French Thin Cap Reform — As of January 1, 2012, French Holding Companies Will Have to Demonstrate That Their Decisions Are Made in France

December 22, 2011

According to a reform applicable as of January 1, 2012, the right to deduct interest due with respect to the purchase of shares in French target companies will be denied, unless the French acquiring company demonstrates — by any means — that (i) the decisions relating to such shares and (ii) the control over the target companies are effectively made by it or by a related party established in France.

For the purpose of this reform, a related party can be a controlling company or an entity controlled by or under common control with the acquiring company.  

This new rule targets the purchase of shareholdings that are eligible for the French long-term participation exemption regime, i.e. mainly shares that represent at least 5% of the financial and voting rights of companies (other than certain real estate property companies).   

If the owner of the shareholdings cannot demonstrate that "the decisions relating to such shares have been made by an entity established in France," the non-deductible portion of the interest borne by the borrower will be calculated as follows (for each financial year until the eighth year following the acquisition):  

Amount of interest due by the French acquiring company x purchase price of the shares
Average indebtedness of the company 

This new rule will apply to financial years (i) open as of the date of acquisition of new shareholdings or, for shareholdings acquired prior to January 1, 2012 (ii) to financial years open as of January 1, 2012. In practice, shareholdings acquired prior to 2004 would not fall in the scope of the new regulation. 

By way of exception, this new rule will not apply to shares held in subsidiaries whose value is less than one million euros. Nor will it be applicable if the holding company can demonstrate that the shares have not been financed through a new loan or if its group indebtedness ratio exceeds its own indebtedness ratio.         

In practice, any time a French company is interposed to buy another company (or takes a 5% or more shareholding in such a company), regardless of whether the target company is French, the French company will have to demonstrate that the decisions relating to the investment are made in France by the purchaser of such shares (or by a related party). As a result of this reform, many LBO transaction structures could be impacted, especially those led by foreign private equity investment funds.  

Unfortunately, the concept of "decisions or control effectively exercised by an entity established in France" is vague and can lead to opposing interpretations among the French tax authorities, the taxpayer and the courts insofar as these interpretations will mostly be based on the discussion of factual evidence.

In that respect, the preamble explaining the purpose of the reform confirms that the holding company will have to (i) establish the "reality of its decision process" in France and (ii) demonstrate that it constitutes a French autonomous decision center for the purpose of managing its shareholdings.

In practice, such a decision center should be deemed to exist in France if the holding’s level of substance fulfills the general criteria used to identify a permanent establishment (i.e. presence of premises, equipment and staff in France and activities of the decision center not limited to ancillary activities).

At a time when the ECJ has confirmed the importance of the freedom of establishment in the context of the transfer of a EU company’s place of management[1], one may wonder if the reform is compatible with such freedom.

Indeed, this reform allows French holding companies to deduct interest, notwithstanding the fact that the control of the target company is, in fact, exercised by an EU grand-parent company, provided that the latter is established in France. But if the EU grand-parent controlling company is not established in France, the French holding company is denied an interest deduction. It is interesting to note that the French Supreme Court has already sanctioned similar thin-cap restrictions under its landmark 2003 Coreal Gestion decision, where French subsidiaries were being discriminated when owned by non-French holding companies.

Nonetheless, passive holding companies controlled by non-French investors are encouraged to significantly improve their substance in France to meet these new requirements.  

[1]   See Decision "National Grid Indus BV", ECJ 29.11.2011 Case C-371/10 whereby the ECJ has held that (i) if EU law does not in principle preclude the charging of tax on unrealized capital gains relating to the assets of a company when it transfers its place of management to another Member State, (ii) immediate recovery of the tax at the time when the company transfers its place of management, without the company being given the possibility of deferred payment of the tax, is not compatible with EU law.

Gibson, Dunn & Crutcher LLP

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn lawyer with whom you work or any of the following:

Jérôme Delaurière – Paris (+33 1 56 43 13 00, [email protected])
Ariel Harroch
– Paris (+33 1 56 43 13 00, [email protected])
Nicholas Aleksander – London (+44 20 7071 4232, [email protected])
Hans Martin Schmid – Munich (+49 89 189 33 110, [email protected])
Jeffrey M. Trinklein 
– New York (+1 212-351-2344, [email protected])

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