New wealth taxes in France create fresh complications. Baker & McKenzie, the global law firm, takes a walk around the rules to explain developments.

Editor’s note: Below is expert commentary from Baker & McKenzie, the international law firm, on important new developments regarding France’s taxation of wealth, an issue that is sure to excite debate in the French private banking industry. The article is reprinted with B&M’s permission. To view the firm’s website, click here.

Introduction

On 6 July the French Parliament adopted a reform of wealth taxation which was subsequently published on 30 July and seriously impacts the wealth management industry in France.

The law confirms expected reforms regarding French wealth tax, the tax shield and inheritance or gift taxes. It also changes the taxation of life insurance, against the government's will, extensively modifies French taxation of trusts, and creates wide disclosure obligations for trustees.  It also revives the exit tax.

Wealth tax is modified and the tax shield is abolished

The threshold above which wealth tax is applicable is increased from €800,000 (around $1.08 million) to €1,300,000. Above this threshold, the tax rate depends on the net wealth: up to €3,000,000 the tax rate is 0.25 per cent and above €3,000,000 the tax rate is 0.5 per cent. Nevertheless, there is a mechanism to reduce the thresholds' effects for taxpayers with a net wealth between €1,300,000 and €1,400,000 and between €3,000,000 and €3,200,000.

The reform will come into force in 2012.  However, in 2011:

-- Taxpayers with a net wealth less than €1,300,000 are fully exempt from wealth tax;

-- For net wealth of less than €3,000,000, taxpayers do not have to attach justifications of wealth to their return.

The tax shield is abolished for income received in 2011 (tax shield 2013). Claims filed in 2011 give a right to refund if they were filed by 30 September 2011, and should be directly offset against ISF payment if made after such date. Claims filed as from 1 January 2012 (ie tax claims related to income received in 2010, taxes paid on such income and wealth tax 2011) should be directly offset against ISF payment.

For wealth tax purposes, loans made by non-residents to real estate-oriented companies are excluded for valuing the shares of the intermediary structure

Non-residents

Non-resident taxpayers are not subject to wealth tax on financial investments, thus a straightforward planning method has been to have a company acquire a French located real estate asset and have the non-resident shareholder providing most of the funds through a loan to the company.

As a consequence, valuation of the shares subject to wealth tax took into account the debt towards its shareholder, whereas the corresponding receivable was not subject to taxation.

The text now provides that receivables directly held by a non-resident taxpayer, or held through one or several interposed companies, in a real estate-oriented company in France shall not be deducted when computing the taxable value of the shares. This will be applicable as per wealth tax 2012.

The rate of gift and inheritance tax is increased

Reductions in the rates of gift tax due to the age of the donor are abolished.  The rates applicable to the two upper brackets relating to inheritances and gifts to ascendants and descendants and between spouses or civil partners are increased by 5 per cent: therefore the marginal tax rate is 45 per cent and the period before benefitting from a new tax-free gift allowance is extended to 10 years instead of 6.

Modifications to the taxation of life insurance

Death benefits paid to beneficiaries of life insurance are subject to a sui generis specific 20 per cent withholding tax (exclusive of inheritance tax) up to the portion of premiums paid before the 70th birthday of the insured person. The 20 per cent withholding tax is increased by 5 per cent (i.e. to 25 per cent) for life insurance above €902,838.

Two loopholes are closed:

-- The territoriality of such withholding tax is specified: the withholding tax will be due (1) if the beneficiary is a French tax resident at the time of the death and has been a French tax resident during the last 6 years, or (2) if the insured person is a French tax resident at the time of death, even if the contract was originally subscribed by a non-French resident.

-- The 20 per cent withholding tax practical application has been modified in order to apply such withholding tax to bare ownership in case of a split of the beneficiary clause between bare ownership and a usufruct.

All these changes apply from the publication of the legislation.

New French taxation regime for trusts

The law provides for a definition of trusts for French tax purposes, corresponding to the definition provided by the Hague Convention on the recognition of trusts, and creates a French tax regime for trusts.  Even if basically intended to be applicable to common law trusts, it cannot be excluded that the text also applies to foundations and other similar succession planning vehicles, considering the broad definition in the legislation.

Regarding income tax, the law confirms that distributions made by a trust are always taxable as income (i.e. capitalised income is taxed when distributed).

And on inheritance and gift tax, the law does not make any distinction depending on the nature of the trust (irrevocable or not, discretionary or not, etc) and applies common rules of territoriality for DMTG (inheritance/gift tax).

If the capital assets of the trust are distributed to beneficiaries, the trust is considered transparent and DMTG is due based on the applicable scale between donor/deceased (settlor) and donee/heir or legatee (beneficiary). If the assets of the trust are not distributed, the relevant tax event for DMTG is the death of the settlor:

1. If beneficiaries are identified and a quantified part of the assets are allocated to each of them: transparency of the trust seems certain and DMTG will be due on each part, depending on the applicable scale between deceased person (settlor) and heir or legatee (beneficiary);

2. If a quantified part of the assets is globally allocated beneficiaries who are all descendants of the settlor: the marginal rate applicable to descendants should apply (45 per cent);

3. In any other case the 60 per cent rate applies.

Beneficiaries are deemed settlors upon death of the settlor, so that DMTG are levied upon each generation change.

If (1) the trust was settled after 11 May 2011 by a French tax resident or (2) if the trustee is subject to the law of a non-cooperative country, the 60 per cent rate will apply irrespective of the link between settlor and beneficiary! These new provisions are applicable for gifts made and death occurring as from the publication of the legislation.

ISF and specific withholding tax: assets of the trust are included, for ISF purposes, in the settlor's taxable wealth irrespective of the trust's nature (irrevocable or not, discretionary or not, etc).

The law creates a specific annual withholding tax at a 0.5 per cent rate for which the trustee is responsible for the filing and payment. This withholding tax is applicable when the settlor or one of the beneficiaries is a French tax resident, or when the trust holds an asset or a right located in France, eg among others shares in a real estate-oriented company in France. Such withholding tax is not due if (1) the respective assets have been duly reported and subject to ISF in the settlor's taxable wealth and (2) disclosure obligations have been complied with (see below). These new provisions are applicable as from 1 January, 2012.

Irrevocable trusts having exclusively charitable beneficiaries (as defined by French tax law) are not subject to ISF or specific withholding tax.

Disclosure obligations:

The law creates a wide disclosure obligation for trustees if (1) the settlor or at least one of the beneficiaries is a French tax resident or (2) the trust holds an asset or a right located in France, e.g. among others shares in a real estate oriented company in France.

The trustee must disclose (1) the setting up, modification, and, when applicable, the end of the trust, (2) the main terms of the trust, and (3) fair market value as at 1 January of the assets subject to the specific withholding tax.  This new obligation will apply in addition to the 3 per cent tax disclosure obligations.

Non-compliance with such disclosure obligations triggers a penalty amounting to 5 per cent of the assets held in the trust, with a minimum of €10,000. Please note that not complying with the disclosure obligation might also trigger the application of the specific withholding tax. These new provisions are applicable as from 1 January 2012.

The exit tax is resurrected

An exit tax is resurrected and capital gains are subject to income tax (19 per cent) and social taxes (12.3 per cent) based on the value the day before the transfer of residence. The scope of the exit tax, its practical application and taxable basis are clarified.

Taxpayers are subject to exit tax if they transfer their residence abroad after qualifying as a French tax resident for at least 6 of the last 10 years prior to the transfer, and if at the time of the transfer they hold together with the others member of the tax household, (1) a direct or indirect participation of at least 1 per cent in a company subject to corporate tax or equivalent taxation except for SICAV or (2) various direct or indirect participations in a such companies if the participations have together a value above €1,300,000 at the time of the transfer.

The taxable basis of the capital gain subject to exit tax is defined as the difference between the value of the shares at the transfer date and the purchase price. Allowances for holding periods are taken into account.

An automatic deferral of payment without any guarantee being required is granted to a taxpayer transferring his residence (1) to an EU member State, (2) to an EEA member State that has concluded with France an administrative assistance agreement  (excluding Liechtenstein) or a mutual assistance agreement or (3) out of the EU or EEA provided that France has entered into an administrative assistance agreement and a mutual assistance agreement for recovery with the host country of the taxpayer and that the transfer of residence is based on professional reasons. The deferral is also available for the connected personal income tax payment and social taxes.

The deferral of payment ends when shares are sold, repurchased, reimbursed, cancelled or, in certain cases, transferred by gift.

Income tax on unrealised capital gains may be cancelled or reimbursed if it has been paid (i) at the end of an eight-year period following the taxpayer's transfer of residence from France or (2) on the date that the taxpayer is again resident in France if he still holds the shares or (3) upon the taxpayer's death.

The exit tax is reduced if the effective capital gain realised upon the transfer of the shares is lower than the unrealised capital gain which has been taxed. Moreover, tax paid abroad in the country of residence at the time of the sale will be credited against the tax paid in France on the unrealised capital gain.

This mechanism is applicable with a retroactive effect to transfers of residence abroad as from 3 March 2011. We have still some doubts regarding the compliance of the new version of exit tax with the European rules and the double tax treaties' provisions, even if the new wording has taken into account the comments of the ECJ on the first attempt at an exit tax.