French Court rules on transfer pricing issue concerning a financial transaction

A French court, in its decision of 29th November 2023, rules that the conversion of fully convertible bonds, issued by a wholly owned subsidiary to its parent, into ordinary shares has a zero present value for the parent from an asset point of view and can not be leveraged in determining the arm’s length interest rate of the subscribed bonds.

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Facts of the case

A French company, Electricite de France International (EDFI), belonging to the EDF group, subscribed to all 68,285 bonds issued by its wholly-owned British subsidiary, EDF Energy Limited. The bonds had a five-year maturity and were convertible into ordinary shares (OCA) at any time after a three-year lock-in period. The bonds issued had a par value of 50,000 euros, representing a subscription price of 3,314,250,000 and paying an annual interest rate of 1.085%.

EDFI determined the interest rate of comparable conventional bonds to be 4.41% (mid-swap rate and a premium of 1.70%). However, it determined that the sum of the present value of the flows of the “debt” component of the bond at an interest rate of 1.085% and the value of the conversion option was equal to the subscription value of the OCAs. Therefore, the annual interest was charged at the rate of 1.085%.

Position of tax authorities

Tax authorities audited the accounts of EDFI and held the conversion component under the OCA mechanism had a zero value for EDFI from an asset point of view because the conversion operation is neutral as the holding is in the wholly owned subsidiary. ?It considered that the interest rate of 1.085% was insufficient and should be increased to an arm’s length rate of 4.41%. The shortfall in remuneration corresponding to the difference between the two rates constituted a distribution of profits abroad, on the basis of Article 57 of the French General Tax Code, in respect of years 2009 to 2014. The interest income resulting from the difference in interest rate was reintegrated into the profits of EDFI.

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Proceedings before the courts

The taxpayer won at lower levels in the first round of litigation, but the Conseil d’Etat sent the case back to CAA de Versailles for reconsideration. This court confirmed the position of the tax authorities.

The Court referred to the terms of the first paragraph of Article 57 of the French General Tax Code, applicable to corporate income tax by virtue of Article 209 of the same code: "For the purposes of determining the income tax due by companies that are dependent on or that control companies located outside France, profits indirectly transferred to the latter, either by way of an increase or decrease in purchase or sale prices or by any other means, are incorporated into the results shown in the accounts (...)".

It follows from these provisions that when the tax authority finds that the prices invoiced by a company established in France to a foreign company linked to it - or those invoiced to it by this foreign company - are lower - or higher - than those charged by similar companies operating normally, in such cases, the tax authorities must be deemed to have established the existence of an advantage which they are entitled to reintegrate into the results of the French company unless the latter can justify that this advantage had at least equivalent counterparts for it. In the absence of such a comparison, however, the tax authority is not entitled to invoke the presumption of profit transfer thus established but must, in order to demonstrate that a company has granted a liberality by invoicing services at an insufficient price - or by paying an excessive price for them - establish the existence of an unjustified difference between the agreed price and the market value of the asset transferred or the service rendered.

To justify the disputed taxes, the tax authorities relied on the fact that, by accepting a rate of interest lower than the market rate for bond issues, EDFI granted EDFE, located outside France, an advantage which was not offset by a conversion gain (bonds converted to shares), since the value of the conversion option, which consists exclusively in the right to acquire a fraction of the share capital in repayment of the bond loan granted, is necessarily zero when the option is granted to the person owning the entire share capital at the issue date.

The Court held that the sole shareholder has the power to decide, at any time, on the issue of new shares and their allocation to it in repayment of the bond loan it has granted to the company. The conversion operation is necessarily neutral for EDFI from an asset point of view since it owns, both before and after the conversion, all the capital of a company whose value is increased by the amount of the debt it has discharged up to the exact amount of the claim he had on it.

In these particular circumstances, even though the interest rate applied to the OCAs issued by EDFE was in line with the rate that would have been applied in an arm's length situation between unrelated companies, the tax authorities have established that the transaction at issue constitutes an intra-group financing transaction remunerated at a rate lower than the market value of services.

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?The claim of the EDFI that British Energy, now EDFE, could not have paid an interest rate of 4.41% on an additional 30% of the cost of its acquisition by EDFI, that there was no alternative financing for the transaction and that capital financing would not have been interest-bearing, was also negated by the Court.

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Transfer of profits without consideration is an abnormal act of management in which a company decides to impoverish itself for purposes not in its interest.

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Under these conditions, it must be considered as established that EDFI has impoverished itself, without compensation, to benefit its non-resident subsidiary EDFE.

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