By Ambroise Brice, Mathieu Gautier and Marie Pierre Hôo
This material has been prepared by professionals in Taj, French tax and legal firm, member of Deloitte Touche Tohmatsu

The French tax authorities (FTA) published guidelines on 31 December 2007 on the thin capitalization rules that were enacted on 1 January 2007.

The 2007 rules introduced an arm's length test for related party financing arrangements. Interest paid to related parties is fully deductible only if the interest rate is an arm's length rate. An interest rate will be deemed to be arm's length if it does not exceed the average annual floating rate applied by banks to two-year loans granted to businesses. If the interest exceeds that rate, the taxpayer will have to demonstrate that the rate complies with arm’s length principle. In its guidelines, the FTA has accepted that companies may demonstrate an arm’s length rate by means other than a credit offer issued by banks, which might prove to be difficult to obtain in practice.

Even if the interest rate is acceptable, however, an interest deduction still may be disallowed if the interest exceeds certain limits. Interest paid to related parties will not be fully deductible if it simultaneously exceeds all of the following thresholds:

Interest is deductible up to the amount corresponding to the highest of the above ratio/thresholds, with the possibility to carry forward the nondeductible amount within certain limits (reduced by 5% each year as from the second year), unless the company can demonstrate that its own total debt-to-share capital ratio does not exceed the worldwide group’s third party debt-to-share capital ratio.

If these cumulative tests are met simultaneously, the interest deduction is limited, although any excess interest may be carried forward.

The guidelines confirm that the debt-to-equity-ratio must be calculated based on the net equity position of the company. However, when its net equity is negative due to accumulation of losses, a company is allowed to calculate its debt-to-equity ratio based on its share capital.

Complex rules applying to tax consolidated groups and cash pooling also are detailed in the guidelines.

It is worth noting that the FTA intends to apply the thin capitalization rules to a French branch of a foreign company, even though this probably conflicts with the terms of the law.

Finally, the guidelines resolve the issue regarding partnerships held by corporate taxpayers. The thin capitalization rules do apply to partnerships which could result in double taxation when a partnership is funded by a corporate taxpayer. In such a case, the guidelines provide that the partner is allowed to restrain from invoicing interest to the partnership.

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