October 8, 2024 - Cara Avocats

THE FACTS

Following an audit of the accounts of Sumitomo Chemicals Europe (SCAE), the tax authorities considered that the intra-group transactions in which the company was involved did not comply with the arm's length principle. The advantages thus granted were classically qualified as "deemed distributed income", which, in view of the applicable tax treaties, gives rise to a withholding tax. Insofar as the company obviously failed to declare this withholding tax, the existence of which only came to light following the rectification, the penalty provided for in article 1728 of the CGI.

THE RULE

As a reminder, when the tax authorities make an adjustment under Article 57 of the CGI, they consider that an indirect profit transfer has taken place, which must then be treated in the same way as dividend distributions. A withholding tax is then levied, in addition to corporate income tax, the rate of which is calculated by reference to the tax treaty applicable to the case in question. This is a collateral consequence of transfer pricing rectifications, which has been validated on numerous occasions by the tax judge, and which we will not discuss here.
The penalty referred to in article 1728 of the CGI penalizes failure to file within the prescribed time limit a declaration or document indicating the elements to be retained for the assessment or liquidation of tax. This penalty, expressed as a percentage of the amount of duty payable by the taxpayer or resulting from the late filing of the return or deed, is equal to 10% in the absence of formal notice, which is the case following an adjustment highlighting income deemed to have been distributed.

THE JUDGES' POSITION

In 2021, the Lyon TAA ruled in recital 20 that "By merely pointing out the non-voluntary nature of this omission and its right to make a mistake, the applicant company is not contesting the validity of the penalties imposed on it on the basis of the aforementioned provisions". In many cases, however, the taxpayer is not claiming good faith or the right to make a mistake, nor is he asking for the penalties to be reduced, which the tax judge has always refused to do. On the contrary, it is a question of the relevance of an automatic penalty, linked to an offence whose existence and quantum the taxpayer cannot know prior to the rectifications.
The CAA persists, however, and considers that "the aforementioned provisions proportion the increase to the taxpayer's actions by providing that its amount is set as a percentage of the duties evaded. Moreover, it is clear from the provisions of article 1728 that the rates of increase applied vary according to whether the failure to declare within the time limit was noted without formal notice to the interested party or after one or two unsuccessful formal notices, so that the law itself has thus ensured, to a certain extent, the modulation of penalties according to the seriousness of the penalized behaviors. It follows that the argument based on the automatic nature of the application of a 10% surcharge can only be rejected".

OUR ANALYSIS

A PENALTY IMPOSSIBLE TO PREDICT IN PRINCIPLE...

Insofar as the penalty under article 1728 of the CGI is applied automatically, in a situation where the taxpayer is unable to comply with it, it exceeds in our view the objective that this article is supposed to pursue, and therefore creates an error in the assessment of the legal basis.
It seems to us that the tax merits of an automatic penalty should be reconsidered, since it sanctions behavior that is not only involuntary on the part of the taxpayer, but above all unavoidable, given that the taxpayer can be unaware of either the existence or the amount of the withholding tax to be declared.
In fact, this penalty affects the withholding tax, which is itself a collateral consequence of a main corporate tax adjustment, and whose existence and quantum are only known at the end of the
audit procedure:
On the temporal aspect on the one hand: this withholding tax arising from the indirect transfer of profit can logically only be known to the taxpayer at the end of the tax audit, i.e. after the administration has considered that an indirect transfer of profit has taken place. It is therefore materially impossible for the taxpayer to produce the withholding tax within the time allotted to him, since the event giving rise to the withholding tax is then unknown to him. In the case in point, the French tax authorities brought to light the existence of the withholding tax in its proposed rectification of August 4, 2014, i.e. for the 2010 tax year, 44 months after the deemed taxable event; and 32 months after the taxable event for the 2011 tax year. In order to comply with article 1728 of the CGI, the taxpayer should theoretically have declared the transfer of profits before the fifteenth day following the month of the transfer, i.e. before January 15, 2011 for 2010 and before January 15, 2012 for 2011.

NOR IN ITS QUANTUM!

Secondly, in terms of quantum: the penalty is expressed as a percentage of the withholding tax, itself calculated by reference to transfer pricing adjustments.
More precisely, this withholding tax is applied to the basic adjustment made under article 57 of the CGI, which is then qualified as deemed distributed income. However, transfer pricing is a subjective discipline, the limits of which are not clearly defined. Whether we are talking about transactions falling within the scope of transfer pricing, or the calibration of deemed profit transfers, the taxpayer cannot rationally know in advance the exact amount of an indirect profit transfer, and hence the theoretical amount of withholding tax he should have declared.

BENCHMARKS FOR ALL?

Finally, we would like to remind you that tax penalties, which are synonymous with sanctions, are intended to punish the taxpayer's behavior. This is the very essence of the difference with interest on arrears, which is intended to compensate for financial loss. The case law of the Conseil d'Etat is clear on this point, underlining a contrario the intrinsic link between tax penalties and the taxpayer's behavior. However, in our case, the taxpayer's behavior can in no way be voluntary, nor can it be modifiable or anticipated. In this respect, we believe that article 1728 of the CGI cannot be applied in such cases, as its provisions should be limited to cases where the taxpayer is aware of the obligations incumbent upon him.
Maintaining the sanctions of article 1728 would mean removing their status as tax penalties, and turning them into real taxes. In effect, these penalties would be dissociated from conduct, which constitutes the intrinsic element for falling within the scope of tax penalties, but would in reality automatically apply a rate (in this case 10%) to a base (the deemed transfer of profit), just like a tax.

In recent years, article 39-1-3 of the French General Tax Code has become one of the best-known tax provisions. Like a kind of code, a digital password reserved for a community apart. We no longer speak of the deductible interest rate. We say "the 39-1-3 rate". Take the test and you'll be able to spot the tax experts in the audience.

As a reminder, this text, as incongruous and anti-economic as it may be, specifies that "interest paid to partners on sums they leave or make available to the company, in addition to their share of the capital, whatever the form of the company, [is deductible] up to the limit of that calculated at a rate equal to the annual average of the average effective rates charged by credit institutions and finance companies for variable-rate loans to companies, with an initial term of more than two years".

Incongruous, because it is a French speciality, a secret of Bercy's, and adds to an already long list of measures designed to restrict companies' financial burdens.

Anti-economic, as it forces companies to limit the tax deductibility of the interest they pay to minority (or even very minority) shareholders, whereas an exception is made for shareholders holding more than a majority of the debtor's share capital, thanks to the alternative provided for in Article 212-I. In practice, this can lead to companies having taken out a loan, or having issued bonds to third-party banking institutions, and which, as is often the case, acquire a stake in the said company in order to follow its development. Consider the paradox: the BPI, which contributes to the growth of our economy, very often holds minority shares in the capital of the companies it supports. These same companies will therefore not be able to deduct all the financial interest they pay it, since the interest rates charged to them when they are starting up, or for the bonds they issue, are statistically well above the rate of the famous article 39-1-3.

But if these minority shareholders are located in a country other than France, can the provisions of Article 39-1-3 of the CGI withstand the arm's length principle referred to in Article 9 of the OECD Model Tax Convention? The arm's length principle may in fact offer a radically different rate, since it reflects market conditions and what independent companies in a similar situation would have negotiated with each other.

If we consider for a moment, the limitation provided for in this article 39-1-3 contradicts article 9 of the model, which is found in all the treaties signed by France, and which allows an alternative rate to be applied. The principles of subsidiarity and the primacy of treaties would then have to play their role, dear to the minds of tax law theorists, and thus give precedence to the possibility for related parties to demonstrate the correctness of the rate they have actually applied.

In many conventions, Article 9§1 refers to the case of "an enterprise of a Contracting State [which] participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State". However, direct or indirect participation in the management or capital does not require a majority shareholding. If we leave it at that, the arm's length principle could therefore be applied to any partner who, by nature, "participates in the capital". But since every good tax expert is a potential paranoid, let's go a step further and take a moment to consider the notion of "control", which seems more ambiguous. It has to be said that the OECD's definition of this notion is as grey as the concrete of the château de la Muette that houses its services.

The OECD comments state that "Two enterprises are associated if one of them fulfils the conditions set out in Article 9 paragraphs 1a) or 1b) of the OECD Model Tax Convention in relation to the other enterprise".

The comments on Article 9 of the Model Convention state that "the Committee has devoted considerable time and effort (and continues to do so) to studying the conditions of application of this article, the consequences of such application, and the methodologies applicable for the adjustment of profits when transactions have been concluded under conditions other than at arm's length. The conclusions of this study are described in the report entitled "Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations", which is periodically updated to take account of developments in the Committee's work on this issue. This report represents internationally accepted principles and provides guidelines for applying the arm's length principle, of which Article 9 is the authoritative statement".

So let's continue the treasure hunt and refer to the OECD guidelines, which reproduce the same definition as the comments under the model convention.

It therefore appears that the notion of control, which is key to the applicability of the arm's length principle, is not explicitly or formally defined by international law standards. As nature abhors a vacuum, it is best to refer to the domestic law of each State.

In our case, Article 39-12 of the French General Tax Code stipulates that "two companies are deemed to be dependent on each other when: (a) one of them directly or through an intermediary holds the majority of the share capital of the other, or in fact exercises decision-making power over it; (b) both of them are placed, under the conditions defined in (a), under the control of the same third party". From the point of view of French positive law, therefore, control seems to be assessed from the angle of majority (of capital or of decision-making power).
Would this have led to a dead end, leaving the taxpayer to face the cold injustice of article 39-1-3? Well, perhaps not for long. On September 12, 2023, the European Commission unveiled two draft Directives, on the "BEFIT" initiative and on the harmonization of transfer pricing rules within the EU. The second draft directive aims to simplify the applicable rules and reduce the risk of double taxation, by incorporating the arm's length principle into EU law. One of the ways in which tax certainty could be strengthened is by harmonizing the main transfer pricing rules, creating the possibility for the Commission to establish common rules on specific subjects within the Union.

In order to define an associated undertaking, Article 5 of the draft Directive proposes a minimum threshold of 25% of an entity's voting rights, capital or profits, in order to establish a relationship of dependence. Transposition of the Directive as it stands would therefore automatically and necessarily lead to minority shareholders being able to rely on the arm's length principle, and thus defeat the provisions of Article 39-1-3 of the CGI, which, by freezing an interest rate, contradicts the alternative offered by international law, and more specifically Article 9 of the Model Tax Convention. The constraints currently imposed on minority shareholders by the provisions of article 39-1-3 of the CGI would therefore be lifted for certain shareholders only, who on the one hand hold at least 25% of the share capital, either directly or indirectly, or who are placed under a common entity exceeding this threshold; and on the other hand, who are resident in a country other than France.

However, our positive law would create a double discrimination, by keeping under the yoke of Article 39-1-3 ultra-minority partners, holding less than 25% of the debtor company's capital, and partners established in France. For the latter, reverse discrimination has already accustomed us to treating purely domestic operations less favourably.

For foreign partners holding less than 25%, the taxman will tell you: you always need someone smaller than you.

Day: October 8, 2024

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