French tax authorities have become big fans of the principal purpose test, which they regard as both preventive and curative: a silver bullet against tax avoidance and a weapon of mass reassessment. In the last few years, principal purpose test rules have thrived, both in the French tax code (FTC) and the French tax treaty network.
A specific principal purpose test had already been introduced into French law when implementing the first EU Parent–Subsidiary Directive of 1990, which provided for a withholding tax exemption on dividend distributed to an EU parent company (Article 119 ter 3 of the FTC). This specific anti-abuse provision was not a “copy-paste” of one of the directive’s provisions but resulted from the possibility left to member states to introduce an anti-abuse rule into their domestic law. Because the anti-abuse provision had been so poorly drafted, the Court of Justice of the European Union ruled that it was too extensive and then introduced a general presumption of tax avoidance which was not compatible with EU law (case C-6/16 of September 7, 2017, Sté Holcim).
Since then, the EU Parent–Subsidiary Directive has been modified to include a specific anti-abuse provision which entered into force in January 2016. This anti-abuse provision aims at denying the benefit of the directive when an arrangement or a series of arrangements has been put into place with the main purpose of obtaining a tax advantage and is not genuine considering all relevant facts and circumstances (Article 1 of Council Directive (EU) 2015/121 of January 27, 2015 amending Directive 2011/96/EU).
France has also recently introduced a general principal purpose test rule in the FTC: French Finance Act for 2019 n°2018-1317 of December 2018–art. 109, which will be applicable as of January 1, 2020 (Article L64 A of the French tax procedural code. Please note that this provision applies to all taxes but corporate tax, which is covered by a specific principal purpose test rule derived from the Anti-tax Avoidance Directive (see note 5)).
Until then, French domestic provisions regarding anti-abuse are to be restricted to a sole purpose test—so-called abuse of law provision (Article L64 of the French tax procedural code. In late 2013, an attempt to substitute the principal purpose for the sole purpose in this provision was repealed by the French Constitutional Court).
Another principal purpose test rule recently introduced in the FTC, and which has been applicable since January 1, 2019 (Article 205 A of the FTC), results from the implementation into French law of the EU Anti-tax Avoidance Directive (ATAD) general anti-abuse rule (Article 6 of Council Directive (EU) 2016/1164 of July 12, 2016) which, for the purpose of calculating the sole corporate tax liability, aims at ignoring non-genuine arrangements put into place for the main purpose or one of the main purposes of obtaining a tax advantage. A non-genuine arrangement is described as one which has not been put into place for valid commercial reasons which reflect economic reality, regarding all relevant facts and circumstances.
As regards the French tax treaty network, the introduction of the principal purpose test results from the latest bilateral agreements—for example, Article 28 of the 2015 tax treaty between France and Singapore—or the signing and ratification of the Organization for Economic Co-operation and Development (OECD) base erosion and profit shifting (BEPS) multilateral instrument (MLI).
This article will focus on the latter and more specifically on the principal purpose test as it has read in the tax treaty between France and the U.K. since January 1, 2019 (the MLI entered into force in the U.K. on October 1, 2018 and in France on January 1, 2019, resulting in the according amendment of the tax treaty as of January 1, 2019).
In the OECD anti-BEPS paraphernalia, the principal purpose is a default provision intended to meet BEPS minimum standard of prevention of treaty abuse, and states:
“Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.” (MLI, Article 7.1)
The Principal Purpose Test Rule in the France–U.K. Tax Treaty
As a default provision, the principal purpose test is to be included into all signatories’ tax treaties, unless they reserve and intend to otherwise meet the minimum standard—using a combination of detailed limitation of benefits provisions, for instance.
As neither France nor the U.K. made any reservation on the principal purpose test, this rule is included in the France–U.K. tax treaty. As a consequence, taxpayers may be required to demonstrate that the principal purpose of the arrangement or transaction they entered into and which is covered by the France–U.K. tax treaty, is not to obtain a tax advantage.
Following the OECD’s matching exercise between the MLI and the bilateral tax treaty, the principal purpose test rule slots into Article 11—Dividends (paragraph 6 is replaced by the principal purpose test rule), Article 12—Interest (paragraph 5 is replaced by the principal purpose test rule), Article 13—Royalties (paragraph 5 is replaced by the principal purpose test rule) and Article 23—Other income (paragraph 4 is replaced by the principal purpose test rule).
The scope of the principal purpose test rule, then, seems to be limited to some categories of income. In other synthesized texts of the MLI and bilateral tax treaties, the principal purpose test rule would slot in right after the preamble and would then have to be understood as covering all categories of income; for example, the tax treaty between France and Germany.
Does the way the principal purpose test rule slots into the France–U.K. tax treaty mean that the scope of this provision is restricted to some categories of income (dividends, interest, royalties and other income than those specifically mentioned in the tax treaty)? We do not think so, as another default rule of the MLI, which slots into the preamble of the tax treaty, refers to the object and purpose of the tax treaty (MLI—Article 6.1).
Where such object and purpose used to be restricted to “the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains,” it now encompasses “opportunities for non-taxation or reduced taxation through tax evasion or avoidance.” This new definition of the object and purpose of the tax treaty, set in the preamble, certainly acts in itself as an anti-abuse provision covering the whole content of the tax treaty: any analysis of whether the principal purpose for entering into a transaction or arrangement is obtaining a treaty benefit will ultimately observe whether granting that benefit is in accordance with the treaty’s object and purpose.
Regardless of the way the principal purpose test rule slots into the France–U.K. tax treaty, it leaves room for discussion around the vagueness of its wording and the ensuing legal uncertainty for taxpayers.
Interpreting the Principal Purpose Test Rule in the France–U.K. Tax Treaty
The principal purpose test is far from being a bright-line rule. There is currently no crystal clear and unequivocal definition of the principal purpose that would bring some certainty to taxpayers. Taxpayers will, then, have to weigh the respective significance of the different purposes of an arrangement or transaction, which is highly subjective and will undeniably give the tax authorities flexibility to deny tax treaty benefits should they consider it reasonable to conclude that obtaining tax benefits was the principal purpose for entering an arrangement or transaction.
It is obvious that entities situated in some states simply to get access to treaty benefits without further justification will be denied those benefits. Yet such situations are the stuff that textbooks are made of; most cases are a lot less straightforward and require in-depth analysis.
What Guidance is there for Taxpayers?
What are the tools taxpayers may rely on to run the analysis and secure their situation?
Some guidance for the application of the principal purpose test was included in BEPS action 6 and is reiterated word for word in the commentaries of the 2017 Model Tax Convention on Income and Capital (commentary on Article 29, paragraph 169 et seq.). Yet those guidelines are not particularly enlightening, as broadness and vagueness prevail.
Regarding the term “benefit,” it is specified that it includes all limitations (e.g. tax reduction, exemption, deferral or refund) on taxation, the relief from double taxation, the non-discrimination provision or any other similar limitations. Similarly, the terms “arrangement or transaction” are to be interpreted broadly, as they “include any agreement, understanding, scheme, transaction or series of transactions, whether or not they are legally enforceable.”
Regarding the principal purpose, a definition falls short of expectations, as “one of the principal purposes” is defined as one which is not the sole or dominant purpose… To counterbalance this lack of a suitable definition, focus is drawn to the reasonableness test as it is supposed to objectify the subjectivity of the rule: an objective analysis must be made of the facts and circumstances in order to reach the conclusion on whether the principal purpose is obtaining a treaty benefit.
Nothing is supposed to be based on assumptions, either from taxpayers or the tax authorities. Yet if any assumption by a taxpayer that an arrangement is not abusive would certainly be discarded with no further notice by the tax authorities, the very wording of the rule makes it easy for the latter to assume abuse and then rely on relevant facts and circumstances that tend to confirm it.
Turning to guidance available from the French tax authorities, the taxpayer will be equally disappointed. No commentary is currently available on the MLI principal purpose test rule. The recently issued administrative guidelines on the French implementation of the ATAD principal purpose test rule (Article 205A of the FTC) could be relied on but prove to be no more instructive than the OECD guidance: same lack of a definition of the principal purpose—with a specific mention that the principal purpose rule covers a wider scope of situations that the “abuse of law” rule which is restricted to arrangements whose sole purpose is obtaining a tax advantage—and same emphasis put on the importance of running an analysis based on facts and circumstances.
However, the French tax authorities state that where the following two conditions are met, the principal purpose test rule applies:
- first, the arrangement is set up with a main purpose to obtain a tax advantage contrary to the object/purpose of tax law;
- second, the arrangement is considered as not genuine, meaning there is no sound economic reason behind it.
As the principal purpose test rule and the related guidance leave so many gray areas, there is no doubt that cases will surely be brought before the courts, and that the interpretation of the principal purpose will ultimately be left to judges. In this respect, they will interpret the principal purpose according to established case law which states that the object and purpose of a tax treaty is to prevent double taxation without creating opportunities for non-taxation: CE 9 nov 2015 n°371132, Sté Santander Pensiones SA and n°370054, min. c/ Landesärztekammer Hessen Versorgungswerk. Weighing the various purposes of a transaction may be delicate and will require a philosophical/moral approach to the taxpayer’s behavior to determine if it is “reasonable” to conclude there is/is not abuse.
From the French case law on the application of the first principal purpose test on EU dividend distributions, and our practical experience of tax audits, it is clear that the burden of proof lies with the taxpayer and that the latter will have a hard time getting through if failing to provide sound evidence of commercial/business reasons justifying the arrangement. In this respect, it is fortunate that the French tax authorities acknowledge that holding companies with a pure financial activity, or entities set up with a group structuring purpose, must not be in itself regarded as abusive.
A last moot point to address is the possible combination of the tax treaty principal purpose test rule and the French “abuse of law” provision (Article L64 of the French tax procedural code). The French Administrative Supreme Court (Conseil d’Etat) ruled in late 2017 that the “abuse of law” provision could be applied to a bilateral tax treaty (CE 25 Oct. 2017 n°396954, Cts Verdannet).
So, where one could have thought that a general anti-abuse provision stipulated in a tax treaty excluded the use of another general anti-abuse provision such as the “abuse of law” provision, it appears that the French tax authorities will be able to choose between those two grounds for reassessment.
At the end of the day, taxpayers will be left with nothing but uncertainty as well as both the burden of proof and the burden of litigation costs. Not much of a win–win…
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners