French tax rules regarding the deductibility of interest charges paid by holding and operating companies are generally regarded as quite favorable. As an example, there is no restriction on the deductibility of interest paid or accrued in respect of the financing of an investment generating tax exempt dividends or capital gains.
Leaving aside two specific anti-abuse regimes challenging the deductibility of interest paid to non-cooperative off-shore jurisdictions or interest deemed artificially borne in the context of a consolidated tax group, the main constraint for the operators derives from the French tax thin capitalization rules.
Still, these rules proved to be quite easy to live with for French and foreign investors as they used to cover exclusively loans made by related companies, loans from third parties — even if guaranteed by an affiliate of the borrower — remaining outside of the scope of the legislation.
Things are changing now as the Finance Law for 2011 extends the scope of French thin capitalization rules to loans granted by third-party lenders where such loans are secured by an entity directly or indirectly related to the French borrower.
Scope of the French Thin Capitalization Rules Prior to The Reform
Section 212 of the French Tax Code (FTC) limits the tax deductibility of interest borne by a French entity in connection with “related-party” loans. In this respect, two companies are said “related” where (i) a company holds, directly or through intermediate entities, a majority of the share capital of the other company or actually exercises the power of decision in such company, or (ii) both companies are under the control — within the same meaning as under (i) above — of a third entity.
Interest borne in respect of a related-party loan is not fully deductible under thin capitalization rules if for a given fiscal year, the three following ratios are simultaneously exceeded :
- The borrowing company exceeds a 1.5/1 debt-to-equity ratio computed by comparing its net equity (including share premium and retained earnings) with the average amount of its related-party debts during said fiscal year. The maximum amount of deductible interest under this test is determined pursuant to the following formula: Interest borne in respect of related party lenders x (1.5 net equity of the borrower / average amount of related party loans); and
- The interest paid on related party loans by the borrowing company exceeds
- 25 percent of the borrowing company’s operating profit before tax, increased in particular by said interest and by the depreciation allowances booked during the relevant fiscal year ; and
- Interest paid on related party loans by the borrowing company exceeds interest it receives itself from related parties.
If the three limits above are simultaneously exceeded in a given fiscal year, the portion of interest which is in excess of the highest of those three limits is disallowed in respect of such fiscal year to the extent it exceeds €150,000. It remains potentially deductible in a subsequent fiscal year though, subject to significant restrictions and with a decrease of its amount by 5 percent for each year after the second year.
Under a safe harbour rule, the thin capitalization provisions shall not apply if the borrowing company can demonstrate that the overall debt-to-equity ratio of its economic group is higher than its own debt-to-equity ratio in respect of the fiscal year concerned. Specific rules further apply in tax consolidated groups.
Extension of the Scope of French Thin Capitalization Rules to Third Party Loans Guaranteed by Related Entities
As rules were previously drafted, third-party financings could never qualify as “related party loans” for purposes of thin-capitalization rules even when such financings were secured by parties related to the borrower, which principle French tax authorities regarded as a loophole. The extension of thin capitalization rules achieved by the 2011 Finance Law was initially intended to defeat back-to-back loans, but the new language included in Section 212 of FTC is worded in such general terms that it may have a more extensive impact. Tax authorities are expected to take constructive positions for the qualification of these new rules to avoid a detrimental impact on fair financing schemes.
Under the new legislation, loans granted to a French entity by third-party lenders now fall within the scope of thin capitalization rules if they are guaranteed (i) by a company related to the French borrower or (ii) by a third party whose commitment is in turn secured by a company related to the French borrower. As stressed above, the new rules do not simply focus on back-to-back loans, but may also impact standard financing schemes commonly implemented.
The new rules provide for three exceptions:
i) A safe harbour clause is specifically provided to exempt public offerings of bonds within the meaning of Article L411-1 of the French Monetary and Financial Code. This exception also applies to bonds issued in accordance with a foreign legislation equivalent to the French legislation on public offerings of bonds.
By contrast, financings giving rise to private placements should indistinctively fall within the scope of the new rules as currently drafted. The scope of this safe harbour clause is too restrictive. As an example, capital markets debts, such as high yield bonds, privately placed under Rule 144 A and Regulation S within a French/EU public offer exemption and listed on an unregulated market, should not be considered as being offered to the public for purpose of this exception and should therefore not benefit from the exemption. French tax authorities are, however, expected to take a liberal approach on this issue and extend the exemption to some private placements.
ii) Another exception applies where the guarantee granted by the related party exclusively consists of (i) a pledge over the shares of the borrowing company or over receivables held over the borrowing company or (ii) a pledge over the shares of an intermediate company which directly or indirectly holds the shares of the borrowing company. However, in the case referred to in (ii), the exemption will only apply provided the holder of the pledged shares and the borrowing company are members of a same French tax consolidated group. There is a true issue as to whether this requirement is consistent with EU law and/or non discrimination clauses included in tax treaties signed by France as it clearly discriminates structures involving foreign intermediary holding companies compared to French intermediary holding companies. Notably it jeopardizes “Double LuxCo structures” commonly set up in recent French LBO transactions for security law reasons.
In addition, this second exemption applies where the guarantee granted by the related party “exclusively“ consists in those listed above and this reference to an exclusive guarantee deserves clarification. What if the loan is further secured by additional guarantees as it is generally the case? Would the exemption still apply up to a certain portion of the loan and if so, how shall this portion be determined? Tax authorities are due to take a position on this issue.
iii) A last exemption covers loans contracted for purposes of refinancing an existing debt which reimbursement is made mandatory as a result of a change of control of the borrower (by virtue of a specific provision contained in the initial loan agreement). In this situation, the refinancing loan would be outside of the scope of the thin capitalization rules up to the principal amount of the existing debt which is being reimbursed and any interest falling due.
The new legislation is effective for fiscal years closed as from December 31, 2010 so that it may have a retroactive effect on 2010 fiscal years. However it contains a grandfathering provision that covers loans contracted before January 1, 2011 for the financing or the refinancing of an acquisition of shares.
Financial structures of past LBOs should therefore not be impacted by the new rules, contrary to corporate loans or loans financing the acquisition of real estate assets. The concept of refinancing will however require further clarification. The exemption described in (iii) above should indeed apply with no time limit to the extent the refinancing takes place in the context of a change of control. Refinancings occurring outside the context of a change of control as from 2011 will themselves need to be carefully scrutinized as they may raise thin capitalization issues depending on the way there are structured and, in particular, on whether they may be regarded as giving rise to a new loan or the mere continuation of the existing loan.