France’s current thin capitalisation rules have often been perceived as insufficient and indeed the Conseil d’Etat (France’s highest administrative court) has found that France’s controlled foreign corporation rules are contradictory to both EU Law and international tax treaties.

This has historically meant that multi-national corporations have found it comparatively easy to extract pre-tax profits from France by way of interest payments. Furthermore, much of the legislation currently in place has been perceived as ineffective and ambiguous leaving to many drawn-out arguments between tax authorities and companies.

One and perhaps the most important purposes of France’s Finance Bill for 2006 is to introduce stricter rules relating to thin capitalisation. These rules will take effect as of 1 January 2007.

The new rules have been extended to the interest paid to all related parties (companies controlling a borrower or under common control with it, directly or indirectly) not only to companies having direct control over the borrower.

In short, the deduction of interest paid as from 2007 to related parties has to pass both an interest rate test and a leverage test:

Interest rate test : The deduction of interest paid to related parties will be limited to an amount of interest computed by reference to:

1- the annual average interest rate granted by banks to business borrowers for medium-term loans (two years or more). This was 4,21% in 2005, or

2- a higher rate if the French debtor can demonstrate that it is a higher market rate, e.g. an interest rate that the companies might have obtained from an independent bank under similar circumstances.

Leverage test : Once a company has passed the interest rate test it must also satisfy at least one of the following three conditions to avoid being considered as under-capitalized (but see below as to consequences)

1- the intercompany loan must not exceed 1.5 times the net worth of the borrowing company (this ratio is computed by taking into account related-party debt only);

2- interest must not exceed 25 percent of an adjusted operating profit, which is the operating profit before tax, before related-party interest, before depreciation and amortization, and before certain specific lease payments;

3- interest paid to related parties must not exceed that received from related parties.

Where a company does not pass the leverage test, interest remains deductible but only up to the highest of the three limits above.

In addition, interest relating to the amount exceeding the highest of these three limits is however tax deductible if (i) the amount is less than 150,000 Euros, or (ii) the company can demonstrate that the debt/equity ratio of the group to which it belongs exceeds its own debt/equity ratio.

There are a number of qualifications to the rules. Namely, the limitation does not apply to interest payable to authorised banks, credit institutions and certain leasing enterprises or to interest payable to some cash pooling arrangements by the enterprise in charge of that arrangement also to interest payable in connection with the financing of certain leasing operations. Most importantly, they do not apply to loans from a third party (such as a third party bank).

Lastly, even if the company fails the new thin cap test in a given year (N), it will be possible to allocate the non-deductible portion of the interest for year N to the results of later years (i) if (and only to the extent that) in those years the company complies with the limits of the new rules and (ii) subject to a deduction of 5% per annum.