption agreement pursuant to which Company Y transferred the B PShares Subscription Right to Company TP;
- Company TP subscribed the B PShares and the C Shares using a shareholder loan from Company X;
- Company TP and Company Y entered into a forward sale agreement ("FSA") pursuant to which Company TP undertook to sell, and Company Y undertook to buy, all of the B PShares held by Company TP into Company Z, within a period of five years renewable once, and for an agreed price;
- Company Y and Company Z entered into a guaranty agreement ("GA") pursuant to which Company Y undertook to make available to Company Z the funds needed in order to distribute the dividends attached to the B PShares;
- The funds contributed by Company TP to Company Z, by subscribing the B PShares, were then made available to Company Y so that its parent, Company X, could reimburse the financing debt pertaining to the aforementioned takeover bid (Company Z inter alia provided (i) a loan to certain US operating companies so that they can distribute to Company Y dividends that had been voted before the Contribution, and (ii) a loan to an affiliate of Company Y which then on-loaned the same amount to Company Y).
The features of the second financing ("Transaction 2," together with Transaction 1 the "Transactions") may be summarized as follows (steps 2 to 4 took place within the same week):
- Company X transferred the cash pooling activities of its group to company B, a subsidiary located in Belgium ("Company B"), inter alia by increasing the share capital of Company B (NB: Company B used the notional interest legislation in Belgium);
- Company B provided a loan to Company TP ("Loan");
- Company TP reimbursed to Company X a shareholder loan for the same amount;
- Company X increased the share capital of Company B by the same amount;
- Eighteen months later, Company TP reimbursed the Loan to Company B by using a shareholder loan from Company X, and Company B redeemed its share capital for the same amount.
The French Tax Authorities' Position. The French tax authorities challenged Transaction 1 on the ground that it amounted to a wholly artificial arrangement whose sole purpose was to allow Company TP to benefit from the French participation-exemption regime with respect to the dividends received from Company Z B PShares.
The tax authorities inter alia elaborated that the FSA essentially was a collateralized stock loan in respect of which Company TP was not exposed to any Company Z shareholder risk as (i) the reimbursement of its investment into the B PShares was guaranteed by the FSA, and (ii) the payment of the dividends was guaranteed by the GA. The tax authorities thus considered that the dividends distributed in respect of the B PShares were to be recharacterized as interest payments, and thus to be subject to corporation tax under the standard applicable regime.
The tax authorities also mentioned that Transaction 1 was treated, for US tax purposes, as an indebtedness resulting in the payment of the deductible interest.
The French tax authorities challenged Transaction 2 on the ground that it amounted to a wholly artificial arrangement whose sole purpose was to allow the deduction of interest expenses to Company TP.
The tax authorities inter alia elaborated that (i) the combination of the capital increase of Company B, the Loan, and the reimbursement of the shareholder loan essentially was a share capital increase of Company TP, (ii) Company B was not autonomous vis-à-vis Company X in terms of material means and decisional process, and (iii) Company B was not bearing any financial risk with respect to the financings provided (the risk being borne by Company X as head of the group).
The Taxpayer's Position. With respect to Transaction 1, Company TP articulated the following arguments:
- Given the absence of third parties in the capital of Company Z, Company TP and Company Y had a common interest in jointly controlling Company Z, i.e., the investment of Company TP in the B PShares carried an actual shareholder intent;
- As Company Z is a Delaware corporation, accordingly its corporate life and the characterization of the dividends it pays to its shareholders may be analyzed only from a Delaware corporation law perspective;
- Under a general French tax law principle, a given company is free to choose its financial structure (debt versus capital);
- Transaction 1 did not amount to a collateralized stock loan as Company Y did not subscribe the B PShares and could not have remitted them as collateral;
With respect to Transaction 2, Company TP considered that the tax authorities have not demonstrated its exclusive tax motivation as Transaction 2 had no consequence on its taxable result (i.e., Company TP substituted the interest paid to Company X by the interest paid to Company B).
The AoL Committee Q4 Opinions. With respect to Transaction 1, the AoL Committee found that, while formally documented as an equity investment of Company TP into Company Z, it essentially was a contractual arrangement whose purpose was the refinancing of Company Y by Company TP through a stock loan with the B PShares posted as collateral for such loan.
The AoL Committee consequently considered that the tax authorities rightfully applied the AoL procedure as Transaction 1 should be regarded as a wholly artificial arrangement whose sole motivation was to allow Company TP to benefit from the French participation-exemption regime with respect to the dividends received from Company Z while the same dividends were viewed as deductible for US tax purposes.
In order to justify its opinion, the AoL Committee listed the following points:
- The Contribution actually benefitted to Company Y as a result of the various loans provided by Company Z;
- The B PShares were (i) initially supposed to be subscribed by Company Y and (ii) eventually transferred to Company Y pursuant to the FSA;
- Company TP undertook to sell the B PShares to Company Y within a period of five years, renewable once, pursuant to the FSA;
- The rights attached to the B PShares, together with the FSA and the GA, effectively gave to Company TP rights similar to those that Company TP would have had under a stock loan collateralized by the B PShares;
- There was no economic motivation to Transaction 1, whose sole purpose was to reduce the group taxable result in France while maintaining a deductible interest for US tax purposes;
- Company Z had no employee, was not carrying out any activity, did not invest into any asset other than the US operating companies received upon the Contribution, did not receive any dividends from such companies, and was managed by Company Y directors (whereas Company TP did not have any representative at the Board of directors of Company Z).
With respect to Transaction 2, the AoL Committee found that the tax authorities could not avail themselves of the AoL procedure as the taxable result of Company TP was not reduced as a result of the operations carried out (i.e., the same amount of interest would have been deducted by Company TP with or without Transaction 2).
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.