France introduced thin capitalisation rules in the Finance Bill 2006. The rules were codified under article 212 of the French tax code. However, under the Finance Bill 2011 (article 12 of law no 2010-1657 dated 29 December 2010), from 31 December 2010 the scope of the French thin capitalisation rules has been extended to become potentially applicable to all loans, including bank loans.
Originally the French thin capitalisation rules were only applicable to the interest expenses relating to intragroup loans (eg shareholder loans or loans between affiliated companies). The recent extension of the scope of the French thin capitalisation rules could potentially result in a limitation of the tax deductibility of interest owed to a bank including in relation to most structures using a bank financing mechanism such as asset finance, leveraged buyout and other corporate finance structures.
This limitation on the tax deductibility of interest expenses is an issue for the French borrower, as well as for all banks and lenders that have granted or will grant a loan to a French company. Indeed, the non-deductibility of all or a portion of the interest expenses increases the corporate income tax at the level of the French borrower. It can also impact the cash flow capacity of the French borrower and limit the capacity of reimbursement. Consequently, it is now important to consider the application of French thin capitalisation rules to a French borrower.
It is worth noting that the French tax authorities issued draft guidance on the new French thin capitalisation rules on 17 May 2011, which is subject to comments and suggestions until 17 June 2011. Comments included in the present article may therefore need to be updated further when the final guidance is issued by the French tax authorities (expected this summer).
OVERVIEW OF RULES
The French thin capitalisation rules, as defined in article 212 of the French tax code, provide for two limitations on the tax deductibility of interest expenses.
The first limitation relates to the interest rate that shall not exceed the higher of the two following limits:
- the maximum interest rate determined by article 39-1-3 of the French tax code (the maximum interest rate was 3.82% for the fiscal year ending on 31 December 2010); or
- the interest rate that independent banks or financial institutions would have granted on such a loan to a borrower on the same terms.
It should be noted that the first limitation above only applies to intragroup loans and not loans granted by a third party, even if they are guaranteed by a company that is an affiliate of the borrower. The extension of the scope of the French thin capitalisation rules referred to above only applies to the second limitation, detailed below.
The second limitation provides that the interest expenses due by a French company in relation to intragroup loans and, now, also third party loans guaranteed by an affiliated company are not fully tax deductible if the three following ratios are cumulatively exceeded in the relevant fiscal year:
- The debt/equity ratio: the average amount of intragroup loans must not exceed 1.5 times the amount of the net equity (or the amount of share capital if this is a higher amount) of the French company as determined at the beginning or at the end of the fiscal year.
- The earnings ratio: the amount of interest expenses relating to intragroup loans must not exceed 25% of the sum of the earnings before taxes of the French company for the fiscal year plus the interest expenses due to affiliated companies, plus amortisation expenses, plus the portion of lease expenses related to a leasing operation that are taken into account to determine the purchase price at the end of the leasing operation.
- The interest income test: the amount of interest expenses relating to intragroup loans must be less than the amount of interest income received by the company from related entities, determined in accordance with article 39.12 of the French tax code.
If the three ratios described above are cumulatively exceeded, the portion of the interest exceeding the highest of the three above limits will not be tax deductible for the purposes of French corporate income tax. As an exception to the above, if the portion of interest exceeding the highest of the three above limits is equal to or less than €150,000, the interest remains fully tax deductible.
However, it should be noted that the amount of interest that is not tax deductible as a result of the French thin capitalisation rules for one fiscal year can be deducted under the same conditions in subsequent fiscal years after a 5% write-off per year, applicable after the second year.
As a safe harbour provision, the second limitation described above does not apply if the borrowing company demonstrates that the overall debt/equity ratio of the group to which it belongs is higher than, or equal to, its own overall debt/equity ratio. It should be noted that this exception is rarely applicable because of difficulties in determining the overall debt/equity ratio of a group having companies in different countries.
French thin capitalisation rules also apply to companies that are members of a French tax consolidated group. The complex rules and specific adjustments resulting from the tax consolidated regime are, however, not described in this article.
Furthermore, the above thin capitalisation rules, that only applied to intragroup loans in the past, are now applicable to intragroup loans and third party loans (including bank loans) when the reimbursement of such loans is guaranteed by a party who is an affiliate of the borrower.
EXTENSION OF THE SCOPE OF THE RULES FOLLOWING FINANCE BILL 2011
Prior to the Finance Bill 2011 loans granted by third parties (eg banks) were outside the scope of the thin capitalisation rules, even if these loans were guaranteed by a parent, sister or other affiliated company of the borrower.
The Finance Bill 2011 has extended the scope of the French thin capitalisation rules to all loans granted by non-related lenders when these loans are secured by a guarantee given by a company that is a direct or indirect affiliate of the borrower.
Consequently, a bank loan that is guaranteed by a personal guarantee, granted by a company that is an affiliate of the borrower, will be treated as an intragroup loan for the purposes of the ratio described above under the French thin capitalisation rules.
When reviewing the scope of the amended French thin capitalisation rules, the terms 'affiliated company' and 'guarantee' are the key terms to consider and these have been defined by the Finance Bill 2011 to cover most of the situations where a loan granted by a third party is guaranteed by a company that is part of the same economic group.
Affiliated company
The amended thin capitalisation rules refer to paragraph 12 of article 39 of the French tax code for the definition of the term 'affiliated company'. Under this article, a company is considered to be an affiliate when it holds, directly or indirectly, the majority of the share capital of the borrower or has, de facto, the power to control the decisions of the borrower. Companies are also considered as affiliated companies when they are both controlled by the same third company, according to the abovementioned conditions.
Consequently, a bank loan guaranteed by a sister company or a grandparent company may fall within the scope of the amended French thin capitalisation rules.
Guarantees
The scope of the relevant guarantees is also very broad and includes personal guarantees (ie French 'cautionnements' as per article 2288 of the French civil code), the first demand guarantee and all autonomous guarantees as per article 2321 of the French civil code. Real securities, such as pledges, mortgages and all guarantees 'in rem', granted by an affiliated company also fall within the scope of the amended French thin capitalisation rules.
The portion of the loan granted by a third party that must be treated as an intragroup loan for the application of the French thin capitalisation rules is determined by the amount of the guarantee granted by an affiliated company. As far as the real securities are concerned, the portion of the loan treated as an intragroup loan is determined according to the value of the real security at the date when the guarantee is granted by the affiliated company.
In the event of several guarantees by affiliated companies, the portion of the loan that must be assimilated to an intragroup loan is equal to the sum of the guarantees. The draft guidance from the French tax authorities gives the following example: C1, C2 and C3 are three affiliated companies according to article 39-12 of the French tax code and C1 borrows €200,000 from a third party. The debt of C1 is guaranteed as follows: C2 has granted the repayment of the loan for €150,000 and C3 has guaranteed the repayment of the loan for €50,000. In such circumstances, the entire amount of the loan is treated as an intragroup loan for the application of the French thin capitalisation rules.
SOME EXCEPTIONS TO THE EXTENSION OF THE RULES
Notwithstanding the enlargement of the scope of the French thin capitalisation rules, the Finance Bill 2011 includes several exceptions.
Under certain conditions, some loans do not fall within the scope of the amended French thin capitalisation rules, even if they are guaranteed by an affiliated company. These exceptions cover notably:
- bonds issued under a public offer mechanism (article L411-1 of the French monetary and financial code);
- loans contracted for repaying a debt due to a change of control of the borrowing company;
- under specific conditions, loans contracted by the company managing the cash pooling of a group; and
- loans entered into prior to 1 January 2011 in connection with an acquisition of shares.
As another interesting exception, loans guaranteed exclusively by a pledge over the shares of the borrower or by a pledge over amounts payable by the borrower are not subject to the amended French thin capitalisation rules. Draft guidance from the French tax authorities has indicated that the term 'exclusively' refers to other guarantees granted by an affiliated company but does not refer to guarantees granted by the borrower itself on its own assets. According to this exception, a bank can obtain securities granted by the borrower (eg pledge or mortgage on its assets) plus the pledge of shares of the borrower granted by the parent company without triggering the application of the French thin capitalisation rules.
CONCLUSION
The French thin capitalisation issue should now be systematically reviewed when a borrower is negotiating a security package with a lender. This review is also in the interests of the lender, since the non-deductibility of interest can impact the capacity of the borrower to repay the loan to the lender. For project finance operations, the new French thin capitalisation rules should be anticipated in the preparation of the financial model of the French borrowing entity and should be discussed between borrower, lender and sponsor as early as possible.
By Romain Girtanner, tax partner, Watson, Farley & Williams (Paris) LLP. E-mail: rgirtanner@wfw.com.
