Paris Court of Appeal says no to the Parent–Subsidiary Directive for funnel entities

Tuesday 28 March 2023

Pierre Bonamy

Reinhart Marville Torre, Paris

pierre.bonamy@rmt.fr

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Background

A recent decision by the Administrative Court of Appeal of Paris (the Court) provides the opportunity to take a deep dive into the notion of 'beneficial owner' in the context of a structure holding French real estate through a foreign holding company.

In the case at hand, a French company was denied the exemption from withholding tax on a dividend payment of EUR 3.6m made to a Luxembourg company in 2014. Following an audit, the tax authorities considered that the Luxembourg company was not the beneficial owner of the said payment and issued a reassessment for EUR 1.5m.

The administration relied on the fact that the Luxembourg holding company had transferred the entirety of the funds the day after they were received to its sole shareholder, which happened to be another Luxembourg company. The intermediary Luxembourg holding company did not have any human or material resources (the company claimed yearly expenses for rent and fees of approximately EUR 25,000), its role being limited to holding the shares of the French property company. It also had the same directors as its sole partner.

In essence, the Court's decision confirms the tax authorities' assessment of the apparent beneficiary status of the ‘funnel’ holding company. From a legal standpoint however, the decision seems bold in its appreciation of the autonomy of the condition of beneficial ownership, especially in an intra-EU context.

Autonomy of the notion of beneficial ownership in the absence of a third country

The French company's defence focused first on the argument that the tax administration implicitly relied on the abuse of law without providing the taxpayer with the guarantees attached to this procedure (such as the involvement of a special committee during the audit). Even though the courts rarely sanction the use of an implicit abuse of laws, the company's arguments are not without merit.

The Parent–Subsidiary Directive does not contain any express reference to the notion of beneficial ownership (unlike the Interest and Royalties Directive). The Court of Justice of the European Union (CJEU), in the so-called ‘Danish cases’ (CJEU, 26 February 2019, aff. C-116/16 and C-117/16, paragraph 111), established a general principle according to which individuals cannot fraudulently or abusively rely on the norms of EU law. This principle can be used to refuse, where applicable, the exemption from withholding tax provided for by the Parent–Subsidiary Directive, even when domestic law does not provide for it (as was the case in Denmark).

In this respect, French law already contains, in addition to the provisions relating to abuse of law, an anti-abuse clause specific to the parent–subsidiary regime (Article 119 ter, 3 of the French Tax Code) targeting artificial arrangements primarily driven by tax objectives. This clause is a direct result of the transposition into French law of Council Directive 2015/121 of 27 January 2015 (the previous version applicable before 2016 having been found to be contrary to the Directive as it relied on a presumption of fraud in certain cases, see CJEU, 7 September 2017, case C-6/16).

In its decisions of 26 February 2019, the CJEU also stated, with respect to a beneficial owner established outside the EU, that the refusal of the exemption from withholding tax was not subject to a prior finding of fraud or abuse of law (see the abovementioned decisions, paragraph 111), since the exemption would in this case be likely to result in such dividends not being effectively taxed in the EU (paragraph 113). The Conseil d'Etat (‘CE’) – the highest French administrative jurisdiction – used this decision to deduce that ‘the status of beneficial owner of the dividends must be regarded as a condition for benefiting from the exemption from withholding tax provided for by article 5 of the Directive’ (CE, 5 June 2020, n°423809, Sté Eqiom).

It has, however, been noted by some commentators that the autonomy of the beneficial owner condition ‘must be limited to the sole case where the beneficial owner has his tax residence outside the European Union’ and that ‘It is not entirely clear [...] that the lack of beneficial ownership of the recipient of the dividends is sufficient to justify, in the absence of an abuse of law, the non-application of the withholding tax exemption’ (cf O Teixeira in FR Lefebvre 32/20). Not entirely clear indeed!

In the described decision, the Court largely relied on the extracts from the CJEU decisions taken up by the CE in the Eqiom case to reject the applicant's argument, even though the ultimate beneficiary was a Luxembourg entity. It is, therefore, questionable whether this obviously ‘intra-EU’ case should be treated in the same way and could be so easily removed from the guarantees of an abuse of law.

Effectiveness of the notion of beneficial owner

The autonomy granted to the notion of beneficial ownership is not neutral. Indeed, the qualification of apparent beneficiary almost automatically precludes the use of other defence arguments based on: an infringement of the freedom of establishment and the freedom of movement of capital (by discrimination with a resident parent company); and the impossibility for the Luxembourg company to deduct the withholding tax.

In that it deprives the company from claiming the freedoms granted by EU law, the beneficial owner clause shares certain features with the abuse of law procedure, without however offering the guarantees accompanying the latter.

As for the assessment of the status of beneficial or apparent beneficiary, the Court again follows the decisions of the CJEU and the CE, ruling that a company whose sole activity is to pay dividends should be considered a ‘funnel’ company, antonymous to the notion of beneficial ownership. The absence of effective economic activity is based on an array of evidence relating to, inter alia, ‘the management of the company, its balance sheet, the structure of its costs and the expenses actually incurred, the staff it employs and the premises and equipment at its disposal’.

In this respect, the Court was not convinced by the reasons put forward by the taxpayer and considered that the costs incurred by the Luxembourg company were not sufficient to establish the existence of human and material resources. Similarly, the objective of protecting the investors of the Luxembourg company, in view of the shareholders' agreement and the fiduciary agreement concluded with the other investors, did not prevent the qualification of the company as a funnel company. Unsurprisingly, it is the economic reality of the holding company that determines its status as a beneficial owner (for another illustration, see for instance CAA Lyon 13/1/2022 n°19LY03610, SASU Finalgro).

Such an exemption (or even reduction) of the withholding tax was no more likely to succeed on a treaty basis, as the beneficial owner clause is deemed to be ‘implicit’ in tax treaties prior to the 1977 Organisation for Economic Cooperation and Development Model Tax Convention, such as the former treaty with Luxembourg of 1 April 1958, which was applicable in the case at hand (CE, 13 October 1999, n°191191, SA Diebold Courtage and CE, 23 November 2016, n°383838, Sté Eurotrade Juice). As a result, the company could not claim the reduced rate of five per cent provided for by conventional law either. This debate is in any case no longer relevant since the current wording of the Franco–Luxembourg treaty explicitly relies on the notion of beneficial owner.

What’s next?

We would like to stress that the CE recently allowed a taxpayer to claim the benefit of the double tax treaty concluded between France and the country of the ultimate beneficiary after a reassessment was made on the ground of the beneficial ownership, or lack thereof (CE, 20 May 2022, n° 444451, Sté Planet). Therefore, in upcoming audits, taxpayers who face similar reassessments should verify whether the Planet case law is applicable. It should, however, be noted that the burden of proof rests on them to demonstrate the tax residence of the ultimate beneficiary.

Despite the doubts surrounding the autonomy of the notion of beneficial ownership in a purely European context, this decision shows that the use of this notion is becoming more frequent. In addition, a new layer of complexity is expected with the coming implementation of the proposed ATAD 3 Directive, which targets the misuse of shell entities. In this context, it is recommended that current structures be reviewed and new ones be built around the notion of substance, both economic and operational.