tax management international forum - thierry pons · international forum ... guillermo teijeiro and...

Hybrid Transactions in the Form of Loans

In this issue of the International Forum, leading experts from 19 countries and the European Union address the ways

that Forum countries deal with hybrid transactions in the form of loans. Hybrid mismatch arrangements that can pro-

duce multiple deductions for a single expense or a deduction in one jurisdiction with no corresponding taxation in the

other jurisdiction have been a driving concern for the Organisation for Economic Cooperation and Development. In its

final report under Action 2 of its action plan on base erosion and profit shifting (BEPS), the OECD called on tax authori-

ties to adopt domestic rules that would prevent taxpayers from exploiting differences in the tax treatment of a financial

instrument to create unintended tax benefits.

Volume 38, Issue 2

JUNE 2017

www.bna.com

Tax ManagementInternational ForumComparative Tax Law for the International Practitioner

Contents

THE FORUM

5 ARGENTINAGuillermo Teijeiro and Ana Lucıa FerreyraTeijeiro y Ballone, Buenos Aires and Pluspetrol, Montevideo, Uruguay

14 AUSTRALIARobyn Basnett and Grant Wardell-JohnsonKPMG, Sydney

19 BELGIUMJacques Malherbe and Martina BerthaSimont Braun, Brussels

31 BRAZILPedro U Canto and Antonio SilvaUlhoa Canto, Rezende e Guerra Advogados, Rio de Janeiro

35 CANADARick BennettDLA Piper (Canada), Vancouver

39 PEOPLE’S REPUBLIC OF CHINAJulie Hao and Eric W. WangEY, Beijing

42 DENMARKNikolaj Bjørnholm and Bodil TolstrupBjørnholm Law, Copenhagen

48 FRANCEThierry PonsTax lawyer, Paris

56 GERMANYJorg-Dietrich KramerSiegburg

60 INDIARachna Unadkat and Himanshu KhetanPwC, Mumbai

64 IRELANDPeter Maher and Philip McQuestonA&L Goodbody, Dublin

68 ITALYGiovanni RolleWTS R&A Studio Tributario Associato, Milan

72 JAPANYuko MiyazakiNagashima Ohno & Tsunematsu, Tokyo

75 MEXICOTerri Grosselin and David DominguezEY LLP, Miami and Mexico

2 06/17 Copyright � 2017 by The Bureau of National Affairs, Inc. TM FORUM ISSN 0143-7941

THE TAX MANAGEMENTINTERNATIONAL FORUM is

designed to present a comparativestudy of typical international tax lawproblems by FORUM members whoare distinguished practitioners inmajor industrial countries. Theirscholarly discussions focus on theoperational questions posed by a factpattern under the statutory anddecisional laws of their respectiveFORUM country, with practicalrecommendations wheneverappropriate.

THE TAX MANAGEMENTINTERNATIONAL FORUM ispublished quarterly by BloombergBNA, 38 Threadneedle Street,London, EC2R 8AY, England.Telephone: (+44) (0)20 7847 5801;Fax (+44) (0)20 7847 5858; Email:[email protected]

� Copyright 2016 Tax ManagementInternational, a division ofBloomberg BNA, Arlington, VA.22204 USA.

Reproduction of this publicationby any means, including facsimiletransmission, without the expresspermission of Bloomberg BNA isprohibited except as follows: 1)Subscribers may reproduce, for localinternal distribution only, thehighlights, topical summary andtable of contents pages unless thosepages are sold separately; 2)Subscribers who have registered withthe Copyright Clearance Center andwho pay the $1.00 per page per copyfee may reproduce portions of thispublication, but not entire issues. TheCopyright Clearance Center is locatedat 222 Rosewood Drive, Danvers,Massachusetts (USA) 01923; tel:(508) 750-8400. Permission toreproduce Bloomberg BNA materialmay be requested by calling +44 (0)207847 5821; fax +44 (0)20 7847 5858 ore-mail: [email protected].

www.bna.com

Board of Editors

Managing DirectorAndrea NaylorBloomberg BNALondon

Technical EditorNick WebbBloomberg BNALondon

Acquisitions Manager − TaxDolores GregoryBloomberg BNAArlington, VA

80 THE NETHERLANDSMaarten J.C. Merkus and Bastiaan L. de KroonMeijburg & Co., Amsterdam

86 SPAINLucas Espada and Alfonso SanchoBaker & McKenzie Madrid

89 SWITZERLANDSilvia Zimmerman and Jonas SigristPestalozzi Attorneys at Law, Zurich

94 UNITED KINGDOMCharles GoddardRosetta Tax Ltd., London

99 UNITED STATESPeter GlicklichDavies, Ward, Phillips & Vineberg LLP, New York

106 APPENDIX — Hybrid Mismatches: An EU PerspectivePascal FaesAntaxius, Brussels

06/17 Tax Management International Forum Bloomberg BNA ISSN 0143-7941 3

FRANCEThierry PonsTax lawyer, Paris

I. Possibility of French Tax AuthoritiesRecharacterizing Advance of Funds by FCo toFrenchCo

A. FCo Treats the Transaction as a Loan for FCAccounting and Income Tax Purposes

1. General Comments on the Characterization ofHybrids

Whether the transfer of funds to a French entity sub-ject to corporate income tax (CIT) represents debt orequity for French tax purposes has obvious and sig-nificant consequences for the tax treatment of theincome and expense flows related to the financing in-strument by each party.

The main aspect on which this paper will focus is that,while a French borrower is allowed to deduct the in-terest payable under a debt instrument, even thoughthe deduction may be subject to various limitations,no deduction is allowed with respect to a dividendpayment. One area in which debt/equity issues areparticularly relevant is in the treatment of hybrid in-struments, i.e. instruments that are treated as debtunder the tax rules of one country but as equity underthose of another country. As a result of this differencein treatment, the use of a hybrid instrument may, in-tentionally or unintentionally, achieve a position inwhich a deduction for an interest payment is obtainedin one country without a corresponding income inclu-sion in the other country.

There are other important aspects particular toeach method of financing (i.e. debt or equity), notablythe treatment of the related income flows with respectto withholding taxes — no withholding tax normallyapplies to interest paid by a French borrower, while a30% withholding tax potentially applies to dividends,subject to the effect of France’s tax treaties and the ex-emption granted under France’s domestic law imple-mentation of the EU Parent-Subsidiary Directive(Article 119 ter of the French Tax Code (CGI) providesa total exemption from withholding tax for dividendspaid to an EU resident company holding more than10% of the French distributing company).

In the reverse situation, where the financing isgranted by a French entity to a foreign entity, classifi-cation of the relevant instrument as equity rather thandebt may allow the related income flows to benefitfrom the participation exemption under France’sholding regime. This latter situation is, however, not

covered in this paper, which focuses instead on thetreatment of a French entity (FrenchCo) subject toCIT in France and financed by a foreign entity (FCo).

As a general principle and as provided by Article 38quater of Appendix III to the CGI, the legal classifica-tion and accounting treatment of a transaction underFrench GAAP (Plan Comptable General or PCG) deter-mines its tax treatment,1 except where the tax law pro-vides for a different treatment. In the absence of aspecific definition of debt or equity in French tax law,the legal classification and accounting treatment willprevail for purposes of determining the relevant taxtreatment.

From a French statutory accounting standpoint, theissuance of bonds convertible into equity is treated ina similar way to the issuance of conventional bonds,i.e. they are booked as debts and interest paid by theissuer is considered a financial expense. The sametreatment applies to bonds issued with a warrant(OBSA) and subordinated debt. The accounting treat-ment of bonds redeemable in shares (ORAs) is moreambiguous since, in some circumstances, such instru-ments are recorded under French GAAP as ‘‘otherequity funds.’’ ORAs have consequently historicallybeen the subject of more debate than other such in-struments (see below), but normally remain subject totreatment as debt.

Although the French tax authorities must normallyrely on the legal and accounting classification of atransaction, they may challenge such classification byreference to the legal and economic characteristics ofthe transaction if they have sufficient elements to es-tablish that the contractual or accounting treatment iserroneous, based on either the misclassification of thetransaction with respect to its legal analysis, or be-cause the transaction is abusive or fraudulent.

Except in situations where the accounting and legalclassification of an instrument as debt would be obvi-ously incorrect, the recharacterization of debt asequity would be subject to the abuse of law (or frauslegis) procedure rules contained in Article L 64 of theFrench Tax Procedure Code (LPF), which is quite de-manding for the tax authorities to implement.2 In allcases, the burden of proof would, in principle, lie withthe tax authorities but the French entity would be re-quired to provide clear information on the featuresand purposes other than tax of the transaction con-cerned (in that sense, the burden of proof is in factshared between the taxpayer and the tax authorities).

The purpose of the discussion that follows is not todeliver a precise analytical grid (which anyway does


not exist), but to comment on how this issue has beenapproached by the tax authorities and to provide illus-trations by reference to the few existing cases that ad-dress the matter. In any event, the question of how aninstrument is to be classified has lost much of its rel-evance and materiality from a tax perspective as aresult of recent changes to the law, which automati-cally limit the effect of hybrid instruments (see II.,below).

2. Comments of the French Tax Authorities

As indicated above, the French tax authorities havenot provided any precise analytical grid for classifyingan instrument as either debt or equity and have statedthat a case-by-case analysis should be conducted,based on the characteristics of the particular instru-ment concerned. No single element is decisive in de-termining how an instrument is to be classified andonly a comprehensive analysis of a transaction canlead to its potential reclassification. It is, however,worth referring to some of the past comments of thetax authorities on this subject, though only by way ofillustration and not as representing a rule.

The French tax authorities’ guidance (in the form ofa statement of practice) on the thin capitalizationrules,3 for example, acknowledges the existence ofhybrid instruments that share features of both debtand equity. The tax authorities indicate that equityfeatures would, in particular, be the absence of a pre-defined reimbursement date and the ability of theissuer to suspend the remuneration in the case of in-sufficient profit, and that debt features would be theexistence of predefined fixed or variable remunera-tion, the absence of voting rights and the right to liq-uidation surplus. The authorities conclude theirstatement of practice by noting that once the analysisof an instrument is made that results in its classifica-tion as debt, then the interest paid on the instrumentis subject to the thin capitalization rules commentedon in the guidance.

The French tax authorities also had to comment onthese questions in their guidance4 on the tax treat-ment of Islamic Finance and Sharia-compliant instru-ments (Shariah law forbids the payment of any formof interest). The tax authorities indicated that such in-struments should be treated in a manner similar todebts, to the extent certain requirements are met. Inparticular, the tax authorities indicated that ‘‘Sukuk’’Sharia transactions should be equated with debt in-struments, provided:

s The Sukuk holders have priority over shareholderswhatever the nature of the equity stakes of the latter.

s The Sukuk holders do not have rights that are spe-cific to shareholders, namely voting rights and rightsto share liquidation surplus (unless the Sukuks havebeen converted into shares).

s Remuneration on the Sukuks is based on the perfor-mance of the collateralized assets, but must includean expected rate of return that must be capped at anaccepted market rate (EURIBOR, LIBOR) increasedby a margin consistent with market practice in rela-tion to debt instruments. The remuneration couldbe zero in the case of an issuer in a loss-making po-sition. The Sukuks can be reimbursed at below par

value (because of the index-linking mentioned in theSukuk agreement).

It is worth noting that the author has provided com-parable analysis with respect to the tax treatment ofconvertible contingent bonds (CoCos) issued by banksto enhance their Tier 1 equity funds,5 since hybrid in-struments are of great interest to banks from a regula-tory perspective, quite apart from any tax advantagethat they may confer.

3. Case Law

There is so far little case law on the recharacterizationof debt into equity, or the reverse (equity into debt,where a hybrid instrument is used to finance a foreigninvestment and the French investor claims the benefitof the participation exemption).

The Abuse of Law Committee (which is an adminis-trative committee, not a Court, and does not create‘‘case law’’ per se since the advice of the Committee isnot binding on the Courts, even if a positive answer ofthe Committee shifts the burden of proof to the tax-payer6) had to comment on the treatment of excep-tional distributions made by a French entity by way ofthe issuance of ORAs and confirmed the authorities’view that the transactions concerned could be re-garded as constituting fraus legis under the generalanti avoidance rules contained in Article L 64 of theLPF (which is also referred to as being designed tocombat ‘‘abuse of law’’ or ‘‘fraud to the law’’).7 In a de-cision handed down on the same day, the same Com-mittee concluded that the implementation of aparticipating loan, concomitant with a reduction ofcapital through a share repurchase, was not abusive.8

In the opposite situation (where the issue was theequity financing of a foreign corporation held by aFrench holding entity and the benefit of the exemp-tion for dividends received by the French entity), theCommittee concluded 9 that a transaction involvingthe use of preferred shares and a number of other spe-cific elements, was a sham that allowed a bank to ben-efit improperly from the participation exemption.

As regards actual court cases, the most significantdecision on the subject under discussion is the recentdecision of the High Court in SAS Ingram Micro,10

even though this concerned the payment of an excep-tional dividend distribution by the way of the alloca-tion of ORAs, rather than a pure hybrid situation. TheHigh Court confirmed that the overall transaction,which, in practice, allowed equity reserves to be re-placed by debt, without any cash movement, was afraud. The fact that the reimbursement took the formof ORAs played a part in the analysis (because the re-financing was considered circular since it did not in-volve any cash movement and used an instrumentdesigned to revert to equity on redemption), but cer-tainly does not allow the conclusion to be reached thatORAs are not debt instruments.

The case created some doubt as to whether the HighCourt intended to challenge the old principle accord-ing to which taxpayers are totally free to decide howthey finance themselves, whether by debt or equity(which is a different issue from the treatment of hy-brids). Some comments on the case seem to indicatethat the intention of the High Court was not to chal-lenge this principle and that the case should remain


an isolated instance — one can but hope that the taxauthorities will share a similar conviction.

Another interesting case in this respect was heardby a local court of appeal,11 which held that the cre-ation of debt resulting from a share buy-back financedby debt did not run counter to the interests of aFrench entity, which remained free to decide how itshould be financed, irrespective of the existence of anadvantage for the foreign investor concerned. TheCourt noted that the fact that a transaction affords ad-vantages to a shareholder in a French entity is not ofitself sufficient for the transaction to be regarded asabnormal if the transaction also affords advantages tothe entity.

Hence, a challenge to the effect that debt has beenartificially created can be made on the grounds offraus legis and Article L 64 of the LPF (but only in lim-ited situations if decades of case law confirming freechoice as to financing are to be believed) and otherspecific debt creation rules provided for by French law(see II.C., below), not on abnormal management ortransfer pricing grounds. But again, this concernsdebt creation more than it does the use of hybrids assuch.

4. Tentative Conclusion

Situations in which a financial instrument that is clas-sified as debt for French commercial law and account-ing purposes is recharacterized by the tax authoritiesas equity for tax purposes remain rare and it is impos-sible to draw a clear line between the two types of fi-nancing. A multi-criteria approach is required, withno particular criterion predominating.

The terms of remuneration, participation in profitsand losses and the modalities of redemption are, ofcourse, important factors in the analysis of a financialinstrument, but it is not easy for a loan to be recharac-terized as equity: convertible bonds and ORAs are, inprinciple, treated for tax purposes as debt, at leastuntil they are converted into or redeemed with shares.As discussed above, the use of ORAs to replace equityreserves by debt was held by the High Court in SASIngram Micro to constitute an artificial arrangementand treated as an instance of fraus legis, but this deci-sion was essentially driven by the specific fact patternat issue.

Nor does the fact that a security does not have a pre-determined duration disqualify it from being a bond.For example, subordinated bonds (titres subordonnesa duree indeterminee or TSDIs) do not have a statedmaturity and are reimbursable on the judicial liquida-tion of the issuer, but this does not allow them to bereclassified as equity (the same is true of perpetualbonds — CoCos). From an accounting standpoint,12

TSDIs are classified as debt instruments and theFrench tax authorities also equate TDSIs with debt fortax purposes.13

Nor is the fact that the remuneration for a loan iscontingent on, and partly or wholly determined withrespect to, the profits of the issuer a decisive factorpointing to the conclusion that the loan should beclassified as equity. Participating loans, for example,are, in principle, treated as debt, as are indexed bondsand Sukuks.

Where an instrument ranks on the liquidation of theborrower is an important factor in determining itscharacter as either debt or equity (see the discussionof Sukuk at I.A.2., above, in this regard). For example,in the case of a company that has been granted a par-ticipating subordinated loan, the lender is reimbursedbefore the company’s shareholders. However, like theother criteria weighed in making the debt/equity dis-tinction, such ranking cannot be taken into account inisolation: for example, on liquidation a preferredshare can be refunded before the rest of the equity, butthis does not make it a debt.

As suggested above, these complex discussions havelost some of their significance now that France has en-acted the measures recommended in the OECD’sguidelines allowing a deduction to be denied to thepayor where the payment concerned is not recognizedas income by the recipient. The relevant rules are dis-cussed in II.A., below.

In light of the above remarks, it can be seen that theassumption in the case under discussion that the fi-nancing transaction between FCo and FrenchCo isnot supported by any legal documentation would notbe fatal to the argument that the financing should beregarded as debt.

Even in the event that FrenchCo and FCo failed todraw up legal documentation (which would be bothunwise and, in practice, highly unlikely), the account-ing treatment (which would normally be based on alegal analysis under French GAAP) would be a crucialelement in the analysis of the arrangement, since theaccounting treatment is binding on the taxpayer andis deemed to reflect its management decisions, even ifthose decisions can be challenged by the tax authori-ties. This can be illustrated by the conclusion reachedby the High Court in a recent case14 in which a branchrecorded a transfer of funds to its head office as a re-ceivable rather than as repatriation of equity: the HighCourt held that interest should have been charged tothe head office on the recorded receivable.

As regards the consequences of FCo’s treating theinstrument as debt (as assumed for purposes of thissection), the approach of the French courts in deter-mining the character of a cross-border transaction isalways to rely exclusively on French criteria. The clas-sification of the transaction under foreign rules is ig-nored. For example, the High Court has held15 thatthe character of a foreign partnership (in the case con-cerned, a U.S. general partnership) should be deter-mined by comparing it with similar French entitieswith comparable legal features, not by reference to itsclassification or tax treatment in the foreign countryconcerned. The same reasoning was used in a caseconcerning a U.S. LLC.16 More recently, the HighCourt17 held that a debt waiver granted by a Frenchcompany to its U.K. subsidiary should not necessarilybe treated as a (non-deductible) capital contribution,even though it was so treated for U.K. accounting pur-poses: The High Court reversed the decision of theCourt of Appeal, because the lower court should haveclassified the debt waiver by reference to French legaland accounting standards, irrespective of its foreignlaw treatment.

The fact that the issuer treats an instrument as debtdoes not, of itself, prevent the tax authorities reclassi-


fying the instrument as equity if this is the correctanalysis under French corporate law and accountingrules.

However, even though the characterization of theinstrument as debt by FCo is irrelevant for the legalanalysis, it is an element that would be considered inthe overall factual analysis. The foreign treatment andwhether or not the parties are related in practice (evenif not in theory) will clearly have an impact on the con-clusion reached by both the tax authorities and theCourts, since establishing fraus legis requires ananalysis of the intention of the parties to the transac-tion concerned. In the author’s opinion, it is unlikelythat the abuse of law procedure could apply or even beinvoked by the tax authorities where the hybridity be-tween unrelated parties is merely the result of a differ-ence in treatment of one single instrument and not theresult of a contorted attempt to achieve different treat-ment in each of the countries concerned (for example,the use of listed CoCos by banks to enhance their Tier1 ratios).

The fact that interest on a debt is taxed in the handsof the recipient will, however, have direct conse-quences in the context of new limitations on the de-duction of interest (see II.A., below).

B. FCo Does Not Treat the Transaction as a Loan for FCAccounting and Income Tax Purposes

The fact that FCo and FrenchCo are related does notof itself point towards either debt or equity treatment,but it does invite an analysis of how the instrument istreated by the financing entity in the foreign country(FC).

As noted above, the treatment of the instrument byFCo, i.e., its classification as equity, is, in theory, nottaken into account for purposes of determining itstreatment under French tax law in the hands ofFrenchCo. However, even though the position underthis second scenario should consequently be the sameas under the first scenario (see I.A., above) the treat-ment of the instrument as equity by FCo and the con-sequent exemption of the payments made to it byFrench Co are, in practice, likely to affect the analysisfor French tax purposes.

In SAS Ingram Micro, the High Court regarded theabsence of taxation of the foreign company concernedin its country of residence as a relevant factor. Thewording of the decision indicates that this was not acrucial element in the Court’s analysis (the Courtrefers to it incidentally — ‘‘au demeurant’’), but itseems likely that the existence of a hybrid mismatch(deduction/non-inclusion) was regarded as importantin this particular case. Fraus legis requires the identi-fication of an element of intention to avoid tax and itseems unlikely that the recharacterization would havesucceeded had the judges felt that the hybrid mis-match was merely the result of differences in tax treat-ment between the two countries.

Finally, as already noted, the absence of documen-tation suggested in the case study would not necessar-ily be fatal to the analysis of an instrument as debt. Inthe hypothetical absence of documentation, the ac-counting treatment by FrenchCo would be a clear in-dication of how the instrument should becharacterized (see above), but the tax authorities

would be able to mount a challenge using the ap-proach described above. The absence of any docu-mentation would be a poor platform for a Frenchborrower wishing to argue for the existence of a debtfor French tax purposes if the instrument concernedwere treated as equity in the lender’s country of resi-dence.

C. Difference if a Loan Agreement of Some Sort Exists

Where a loan agreement exists, the loan agreement is,in principle, treated as such, but the tax authoritiescan recharacterize it, based on the approach dis-cussed above. In any event, new rules would apply tolimit the deduction of interest if the counterparty wasnot taxed or was only taxed at a low rate (see II.A.,below).

II. General Rules Regarding the Deduction ofInterest Paid to a Nonresident Lender (Assumingthe Transaction Is Accepted as a Loan)

A. Effect on General Rules if It Is Known That the LenderDoes Not Include the Interest Income in Taxable Income

Assuming the instrument is treated as debt, interestpaid by a French taxable entity is, in principle, deduct-ible on an accrual basis (including capitalized inter-est). Unlike in a number of countries, interest isdeductible in France even if the debt on which it ispayable is related to the acquisition of shares in a con-trolled entity (whether in France or abroad), which isan important element in the computation of theFrench taxable base. Even though, as is widely known,France has a high nominal corporate tax rate (thoughthis may change under a new presidency), this interestdeduction can significantly reduce the effective rate oftaxation (at least it could when corporate rates werehigher than they are currently).

Interest payable by FrenchCo may, however, be sub-ject to various rules limiting its deduction. Most — butnot all — of the limitations concerned apply to inter-est paid to related parties. The residence of the lenderis in principle irrelevant for purposes of determiningwhether a deduction is available — any rule to thecontrary could be denounced as discriminatory (seeV., below).

The new rules on hybrids and payments to low-taxcountries are summarized in this section. Other ruleson debt-to-equity ratios and thin capitalization will bedescribed in II.B., below, and other limits on interestrates and the debt creation rules will be described inII.C., below.

Hybrid instruments are a major focus of attentionin the current initiatives of the OECD and EU authori-ties — not only in the context of efforts to combat taxavoidance and prevent the OECD membercountries/EU Member States suffering tax leakage,but also because hybrid mismatches are regarded asgenerating unjustified competitive advantages for themultinational groups that can implement them. Nei-ther the OECD nor the EU proposals will be addressedhere since they are not purely a question of French do-mestic law and have anyway been extensively dis-cussed elsewhere.


France has implemented most of the recommenda-tions made by the OECD as well as EU recommenda-tions and Directives (see further at VI., below).Whether interest is to be included in the lender’s tax-able income and how it is to be taxed have become rel-evant issues since the introduction by the 2014Finance Bill of what is now Article 212, I-b of the CGI,which establishes a new condition for the deductionof interest by reference to a minimum level of taxationin the hands of the beneficiary, where the beneficiaryis a related party of the payor. The law applies for fi-nancial years closed after September 25, 2013.

In summary, to obtain relief for interest it pays, aFrench borrowing entity must now be able to estab-lish, when requested to do so by the tax authorities,that the lender (where the lender is a French or for-eign related party) is subject to income tax on the in-terest received from the French borrower at a rate ofat least 25% of the standard French CIT rate (i.e.,33.33% x 25% = 8.33%) or, according to the tax au-thorities, at a slightly higher rate of 9.5% in situationswhere additional contributions assessed on CITwould be due. The purpose of this new rule is, there-fore, not only to combat hybrid instrument mis-matches and situations of double non-taxation, butalso to target payments of interest to low-tax coun-tries.

The rule applies only to interest paid to related par-ties, not to interest paid to other lenders. If the lenderis a transparent entity: (1) the rule only applies if theFrench borrower and the members of the transparententity are related parties; and (2) whether the mini-mum taxation threshold is met is tested at the level ofthe entity’s members (subject to certain conditions).

If the lender is a foreign tax resident, the character-ization of the instrument in the lender’ country of resi-dence is irrelevant — the only relevant questionconcerns the level of foreign tax applicable to theincome received by the lender. The comparison be-tween the minimum 25% threshold and the rate of for-eign tax is made with respect to the gross interestincome, computed in accordance with French taxrules (for example, the interest is computed on an ac-crual basis and no account is taken of any basis rebateor deduction for expenses that may apply for foreigntax purposes). The foreign tax rate is computed basedon the theoretical foreign tax payable at the nominalrate, not on the effective tax paid. Thus for example,the fact that the lender is in a loss position or does notpay tax because of local tax consolidation or grouprelief rules is not taken into account. Nor, in principle,is the fact that the lender may itself pay interest to an-other party.

Because of its general objective of combatting taxoptimization (a broader concept than tax avoidance),this rule works mechanically to determine the taxablebasis, quite independently of any tax avoidance con-siderations. There is no safe harbor allowing the tax-payer to avoid the application of the rule byestablishing that there is no tax avoidance motive(unlike under other anti-avoidance measures, such asthe controlled foreign company (CFC) rules).

Nonetheless, the tax authorities explained in com-ments issued in December 2015 concerning schemesthat can be regarded as fraudulent, that fraus legis canbe invoked in the following situation: A corporation in

State A creates a subsidiary in State B financed byequity; the subsidiary in turn establishes a branch inState C (a low-tax country) that on-lends to a Frenchborrower and the interest is not ‘‘effectively’’ taxed inB and C (although the computation should in prin-ciple only take into account the theoretical tax paid inState B). Taxpayers in this position are invited by theguidance to disclose themselves to the tax authorities— and, one might say, frauslegis gets back in throughthe back door.

Should the income received by the foreign lender betaxed in France under the French CFC regime,18 theinterest would be regarded as being sufficiently taxed(so that there would be no cumulative application ofthe two sets of measures).

B. Specific Limits on Interest Deductions Based on theRatio of Debt to Equity

The relevant rules will not be discussed in any greatdepth here, but may be summarized as follows:

s Thin capitalization rules (related party loans): Ar-ticle 212 of the CGI provides that a borrowing entityis deemed to be thinly capitalized if the total amountof interest incurred on related party loans that is de-ductible under the interest rate test fails all threetests below (i.e., the tests are cumulative tests):

(1) Debt-to-equity ratio test: the average ofamounts made available to the borrowing com-pany in the form of debt by related entities (includ-ing non-interest bearing loans and loans obtainedfrom third parties but guaranteed by a relatedentity) may not exceed 1.5 times the amount of theborrowing company’s net equity or share capital.For each financial year, the taxpayer is free to useeither the total equity at the beginning of the yearor the total equity at the close of the year. If it ishigher than its net equity, the borrower can use theshare capital at the end of the financial year. Theinterest on the excess portion of debt may be non-deductible, depending on whether two other con-ditions are fulfilled.(2) Interest coverage ratio test: interest payablemay not exceed 25% of the borrowing entity’s oper-ating profit before tax, increased by: (a) interestpayable to related parties; (b) depreciation allow-ances taken into account in determining the enti-ty’s pre-tax operating profit; and (c) the portion offinance lease payments taken into account in deter-mining the sale price of leased assets at the end ofthe lease.(3) Interest received test: the above limitationsonly apply if interest paid to related parties exceedsinterest received by the borrowing entity on loansit has itself made to related parties. The existenceof this test can increase the level of deduction al-lowed compared to what would be allowed if onlythe first two tests applied, especially in the case ofa pool leader located in France.

s The deductibility of the excess portion of the inter-est paid (the excess portion being computed by ap-plying that of the three tests above that produces themost taxpayer-favorable result) is deferred, if it ex-ceeds 150,000 euros (the deferred deduction may betaken in a subsequent year to the extent allowedafter applying the above limitations in that subse-


quent year). However, the application of these rulescan be avoided if the company can establish that itsdebt-to-equity ratio is lower than the overall debt-to-equity ratio of the group of which it is a member.

s General limitation on interest relief (this applies toall debt, i.e., it is not restricted to related-party debt):in addition to the above rules limiting deductionsfor interest paid to related parties, a 75% generallimitation applies to the deduction of net financialexpenses, i.e., the net difference between all finan-cial income and all financial expenses, when this dif-ference exceeds 3 million euros. Once this thresholdis reached, the 75% limit applies to the wholeamount of the net expense, from the first euro (andnot only to the amount of net expense in excess of 3million euros). In the case of a tax consolidatedgroup, this threshold is not increased in proportionto the number of companies in the group. The limi-tation applies to all interest and financial expenses,even those incurred in transactions with unrelatedparties.

C. Limits on Interest Deductions Based on Other Factors

The following limitations on interest deductions mayalso apply:s Limitation on the maximum interest rate (related

party loans): this limitation, which applies only toloans granted by related parties when the borrowingentity is subject to CIT, is computed by reference tofloating-rate loans with terms of over two yearsgranted by French banks (2.15% in 2015, 2.03% in2016). It is however possible to avoid the limitationby establishing that the rate that could have beenobtained in a similar situation from an independentcredit institution would have been higher.

s Rules preventing artificial debt push-downs andearnings stripping:/ Under Article 223 B of the CGI (the ‘‘Charasse’’amendment), a specific limitation applies to inter-est on debt related, or deemed related, to the acqui-sition from a related party of shares in a companythat becomes part of the tax consolidated group./ Under Article 209 IX of the CGI, a similar limita-tion (the ‘‘Carrez’’ amendment) applies to intereston debt (including third party debt) related to theacquisition of shares in a French or foreign com-pany, when the acquiring entity cannot demon-strate a sufficient level of involvement in the targetcompany’s management.

s Interest paid to beneficiaries located in non-cooperative countries and tax havens: under Article238 A of the CGI, interest paid to beneficiaries insuch countries is deemed non-deductible, unless theborrower can demonstrate that the expense corre-sponds to a genuine loan (interest paid to beneficia-ries located in listed ‘‘non-cooperative’’ countries19

may be subject to a high rate of withholding tax —up to 75%).

D. Possibility of a Transaction Being BifurcatedInto a Portion That Permits Deductible Interest anda Portion That Does Not

Recharacterization of debt as equity (and vice versa) isnot made in accordance with the provisions of a par-

ticular law but with the broad concept of fraus legis,which relies entirely on a case-by-case analysis. No bi-furcation in characterization would seem to be pos-sible, assuming the instrument concerned is a singleinstrument. Other rules limiting interest deductionsmay give rise to bifurcated treatment, especially thosethat apply only with respect to loans from sharehold-ers or related parties.

E. Effect of an Income Tax Treaty Between Franceand FC

France’s tax treaties generally do not include provi-sions that would directly allow the recharacterizationof debt as equity (or vice versa).

III. Difference if FCo Were an Entity That Is Treatedas Transparent for FC Tax Purposes

Compared to those of most countries, France’s ruleson the treatment of partnerships are quite specific.20

In principle, unlike in most countries, which apply apure look-through approach for tax purposes, inFrance a partnership is regarded as an entity/persondistinct from its partners and tax liability is computedat the level of the partnership. Despite the fact that apartnership is recognized as a separate entity for tax(and legal) purposes, in principle, the persons liablefor the tax on (their shares of) the partnership incomeare the partners, even though the income will not nec-essarily have been distributed to them.

Whether it would make any difference to the posi-tion set out in II., above if FCo were an entity that istreated as transparent for FC tax purposes woulddepend on the status of the foreign partnership fur-ther to the analysis described immediately above. Inessence, the position would probably not be much af-fected.

IV. Withholding Tax Issues

As noted in I.A., above, the characterization of an in-strument has a direct impact on the treatment of theincome flows attached to it for withholding tax pur-poses, since payments of interest are, in principle, notsubject to withholding tax (except where the pay-ments are made to beneficiaries in non-cooperativeStates), while dividends may be subject to withhold-ing tax. The rate of withholding tax on dividends willdepend on whether there is a tax treaty betweenFrance and the country of residence of the beneficiaryand, if there is an applicable treaty, what rate(s) is/areprovided for in that treaty.

V. Difference if FCo Has a PermanentEstablishment in France

Both French constitutional rules (the principle ofequality enshrined in Article 13 of the 1789 Declara-tion of Human and Citizens Rights) and EU rules (theprinciples of freedom) proscribe the discriminatorytreatment of investments made by foreign investors,not only in an EU context but also in a non-EU context(although this aspect will not be elaborated on in thispaper). The non-discrimination rules contained inmost of France’s tax treaties also have the same impli-cations.


For this reason, most rules enacted in French laware now (in principle) designed in such a way as toensure that a foreign investor is not treated less ad-vantageously than a French investor. The new anti-hybrid rules therefore apply in a purely domesticcontext (i.e., where a French borrower and the Frenchbranch of a foreign financing entity are involved) aswell as in a cross-border context. That being said, thisis largely an academic matter because situations inwhich there is a mismatch in the French tax treatmentof two French taxpayers (including where one is abranch) are unlikely to occur.

VI. Legislative Changes

To say that the French Administration has been veryactive in promoting the OECD and EU initiatives re-ferred to above is perhaps to put it mildly — most ofthe relevant measures had been incorporated intopositive law even before the final OECD BEPS reportswere published or the EU Directives issued.

Further to Directive n° 2014/86/EU of July 8, 2014, a‘‘linking rule’’ was introduced by the amending Bill for2014. As of January 1, 2015, dividends that can be de-ducted from the taxable income of the distributingcompany are excluded from the benefit of the partici-pation exemption.21

In addition, further to Directive n° 2015/121/EU ofJanuary 25, 2015, the Amending Bill for 2015 intro-duced new restrictions on the exemptions derivingfrom the EU Parent-Subsidiary Directive (i.e., exemp-tion from CIT for dividends paid by EU subsidiaries inthe hands of their French parent companies and ex-emption from French withholding tax for dividendspaid by French parent companies to their EU subsid-iaries).22 The restrictions apply to schemes designedto obtain artificially the benefit of these exemptions.These restrictions will not be discussed any furtherhere because they do not directly concern the situa-tion discussed in this paper.

Turning to the subject matter of this paper, no spe-cific rules have yet been implemented regarding thetreatment of hybrid entities, even though the DraftBill for 2014 required the Administration to prepare areport on such hybrid structures. Article 9 of the Anti-Tax Avoidance Directive (ATAD),23 however, does pro-vide further rules on hybrids. Article 9 provides asfollows:1. To the extent that a hybrid mismatch results in a

double deduction, the deduction shall be given onlyin the Member State where such payment has itssource.

2. To the extent that a hybrid mismatch results in a de-duction without inclusion, the Member State of thepayer shall deny the deduction of such payment.

These rules must be implemented by the EUMember States by December 31, 2018, at the latest.

This proliferation of measures seems certain to giverise to a host of questions as to how the measures willapply in practice — not only from a purely Frenchpoint of view (what is the scope of the measures? whatis the order of priority among the various rules?), butalso from the point of view of the interaction betweenthe rules of the various countries concerned (potentialdifferences in scope, timing and the order of priorityamong the various rules in each country) since, under

the ATAD, implementation of the measures is manda-tory (high-tax countries will be concerned that thefailure of some countries to implement these rules ina sufficiently rigorous manner may create new‘‘unfair’’ competitive advantages).

The profusion of rules will also doubtless generate adeal of uncertainty and multiply the number of in-stances of double taxation that it will require arbitra-tion to resolve. One of the objectives of the BEPSinitiative was to create economic efficiency by elimi-nating the artificial tax advantages enjoyed by somemultinationals. Unfortunately, it seems that the initia-tive is going to give rise to considerable complexityand economic inefficiency affecting a large number ofstakeholders.

The French tax authorities have for many years hadadequate tools to challenge transactions that could beregarded as purely tax-driven (in France, the abuse oflaw procedure has been part of statutory law since1925 with respect to registration duties and since1941 with respect to direct taxes) and all the talk sur-rounding BEPS has put taxpayers on such notice thatfew would deliberately (or lightly) engage in thesekinds of transaction, with the attendant risk of facingdouble taxation rather than achieving double deduc-tion.

The effect of the BEPS rules is to enlarge signifi-cantly the scope of transactions that are potentiallywithin the ambit of anti-avoidance provisions. This isthe result of a shift away from the subjective approachof general anti-avoidance rules (such as the Frenchabuse of law rules), in which the intentions of the tax-payer are scrutinized, to specific measures that applymechanically and catch not only tax-avoidance butalso mere tax optimization arrangements, in which nofraud can be detected, and even situations in whichthere are mismatches of a purely mechanical nature.In this respect, these rules represent not only a meansof combatting tax evasion and optimization, but a wayfor high-tax countries to reduce the attraction oflower-tax countries. The absence of safe harbor rulesin most of these new measures will no doubt increasethe number of instances of double taxation. In thisnew environment, tax optimization is not so much amatter of identifying opportunities to achieve doubledeductions as a matter of steering clear of the risk ofdouble taxation, just as it is in the transfer pricingarena.

NOTES1 French Tax Code (Code General des Impots or CGI), Art.38 quater of Appendix III.2 See Thierry Pons, The Economic Substance Doctrine,France response, Tax Mgmt. Int’l. Forum (June 2010).3 Tax instruction 4 H-8-07, December 31, 2007.4 Tax instruction 4 FE/S2/10, July 23, BOI-DJC-FIN-20.5 See Thierry Pons, Tax Implications Of Contingent Con-vertible Securities, France response, Tax Mgmt. Int’l.Forum (June 2012).6 For further explanation, see Thierry Pons, The EconomicSubstance Doctrine, France response, Tax Mgmt. Int’l.Forum (June 2010).7 Committee of December 7, 2010 Affaire n° 2010-12 con-cernant la societe X France Holding.8 Committee of December 7, 2010 Affaire n° 2010-13 con-cernant la SAS Z France Holdings.


9 Committee of December 5, 2014 Affaire n° 2014-30 ‘‘SAX.’’10 CE 13-1-2017 no 391196.11 CAA Versailles n° 10VE03601 January 24, 2012.12 Memento comptable 2012 n° 2130-4.13 See in this context: Tax instruction 4 C-3-95 n° 3, April25, 1995, and administrative doctrine 4 C-2342 n° 3, Oc-tober 30, 1997, BOI-BIC-CHG-50-30-20-10 n° 60, Septem-ber 12, 2012. For relevant case law, see CAA Versailles July5, 2016 no 14VE02647, SA Carrefour.14 CE November 9, 2015 no 370974, Ste Sodirep TextilesSA-NV.15 CE 24-11-2014 no 363556 Ste Artemis.16 CE 27-6-2016 no 386842 Ste Emerald Shores LLC.17 CE 31-3-2017 no 383129 SAS Senoble Holding.18 CGI, Art. 209 B. See Thierry Pons, CFC rules, France re-sponse, Tax Mgmt. Int’l. Forum (March 2011).

19 ‘‘Non-cooperative’’ countries are specified in a list pub-lished every year by the tax administration. A non-cooperative country is a non-EU Member State that :s Has been subject to OECD review;

s Has not concluded a tax treaty with France allowing for the full ex-

change of information for purposes of applying the Contracting

States’ tax legislation; and

s Has not concluded such treaties with at least 12 other countries.

The last list published by the Administration includes Bo-tswana, Brunei, Guatemala, the Marshall Islands, Nauru,Niue and Panama.20 See Thierry Pons, Taxation of Inbound Investment by aForeign Partnership, France response, Tax Mgmt. Int’l.Forum (March 2016).21 CGI, Art. 145, 6, b.22 CGI, Arts. 145, 6, k and 119 ter, 3.23 EU Directive 2016/1164 of July 12, 2016, laying downrules against tax avoidance practices that directly affectthe functioning of the internal market.


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