Denial of transparency

In a recent decision, the French Administrative Supreme Court (Conseil d’État, the Court) raised potential issues regarding the tax treatment in France of income realised by a US trust held by French residents.

Under French domestic law, there is no comprehensive tax regime regarding the treatment of a foreign trust for income tax purposes (since 2012, a specific trust law covers the tax treatment of foreign trusts and foundations for wealth tax and estate tax purposes),[1] with the exception of art.120-9° of the French Tax Code (the Code). This article provides for the taxation of French individual residents on distributions received from foreign trusts as a standard dividend (taxed under the maximum global tax rate of 34 per cent).

The Treaty

In the France-US context, the situation has been quite different because a specific article of the US-France Tax Treaty (the Treaty), with respect to taxes on income and capital,[2] addresses the situation of ‘partnerships’ that must be treated, under art.4, as transparent entities for income tax purposes by both states. This provision requires that income realised by the entity qualified as a partnership must be treated as that of the members or shareholders of the partnership and the corresponding treatment provided for by the Treaty must be applied as if the partnership does not exist.[3] Since the Treaty’s definition of partnership is broad (i.e., ‘every entity that is fiscally transparent’), it has been commonly accepted in France that US trusts with French-resident beneficiaries could be treated as a partnership for the purpose of the Treaty, provided that the US trust is regarded under US tax law as a transparent entity.

This position was supported by the fact that the French tax authorities released an official guideline[4] whereby they considered that some US trusts (e.g., grantor trusts) could be treated as tax-transparent entities for the purpose of the previous double taxation treaty between France and the US, dated 28 July 1967. This position regarding the interpretation of the Treaty is quite favourable to US citizens residing in France, as it might be considered that the specific provision in the Treaty allowing them to benefit from an exemption of French income tax on certain US-source income or gains was also applicable when said US income or gains were realised by a US trust of which they are beneficiaries.

However, this solution has been brought into question by a recent decision of the Court.[5] This decision is not, strictly speaking, a court ruling. Rather, it may be regarded as legal advice requested from the Court by the French tax authorities about the case of a revocable and non-discretionary US trust, of which the settlor, trustee or beneficiaries are French-tax resident. The French tax authorities asked the Court to deliver a legal opinion about the tax treatment resulting from the Treaty in this situation regarding income or gains realised by the US trust at the level of the French-tax resident beneficiaries.

In its published opinion, the Court considered that such a US trust cannot be recognised as a US fiscally transparent entity in cases where the beneficiaries are French-tax resident because the Treaty’s provisions require that the domestic law of the state of the member of the entity (i.e., France) applies a tax-transparency treatment regarding the income or gains realised by the entity in order to be qualified as a partnership. Considering art.120-9° of the Code, the Court stated that French domestic law does not provide for a tax-transparency treatment to foreign trusts as income coming from trusts is only taxed at the level of the beneficiary upon an effective distribution to them. As a result, the Court found that if a US trust is fiscally opaque for French domestic law, the partnership clause of the Treaty cannot be evoked in the context of French beneficiaries of a US trust.

As a solution, the Court held that the tax-transparency treatment should be denied in France to a US trust when it includes beneficiaries who are French-resident individuals, with mainly negative consequences. US trust income and gains can be taxed at the level of the beneficiaries only upon an effective distribution of proceeds from the trust (subject to a specific domestic anti-abuse mechanism of taxation on a look-through basis). However, in this case, the distributed proceeds cannot be treated pursuant to the Treaty according to the source/nature of income or gains realised by the trust. For instance, if the proceeds come from US rental income derived by the US trust, it should not be possible to consider, by a transparency approach, that arts.6 and 24 of the Treaty lead to a tax exemption in France of said trust’s income.

The denial of transparency to the US trust could raise many issues of double taxation between France and the US for French-resident beneficiaries. Indeed, in some cases, these beneficiaries are first directly subject to income tax in the US, through a transparency regime, on the income or gains realised by the trust. In France, the trust proceeds are taxed at the moment of the distribution to the beneficiaries, but the distribution changes the nature of the income and the date of the taxable event, which involves the risk that the US-source tax cannot constitute a tax credit to be offset against French individual income tax. Indeed, the other risk is that France would consider that a US trust, subject to tax-transparency treatment in the US, cannot qualify as US-tax resident for the purpose of the Treaty because it requires the resident to be personally liable to tax (which is not consistent with a tax-transparency regime). The consequence of this denial is that the distribution received from a US trust cannot be viewed as dividends covered by art.10 of the Treaty.

Conclusion

This decision cannot be deemed case law because it is only legal advice rendered by a specific section of the Court. But that the French tax authorities decided to publish it could be viewed as a willingness on their part to now treat US trust income derived by French individuals in this way. In addition, in cases of a dispute between a taxpayer and the tax authorities regarding the same legal issue, the litigation section of the Court might adopt the same solution, validating such an interpretation of the Treaty, which is generally unfavourable for the beneficiaries of the trust, especially if they are a US citizen who could benefit from the income tax exemption in France on US-source investment income provided for by the Treaty if they directly derive this US income or gain.