Upcoming litigation after French ruling on a state’s right to tax
Sandra Louiset of DS Avocats reports that the Council of State has taken a novel position regarding a state’s right to tax.
The Council of State (Conseil D’Etat, or CE) has departed from the position adopted in the United States and ruled that capital gains that result from the sale of shares must be regarded as social rights and are therefore taxable in the state of residence of the transferor.
If we can be satisfied that the French high assembly has made a decision, the difference in treatment between the two jurisdictions remains, which may generate many disputes in the future.
Summary of the case
The details of the relevant case (CE 9e-10e ch.2-2-2022, No. 443154) are as follows.
A French resident who sold the shares he held in a partnership governed by American law considered that the transfer of the shares of this entity that operates in the United States should be regarded as the transfer of a permanent establishment. The gain generated by the sale was therefore taxable in the United States under Article 13-3 of the Franco–American tax treaty of August 31 1994.
The tax authorities considered that the transfer was analysed as a gain from the transfer of social rights taxable in the state of residence of the transferor in accordance with Article 13-6 of the agreement.
French judges recall the method to be adopted
In line with the ARTEMIS decision of 2014, the CE returned to the purpose of tax treaties, which is to distribute the right to tax; in particular, by category of income.
After this reminder, the judges recalled that it is necessary to determine whether a state (in this case, France) has the right to tax.
In the event that the right to tax belongs to France, the income will be taxed in accordance with the rules of this state.
In order to apply the appropriate article, the nature of the income still had to be certain.
The need to determine the nature of the income
The seller considered that the gains from the sale of the shares of the partnership operating in the United States had to be regarded as gains from the sale of all or part of a permanent establishment.
The principle of tax transparency applicable to income from the entity would have been, according to a broad interpretation, also applicable to the sale of the equity ownership held in the entity.
Article 7-§4 of the Tax Convention stipulates "a member of a partnership is considered to have earned income or benefited from deductions commensurate to their share in the partnership as provided for in the partnership agreement… The character – including the source and the imputability to a permanent establishment – of any element of income or of any deduction attributable to such a partner is determined as if the partner had realised these elements of income or benefited from these deductions from the same way as partnership.”
As mentioned above, it is a question here of defining who has the right to tax the income derived from the operation of a partnership under American law.
In this context, the principle of transparency that can be implemented leads to the taxation of income directly in the hands of the partner as if they were their own entity, while operating the partnership.
Sale of partnership shares: Sale of the permanent establishment?
Article 13-3 of the convention provides that "gains from the alienation of movable property which forms part of a permanent establishment or a fixed base which an enterprise or a resident of a Contracting State has in the other Contracting State, including such gains from the alienation of such permanent establishment or fixed base, may be taxed in that other State.”
By a combination of Article 13-3 with the provisions of Article 7 of the agreement, the taxpayer considered that he exercises in partnership via a permanent establishment emanation of his person locally.
Thus, when he sells his shares in the entity, he would be regarded as selling the permanent establishment or selling part of the assets of the partnership.
Indeed, Article 13-3a) deals with the case of the alienation of movable property forming part of the assets of the permanent establishment and also of the gains resulting from the alienation of the permanent establishment itself (“including such gains from the alienation of such permanent establishment”).
It may be regretted that the question of the existence of a permanent establishment has not been judged on the merits here.
Nevertheless, one can understand the temptation of the transferor to consider that the transfer of his rights in the partnership may fall into this category.
Without commenting on the complex subject of the existence of a permanent establishment, the solution could be to consider the transfer of shares as a transfer of part of the assets of the partnership.
The French judges will not decide on this point on the merits.
The question nevertheless seemed interesting and amounted to considering – in our view, in a less far-fetched way – that the shares of the partnership constituted elements of the assets allocated to the professional activity of the partner who exercises his professional activity within the partnership.
Without carrying out a detailed legal analysis of the nature of what is transferred, the judges ruled out the application of paragraph 3 on this basis, specifying, however, that the transferor only owned 25% of the partnership.
This reference to the conditions provided for in Article 151 nonies of the French General Tax Code could suggest that in the event of compliance with the criteria detailed in this article, the reasoning of the judges could be different.
The question would then arise of the effective exercise of the professional activity possible on the other side of the Atlantic unless the conditions under which the partner exercises their professional activity in the partnership are demonstrated.
On this point, Public Rapporteur Emilie Bokdam-Tognetti, in her conclusions under the decision, stated that the fact that "the shares held in a partnership comparable to a partnership are considered as elements of the professional assets of the taxpayer does not seem to us to have an impact on the application of Article 13 of the Franco-American Convention”.
The French code makes no reference to the notion of professional property within the meaning of French law.
The analysis carried out by the Public Rapporteur thus seems to close the way to any attempt at an extensive interpretation of Article 13-3 of the agreement.
By analogy with the reasoning used in French domestic law, a person who sells the shares of an American partnership is regarded as selling part of their assets.
The related gain is therefore a gain from the sale of corporate rights and falls under Article 13-6 of the agreement, which gives the right to tax in the country of residence of the partner.
The analysis grid implemented by the state of residence of the partner may generate conflicts with the reasoning of the Internal Revenue Service (IRS), the conclusions of which are different.
The risk of double taxation
The solution adopted by the French judges, in deciding on the right to tax, is in accordance with the French doctrine that specifies that "the transfer of his rights in a partnership by a resident of one of the Contracting States is analysed as a transfer of shares taxable in the State of residence, in accordance with paragraph 6 of Article 13 of the Convention. It follows that the transfer of such rights by a resident of France is taxable in France in accordance with the provisions of the applicable domestic law” (BOI-INT-CVB-USA-10-20-30, No. 1).
However, it again highlights the differences in interpretation between the two tax authorities regarding the transfer of rights in a partnership.
For the American authorities, similar to what the transferor was defending in the above case, the transfer of shares is assimilated to a transfer of part of the assets of the partnership, given that the partnership is totally transparent for tax purposes.
For the IRS, if assets are assigned to the pursuit of a commercial or industrial activity within the framework of a permanent establishment, the ‘outgoing’ partner will be considered as ceding part of this permanent establishment in proportion to their rights in the partnership.
The right to tax the capital gain made by a resident of France belongs to the United States on the basis of the stipulations of Article 13 § 3.a) of the Franco–American convention.
More generally, the US tax authorities consider that the capital gain or loss of a partner of a non-resident US partnership, which has a local activity, is of US source.
The sale of the shares falls under the provisions governing the sale of assets of permanent establishments taxable in the United States in accordance with the provisions of the Internal Revenue Code (IRC), namely that “in the case of a nonresident alien individual or a foreign corporation engaged in trade or business within the United States during the taxable year, the rules set forth in paragraphs (2), (3), (4), (6), (7), and (8) shall apply in determining the income, gain, or loss which shall be treated as effectively connected with the conduct of a trade or business within the United States” (Article 864 c) 1 A).
Also, “except as provided in paragraph (6), (7), or (8) or in section 871(d) or sections 882(d) and (e), in the case of a nonresident alien individual or a foreign corporation not engaged in trade or business within the United States during the taxable year, no income, gain, or loss shall be treated as effectively connected with the conduct of a trade or business within the United States” (Article 864 c 1 B).
Summary and opinion
The analysis of the nature of the gain and the application of the resulting contractual stipulations are different from those carried out by the French tax department and national judges.
From their perspective, the transfer represents a capital gain taxed exclusively in the state of residence of the transferor.
The subject could be closed if the divergence of interpretation did not lead to the generation of double taxation, the elimination of which can sometimes be long, complex, and costly.
An agreement between the states would, in the author’s view, be more effective.
It would save the commitment of an amicable procedure in which the processing time and conclusion are too often uncertain.
In order for the competent authorities to be able to rule on the same question as that decided by the French judges – namely, who has the right to tax, in order to eliminate ‘undue’ taxation – the question of the nature of the gain is itself decided.
It would therefore be preferable for the two states to agree and, in passing, to arbitrate on matters related to the right to tax.
The specificities inherent in the taxation of capital gains generated by the sale of shares in transparent companies could also be addressed during discussions between states.
Beyond the single question of the elimination of double taxation that could be generated, the subjects of determining the tax base, taking into account the years of detention, the application of the Quemener corrective, or liability to social contributions could be decided during interstate negotiations.
Residents of both states would thus be offered the legitimately expected legal certainty and would thus feel encouraged to carry out cross-border transactions.
A good agreement is worth more than a long dispute.
While waiting for the agreement, shouldn’t the litigation seek to settle the unresolved issues on the merits?