The French Finance Bill for 2011, passed in late December 2010, extends the scope of French thin capitalization rules to loans granted by thirdparty lenders when such loans are secured by a company related to the French borrower.
Current French Thin Capitalization Rules
Article 212 of the French Tax Code (FTC) limits the tax deductibility of interest borne in connection with “related-party” loans. In this respect, two companies are said to be “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-making in such company or (ii) both companies are under the control — within the same meaning as under (i) above — of a third company.
In summary, interest borne in respect of a related-party loan is deductible if, for a given fiscal year:
- The borrowing company complies with 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 relatedparty debts during the 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)
- The interest paid on related-party loans by the borrowing company does not exceed 25 percent of the borrowing company’s operating profit before tax, increased in particular by the said interest and by the depreciation allowances booked during the relevant fiscal year
- The interest paid on related-party loans by the borrowing company does not exceed the 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. It remains potentially deductible in a subsequent fiscal year, though subject to significant restrictions and limits and with a decrease of its amount by 5 percent for each year after the second year.
Note that the thin capitalization provisions do 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 also apply in tax consolidated groups.
Extension of the Scope of French Thin Capitalization Rules to Third Party Loans Guaranteed by Related Entities
Under previous rules, third-party financings did not qualify as “relatedparty loans” for the purposes of thincapitalization rules even when they were secured by parties related to the borrower, which French tax authorities regarded as a loophole.
Under the new legislation, loans granted to a French entity by thirdparty 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 secured by a company related to the French borrower.
The following loans however remain outside the scope of the new rules:
- A safe harbor clause is provided for a public offering of bonds. This exception further extends to bonds issued in accordance with a foreign legislation equivalent to the provisions of Article L 411-1 of the French Monetary and Financial Code.
Conversely, financings giving rise to private placements will fall within the scope of the new rules. As an example, capital markets debt, 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, will not be considered as offered to the public for purposes of this particular exception and thus will not be exempted.
- A 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, this latter exception only applies if the holder of the pledged shares and the borrowing company are members of the same French tax consolidated group so that “double LuxCo structures” set up in most recent LBO transactions will not be exempted.
- Finally, loans contracted for the purposes of refinancing an existing debt for which reimbursement has become mandatory as a result of a change of control of the borrower. The refinancing loan is exempt 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. However, it contains a grandfathering provision that covers loans contracted before January 1, 2011 for the financing or refinancing of an acquisition of shares. Financial structures of past LBOs should not therefore be impacted by the new rules, contrary to corporate loans.