Pierre Appremont of Lefèvre Pelletier & associés provides an overview on the trends and taxation of French real estate.

Introduction

The year 2008 promises to be an exceptional one for French real estate investment in view of the changing conditions affecting financing and the market in general.

However, it will also be a busy year on account of the relative fall in values and in particular with the maturing of a number of funds launched at the beginning of the new millennium.

In this context, the recent changes to the taxation of real estate will also have a certain impact on investor strategies. In the same way, certain currently existing funds are now planning restructuring operations to meet the changes to the tax regime.

The year 2008 will see the “two-speed” taxation of real estate:

• a tightening of the tax treatment applied to non-regulated operators;
• the extension of regulated, fully-exempt investment tools to almost all players.

This change is aimed at attracting real estate operators towards tax-exempt tools that are under the control of the regulatory authorities. It thus diminishes the space allowed to purely private funds with sophisticated structures. Nevertheless, given that the French authorities are restricted by those currently existing tax treaties that still require renegotiation, certain opportunities remain.

Structured Investment funds: a tightening of the tax regime

The most striking aspect in this regard has been the application, since 26 September 2007, of corporation tax (CT) at the ordinary law rate of 34.43% to disposals of shares in companies that hold the majority of their assets in real estate (REC). This increase (such disposals were previously taxed at a rate of 15.5%) was made without any prior consultation, and clearly aims to slash the use of RECs in the structuring of real estate investment funds at a reduced rate of taxation.

During the same period, an amendment to the Franco-Luxembourg tax treaty was ratified, putting an end to the double exemption on the holding and disposal of French real estate assets by Luxembourg companies that had arisen from a difference in the interpretation of the law in France and Luxembourg.

Finally, the new rules governing thin capitalisation came into effect in 2007 which, in contrast to their predecessors, actually do limit deductible interest mainly to the higher of the following two thresholds:-

• debt from groups less than one-and-a-half times the shareholders’ equity of the borrowing company;
• interest paid to the group less than 25% of the current result before group interest and depreciation (this regime also contains a trigger threshold of €150,000 and certain special provisions covering tax groups, treasury pools or interposed companies in the context of a financing operation).

Taken together, these measures have resulted in a tightening of the taxation applicable to real estate investments, particularly those held by non-residents, with the effect that the income and capital gains from such activities are subject to CT at 34.43% under French ordinary law.

Setting up of private regulated funds

The “SIIC” regime in France in fact preceded the REITs regime. However, as such vehicles require a public issue and must be quoted, they are held by a relatively small number of investors, all the more so as, after the authorities noted the tax leakage following the introduction of the device, the SIIC regime was tightened up to prevent its further use by private investment funds (in particular, the specific taxation of dividends received by shareholders that are legal entities with a holding of over 10% and that are taxed at a low rate; maximum holding of less than 60% by any one shareholder).

Consequently, 2005 saw the launch of the OPCI (real estate collective investment fund), an investment vehicle that benefits from CT exemption in a similar way to REITs, but for which a public issue is not necessary: however, they are in any case regulated.

This device, which took some time to appear, has finally been introduced and the first “club deal” OPCIs appeared at the end of 2007. They offer full exemption for the investment vehicle itself, both as regards rental incomes and capital gains, subject to a distribution obligation (85% of rental income and 50% of capital gains) and the actual taxation of dividends in France. In fact, the French government has indicated that the OECD-type tax treaties that it signed will not be applicable to such vehicles since they are not subject to tax. Dividends paid to non-residents will thus be subject to withholding tax at a rate of 25% (the rate applicable under French law to distributions of dividends to non-resident beneficiaries).

More generally, France has indicated that it intends to follow the recommendations of the OECD discussion draft on REITs, namely that investors holding more than 10% of a fund are to be subject to the taxation applicable to real estate in France (i.e. 25%), whereas investors holding less than 10% will be taxed in the same way as financial investors (through application of the tax treaties with a reduction in the withholding tax applicable to dividends, i.e. in general a rate of from 0% to 15%).

The French regime will thus produce the following situation:

• unregulated funds will be subject to taxation at a rate of 34.43%;
• non-resident investors in exempt regulated funds will be taxed in France at 25% or between 0% and 15% if they hold less than 10% in the investment vehicle.

While this regime is rational, it nevertheless suffers from certain teething troubles, resulting mainly from the existence of international tax treaties that cannot be unilaterally modified by France.

Such problems are undoubtedly temporary in the regime as it stands and relate mainly to older treaties that do not include two special clauses contained in the OECD model:

• the taxation of capital gains relating to RECs shall be in the country in which the real estate is located;
• the investor shall be subject to tax in one of the signatory states in order to benefit from the treaty provisions.

The lack of taxation in France of capital gains on RECs that own French real estate assets permits the creation or holding of investment funds where the holding company is located in a country that has concluded such a treaty with France.

In this case, if the disposal relates to securities, the capital gain will not be taxable in France and very often the law of the country in which the holding company is located will exempt such gains (many countries exempt capital gains on the disposals of securities in companies, irrespective of whether or not such companies hold the majority of their assets in real estate, e.g. in Luxembourg).

Taxable rental income is however generally very low for the first five to seven years of the investment owing to the deduction of the acquisition costs (6% to 8% in France: this is immediately deductible) and on account of external and internal financial costs, subject to the rules governing thin capitalisation and depreciation.

In the same way, as regards OPCIs, if the investor is located in a country that has concluded a treaty with France that is applicable to French companies not subject to tax, the relevant withholding tax provisions will be applicable to any dividends paid.

Consequently, if the treaty reduces or provides for an exemption from withholding tax, the OPCI shareholders will benefit from this, thus reducing the total taxation borne by the investment in France that is charged on incomes (rents and capital gains realised by the OPCI).

Moreover, certain types of OPCI can use a strong system of financial leverage that will absorb practically all of the rental income via interest charges that are not subject to withholding tax.

Obviously, this type of structure is time-limited as France is currently renegotiating its tax treaties. Negotiations are proceeding more quickly in certain cases where the other state is also a target for investment and has an interest in updating the treaty (for example Germany). For other countries, it will undoubtedly require a few years before the changes desired by the French tax authorities are achieved.

Given its inability to modify the treaties in the immediate future, France is becoming increasingly rigorous in its application of the treaties, in particular with regard to the actual substance and tax residence of holding companies. Several unexpected tax controls have thus been witnessed, aimed at showing that the foreign holding structure around which the fund pivots is actually managed from France, thereby allowing the tax authorities to deny the application of the treaty and to subject the fund to French taxation. In this area, such actions have found a positive echo in the courts. Investors are thus strongly advised to be vigilant regarding the substance and chosen residence of the companies making up the funds.

Conclusion

In conclusion, we can say that the changes to real estate taxation in France are probably not yet finished: they form part of an international movement aimed at taxing income from real estate, including capital gains, in the country in which the asset is located. It would thus be highly risky not to take account of such developments for real estate investments where non-residents are likely to be involved.

Nevertheless, the changes described above are by their nature slow to evolve: there remain certain options which, if all the conditions are met, may still prove attractive.

About Lefèvre Pelletier & associés

Lefèvre Pelletier & associés is one of France’s leading law firms, with a major involvement in real estate, mergers & acquisitions, private equity, banking / finance and litigation. The firm has more than 150 lawyers, including 33 partners, and four overseas offices. (Hong Kong,Guangzhou, Algiers and Casablanca). The firm pools the skills of its teams in all areas of business law to provide advisory and litigation services to its French and international clients. Lefèvre pelletier & associés covers all areas of real estate from investment to commercial leases as well as financing, construction, taxation and environmental issues.

Lefèvre Pelletier & associés, Avocats
136, avenue des Champs-Elysées - 75008 Paris
Tél. : +33 (0)1 53 23 12 09
Fax : +33 (0)1 53 93 30 30
www.lpalaw.com

Article Added Friday, 28 March 2008 | 1810 Hits

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