December 26, 2018 - Cara Avocats

Once again this year, statistics from the World Tourism Organization reassure us on one point: France remains the world's leading tourist destination, far ahead of its European competitors and the United States. Travellers from all over the world come to our roads to admire the architectural wonders that embellish our cities, to taste the diversity of our culinary expertise, or more prosaically, to raid the stores on the beautiful avenues to display the products and brands that make up our dynamic economy. In this respect, let there be no doubt: France remains eminently attractive, thanks to all the intangible elements with which it abounds and which set it apart from other destinations.

But what's true for the tourist, is it equally true for the tax expert? Once he's rid himself of his guidebook and camera, the taxman must face the facts: France has a paradox on its hands. It's a paradox that France trains immensely talented engineers; that it bases its success largely on intangible, distinctive and value-bearing elements; but that it doesn't pamper these elements from a tax point of view. At a time when society is going digital and intangible assets are playing a major role in growth plans, it would be a good idea to offer an attractive environment for those who wish to house their industrial property and make it grow without having to pay the taxman's price.

Is the French preferential tax regime applicable to patent assignments and concessions outdated?

Our preferential tax regime is best known by its code number, "39 terdecies", in reference to the article of the French General Tax Code that refers to it. Its name, which smacks of technocracy, reminds us that it was first introduced in 1965 and has undergone only minor modifications since then.

Under this system, transfers or concessions of patents, patentable inventions, manufacturing processes ancillary thereto and plant breeders' certificates are taxed not at the standard rate, but at the rate applicable to long-term capital gains, i.e. 15% for companies subject to corporation tax, or 12.8% for others.

Let's be frank: in our view, the 39 terdecies mechanism suffers from two major pitfalls. First, its rate. Even when reduced, the current 15% rate applied to companies subject to corporation tax remains high, particularly when compared with those adopted by several of our European partners. With their "knowledge development box", the Irish offer a rate of 6.25%. The Dutch have done even better with their "Innovation box regime", breaking the codes and taxing income from the exploitation of patents and other inventions at 5%. Luxembourg has opted for an abatement approach, taxing a mere 20% of income. The UK has set the bar at 10%. Another way of looking at it is to compare the reduced rate of 15% with the standard rate, which is set to rise to 25% by 2022 for all companies subject to corporation tax. When our rate was still 33.33%, the time lag could give the illusion of a truly attractive rate. Now, the 15% rate means that companies lose "only" 10 points, whereas the countries mentioned above have opted for deeper cuts.

The other stumbling block is the scope of the preferential regime. It currently covers only patents and similar inventions. Admittedly, administrative doctrine and the tax judge have intervened on numerous occasions to extend the list of rights concerned and bend the initial text a little. But the regime is confined to inventions, even in the broadest sense of the term. For the time being, software is not covered, although it benefits from certain more favorable amortization mechanisms, but its exploitation is not particularly favored from a tax point of view. Trademarks, methods and processes (especially biological ones) also escape the French preferential regime ⁽²⁾.

For these reasons, we feel it is necessary to revise our preferential treatment system to bring it fully into line with the global economy of the 21st century. The OECD provides us with a unique opportunity to do so, by laying the foundations over the past few years for a model towards which all preferential treatment schemes should henceforth strive.

The OECD has kicked the tax can down the road

Driven by the twin objectives of consistency and substance, the OECD has laid the foundations for a common-sense approach. In Action 5 of its BEPS program ⁽³⁾, the Organization suggests linking the benefit of preferential regimes offered by countries to the performance of "substantial activities". Without having a clear definition of these activities, it would appear that they include research work leading to an invention. In so doing, the OECD seeks to exclude empty shells whose only merit is to legally hold assets without ever having contributed to their development. Favored tax regimes therefore appear to be the counterpart of real activities, having mobilized concrete human, material and financial resources.

This concept is described as the "nexus approach". Without being chauvinistic, we prefer it to the Anglo-Saxon " nexus" approach, which sounds more like a mystical incantation. According to this approach, the OECD explains: "we examine whether the IP regime makes its benefits dependent on the importance of the research and development activities of the taxpayers who benefit from it. It is inspired by the basic principle that governs R&D credits and similar inbound tax regimes that apply to expenses incurred in the creation of IP. [...] The nexus approach extends this principle to apply on exit to tax regimes that apply to income earned after the IP has been created and exploited" ⁽⁴).

It is interesting to note that the linkage approach is unrelated to the tax rate applied under the preferential regime. Some countries, like our European neighbors, have already modified their domestic regulations to incorporate the nexus approach, while offering very low tax rates. It is therefore essential to make it clear that the OECD's work is not aimed at eliminating tax competition, but simply at rationalizing and structuring it.

In the future, our preferential treatment system will be in line with the OECD recommendations, but could go even further.

In its work on Action 5 of the BEPS program, the OECD set out to analyze the preferential tax regimes of member countries and of the "inclusive framework", in order to detect whether they incorporated the linkage approach. Surprisingly, France has been downgraded. Not that our 39 terdecies regime really contributes to the "harmful tax practices" tracked by the Organization. But its current wording makes no reference to the said substantial activities carried out on our territory, nor does it correlate the reduced rate with the commitment to R&D expenditure.

It was therefore imperative to amend the text of Article 39 terdecies. Seized of the subject, the French National Assembly mandated Bercy's Tax Legislation Directorate, which then launched a public consultation from April 24 to May 25, 2018 on corporate tax reform. Among the subjects studied, the tax regime for intellectual property was at the top of the list.

Immediately, the "DLF" postulates. The reform that will soon see the light of day in the 2019 Finance Act will have to proportion the income benefiting from the reduced tax rate to the level of R&D expenditure carried out. The "link" approach will therefore be enshrined in French law. However, the main purpose of the consultation was to analyze the appropriateness of using the additional room for maneuver provided by the OECD.

This is where the initiative disappoints. There is no reference to a revisited reduced rate, more in line with the practices of our partners. While it is certainly utopian to imagine that our face rate will ever be low, we could have dreamt that it would show a real break with the future common law rate of 25%, if only to create the appearance of attractiveness.

However, several other avenues were being explored to maintain the scheme's efficiency and strengthen its role in supporting business innovation. The DLF puts forward three distinct options. We would have liked them to be complementary.

The first option is to extend the scope of assets eligible for the reduced rate. The new regime could apply to income from the use of software recognized and protected by the French Intellectual Property Code. Option 2 suggests incorporating the notion of notional income. At present, the preferential regime only applies in cases where the invention is transferred or made available. When the patent is simply exploited by the company that originated it, it does not benefit from any preferential treatment. To provide greater support for innovation by companies (especially SMEs), reduced taxation could then be applied to a proportion of the selling price of goods and services corresponding to the value added by the patented innovation. Finally, under Option 3, taxpayers could claim the reduced rate for capital gains on the sale of patents, even within groups.

Admittedly, these options demonstrate a clear willingness on the part of the government to revisit our preferential treatment scheme, going beyond simple refurbishments. Even so, it's hard to resist a touch of pessimism. The reforms envisaged could have gone further, drawing on the work of the OECD, feedback from the business world and feedback from neighboring countries.

At the time of writing, the Government had registered the draft law with the French National Assembly on September 24. It has to be said that, for the time being, it contains very timid advances, and confines itself to transposing the link approach, in addition to extending the regime to software (Option 1 above). This bill, as its name suggests, may still undergo major changes before its final version. So let's try to remain positive. We'll know in the next few months whether France is destined to remain a tourist destination, or whether it is on the way to becoming a tax haven as well.

(article published in Les Nouvelles Fiscales Lamy, n°1233, December 1, 2018 ¹ )

(1) Courtesy of Ms. Sabine Dubost, Head of the Tax and Corporate Law collection.
(2) Bofip n° BOI-BIC-PVMV-20-20-20-20140414, updated April 14, 2014.
(3) Fighting harmful tax practices more effectively, taking into account transparency and substance, final report published in October 2015.
(4) OECD, Final Report on Action 5, 2015, §28, page 28.

Rarely has the taxpayer been accustomed to such a succession of texts in such close succession. After the 2018 Finance Act had profoundly reshaped the transfer pricing documentary obligation contained in Article L13 AA of the French Tax Procedure Book ⁽²⁾, the Executive published a decree on June 29, 2018 aimed at clarifying many of its provisions ⁽³⁾. In the wake of this, visibly little slowed by summer absences, the administration quickly updated its tax doctrine ⁽⁴⁾. In its zeal, it is interesting to note that it overrode its previous doctrine, which was still applicable to fiscal years opened up to December 31, 2017 and therefore still open to audit.

Transfer pricing: a key target for tax authorities

Let's dispel any doubts: the enthusiasm with which the legislator, the executive and the administration have created and then clarified this documentary obligation, resounds loud and clear as an unequivocal determination to make transfer pricing a priority in future tax audits. Admittedly, the subject was already high on the tax inspectors' shopping list, when, on the occasion of their first visit, they set out the focus of their audits. However, the combined involvement of the various authorities and the speed with which the texts have been published show that the administration expects taxpayers to be able to produce exhaustive documentation for financial years starting on or after January 1, 2018.

Perhaps this overzealousness is a continuation of the work of the Director of the OECD's Centre for Tax Policy and Administration, who initiated the BEPS program and who, it should be remembered, came from the Tax Legislation Directorate. The fact remains that transfer pricing documentation will now be undeniably more time-consuming than it was, and will require efforts and resources for which many companies are not yet prepared.

Doesn't doctrine overstep its role?

It is worth pointing out that the legal literature provides a number of welcome examples in certain sections, which had previously seemed very cryptic. In this sense, the Bofip fulfills its role perfectly, providing much-needed clarification of the provisions set out in the 2018 Finance Act. It remains to be hoped, however, that the other countries that have transposed Action 13 share these same definitions.

And therein lies the rub. As the new article L13 AA of the LPF is based on the OECD model ⁽⁵⁾, French administrative doctrine runs the risk of reformatting, through its numerous clarifications and suggestions for presentation, the spirit that initially inspired the Committee on Fiscal Affairs. Indeed, who can say that the sequence of information now described in the Bofip corresponds to what other countries that have adopted Action 13 of the BEPS plan, sometimes even before France, intend to require of their taxpayers?

Finally, the Bofip attempts to include a few additional items of information that are not included in the law. Such is the case of the "description of the competitive environment" ⁽⁶ ) which, although included in the OECD model, had been dropped from the new version of article L13 AA. The aim was undoubtedly to rectify an unfortunate omission, induced by the hasty preparation of the text of the law. Nonetheless, in doing so, the administrative doctrine is adding to the law, something it is legally prohibited from doing.

The OECD principles integrate the hierarchy of standards

This point will delight those in the legal profession who, along with economists, claim a link with transfer pricing. It is interesting to note that the Bofip makes several express references to the OECD principles.

Until now, administrative doctrine has only cited the OECD principles to clarify the notion of arm's length towards which all intra-group transactions must imperatively aim. Now, the doctrine confirms that the law has been directly borrowed from the work of the OECD. What's more, it confirms that the documentary insights provided by the OECD are just as useful in understanding the underlying principles of article L13 AA. In this way, it can now be asserted without blinking that the OECD principles now occupy a real place in the hierarchy of French standards. This place, which one might be tempted to place at the level of doctrine, would therefore legally allow the guiding principles to be set against the tax authorities, without the latter being able to add to or contravene the law or decrees.

The fantasy of automation

A careful reading of the Bofip (and the decree before it) reveals the level of detail now expected from tax authorities. Documentation, which should have become standardized thanks to the OECD, now takes on an unprecedented dimension in France. What's more, the documentation will have to be regularly updated, and the work will have to be constantly put back on the drawing board.

In this environment, IT tools are emerging to automate and standardize the drafting of Master and Local Files, and to update them regularly. Let's face it: the nature of the information required in these documents, as well as its source and the ability to articulate it, should challenge companies about the realistic options open to them. For the time being, we doubt that a robot can take the place of an expert capable of asking the right questions, gathering information and digesting it intelligently, so as not only to complete the new documentation, but also to avoid putting the company at fault on certain subjects.

Of course, Bofip suggests presenting certain sections in tabular form. This is a commendable proposal, and attempts to lighten the already heavy burden of documentation. However, the matrix presentation of information in no way detracts from the subtlety required to retrieve data and process it efficiently. Indeed, information is very rarely available in its current state, so that a data vacuum cleaner, even one powered by artificial intelligence, cannot replace the functional interviews and the ability to discern the useful from the dangerous that only human analysis can still provide.

Finally, transfer pricing documentation is the opposite of a commodity product. The Master File is intended to circulate among the tax authorities of all countries of establishment, and is the most comprehensive and universal tax profile ever produced. The new dimension embodied by documentation, and the strategic and financial stakes involved, call for the utmost caution. Against the backdrop of automation and digitalization, we believe that the documentation exercise as newly described in the Bofip requires more than ever a personalized approach.

How to manage transfer pricing documentation efficiently

The proportions that the new transfer pricing documentation has taken on should encourage companies to anticipate the preparation of the Master and Local File. It is a fact that this new obligation will add to the already heavy burden of documentary and declaratory constraints on taxpayers.

In practice, we suggest mobilizing in-house resources to conduct interviews, compile information, digest it and cross-reference it with contracts and financial statements. These people will also have to ensure that reports are filed or sent on time, according to the (often different) schedules adopted by the group's countries of establishment.

If preparation is outsourced to external firms, the challenge for them will be to offer quality assistance, controlling budgets in relation to the documentary work done previously, despite the real additional workload induced by this new vintage.

The fact remains, however, that in its bulimic doctrine, the French tax authorities have laid the foundations for extremely comprehensive documentation, perhaps even the most exhaustive in the world. Taxpayers can rest assured that if they are able to produce documentation for French purposes, it will be much easier for them to replicate it for other countries of establishment.

(published in Les Nouvelles Fiscales Lamy, n°1229, October 1, 2018 ¹

(1)Courtesy of Ms. Sabine Dubost, Head of the Droit fiscal et Sociétés collection.
(2) Law 2017-1837 of December 30, 2017, art. 107.
(3) Decree 2018-554 of June 29, 2018.
(4) BOI-BIC-BASE-80-10-40-20180718, published July 18, 2018.
(5) OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2017.
(6) BOI-BIC-BASE-80-10-40-20180718, § 340.

Day: December 26, 2018

A French paradox: patent taxation lacks inventiveness