The present French Tax Update will focus on (i) the draft guidelines ("Draft Guidelines") published by the French tax authorities ("FTA") on April 15, 2014 with respect to the anti-avoidance provision targeting hybrid debt instruments that was enacted in the very last days of 2013 ("Anti-Hybrid Provision," please see our French Tax Update for February 2014 for further details), (ii) several noteworthy French and European Union court decisions, and (iii) a recent announcement by the FTA that the collection of the newly enacted exceptional tax on high employment income has been postponed.
ANTI-HYBRID REGIME DRAFT GUIDELINES
Applicable to fiscal years closed as from September 25, 2013, interest payments made by a French borrower to an affiliated entity are deductible for tax purposes only if such borrower is able to demonstrate that the lender is subject to an income tax on the corresponding interest income that is at least equal to 25% of the French corporation tax that would have been due had it been computed in accordance with standard French rules ("25% Test"), subject to specific adjustments where the lender is a flow-through entity such as an investment fund or a partnership ("Look-Through Rule").
The language of the Anti-Hybrid Provision being in certain respects unclear, the Draft Guidelines address certain of the issues raised in our French Tax Update for February 2014.
The main developments provided by the Draft Guidelines pertain to the way the comparison of the tax liabilities should operate (i.e., the actual tax liability of the lender on the one hand and its theoretical liability under French standard rules on the other hand).
The Draft Guidelines first provide that the comparison with the French corporation tax that would have been due, had it been computed in accordance with standard French rules, is made not only in reference to the French standard corporation tax rate (33.1/3%) but also taking into account the so-called additional contributions on corporation tax (contribution additionnelles à l'impôt sur les sociétés). While this is not entirely clear, we understand that the FTA thereby intend to encompass both the so-called exceptional contribution (contribution exceptionnelle, which amounts to 10.7% of the basic corporation tax liability arising from the application of the standard 33.1/3% rate for taxpayers with a turnover in excess of €250 million) and the so-called social contribution (contribution sociale, which amounts to 3.3% of the basic corporation tax liability arising from the application of the standard 33.1/3% rate for taxpayers with a basic corporation tax liability in excess of €763,000).
The Draft Guidelines further indicate in a much-awaited clarification that the 25% Test comparison basis should be the theoretical taxation of the gross amount of the relevant interest payment, regardless of (i) the lender's effective tax liability on the interest payments, (ii) the existence of expenses reducing the lender's tax liability (i.e., thereby dismissing back-to-back arrangements), and (iii) the lender's overall taxable result (i.e., thereby not penalizing interest payments made to loss-making lenders).
Separately, the position taken by the FTA appears to reduce the declarative burden of the borrowers, as the Draft Guidelines specify that they must provide documentation to demonstrate compliance with the 25% Test only upon request. It seems reasonable, however, that borrowers verify whether such demonstration is possible before making any deduction.
The Draft Guidelines moreover address certain of the timing issues by:
- Indicating that in the particular case of a mismatch between the borrower's and the lender's fiscal year closing dates, compliance with the 25% Test must be demonstrated for the fiscal year in which the lender will receive the relevant interest payment; and
- Allowing some leniency regarding deferred interest payments and discrepancies of accounting and tax treatment: where, by virtue of specific accounting or tax timing rules, the 25% Test is not satisfied for a given fiscal year, the Draft Guidelines nevertheless allow the borrower to deduct the relevant interest payment during the fiscal year in which such payment is effectively included in the lender's taxable income (provided an additional declaration is filed by the borrower).
Finally, and as suggested by the parliamentary debates, where the lender is a listed REIT-like company (société d'investissements immobiliers cotée, "SIIC"), the borrower will not be subject to the Anti-Hybrid Provision to the extent that it demonstrates that the interest payments received by such SIIC are comprised within its taxable sector (i.e., subject to corporation tax).
Pursuant to the Draft Guidelines, where the lender is a flow-through entity such as an investment fund or a partnership, (i) the Anti-Hybrid Provision limitation applies only to the extent that both the relevant flow-through entity and at least one of its members are affiliated to the borrower, and (ii) the 25% Test is applied at the level of such member(s) of the flow-through entity that are affiliated with the borrower (i.e., notwithstanding the taxation level of the other member(s) of the relevant flow-through entity).
The Draft Guidelines provide that in the case where the 25% Test is not satisfied with respect to a given affiliated member of a flow-through lending entity, the deduction of the entire interest payment made by the borrower should be denied (without taking into account the participation level of the affiliated member failing the 25% Test).
Moreover, the Draft Guidelines elaborate that in the case of a double-tier structure (i.e., where the lender would be a flow-through entity held by another flow-through entity), the 25% Test still applies at the level of the member(s) of the lending flow-through entity (i.e., where such member(s) fail to comply with the 25% Test, the Anti-Hybrid Provision would apply notwithstanding the taxation level of its own ultimate member(s)). In other words, the intermediation of two or more flow-through entities should jeopardize any deductibility.
Overlap With CFC Legislation
As suggested by the Budget Minister during the parliamentary debates, the Draft Guidelines confirm that where the relevant interest payment made to a foreign lender is already subject to corporation tax in France through CFC rules, the Anti-Hybrid Provision should not apply.
Even though it was not the official motivation of the initial proposal, nor the apparent intention of the Parliament, the language of the Anti-Hybrid Provision could effectively result in encompassing hybrid entities (e.g., a same entity being a corporation for tax purposes in one jurisdiction and a partnership or a disregarded entity for tax purposes in another).
The Draft Guidelines do not provide any clarification with respect to the situation of hybrid entities.
Coordination With Foreign Anti-Hybrid Provisions
While the Draft Guidelines organize the interplay of the Anti-Hybrid Provision with the other French provisions limiting the deductibility for tax purposes of interest payments, they do not address the risk of double taxation that could arise from the cumulative application of (i) the Anti-Hybrid Provision at the level of the borrower and (ii) a foreign linking rule at the level of the lender (that would, for instance, deny the application of a participation-exemption regime for dividends in the presence of a hybrid debt instrument, in accordance with the recent OECD and European Commission proposal related to hybrid mismatch arrangements).
EARLY 2014 NOTEWORTHY CASE LAW
Funding Of French Branches
On April 11, 2014, the Conseil d'Etat (French Supreme Court in most tax matters) ruled, in three separate cases, on the tax implications of the financing of the French branches of three foreign financial institutions (Banca di Roma Spa (now Unicredit), Bayerische Hypo und Vereinsbank AG, and Caixa Geral de Depositos).
In each of the three cases, the Conseil d'Etat decided that the foreign head office had no obligation to allocate a minimum amount of capital to the operations of the relevant French branch. Accordingly, subject to other standard limitations (arm's-length rate of interest, etc.), the interest paid by the branch on its indebtedness should be fully tax deductible.
The traditional position of the FTA has been that if the capital allocation to a French branch is not sufficient, then the interest paid by the branch, on the debt financing such insufficiency, should not be tax deductible. In the FTA's view, whether or not a given capital allocation is sufficient should be determined on the basis of the relevant solvency rules applicable to the branch treated on a stand-alone basis.
Technically, the FTA was referring to Article 209-I of the French General Tax Code and Article 7 of the relevant tax treaty between France and the jurisdiction where the head office is located (i.e., Italy, Germany, and Portugal in the cases at hand); these domestic and international rules essentially provide that the operations of the French branch of a foreign entity should be taxed in France to the extent of the profit that is imputable to the branch.
The Conseil d'Etat ruled that while the above provisions indeed enable France to tax the branch's profits, they could not be interpreted as allowing the FTA to discuss and challenge the choice made by the foreign office to allocate or not a certain amount as capital of the branch. Specifically, the Conseil d'Etat stipulated that none of the above provisions allows the FTA to consider that any allocation of capital to the branch should be computed on the basis of the relevant solvency ratios as if the branch were organized on a stand-alone basis (i.e., as a subsidiary).
While the decisions of the Conseil d'Etat went in favor of the relevant taxpayers, it is important to note that the latest OECD comments (published in July 2010) instead support the FTA's view that, for the purposes of the relevant international treaties, the branches should be treated as stand-alone entities.
European Union Court Of Justice Decision In The DMC Case: Potential Consequences Under French Tax Law
In its decision in the DMC case, the European Union Court of Justice ("EUCJ") held that an immediate taxation of unrealized gains upon exit of a Member State is an infringement of free movement of capital but is justified by the objective of preserving the balanced allocation of the taxing power between Member States, given that the Member State imposing such taxation, Germany, was no longer entitled to tax the relevant gains once they would be realized.
The EUCJ further ruled that the ability to spread the collection of the relevant taxation over five years and the requirement to provide a bank guarantee as security of the payment of the relevant taxation were proportionate to the objective of preserving the balanced allocation of the taxing power between Member States.
On the basis of the DMC case, one should analyze the implications for the French exit tax regime applicable to transfers of residence of French companies to another Member State, as its operation is very similar to the German regime. Would the EUCJ decision in the DMC case effectively validate the French exit tax regime? Could not it be then that only the spread of the collection of the relevant taxation over several years or the provision of a bank guarantee should be required?
Incidentally, the EUCJ decision could also cast some doubt with respect to the French tax regime applicable to contributions of assets made by non-French companies to French companies. In practice, the FTA only grants the favorable regime for corporate reorganizations, which inter alia allows for a deferral of capital gains taxation, if the contributing company remains taxable in France (e.g., by interposing a French-based holding company). The EUCJ seems to consider that when analyzing whether a given restriction is justified by the objective of preserving the balanced allocation of the taxing power between Member States, it is not necessary that the taxpayer toward which the taxing power would be preserved remain the same. Thus, one could argue that France does not need that the contributing company remains taxable in France (but simply that the assets contributed so remain at the level of the beneficiary of the contribution).
French Tax Consolidation: Horizontal Consolidation
The current French consolidation regime requires, inter alia, a French corporate taxpayer acting as parent (whether a French entity or the French branch of a non-French entity) owning 95% or more of other French corporate taxpayers.
As a consequence of EU case law, based on freedom of establishment, it has been now accepted that the 95%-owned French subsidiaries may be held through affiliates based within the EU.
What is not currently accepted is that two French entities owned by a non-French corporate taxpayer could form a tax consolidation group (the so-called horizontal consolidation).
Indeed, the French lower courts have decided that such a horizontal consolidation is not possible either because the French rules are based on the principle of a vertical consolidation or because the situation of a non-French parent entity (i.e., without a French branch) is not comparable to the situation of a French parent entity.
However, the situation may change in the future, depending on the outcome of cases currently being discussed before the EUCJ dealing with similar questions under the Dutch tax grouping rules (similar to the French rules). Indeed, the conclusions of the Advocate General clearly favor the horizontal consolidation. She considers that (i) a tax grouping system is really defined by the fact that one company should be held liable for the tax liability of a group of companies and there is no reason that such an approach could not be applied to a horizontal consolidation, and (ii) the impossibility for a parent to consolidate its subsidiaries based in another jurisdiction would go against the principle of free establishment, when one compares the situation with that of a parent consolidating its subsidiaries located in the same jurisdiction.
Characterization Of Management Packages Awarded To Managers: Consequences For The Employer
Management packages are frequently addressed by the advisory committee in charge of abuse of law matters (Comité de l'abus de droit) under the angle of income tax treatment applicable to the capital gains realized by managers who are transferring securities carrying attached warrants (bons de souscription d'actions, "BSAs"). This time, the question has been addressed by the Administrative Court of Appeal of Versailles ("Versailles CAA") under the angle of certain ancillary taxes (as well as social security levies) that must be paid or withheld by an employer on employment income (but not capital gains) received by its employees.
In the case at hand, a Belgian company had issued notes carrying BSAs to a financial institution, and the BSAs were subsequently transferred for free to the employees of the French subsidiary of the Belgian company. Following the exercise of the BSAs, the French company received an assessment from the FTA asserting that the income derived from the BSAs should constitute employment income and thus be subject to social security levies and relevant ancillary taxes at the level of the employer.
The Versailles CAA held that the opportunity offered to the employees of the French subsidiary to receive (through the exercise of BSAs awarded because of their employment by such subsidiary) shares at a price lower than their fair market value should be characterized as employment income, notwithstanding the fact that (i) the BSAs were not issued by the employer itself, (ii) the BSAs had initially been held by a financial institution as a result of a debt offering, or (iii) the income derived by the employees had been imposed as capital gains for personal income tax purposes.
To the best of our knowledge, the decision of the Versailles CAA has not been appealed by the taxpayer, and the above reasoning will therefore not be tested before the Conseil d'Etat.
Other cases should, however, provide such an opportunity because management packages, in particular when they are awarded in LBO-type transactions, are frequently challenged by the FTA.
Tax Treatment Of Certain Currency Gains
On March 12, 2014, the Conseil d'Etat ruled on the treatment of a currency gain derived from the sale, by a French tax resident, of real estate located in Japan.
The FTA took the position that while the capital gain on the sale of the Japanese real estate should be, indeed, taxable in Japan as per the Japan/France tax treaty, the currency gain element should be treated separately and be taxable in France.
The Conseil d'Etat ruled that, in the absence of any provision of the treaty to the contrary, there is no basis to treat the currency gain (which is directly related to the sale of the real estate) differently from the rest of the capital gain, i.e., the latter should be exempt from any taxation in France (even if Japan does not tax such currency gain).
The situation would have been different if the currency were not directly attached to the sale. Indeed, the Conseil d'Etat has decided, in the past, that if the currency gain is related to a foreign currency swap or to a foreign currency borrowing, both related to the hedging and/or financing of the non-French real estate, then it should be taxable in France. The basis of this decision is that it should be detached from the capital gain and/or the income generated by such real estate (assuming that the ownership and management of the real estate do not amount to a permanent establishment in the foreign jurisdiction, in which case the swap and/or financing would be allocated to the foreign permanent establishment).
Deductibility Of Foreign Tax Credits Borne By A Loss-Making Company
On March 12, 2014, the Conseil d'Etat ruled in the Société Céline case on the deductibility for corporation tax purposes of foreign tax credits borne by French loss-making companies (i.e., that do not have any taxable base to offset the foreign tax credits).
In essence, the Conseil d'Etat decided that although foreign tax credits are in principle deductible for tax purposes under French domestic law, such deductibility has to be denied in the presence of a double tax treaty that expressly forbids deduction of foreign tax credits.
This decision thus requires loss-making companies to carefully analyze the "Relief from Double Taxation" articles of the double tax treaties that apply to the withholdable payments they receive from foreign source, so that they can determine whether the relevant provision expressly forbids the deduction of the corresponding foreign tax credits (they would not be able to use otherwise as a result of their loss-making position). The situation of the loss-making companies concerned is thus worsened as a result of the application of a double tax treaty.
POSTPONEMENT OF THE COLLECTION OF THE EXCEPTIONAL TAX ON HIGH EMPLOYMENT INCOME
As a result of certain uncertainties with respect to its scope, the so-called tax on high employment income, which was in principle to be first paid before April 30, 2014, has been postponed to the 15th day following the upcoming publication of the FTA's official guidelines. Under the terms of this tax, enterprises paying an aggregate gross employment income of more than €1 million to a given individual are liable to a 50% tax on the fraction of such employment income that exceeds €1 million. It was formerly known as the "75% tax" and was eventually enacted in the very last few days of 2013.
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.