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France: Recent Developments Impacting Inbound and Outbound Income Flows – Part II — Orbitax Expert Corner

Recent Developments Impacting Inbound and Outbound Income Flows – Part II

France withholds tax on various types of income flows accruing to non-resident recipients. Like elsewhere, the applicable withholding tax may be impacted by tax treaties or EU law. In recent years, however, the complexity of the applicable rules has increased exponentially with on the one hand the introduction of multiple anti-avoidance rules, and on the other hand several national and EU judicial rulings with far-reaching consequences. One of such consequences is the determination of the applicable withholding tax rate when the non-resident recipient of an item of income is not the beneficial owner thereof. Furthermore, when the applied withholding tax is subsequently found to conflict with national or EU law, the question arises as to whether the faulty withholding tax assessment should be scrapped entirely, or only sufficiently adjusted to eliminate the underlying conflict. In the mirror image, French residents in receipt of foreign-source qualifying dividends and capital gains are eligible to a participation exemption regime. Hitherto, the automatic corollary of the regime is that any foreign tax credits attached to the income received are entirely forfeited. Or are they?

This article addresses the consequences of three recent French Supreme Administrative Court rulings dealing respectively with (a) the applicable withholding tax rate when the non-resident apparent recipient of the income is not the beneficial owner thereof, (b) the consequences of applying a withholding tax rate that is subsequently found to be in conflict with national or EU law, and (c) the availability or not of a foreign tax credit with respect to foreign-source income benefiting from the French participation exemption regime. It is presented in two parts: Part I was published in an earlier Expert Corner edition and Part II in this edition.

II-A. Improper Imposition of (Withholding) Tax: Baptism and the Original Sin

As mentioned in the introduction, France levies (withholding) taxes on several income flows accruing to or realized by non-residents. The tax imposed under domestic law may be partially or fully relieved in application of tax treaties or EU law, including, with respect to the latter, in furtherance of the case law of the Court of Justice of the European Union (CJEU). It occurs fairly often that France imposes a (withholding) tax which subsequently proves to be in conflict with the provisions of a tax treaty or EU (case) law. The question then arises as to what the consequences of such improper imposition of tax should be? Should the tax assessed be adjusted downwards but only up to the level needed to eliminate the conflict? Or should it be fully cancelled and refunded since originally levied in conflict with higher legal norms?

The answer to this question is not self-evident because both alternatives are theoretically plausible. Under the first alternative, the source country is merely required to re-establish the situation which should have prevailed had it collected the tax in conformity with the higher tax treaty or EU (case) law norm. Requiring the source country to do more than the strict minimum needed to correct the situation may lead to undesirable results, including the inadvertent creation of reverse discrimination. On the other hand, the argument for a full cancellation and refund of the improperly imposed tax is not without merit since based on the fact that the imposition of the tax was flawed from the start. This dichotomy can be best illustrated by borrowing from the teachings of the Roman Catholic churchi. In analogy with that tradition, the improper imposition of tax could be equated with the “original sin”, whilst relieving the tax but only by merely enough to reestablish the situation which should have prevailed could be equated with “Baptism”. The question then is whether “Baptism, by imparting the life of Christ’s grace, erases original sin…”? or does it?

Over centuries, the answer to this question pinned head-to-head various doctrines within the Church, and so also more recently the French Supreme Court. Indeed, in two rulings AVM International Holding of 14 October 2020, and M. A… B… of 23 June 2022, respectively, the Court in the first case ordered the full cancellation and refund of an improperly imposed tax, before making a U-turn and ordering, in the second case, a mere readjustment of the tax to the level that should have prevailed had it been imposed properly.

The first decision dealt with the issue of withholding tax on capital gains on substantial participations realized by an Italian company, AVM International Holding. Given that the protocol to the France-Italy tax treaty allows France to tax gains on substantial participations realized by a resident of Italy, AVM was charged to tax on the gains at the then applicable French domestic rate of 19%. In contrast to AVM, however, a French resident company in the same circumstances would have benefitted from the French participation exemption, such that its effective tax rate on the gains would have amounted to 3.33% only.  AVM disputed the tax on the grounds of the non-discrimination rules under EU law, and the tax authorities positively reacted by reducing the tax charge to 3.33%, i.e. that which would have been due had AVM been a French resident company benefitting from the participation exemption regime. The tax authorities based the downward readjustment on their own administrative guidelines (Administrative Instruction BOI 4 B-1-08 no 36 du 4-4-2018). One would think that the matter is herewith closed, but AVM disagreed with the adjustment and claimed a full cancellation and refund of the tax on the grounds that its imposition was flawed from the outset and could not be repaired by administrative guidelines.

In its ruling on the matter, the Supreme Court sided with AVM and determined that where the rate applied is incompatible with the EU freedoms, it is not enough to lower the assessment through an administrative determination to remain within the EU law limitations. Instead, the tax levied is flawed and must be fully refunded. From the perspective of the Court, the tax authorities are empowered to interpret legal provisions, but only to the extent there is room for interpretation. In casu, there was no such room: the law stipulated a specific tax rate, and that tax rate meant taxation in conflict with EU law. The administrative act of the tax administration does not redeem this original flaw. As a consequence, the entire construction collapses and the assessment must be declared null and void.

At the time, this position created the impression that the Supreme Court might have inadvertently introduced a reverse discrimination whereby French residents are taxed at 19% (or 3.33% if benefitting from the participation exemption regime), while non-residents initially taxed at a higher rate can claim a full refund and escape the tax altogether. However, the introduction, or at least the acceptance by the Court that its decision may induce reverse discrimination, might not have been inadvertent at all. In fact, the Supreme Court had much earlier knowingly accepted that reverse discrimination may result from its 2007 Denkavit ruling. Also, the case law of the CJEU (inter alia Cases 64/96 et 65/96, Uecker and Jacquet, 05 June 1997) acknowledges and accepts that reverse discrimination may result from CJEU rulings intended to address the initial discrimination. For the CJEU, these instances of “collateral damage” are inevitable and a matter for the national legislator to deal with.

The second Supreme Court ruling was issued on 23 June 2022 and concerned a Swiss national and Monaco resident who realized in March 2012 capital gains on the disposal of French real estate.  French tax law at the time provided for differentiated tax rates on capital gains depending on whether the seller is an EU/EEA resident (19%) or a third country resident (33.33%). The law was amended effective 2015 and provides since for a unified rate, being the rate applicable to French residents (currently 19%). The unification of the applicable rate was enacted by parliament in response to a Supreme Court ruling which held that the imposition of a higher rate on third country residents was incompatible with the freedom of capital movement under the EU treaty.

The Monaco resident, being a third country resident, was initially assessed to tax at the higher 33.33% rate. He contested the assessment on the grounds of incompatibility with EU law, was initially denied relief by the tax authorities, but was granted relief (i.e. the difference between the 33.33% and 19% rates) by the lower tribunal. Nevertheless, the Monaco resident contested the relief granted by the tribunal as it represented from his perspective only a partial relief. He appealed the ruling and claimed a full annulment and refund of the tax on the grounds that the assessment was flawed from the start.

Based on a prima facie reading of the precedent in AVM International Holding, the expectation was that the Supreme Court would accept his claim and order a full annulment and refund of the tax. However, the Supreme Court did the opposite. It rejected the full refund claim and determined that where an assessment is found to be in conflict with EU law, the courts are to compare the situation of the claimant with that of a French resident in comparable circumstances and order a downward adjustment of the tax but only up to the level necessary to re-establish equality of treatment between the two situations. According to the Court, the lower court decision already reestablished equality of treatment and there is nothing in EU law which requires France to grant relief beyond what is strictly needed to correct the original flaw.

So, what happened in the 20-odd months separating the two decisions for the Supreme Court to operate what several commentators saw as a full U-turn and issue diametrically opposed rulings in seemingly comparable situations? In truth, most likely nothing, and on further analysis there is likely no U-turn to start with. Instead, the seemingly conflicting rulings are more likely the natural outcome of a down to earth analysis by the Supreme Court of the grounds for relief under the domestic legal order in the two situations. In the case of AVM, the law clearly established a difference of treatment that is in conflict with EU law. The tax authorities did their best and provided for a reparation mechanism through an administrative guideline. However, an administrative guideline may be accepted as a valid reparation mechanism only if it interprets the law within the window of interpretation afforded by the law itself. In casu, there was no such window of interpretation. The administrative guideline was thus an invalid and ineffective means of repair. Consequently, the original flaw remained unrepaired, and the entire assessment had to be declared null and void, meaning a full refund of the tax. In the case of the Monaco resident, the law initially also provided for a difference of treatment that is equally in conflict with EU law. The difference is that this original flaw was repaired by a valid act of parliament. That act validly reestablished the required equal treatment under EU law. And since EU law does not require anything beyond the re-establishment of equal treatment, the full annulment and refund claim had to be rejected.

In conclusion, and to borrow again from the traditions of the Christian faith, the Supreme Court tells us that there is one original sin but two types of Baptism. The original sin is the imposition of a tax in conflict with a higher legal norm. The first type of Baptism in our case is repair of a flawed tax assessment through an invalid administrative measure, such as in the case of AVM International Holding. That type of Baptism does not erase the original sin and does not bring about redemption. Consequently, the tax assessment remains flawed irrespective of the attempt at repair, can only be entirely annulled and must be fully refunded. The second type of Baptism is repair through an act of parliament (or a valid administrative measure) such as in the case of the Monaco resident.  This type of Baptism in contrast erases the original sin and brings about redemption. Consequently, the flawed tax assessment only needs to be readjusted to its lawful level and does not have to be annulled altogether.

II-B. FTCs and Exempt Income: Now You See Me, Now You Don’t!

Ordinarily, French corporate taxpayers in receipt of foreign-source dividends are subject to regular French corporate tax on account thereof. Where a tax treaty applies, the foreign-source dividends are generally assessed to French tax for their gross amount (i.e. including the foreign withholding tax), and a credit for the foreign withholding tax is then given against (but not exceeding) the resulting French corporate tax liability. In non-treaty situations, the dividends are assessed to tax on their net amount and no credit is given for the foreign withholding tax (i.e. the foreign withholding tax is treated as a deductible cost).  Like many other countries, however, France applies a participation exemption regime intended to relieve the economic double taxation of inter-corporate dividends. Under the regime, dividends received by a qualifying French company from qualifying domestic or foreign subsidiaries are exempt from French tax for 95% of their amount. The exempt amount is increased to 99% for distributions within consolidated groups. The participation exemption regime has been extended to qualifying capital gains but in that case the exemption is limited to 88% of the gain, with the remaining 12% subject to regular corporate tax. The participation exemption regime with respect to dividends is also provided for by the EU Parent-Subsidiary Directive (PSD), and the Directive allows capping the exempt amount at 95%, like French law does. However, the part of the PSD dealing with the exemption of dividends received was not implemented in France as pre-existing French law went beyond the minimum standard prescribed by the Directive.

The immediate corollary of the application of the participation exemption regime with respect to foreign-source dividends is that any attached foreign tax credits are entirely and irremediably forfeited. Indeed, the French tax authorities consider, rightly, that the foreign tax credit is intended to mitigate double taxation. They consider further that since the dividends are exempt from tax in France save for the add-up, there is no double taxation to mitigate. Automatically, therefore, the foreign tax credit becomes purposeless and cannot be claimed. Two Supreme Court and one Court of Appeals rulings have now addressed the position of the tax authorities on this matter. The rulings brought about welcome clarification but left one important question unanswered.

The Nature of the Add-Up

The reasoning of the tax authorities stems naturally from their analysis of the 5% (or 1% and 12%) add-up not as a partial taxation of the dividends (or gains), but as a mere recapture of the expenses related to the participation. This reasoning can be traced to the rationale that originally lay behind the add-up.

Like in most other countries, the general test for the deduction of business expenses in France is that for an expense to be tax deductible, it must contribute to the production or maintenance of a source of taxable income. In contrast to some other countries, however, France generally allows the tax deduction of expenses related to the acquisition and management of participations regardless of the tax treatment of the income derived therefrom. Therefore, the general understanding has been that the 5% (or 1% or 12%) add-up is intended to recapture the tax deduction of expenses related to the participation when the income or gain derived from that participation is exempt from tax. Indeed, since the income derived from the participation is exempt, reason would dictate that associated expenses be denied a tax deduction or otherwise be recaptured by a partial denial of the exemption.  In casu, France has opted for a recapture through the add-up rather than for a blanket denial of the deduction of related expenses. The transposition of this rationale to foreign-source dividends or capital gains leads the tax authorities to the same conclusion: because the add-up is a mere recapture, the foreign-source income is fundamentally exempt from tax in France and there is no room to offset any attached foreign tax credits.

This general understanding is valid with the original iteration of the add-up. Indeed, when originally introduced, the add-up was capped at 5% of the dividends received or the actual amount of expenses incurred by the taxpayer with respect to the participation, whichever is lower. The cap of the add-up to the actual amount of expenses made clear that it should be seen as a mere recapture of expenses and not as a partial taxation of the dividends. The law was, however, amended in 2010 and the add-up was henceforth fixed at 5% (or, later, 1% or 12%) irrespective of the actual amount of expenses. At the time, the elimination of the cap was challenged by taxpayers on grounds of incompatibility with the constitutional principles of equal treatment and contributive capacity. However, the Supreme Court rejected the challenge in two rulings of 2018 (CE no 416514 and CE no 416567) and denied the taxpayers’ plea to refer the matter to the Constitutional Court. The Supreme Court reasoned that by fixing the add-up at 5% of the dividends received, the legislator merely fixed the scope of the exempt portion of the dividends at 95%. Obviously, limiting the exemption to 95% for all eligible taxpayers does not breach the constitutional principles of equal treatment and contributive capacity. As we will see, it is this same reasoning which will boomerang on the tax authorities.

Evolution of the Case Law on the Add-Up

The Supreme Court ruled on the nature of the add-up already in 1997 (SA Fournier Industrie et Santé, CE 23-4-1997 no 145611). In that ruling, the Court considered that the add-up should be analyzed as a mere recapture of the expenses incurred in relation to the participation. The Court reversed its position in its L’Air Liquide decision of 15 November 2021 (CE no 454105), which dealt with the 12% add-up on account of capital gains on eligible participations. In this case, the Court ruled that the 12% add-up must be seen not as a lumpsum recapture of related expenses, but as a partial taxation of the capital gains in France leading in practice to the application of a reduced tax rate with respect to eligible capital gains. The Court did not elaborate on the reasons for its reversal. However, the Advocate General did clarify in her conclusions to the Court that the 1997 ruling was defensible because the law at the time established a clear correlation between the expenses incurred and the quantum of the add-up. This correlation is less obvious when the add-up is expressed as a fixed percentage with no relation to the actual expenses.

In a decision of 27 January 2022 (SCS A. Raymond et Cie, 20LY00698), the Court of Appeals of Lyon extended the reasoning of the Supreme Court in the L’Air Liquide ruling to the 5% add-up in relation to dividends. The case before the Court of Appeals dealt with the treatment of a 15% foreign tax credit attached to Italian-source dividends received by the plaintiff under the participation exemption regime, and thus exempt in France for 95% of their amount. The taxpayer credited the 15% Italian withholding tax against its French tax liability on the 5% add-up. However, in the framework of a tax audit, the tax authorities denied the foreign tax credit on the grounds that because the add-up is a mere recapture of expenses, the dividends are exempt in France and, consequently, the French tax thereon is nil. Since the French tax is nil, there is no room to offset the 15% foreign tax credit provided for under the France-Italy tax treaty. The Court of Appeals, however, ruled in favour of the taxpayer. It reasoned, in furtherance of the Supreme Court L’Air Liquide ruling, that the imposition of tax on the add-up, which is expressed as a fixed lumpsum percentage of the dividends received, must be qualified as a “modality of assessing the dividends to tax” in France, and not as a recapture of the (deemed) expenses incurred with respect to the participation. Therefore, the Court acknowledged the right of the taxpayer to offset the foreign tax credit against the resulting French tax liability and, consequently struck down the reassessment and associated penalties. The tax authorities have appealed the decision to the Supreme Court, but the latter has not yet addressed it. Instead, the Supreme Court had the opportunity to rule on the same issue in the context of its July 2022 AXA decision (CE 5 July 2022 n° 463021, Société Axa).

The plaintiff in the AXA case requested the annulment of part of the guidelines issued by the tax authorities to the extent they deny the offset of a foreign tax credit where the foreign dividends received benefit from the participation exemption regime. In its ruling, the Supreme Court transposed and further clarified its reasoning in the L’Air Liquide decision by holding that “the 5% add-up, to the extent it exceeds the expenses actually incurred in relation to the participation, must be analyzed as aiming not only to recapture the expenses incurred, but also to subject the dividends received to French tax”. Therefore, the taxpayer is entitled to offset the foreign tax credit against its resulting French tax liability.

Conclusion and Unanswered Questions

The L’Air Liquide and AXA rulings of the Supreme Court as well as the SCS A. Raymond et Cie decision of the Court of Appeals reverse the 1997 Fournier ruling and unequivocally determine that the 5% (or 1% or 12%) add-up must be analyzed -at least for its part exceeding the expenses actually incurred by the taxpayer- as a taxation of the dividends (or capital gains) in France. The immediate consequence of this determination is that foreign tax credits attached to such dividends (or capital gains) cannot simply just be forfeited. Instead, the French recipient must be allowed to offset the foreign tax credit against the French corporate tax liability resulting from the add-up. French resident recipients of dividends or capital gains which were unable to offset attached foreign tax credits against the French tax liability resulting from the add-up can, to the extent the add-up exceeds their actual expenses, contest such assessments and claim the right to offset the foreign tax credit within 3 years (e.g. until 31 December 2022 with respect to income received in 2019).

The convergence of case law towards this conclusion is not surprising and its premises were sown by the Supreme Court in its 2018 rulings (see above). The reasoning adopted by the Court in those rulings to deny taxpayer claims against fixing the add-up at a lumpsum percentage, is the same it used in its subsequent AXA and L’Air Liquide rulings to reject the tax authorities’ position that the add-up is a mere recapture of expenses. The Court had in truth no other alternative and the changing nature of the add-up over the years forced its hands. Originally, the add-up was capped at the amount of actual expenses incurred by the taxpayer so that its qualification as a mere recapture of expenses could plausibly be defended. Over the years, however, the cap was removed (in fact, it never applied with respect to capital gains), the percentages were modified in what seemed to be dictated by pure revenue objectives, and every correlation between the add-up and the actual expenses incurred by the taxpayer was lost. This is exemplified by the different add-up percentages currently in force: how can one plausibly argue that 3 different fixed add-up percentages of 1%, 5% and 12% all represent a reasonable approximation of the same expenses incurred with respect to the participation, so that the add-up must not be seen as anything other than a mere recapture of expenses?

The convergence of case law leaves, nevertheless, one important question unanswered: how much of the foreign tax credit can be offset against which portion of the French tax liability? To illustrate this, assume FRco received a dividend of 100 which suffered a 15% withholding tax in the source country and incurred 2 in expenses. Under the add-up rules, FRco is taxable at 25% in France on an add-up of 5, resulting in a French tax liability of 1.25. The question is whether FRco may now offset the foreign tax credit against the entire tax liability resulting from the add-up, or only against the portion of that tax liability corresponding to the excess of add-up over the actual expenses (being 5-2=3). In the first case, the credit would offset French tax entirely, and in the second case the credit would mitigate French tax only partially (in our example, leaving a final French tax liability of 0.75). This is of course if we assume that the foreign tax credit can be used entirely, which is not assured. Indeed, the tax authorities could argue probably against all reason that since only a small percentage of the dividends is subject to tax in France, only a corresponding percentage of the tax credit should be availed of. It is hoped that the appeal of the SCS A. Raymond et Cie decision to the Supreme Court would give the latter the opportunity to clarify the consequences of its rulings.

Footnotes:

iFull disclosure: Although born in the very vicinity of where Saint Augustine, the father of inter alia the “original sin” doctrine, opened his eyes to the world, I am not a follower of the Christian faith. Therefore, borrowing from its traditions is more an expression of temerity than erudition.