During the course of the ongoing debates on the Finance Bill for 2011, the French Senate has recently adopted a new provision, resulting from two amendments adopted on November 18 and 19, 2010 respectively, which significantly extends the scope of the French thin capitalization rules.

The new provision is presented as an anti-abuse provision with a view to preventing companies of the same group from circumventing the thin capitalization rules by securing bank loans via guarantees provided by a related company of the group. Unfortunately, the scope of the provision is very broad and is likely to capture many situations which are not abusive.

Currently, the French thin capitalization rules, codified under Article 212 of the French Tax Code, only limit the deductibility of interest accrued on a related-party debt. On the other hand, these rules do not restrict the deductibility of interest accrued on loans granted by independent third parties such as financial institutions, notwithstanding the fact that such loans are guaranteed by a related party.

In simplified terms, a related party for the purposes of the above rules is a person who (i) holds directly or indirectly the majority of the share capital of the borrower, or (ii) is held by the borrower under the same conditions, or (iii) is held under the same conditions by a third party than the borrower.

The amendments would bring interest paid to independent third parties (including bank loans) within the scope of the French thin capitalization rules, if and when such loans are secured by a related party. Security interests falling within the scope of this new rule would include personal security interests (personal guarantees, first demand guarantees, or even comfort letters) as well as security interests in rem (pledges over the shares of the borrower, collaterals, mortgages, trusts or privileges).

As a softening measure, the following situations are excluded from the scope of this new provision if:

  1. the guarantee is given in the context of bonds issued within the framework of a public offer;
  2. the guarantee is a mere pledge over the shares of the borrowing company;
  3. the guarantee is given in the context of the refinancing of an existing debt which is required as a result of a change of control of the borrower.

However, the above exceptions, which are very limited and are unlikely to provide relief in many situations, will result in an increase in the debt financing costs of French companies. Moreover, the new provision will also impact existing bank loans insofar as no grandfather clause has been provided.

If the amendments as currently drafted are passed by the French Parliament by the end of December 2010, they would apply to fiscal years ending as from January 1, 2011, which, for companies having their fiscal year lined up with the civil year, would mean the new rules will come into effect as from next year.