Under article 57 of the French tax code, profits indirectly transferred by a French company to foreign affiliates, either through reduction of sales price or increase of purchase price, or any other means, are added back to the taxable income of such company.
French case law and French administrative doctrine have clearly stated that it is up to the tax administration to demonstrate that the French company has granted an undue benefit to a foreign affiliate and to evaluate that benefit. Once the demonstration is made, an indirect transfer of profits has been characterized, and it is then up to the taxpayer to demonstrate that the transaction is actually realized at arm's length.
In the past, tax courts had been lenient in accepting the demonstration made by the tax administration. For example:
- sale of products to a Swiss affiliate at a price significantly lower than prices applied on the French market (1969 and 1976);
- sale of products to a Monaco affiliate at a price significantly lower than prices applied on the French market (1964);
- the nondeductibility of royalties paid to a foreign affiliate when their amount is not commensurate with the tax profit after royalties (1942);
- payment of services in excess of amount agreed upon under intragroup contract (U.S., 1982);
- interest-free loans (1958 and 1963); and
- expenses of foreign affiliate borne by French company (1987, 1997, and 2003).
Case law applicable to transfer pricing matters remains limited. France has introduced in the tax code a provision whereby collection of tax is suspended when a mutual agreement procedure or an EU arbitration procedure is introduced(1); consequently, when facing a transfer pricing reassessment, taxpayers often try to strike a deal with the tax inspector in order to reduce the reassessment as much as possible and then open a mutual agreement procedure in order to eliminate double taxation. Of course, this approach is available only when the foreign affiliate is resident of a country that has signed a tax treaty with France, but this represents most transfer pricing disputes. Because the tax collection is suspended, no tax bill is being issued after the tax audit and it is not possible to open a claim before a tax court. One option could be to forgo the suspension of tax collection, go before a tax court, and then open a mutual agreement procedure, but the amount at stake may make this decision difficult. But we still see a few court rulings each year.
More recently, the tax courts have used comparability standards provided by the OECD transfer pricing guidelines that made it harder for the tax administration to provide a successful demonstration, even when prices apparently created a significant downside for the French taxpayer.
A real turn in the case law occurred in the Supreme Administrative Court (Conseil d'Etat) in Cap GeminiI(2). Cap Gemini used to charge a 4 percent royalty to its French affiliates for the use of the CG trade name and logo, while it did not charge any royalty to newly acquired U.S. affiliates. The mere mismatch of treatment between French and foreign affiliates could have lead the court to consider that the burden of proof shifted back to the taxpayer. The court actually ruled that the French tax administration should have demonstrated that the situation of the U.S. affiliates was comparable to the French affiliates; it stated that the value of the trademark and logo was actually dependent on time and markets.
The Paris Court of Appeals issued a similar ruling in Novartis(3): The fact that a French company acquired an active ingredient from its Swiss parent at a price more than four times higher than the price paid by a U.S. affiliate does not constitute an indirect transfer of profit because the tax administration should have compared a transaction with an independent party.
The Versailles Court of Appeals ruled also in favor of a French taxpayer in Société Man Camions et Bus(4) in which a French distributor realized a loss in selling trucks acquired from a German affiliate. First the court ruled that a loss position is not in itself proof that the transaction is not at arm's length. The court then rejected independent comparables provided by the French tax administration on the grounds that they were based in different markets, and no functional analysis had been realized while it appeared that the functions performed by such so-called comparables were different from the functions performed by the French distributor, and that in some cases, products were also not comparable.
Two recent cases, both decided in March 2012, dealt with the same question.
The Paris Court of Appeals ruled(5) on the following fact pattern: A French distributor of hunting products had been charged with service fees from its German parent company, including packing and logistic services, various management services, IT services related to the shift to 2000, and services related to inventory management. The French tax administration considered that such fees were not commensurate with the services received and were able to show discrepancies in the invoicing and a lack of supporting information for expenses charged back to the French distributor. The court considered that the tax administration did not demonstrate a transfer of profits abroad because it did not make any comparison with independent companies in order to show to what extent the fees paid for the services did not meet the arm's-length character.
Again, the trend was confirmed: The French tax administration must do its homework to convince the courts.
Another court case, decided two days earlier, came to a different conclusion. The Versailles Court of Appeals(6) ruled against the taxpayer in the following case: A French affiliate of a Swiss company is a producer and distributor of mineral water. When selling mineral water to a Japanese affiliate, acting as a distributor on the local market, the French affiliate left the Japanese affiliate a net margin of 33 percent; the tax inspector considered that this level of net margin was significantly higher than independent companies with a similar activity and higher than other distribution affiliates, and applied a transfer pricing adjustment. The court described the arguments provided by the tax administration: According to the taxpayer itself, a routine 6 percent net margin would be an arm's-length profit for distribution mineral water; the tax administration performed a comparable search on distributors of nonalcoholic beverages that concluded on an arm's-length range of 7.5 to 9.5 percent net margin, with an 8 percent median; in Japan, a bottle of mineral water distributed by the Japanese affiliate was sold to end-customers at a €2.5 price while the highest market price in a country where the affiliated distributor recognized a routine 6 percent margin was 0.78 percent; if the excess price corresponding to a multiplier of 3.2 is attributable to the Japanese affiliate, its net margin should have been limited to 19 percent. The court noted that this last argument had not been convincingly rebutted by the taxpayer.
Based on these arguments, the court considered that the tax administration had proved that an indirect transfer of profits may have taken place. It then turned to the taxpayer's position to analyze whether there were business reasons for such a beneficial treatment applied to the Japanese affiliate. Apparently, the taxpayer argued that the Japanese affiliate was not a routine distributor, but a co-entrepreneur with the French producer, given the specifics of the Japanese market. This seemed to be a sound argument, but unfortunately, the burden of proof had shifted back to the taxpayer, and the court considered that it did not bring enough supporting information for such a position, and the transfer pricing adjustment was confirmed by the court.
The Versailles Court of Appeals ruling only confirms a long-lasting trend: It is up to the tax administration to demonstrate that an undue benefit has been granted to a foreign affiliate, and only then it is up to the taxpayer to demonstrate that such benefit is justified by sound business reasons. This ruling only shows that the French tax administration had a strong case that the taxpayer might not have taken seriously enough.
Interestingly, transfer pricing documentation requirements that have been effective as of January 1, 2010(7) for French companies with a turnover in excess of €400 million (or which are held directly or indirectly by a foreign company that exceeds this threshold) should help taxpayers build a stronger case in front of the tax courts. Before such requirement was effective, some taxpayers relied on the tax courts' approach and provided limited, if any, support to their transfer pricing policy under the assumption that comparability standards could not be met by the French tax administration before tax courts. Transfer pricing documentation may be considered as a mere compliance exercise, but it provides a functional analysis and economic benchmarks supporting both the transfer pricing method and the level of pricing. It should make the demonstration of the tax administration much more difficult in front of the tax courts.
On July 4, when announcing a draft Rectificative Finance Act for 2012, the new French government proposed to shift the burden of proof on the transfer of profits to tax havens. One of the propositions made by candidate François Hollande before he was elected president was to amend article 57 of the French tax code in order to shift the burden of proof to the taxpayer. False alarm -- the proposed provision applies to French CFC rules (article 209B), not to transfer pricing rules.
The Rectificative Finance Act for 2012 was finally approved on July 31. Indeed, the CFC rules were slightly amended for non-EU controlled corporations resident outside the EU. To avoid that income that enjoyed a tax-privileged regime from being taxed in France, the French parent company will have to demonstrate that such income was derived from an effective commercial or industrial activity performed in the country where the foreign affiliate is established. Interestingly, the original provision indicated that this exception would not apply to passive income such as interest or royalty income; the new wording eliminates this specific exception.
CFC rules (article 209B) and transfer pricing rules (article 57) have a common objective, which is to tax a fair share of worldwide profits in France. However, the mechanism and the scope are different: CFC rules would tax in France profits that have benefited from a privileged tax regime abroad, whether or not such profits have been transferred outside France through transfer pricing; transfer pricing rules would correct transfer prices between French companies and foreign affiliates, on an arm's-length basis, even if foreign affiliates are based in a high-tax country.
This does not mean that article 57 will not be amended. Most of the tax reforms, such as the 75 percent tax rate applicable over €1 million for individuals, have been postponed to the Finance Act for 2013 to be discussed between October and December 2012.
Wait and see? No. Don't wait -- work on your transfer pricing documentation!
1. Article L189A of the tax procedural code (Livre des procédures fiscales, or LPF).
2. Cap Gemini, Conseil d'Etat, Nov. 7, 2005; no. 266436.
3. Novartis Groupe France SA, CAA Paris, 2nd chambre, June 25, 2008; no. 06-2841.
4. Man Camions et Bus, CAA Versailles, 3rd chambre, May 5, 2009; no. 08VE02411.
5. Eduard Kettner, CAA Paris, 9th chambre, Mar. 29, 2012; no. 10PA04193.
6. Nestle Entreprises, CAA Versailles, 1st chambre, Mar. 27, 2012; no. 10VE01171.
7. Article L13AA du LPF.
Tax Analysts Information Magazine , Aug. 27, 2012, p. 849