TAX NEWS - 2010

France Tax: France issues consultation document on transparency treatment of partnerships

The French tax authorities (FTA) published a draft proposal for consultation on 11 May 2011 that would change the tax treatment of resident and nonresident partnerships so as to recognize the concept of the tax transparency of partnerships.


Current rules

France has adopted a rather unique approach to the tax treatment of partnerships (les societes de personnes), such as SNCs (société en nom collectif), SCs (société civile), Economic Interest Groupings (EIGs), European Economic Interest Groupings (EEIGs) and entities without legal personality, such as sociétés en participation. Unlike most countries, which treat partnerships as transparent, France characterizes them as "translucent," which is something of a cross between entity status and pass-through status. Translucent in this context means that the entity – regardless of whether it has legal personality – is treated as a legal entity and is the tax subject. A translucent entity therefore must keep books and file tax returns (the taxable result is determined at the level of the entity) and is subject to tax audits. Yet, unlike in the case of an ordinary company, which pays its own income tax, the income tax due on the results of a translucent entity is payable by the partners/shareholders on a proportionate basis: they must add their pro rata shares in the result of the entity to their own income and pay tax on the total.

Further complicating the regime is the treatment of foreign partners of French partnerships. For instance, while a nonresident partner of a French partnership (such as an SNC) would be subject to tax in France on its share of the results of the SNC, it would not be deemed to have a permanent establishment (PE) as a result of its interest in the SNC because the SNC, not the partner, is the taxable entity. Further, no branch tax would be due. An SNC, like other French partnerships, is a resident of France even if it does not pay tax. The foreign partner has to pay tax on its share of the profits like any other French partner, and is not protected by France's tax treaties, unless a treaty contains specific provisions to consider the foreign partner of the French partnership to be resident for treaty purposes. A 1997 decision of the French Supreme Court in Société Kingroup Inc. addressed this issue. The Kingroup case involved a Canadian company that did not carry out any activities in France. It was a 33% member of a French EIG called "France Canada Seeds EIG" that operated in France, received royalties and was profitable. Kingroup included in its taxable profits in Canada income from its participation in the EIG, but it did not file a declaration of results in France. The French tax authorities issued a reassessment, which was eventually referred to the Supreme Court. The court ruled that EIGs, which have a (fiscal) personality distinct from that of their members, conduct their own business, and to the extent an EIG operates in France, profits generated in France are taxable in the hands of the members of the EIG, including those established outside France, in proportion to their rights, unless otherwise provided in a tax treaty.

The French approach to foreign partnerships has also proved problematic. The Supreme Court issued a decision in 1999 (Diebold case) in which it disagreed with the FTA's position on the tax treatment of foreign partnerships. The court held that royalties paid by a French company to a Dutch CV (a transparent partnership not subject to tax in the Netherlands) with two Dutch-resident partners could benefit from the withholding tax exemption in the France-Netherlands tax treaty because the entity was legally transparent for Dutch tax purposes and the income was paid directly to the Dutch partners that were subject to Dutch income tax. The FTA had argued that the treaty was not applicable because the Dutch CV (which they regarded as the recipient of the royalties) was not subject to income tax and, therefore, was not a resident of the Netherlands within the meaning of the treaty.

Several years after the Diebold decision, the FTA announced that it was initiating a consultation on potential comprehensive changes to the translucency doctrine. However, when administrative guidance was issued on 29 March 2007, it limited the application of pass-through treatment to French-source passive income (i.e. dividends, interest and royalties) received by a foreign partnership. The guidelines recognize the pass-through nature of a foreign partnership and look through to the partners provided the foreign partnership is deemed to be transparent under the tax law of its country of establishment and the partners qualify as resident of the same country, but only with respect to "outbound" payments of dividends, interest and royalties.

These guidelines, which apply only where a tax treaty does not contain a specific provision relating to partnerships, did not  address other types of income (such as capital gains, real estate income, etc.). (The reason for the limited reform was that itwas necessary to amend certain provisions in the French Tax Code and this required presenting the changes to Parliament.)

Clauses have been included in some of France's newer tax treaties and protocols to guarantee the access of French partnerships to treaty benefits (see, for example, the treaties with Australia, Japan, the U.K. and the U.S.).


Proposed changes

The measures in the draft consultation document would lead to increased – but not full – transparency of partnerships. Certain aspects of the translucency policy would remain intact, such as the obligation for the partnership to compute the taxable result and file a tax return and the imposition of capital gains tax on the sale of shares in a partnership, as is currently the case. The discussion document addresses the treatment of both domestic and foreign partnerships, as was planned under the 2006 consultation.

The basic principle in the draft is that the tax treatment of partnerships would be determined systematically in accordance with the rules applicable to the partners: the corporate income tax rules would apply to the share of profits going to a partner subject to corporate income tax and the individual income tax rules would apply to the share of profits going to an individual partner.

Under current rules, if a company subject to corporate income tax wholly owns a partnership that owns another company subject to corporate income tax, the parent cannot benefit from the participation exemption for dividends, nor can it elect to establish a consolidated tax group, even though dividends distributed by the second tier subsidiary pass through the partnership and are taxed in the hands of the parent company. The proposed reform would allow the partners in a partnership that are subject to corporate income tax to benefit from the participation exemption and the tax consolidation regime.

In an international context, France's territoriality principles would be applied to determine pass-through status, according to whether the partners are corporate entities or individuals, French or foreign. Thus, the results of a partnership would be taxed on worldwide income when the partner is an individual located in France or on the basis of the territoriality principle (i.e. a nonresident is taxable in France only if it has a PE in France) if the partner is a corporation subject to French corporate income tax. Special rules would apply where several partnerships are interposed. In this context, the FTA proposes to make a distinction between "operational" partnerships and passive income/private investment partnerships. In addition, France would not tax foreign flows received by a French partnership benefiting a foreign partner – nonresident partners in such a partnership would be taxable in France only on their income from the partnership constituting a French PE (unless a tax treaty provides otherwise).


Conclusion

The limited introduction of the transparency concept into French domestic doctrine in 2007 was a first small step that allowed France to recognize the pass-through nature of foreign partnerships without requiring that such recognition be provided by a specific clause in a tax treaty in order to grant treaty protection to the partners. This planned second step (or giant leap?) would bring French policy more in line with that in many other countries and with the OECD commentaries, which states that: "where a State disregards a partnership for tax purposes and treats it as fiscally transparent, taxing the partners on their share of the partnership income, the partnership itself is not liable to tax and may not, therefore, be considered to be a resident of that State. In such a case, since the income of the partnership 'flows through' to the partners under the domestic law of that State, the partners are the persons who are liable to tax on that income and are thus the appropriate persons to claim the benefits of the conventions concluded by the States of which they are residents."

Once the consultation period ends (mid-June), the proposed changes will be presented to Parliament.