Article 22 of the 2014 Finance Act, no. 2013-1278, of December 29, 2013, adjusts the provisions of Article 212-I of the French Tax Code (“FTC”) pursuant to which the deduction of loan interest paid by a company subject to corporate income tax to a related company is allowed provided that the lender is subject to tax on profits on the interest received amounting to at least 25% of the tax as determined under French tax rules.
Originally, this new mechanism was enacted to limit the use of hybrid instruments which take advantage of different legal qualification of the same flow between two countries and allowing the deduction of the financial interest accrued in France and the exemption of the corresponding interest income received by the lender abroad. The new limitation completes the existing mechanisms that limit deductions of financial expenses, which, for the most part, relate to intragroup loan interest:
- Article 39-1-3° of the FTC, which allows deduction of interest paid on shareholders loans within the limit of a legal interest rate,
- the thin-capitalization rules stated at Article 212 of the FTC,
- the Charasse amendment (Article 223 B of the FTC, which limits the deduction of interest on debt related to the acquisition of shares of a target company which becomes a member of the same tax consolidated group from a person controlling directly or indirectly the group),
- the Carrez amendment (Article 209-IX of the FTC, which limits the deduction of interest expenses related to the financing of the acquisition of shares ) and,
- the general limitation of deductibility of financial expenses (pursuant to Article 212 bis and 223 bis of the FTC, companies subject to corporate income tax are required to add back to their taxable income 25% of the net financial expenses for fiscal years beginning on January 1, 2014 when such amount exceeds 3 million euros).
The 2014 Finance Act consequently adjusts the provisions of Article 212-I of the FTC which applies to interest paid to a related company for fiscal years ending as of September 25, 2013.
The right to deduct interest on loans paid between related parties is subject to the following new demonstration: the borrower must be able to prove, upon tax authorities’ request, that, for the current fiscal year, the lender is subject to a corporate income tax on the interest income received which is equal to at least 25% of the corporate income tax that would be due if computed under the French general tax rules.
As regards transparent entities that are not subject to corporate income tax, such as companies subject to the tax regime of partnerships as provided in Article 8 of the FTC, collective investment funds (OPCVMs), alternative investment funds or similar transparent entities governed by foreign law but not established in a non-cooperative state or territory within the meaning of Article 238-0 A of the FTC, the dependency links (within the meaning of Article 39-12) will have to be assessed not at the level of the transparent entity, but at the level of the owner(s) of such entity or fund. In such event, the taxation test is performed at the level of the shareholders.
As regards the limitation of the interest rate paid to a related company provided by Article 212-I, a) of the FTC, the legislation states that the interest paid by a company to a related company, within the meaning of Article 39-12 of the FTC, is deductible within the limit of interest calculated pursuant to the maximum legal interest rate (2.79% for 2013) or the market interest rate if higher as applied by independent financial institutions. Dependency links are deemed to exist when one company directly or indirectly holds the majority of the share capital of another company or it exercises de facto control over the other company or when these two companies are placed under the control of the same third company.
Although the initial objective of the new limitation was to avoid the use of hybrid instruments between a French borrower and a lender established abroad, in the end, it applies in the same way to all lender, whether they are resident or non-resident. In the latter case, the applicable corporate income tax means the tax on profits that would be payable by the lender on the interest received under French general law if it had been domiciled or established in France.
By not limiting this new limitation to loans contracted with non-resident creditors, the legislator intended to avoid any risk of non-compliance with the principle of freedom of establishment under European law. Tax courts will probably have the opportunity to rule on this issue.