Article 22 of the Finance Bill for 2014 introduced into French law (codified in Article 212.I-b of the French Tax Code) a new limitation to the deductibility of interest expenses (the "Anti-Hybrid Limitation").

Under this article, interest paid or accrued in a given year by a French company (the "Borrower") to a related entity (within the meaning of Article 39-12 of the French Tax Code) may only be deducted if the Borrower can evidence, upon request from the French Tax Authorities, that the recipient of the interest (the "Recipient") was liable in respect of the interest income to a corporate income tax burden at least equal to 25 percent of the French ordinary corporate income tax (the "Minimum Taxation Condition").

If the Lender does not reside in France, the assessment of the level of taxation should be made by reference to the corporate income tax that the Lender would have paid in France on the interest received, had it been subject to tax in France.

This new Anti-Hybrid Limitation applies to all interest borne by French companies in respect of fiscal years closed as from 25 September 2013.

The purpose of the Anti-Hybrid Limitation is to prevent French borrowers from deducting from their taxable income financial charges paid or accrued to a related entity if the corresponding financial income is treated as non-taxable income in the hands of the Recipient. (The new mechanism specifically targets hybrid instruments generating deductible interest expenses in France, whereas the corresponding income is treated as a non-taxable dividend in the Recipient's state of residence.)

However, the way to determine the level of taxation of the foreign lender is still unclear.

Indeed, the reference made to corporate income tax due "in respect of the interest" (as opposed to a tax assessed "on a global net income") seems to indicate that this assessment must be made merely by reference to the applicable tax rate on interest income (which should therefore be at least equal to 8.33 percent, i.e., 25 percent of the French standard corporate income tax rate of 33.33 percent).

Moreover, the word "liable" used in the new law appears to refer to the principle of being subject to taxation rather than to an effective taxation. In that sense, the fact that the Recipient benefits from tax loss carry forwards, or bears charges that reduce its taxable income (and therefore its effective corporate income tax payment) should not prevent the Recipient from being "liable for tax" within the meaning of Article 212.I-b of the French Tax Code, thereby meeting the Minimum Taxation Condition. Thus, as soon as the Recipient is in principle subject to taxation on the interest it receives at a rate superior to 8.33 percent, the Minimum Taxation Condition is likely to be met regardless of any effective payment of a tax locally.

However, this solution has yet to be confirmed by the French tax authorities. Indeed, such construction would significantly restrict the scope of this article, since it would for instance allow the deductibility of interest paid to a foreign Recipient which is itself funded by a non-taxable related party (i.e., hypothesis of an interposition of a "taxable" entity between the Borrower and the foreign tax-exempt Recipient). One cannot fully exclude the risk that the French tax authorities may try to consider, in order to ensure efficient use of the Anti-Hybrid Limitation, that Article 212 I-b requires the effective payment of a tax by the Recipient.

Based on the minutes of parliamentary discussions held during the preparation of the new law, strong arguments should exist against this approach. Nevertheless, taxpayers may wish, in a conservative approach to determine the Recipient's level of taxation by reconstructing its taxable income according to the French corporate income tax rules (in particular considering the limitations applicable in France to the deduction of financial expenses), and to compare the corporate income tax payment that would have been paid in France with the tax paid in the Recipient's state of residence.