France’s tax authorities (the FTA) this month released draft guidance on the way they intend to apply new restrictions under the 2014 French finance act to the deduction of interest on related party loans (referred to as an anti-hybrid rule, although its scope is wider than just hybrid instruments).

Pursuant to this provision, interest on related party loans is tax deductible only if the French borrower can prove that such interest is subject to an income tax in the hands of the lender at a rate equal to at least to 25 percent of the French standard corporate income tax rate (i.e. , 8.61 percent or 9.5 percent, depending on the additional contributions applicable under French law).

The draft guidelines outline a relatively lenient approach.

The main takeaway from these draft guidelines is that the 25 percent test is a statutory rate test, as opposed to an effective tax rate test.

In other words, based on these guidelines, what matters is that:

  • the gross French source interest income is included in the taxable profits of the lender (in the taxable profits of the lender in the financial year during which the corresponding interest expense is deducted from the taxable result of the French borrower) and
  • such taxable result is subject to a statutory tax rate higher than 8.61 percent or 9.5%.

The fact that the lender actually pays no or little tax in its country of residence, for example due to the availability of NOLs, interest expenses (including notional interest deduction) or other tax deductible expenses, is not relevant.

As a result, save for the artificial/abusive structures, "back-to-back" arrangements in which the lender is subject to tax on an arm's length spread at a statutory tax rate higher than 8.61 percent or 9.5 percent should be out of the scope of the new rules.

The guidelines address some issues arising when the lender is a tax transparent entity. In a nutshell, under certain conditions, the French tax authorities will look through the tax transparent lender and assess whether the test is met at the upper level. However, there is no exception for check-the-box structures, under which the interest income is not included in the taxable result of the US lender because the French borrower is disregarded. Such structures will in principle be caught by the new rules.

The guidelines also allow a deferral of deduction under certain conditions when there is a timing difference between the taxation of interest in the hands of the lender, which recognizes the income on a cash basis and the deduction at the level of the borrower, which recognizes the expense on an accrual basis. 

The guidelines are in draft form for now and subject to public consultation until the end of April. The final version should be released at the beginning of May. In the meantime the draft guidelines are binding on the FTA. It is reasonable to expect that the nature of the test (statutory rate test as opposed to effective rate test) will not change in the final version.