Qualification quandary

Law No. 2011‑900 of 29 July 2011 (the Law) aimed to clarify the tax regime applicable in France to foreign trusts, specifically regarding transfer taxes, income taxes and wealth taxes. Although this legislative framework clarified the tax treatment applicable to distributions made by a trust, some grey areas remain, including how to distinguish between the capital and the income of this capital when they are distributed to the beneficiaries of the trust.

In principle, when setting up a trust, the settlor divests themselves by transferring capital into the trust. The transferred capital then produces income, which melts into the existing capital to generate more income. Technically, two different types of funds coexist in the trust and, at the time of the distribution, either capital or income is distributed.

A major question remains: how shall the distribution of the trust capital be distinguished from the distribution of the trust income?

The tax treatment applicable to the distribution of the trust income

The Law does not clearly define what the term ‘products of the trust’ means. Practitioners, however, agree on two points:

• the initial and further settlements contributed to the trust by the settlor qualify as capital; and
• the income generated by the capital qualifies as income.

For income tax purposes, the trust is an opaque structure and the distribution of income to a French‑resident beneficiary is subject (as a company would be) to a 30 per cent flat‑rate tax consisting of a 12.8 per cent income tax and a 17.2 per cent social charge. Under art.120, 9° of the French Tax Code (the Code), the distribution is taxed as financial income, regardless of the nature of the underlying assets or whether the income is generated by real estate, stocks, etc., held by the trust.

However, uncertainty remains concerning proceeds that are capitalised and remain in the trust. Law 2011‑1117 of 19 September 2011 clarified the issue, specifying that only products effectively distributed by the trust to the beneficiaries are subject to tax. Conversely, capitalised products that remain in the trust do not fall within the scope of this provision.

There is an exception to this rule when the trust is subject to a privileged tax regime in the country of establishment. In this case, the trust is considered ‘see‑through’ and accumulated income will then be taxed in accordance with art.123 bis of the Code. A recent decision of the Administrative Court of Appeal of Paris significantly reduced the scope of this provision by ruling that it was impossible to apply art.123 bis of the Code to beneficiaries of a discretionary and irrevocable trust.[1] Indeed, the beneficiaries of the trust have a contingent right to discretionary distributions only and are therefore not entitled to any income. This approach aligns with the relevant parliamentary discussions of 2011.

The tax treatment applicable to the distribution of the trust’s capital

Under French law, the transfer (by donation or estate) of property or rights held in a trust, as well as the products that are capitalised therein, is subject to transfer taxes depending on the family relationship existing between the settlor and the beneficiary.[2] The assets are valued at their net market value on the date of the transmission.

Practical questions arise at this stage: how may the capital of the trust be distinguished from the proceeds of the capital? How is the order of imputation determined when the trustee has discretionary power? Should income be distributed first and then capital, or vice versa? Should we consider that the trustee has decision‑making power in this arbitration?

In some trusts, the trustee has a discretionary power on the distributions. This means that they are the one who decides what is distributed to the beneficiaries and in what order. In such a case, it is difficult for the beneficiary to prove that they have received either capital or proceeds from the capital, unless the trustee makes a statement.

The only information on this point provided for by the French Tax Administration’s guidelines is that proceeds of a trust are taxed as income at the time of their distribution.[3] They are therefore not subject to any transfer taxes whenever the proceeds exit the trust. However, this applies upon the beneficiary’s or the trustee’s evidence that the amount in question qualifies as income of the trust and not as capital.

Difficulties in distinction

Several practical difficulties remain in the distinction between what comes under the qualification of capital and what comes under ‘proceeds’ of the capital, since the law and administrative guidelines do not provide any concrete answer on this question. At this date and to the author’s knowledge, only two instances of case law shed partial light on this question.

In the first case, the Administrative Court of Appeal of Bordeaux (the Court) was questioned on the taxation of sums transferred from a UK trust to French tax residents.[4] The scope of this decision is quite limited insofar as the Court merely stated that the transfer of the trust capital is not taxable within the meaning of art.120,9° of the Code, i.e., it is not subject to income taxes. However, the Court did not draw the conclusion that the transfer was subject to transfer taxes.

One year later, in 2013, the Administrative Tribunal of Cergy‑Pontoise (the Tribunal) confirmed that:[5]

‘a distinction must be made between the sums corresponding to the income generated by the capital allocated to a Canadian trust, and those resulting from the transfers of the capital itself to the beneficiaries’.

In this case, the taxpayer provided a detailed account of movements and operations of the trust capital. He was also able to prove that the distribution reduced the beneficiaries’ share in the trust and that the allocations of the trust’s capital were higher than the questioned payments or distributions. This position was corroborated by a statement provided by the Canada Revenue Agency, which enumerated the funds settled into th­­e trust, as well as the capital payments made to the beneficiaries.

It was therefore easy in this case to distinguish between the capital invested in the trust and the proceeds generated from such capital. The Tribunal then concluded that the capital payments shall be subject to income tax only.

Conclusion

While outlining the difficulties, the courts do not provide sufficient answers. Until guidance is issued, it may be prudent for:

• trusts to maintain separate accounts for income and capital; and
• distribution resolutions to specify the source of the distribution.

The author recommends that the trustee keep probative accounts, since it is the only way to make a clear distinction on the nature of the product distributed by the trust. However, in many countries, there is no statutory duty to establish accounts as there is with companies. How should a distribution be qualified when the trust has non‑probative accounts?

To date, the law and administrative guidelines are silent on these points. Clarifications on how to clearly make the distinction between capital and income of the capital would be more than welcome, since this point will certainly raise serious disputes.