Focus on the anti-avoidance provision targeting hybrid debt instruments

The 2014 Finance Law has implemented yet another limitation of the deductibility for tax purposes of interest payments made by a French borrower to an affiliated entity (i.e., an entity controlled by the borrower, controlling the borrower, or controlled by the same third party as the borrower), this time targeting more specifically cross-border hybrid debt instruments ("Anti-Hybrid Provision" or "AHP").

The AHP is applicable to fiscal years closed as from September 25, 2013, and may thus have an immediate impact on the corporation tax returns to be filed (and the corresponding corporation tax liability to be paid) during the upcoming months.

In essence, interest payments made by a French borrower to an affiliated entity will be deductible for tax purposes only if such borrower is able to demonstrate that the lender (be it French or foreign, even though the provision was clearly designed to target cross-border hybrid debt instruments) is subject to an income tax on the corresponding interest income that is at least equal to 25 percent of the French corporation tax that would have been due had it been computed in accordance with standard French rules ("25 Percent Test"). Specific rules are also provided where the lender is a flow-through entity such as an investment fund or a partnership ("Look-Through Rule").

Given its broad language and the lack of precise guidance within the parliamentary reports and debates that have preceded its enactment, many issues are likely to arise with respect to the scope of the AHP, the operation of the 25 Percent Test, and the reach of the Look-Through Rule. The guidelines to be published by the French tax authorities are thus eagerly awaited.

25 Percent Test. The main uncertainties pertaining to the AHP revolve around the 25 Percent Test and the way the comparison of the tax liabilities (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) will operate. While the 25 Percent Test is at the heart of the AHP, there is no unequivocal indication as to whether the comparison basis should be:

  • The gross amount of the relevant interest payment;
  • The net amount of the relevant interest payment and its repayment, if any, by the lender (e.g., in case of a back-to-back financing arrangement);
  • The net amount of the overall interest payments received and made, if any, by the lender; or
  • The overall taxable result of the lender (i.e., in order to apply every single French tax rule as if the foreign lender was a French tax resident).

While the language of the AHP itself offers little guidance, certain parliamentary debates seem to indicate that the first option (i.e., based on the gross amount) should be followed. Its main upside would be its simplicity, but it would substantially hurt the efficiency of the anti-avoidance motivation behind the AHP. Another upside would be the correspondingly reduced declarative burden, since the taxpayer is the one bearing the 25 Percent Test burden. There is, however, no guarantee that such option will be followed by the French tax authorities or by courts.  

A more conservative approach would lead to the fourth option (i.e., full analysis of the overall tax situation of the lender), which could turn out to be particularly burdensome with respect to both (i) the computation to be made by the taxpayer in order to determine whether the AHP is applicable, and (ii) the demonstration to be provided by the taxpayer.

Other issues, furthermore, stem from the uncertainty among those four possibilities. For instance, what should be the relevant comparison in the situation where the borrower and the lender have different fiscal year starting/closing dates? Likewise, how should financing arrangements—whereby interest payments are either deferred (e.g., deep discount instruments) or subject to a specific accounting or tax treatment—be treated in terms of timing, at the level of the lender (i.e., the overall interest income pertaining to the financing arrangement would satisfy the 25 Percent Test but, by virtue of specific accounting or tax timing rules, the 25 Percent Test would not be satisfied for a given fiscal year)? Although some general French tax principles could provide some guidance, the guidelines to be published by the French tax authorities will have to be closely reviewed in this respect. 

In the end, any of the three latter possibilities would most likely allow for the AHP to catch—in addition to cross-border hybrid debt instruments whereby payments would be deductible in France but exempt in the lender's jurisdiction—the following:  

  • Back-to-back financing arrangements whereby payments would (i) be deductible in France, (ii) comply, on a gross basis, with the 25 Percent Test in the lender's jurisdiction, but (iii) effectively leave a marginal tax base in such jurisdiction by being eventually up-streamed to a third low-tax jurisdiction (thereby failing the 25 Percent Test on a net basis), and
  • Financing arrangements placed under a specific accounting or tax regime as described above.

Look-Through Rule. In essence, the Look-Through Rule provides that, where the lender is a flow-through entity such as an investment fund or a partnership, (i) the AHP limitation applies only to the extent that the borrower and the relevant members of the flow-through entity are affiliated entities, and (ii) the 25 Percent Test is applied at the level of such members.  

This being said, the AHP does not cover double-tier structures where the lender would be a flow-through entity wholly held by another flow-through entity. Should the Look-Through Rule then be applied at each level? Should it rather be read strictly so that the first flow-through entity in the chain would be regarded as shielding the ultimate lender from the AHP?  

Beyond the uncertainties surrounding the 25 Percent Test itself (see above), the guidelines to be published will also have to address the operation of the AHP in cases where several relevant members of the lending flow-through entity are (i) affiliated to the borrower but (ii) in different situations for AHP purposes (i.e., one satisfying the 25 Percent Test but not the other, because of a different location or a different tax regime despite the same location). Should the deduction of the relevant interest payments then be denied for corporation tax purposes on a combined basis? Should it rather be prorated on the basis of the participation of the sole affiliated entity failing the 25 Percent Test?  

Overlap with CFC Legislation. The French CFC rules basically provide that the relevant portion of the profits of an enterprise, company, or entity are taxable in France in the following situations:  

  • If an entity subject to French corporate income tax operates an enterprise outside France or holds, directly or indirectly, 50 percent or more of a company or entity established outside France, and
  • If such enterprise, company, or entity benefits from a so-called privileged tax regime.

Consequently, there is a possible risk that the AHP overlaps with such CFC rules in the case where a non-French lender would not satisfy the 25 Percent Test, but whose profits would ultimately be taxable in France under the aforementioned CFC legislation.  

Although it has been confirmed by the Budget Minister during the parliamentary debates that the purpose of the AHP was not to catch amounts already caught by the CFC rules, precise details will be expected from the guidelines to be published by the French tax authorities.  

Hybrid Entities. Even though it was not the official motivation of the initial proposal, nor the apparent intention of the Parliament, the language of the AHP could effectively result in encompassing hybrid entities (i.e., a same entity being a corporation for tax purposes in a jurisdiction, and a partnership or a disregarded entity for tax purposes in another).

 Indeed, in the case where the French borrower (be it a net borrower or an on-lender of the amounts borrowed) would be disregarded for tax purposes under the tax rules applicable in the jurisdiction of the lender, the AHP could technically kick in as the 25 Percent Test would be regarded as not being satisfied (i.e., if the borrower is disregarded, then the relevant borrowing itself should be disregarded, and it would just not be possible to satisfy the 25 Percent Test).  

As the AHP does not provide for any safe harbor or tiebreaker, taking into account the tax regime applicable in the other jurisdictions involved in the 25 Percent Test comparison, one may wonder to what extent the guidelines to be published by the French tax authorities will at all address the situation of hybrid entities.  

Coordination with Foreign Anti-Hybrid Provisions. While the vote of the AHP was clearly intended to support the recent OECD and European Commission propositions related to the so-called mismatches of hybrid finance instruments, the French unilateral approach based on a denial of the interest deduction now appears to create serious risks of double taxation.  

Indeed, aforementioned multilateral propositions instead aim at denying the benefit of a participation-exemption regime for dividends at the level of the lender (or, rather, financing provider) ("PE-Based Approach") where the dividends so received have given rise to a deduction at the level of the borrower, since the relevant payments could be regarded as interest payments.  

As a result, the confrontation of the AHP with a legislation following the PE-Based Approach (e.g., the German anti-avoidance rule targeting hybrid debt instruments) could give rise, for the same payment, to (i) a denial of the deduction at the level of the French borrower, and (ii) a denial of the participation-exemption regime at the level of the lender.  

As the AHP does not provide for any safe harbor or tiebreaker in the case where the other jurisdiction involved in the 25 Percent Test comparison has adopted a PE-Based Approach, one may wonder to what extent the guidelines to be published by the French tax authorities will at all address the double taxation risk.

 

Recent Case Law Affecting French CFC Rules

During the last 15 months or so, French tax courts have issued various decisions that may have a significant impact on the application of the French CFC rules (article 209 B of the French tax code (Code général des impôts, or "FTC")).  

Basic Operation of the French CFC rules. The French corporate tax rules are on a strict territoriality basis, i.e., only profits generated in France are liable to tax.

Article 209 B introduces an exception to the above territoriality principle, and it may be summarized as follows :

  • If a French corporate taxpayer owns, directly or indirectly, more than a certain threshold (currently 50 percent) of the share capital or voting rights or financial rights of a non-French entity; and
  • Such non-French entity benefits from a so-called "privileged tax regime" in the jurisdiction where it is located (i.e., its effective tax rate in such jurisdiction is more than 50 percent lower than the effective French tax rate that would have been applicable in similar circumstances); then
  • The French corporate taxpayer would be deemed to receive fully taxable dividends, from such non-French entity, in proportion to its participation in the latter.

When the non-French entity is located within the European Union, a specific safe harbor rule applies whereby article 209 B is applicable only if the participation of the French corporate taxpayer, in the above entity, is an artificial scheme targeting the avoidance of French tax legislation.  

When the non-French entity is located outside of the EU, article 209 B is disapplied if the French taxpayer can prove that the principal purpose and effect of the operations, effected by the above entity, do not consist of a transfer of profits to a tax-privileged jurisdiction ("General Safe Harbor"). Article 209 B provides that, inter alia, such evidence is deemed to be provided when the non-French entity has, principally, an effective industrial or commercial activity in the jurisdiction where it is located ("Deemed Safe Harbor").  

Case Law Interpretation of the Safe Harbor Rules. The case law referred to, at the beginning of this section, concerns the interpretation of the above safe harbor rules, and although they relate to a period where the wording of article 209 B of the FTC was a bit different, the resulting principles are valid under the current version.   The case law refers to two different situations, both involving a French bank:

  • If a French corporate taxpayer owns, directly or indirectly, more than a certain threshold (currently 50 percent) of the share capital or voting rights or financial rights of a non-French entity; and
  • Such non-French entity benefits from a so-called "privileged tax regime" in the jurisdiction where it is located (i.e., its effective tax rate in such jurisdiction is more than 50 percent lower than the effective French tax rate that would have been applicable in similar circumstances); then
  • The French corporate taxpayer would be deemed to receive fully taxable dividends, from such non-French entity, in proportion to its participation in the latter.

In both cases, the initial query was whether, for the purposes of the safe harbor rule, one should refer to the "purpose" or to the "effect" of incorporating the non-French entity in a tax privileged jurisdiction.   The position of the French tax authorities was that only the "effect" should be taken into consideration, i.e., if the presence in the non-French jurisdiction enabled a reduction in tax liability (as defined by article 209 B), then any question about the motivation or "purpose" of such presence would be irrelevant. Actually, the position of the French tax authorities seemed correct on the basis of the then-current version of article 209 B, which was indeed referring only to the effect (Note: the current version refers to the object and the effect). However, the Conseil d'Etat decided that, despite the wording of article 209 B, one should refer to the motivation of the taxpayer for the purpose of the safe harbor rule.  Without going into the procedural details, the cases were first decided by the lower courts, and afterward, the Supreme Court (Conseil d'Etat) voided these decisions and referred them back to the lower courts. They were finally decided in summer 2013.  

Indeed, the Conseil d'Etat took the view that, from a constitutional perspective, the taxpayer should be in a position, when challenged on the basis of an anti-abuse legislation (such as article 209 B), to provide the evidence that its operations were not principally tax motivated despite the local low effective rate of taxation. In other words, if only the effect were taken into account (i.e., the low tax rate), it would have been extremely difficult for the taxpayer to be protected under the safe harbor rule. Once this principle was established by the Conseil d'Etat, the lower court decided as follows:

  • In the case of the Guernsey subsidiary of the French bank, the lower court took the view that the subsidiary was targeting international individual clients who were attracted by the banking and tax legislations applicable in Guernsey; in other words, these international clients, given their specific needs, would not have been attracted by the French bank acting from France. Interestingly, the lower court added that even if some of these clients were French, and they used French-sourced funds, the above reasoning should not be modified given that article 209 B targets the motivation of the French bank and not the motivation of its clients.
  • In the case of the Hong Kong subsidiary of the French bank, the lower court took the view that the subsidiary was managing the Asian currency position of the banks' affiliates in the region (specifically by investing in the Korean market), and that such an activity could not have been effected from France given the time difference and the required expertise that may only be found locally. As with the Guernsey situation, the French tax authorities were arguing that some of the clients and funds available to the subsidiary were potentially of a French origin, and the court decided that even if these allegations were true, they would be irrelevant for the purposes of the application of the safe harbor rule.

While it is too early to decide whether there has been a definitive change in terms of application of article 209 B (from a safe harbor rule perspective), one can expect certain tendencies:

  • Contrary to the position of the French tax authorities, the courts would take into account the motivation of the French taxpayer (and not only the effect of being located in a low tax jurisdiction); and
  • The Deemed Safe Harbor would be less used in the future as it would imply that the relevant activity is performed in the jurisdiction where the entity is located; typically, in the Guernsey situation discussed above, the General Safe Harbor was more efficient given the bank's international clients (who are obviously not located in Guernsey).