Keith O'Donnell of Atoz and Franck Llinas of Arsene -Taxand examine the impact of a ruling which allows Luxembourg to seek revenue from French real estate structures
Due to their common past, Luxembourg and France share, to a certain extent, similar legal forms of companies which can be divided between sociétés de capitaux, covering corporations, limited liability companies and partnerships limited by shares, and sociétés de personnes, including general partnerships, limited partnerships, and civil companies (sociétés civiles). Civil companies are often used by international investors to invest in French real estate, in which case they are denominated real estate civil companies (société civile immobilière, SCI). Usually, a Luxembourg company, generally called SOPARFI, is the holder of the French SCI.
Recent developments in Luxembourg jurisprudence may make investments in SCIs more problematic. Under Luxembourg domestic law, Luxembourg sociétés de personnes, including sociétés civiles, are generally fiscally transparent. The tax treatment applicable to the income derived by a Luxembourg tax payer from a foreign company depends on the qualification of such company under Luxembourg domestic law. In this respect, given that the legal characteristics of a French SCI and a Luxembourg société civile are the same, it is commonly assumed that French SCI should be considered as a tax transparent entity for Luxembourg tax.


Luxembourg
One of the consequences of this analysis would be to consider that income received by a Luxembourg corporate company from a French SCI should be tax exempt in Luxembourg, based on the provisions of article 3 of the convention between France and the Grand-Duchy of Luxembourg for the avoidance of double taxation and the establishment of rules of reciprocal administrative assistance with respect to taxes on income and capital dated April 1 1958, and amended by a first protocol on September 8 1970 (DTT).
However, the Luxembourg Administrative Court (the Superior Court in tax matters) has recently denied the benefit of article 3 to income and capital gains realised by Luxembourg residents from the shares held in a French SCI, considering that article 19-2 of the DTT provides for special provisions in the case of investment through sociétés de personnes.
The C-case – The lower court
In a judgment dated December 20 2006 (the C case) the Luxembourg Administrative Tribunal considered that capital gains on the sale of real estate located in France realised by a Luxembourg company through a French SCI which is not subject to French corporate income taxation could not be considered as an income from participation, (produit de participation) within the meaning of article 19-2 of the DTT.
Given its legal characteristics, the tribunal considered that the French SCI should be treated in the same way as a Luxembourg société civile and should be considered as transparent for Luxembourg tax purposes (§ 11 bis StAnpG).
The gain had to be considered as income from immovable property within the meaning of article 3 of the DTT, which provides that "income from immovable property and property accessory thereto, including profits from agricultural and forestry undertakings, shall be taxable only in the state in which the property is situated. This also applies to profits derived from the alienation of such property", and therefore only taxable in France.
The tribunal also considered that the income was real estate income within the meaning of article 3 of the DTT and that this article prevailed over other provisions applicable to other types of income, and especially article 19-2 of the DTT which provides that "notwithstanding the provisions of this convention, each of the two contracting states retains the right to tax in accordance with its statutory regulations, earnings from participations in [an] enterprise constituted as private companies (société civile) ".
According to the tribunal, the concept of "income from a participation" within the meaning of article 19-2 of the DTT refers only to current income but does not include capital gains such as capital gains on the sale of the real estate. In the case at hand, it appeared to the Tribunal that the income was only taxable in France based on article 3 of the DTT and exempt in Luxembourg.
This decision of the tribunal was in contradiction to recent case law.
Previous case law
In another recent decision (SOPARES/Malux case law: judgment of the tribunal of July 20 2005 and decision of the administrative court of January 10 2006), the tribunal and the Luxembourg Administrative Court (to which administrative tribunal decisions can be appealed) had decided that capital gains realized on the sale of shares of a French SCI that opted to be subject to the French corporate income tax (opaque SCI) had to be considered as a capital gain fully taxable in Luxembourg without any possibility to benefit from the Luxembourg participation exemption.
The tribunal in that case considered that no distinction had to be made between current income and capital gains realised by a Luxembourg tax payer through a French SCI and considered therefore that both were covered by article 19-2 of the DTT so that Luxembourg could tax income or gains derived from a SCI. This position was confirmed by the administrative court.
The right to benefit from the Luxembourg participation exemption regime was denied based on the fact that such regime did not cover at the time partnerships incorporated in an EU member state.
There was still a doubt in some quarters. Although Luxembourg could tax the income in accordance with article 19-2, some advisers felt that Luxembourg, in exercising its right to tax the income, should apply general internal law principles to disregard the SCI and therefore the income would fall back into the DTT and be exempted under article 3. This analysis was appealing in that it fitted the general Luxembourg law and practice of treating SCIs as transparent and indeed the lower court in the C-Case followed this analysis. However the analysis had one major flaw which the administrative court relied on in overturning the administrative tribunal.
The C case – The superior court
The C-Case decision rendered by the tribunal was appealed by the Ministry of Budget. The Luxembourg Administrative Court overruled the tribunal in a decision dated May 3 2007.
Based on the Luxembourg Administrative Court decision, income from participation within the meaning of article 19-2 should be understood as encompassing regular income from French real estate assets received through a French tax transparent SCI as well as capital gains realised by a Luxembourg taxpayer upon the sale of the shares in a French SCI.
It is the view of the Supreme Administrative Court that article 19-2 is of application notwithstanding the tax transparency of the French SCI or the provisions of article 3 of the DTT. Luxembourg is therefore entitled to tax income from participation in a French SCI realised by a Luxembourg resident.
Once taxable in Luxembourg based on the provisions of article 19-2 of the DTT, the administrative court has also decided that capital gains realised by a Luxembourg corporate company upon the disposal of the shares of a French SCI cannot qualify to the Luxembourg participation exemption regime. Partnerships may only qualify to the Luxembourg participation to the extent that is legally incorporated in an EU member state as and is automatically subject to corporation tax in its home country without any possibility to opt for an exemption, which is not the case of a French SCI.
In order to avoid the double taxation, the Luxembourg taxpayer is allowed, under article 19-2 of the DTT, to deduct the tax paid in France up to the amount of taxation due in Luxembourg on such income.
French tax treatment
From a French legal perspective, a French SCI is a company with a separate legal personality. From a tax standpoint, it is however treated as a pass-through entity unless the company has elected to be subject to corporate income tax (CIT). Earnings of pass-through entities are computed at the level of the company based on CIT rules and/or individual income tax rules depending on the members. They are deemed to pass through to the members of the SCI and are subject to French personal income tax (if the recipient is an individual) and/or to French CIT (if the recipient is a company-tax entity) on their pro rata share of the income of the French SCI.
In the case where a French SCI is fully owned by a Luxembourg SA, the determination of the net taxable income of the French SCI is basically computed according to the French CIT rules. Consequently, the current income (such as the rental income) but also the capital gains upon disposal of real estate assets generated by the French SCI are subject to French CIT at the rate of 33,1/3% (or 34,43% if the taxable income exceeds 2.289.000 ) which the Luxembourg corporate company is liable for.
Based on the French tax treatment and according to C-case and Malux case decisions described above, the current income and the capital gains generated by the French SCI are taxable both in France and in Luxembourg.
One could wonder whether the French courts could follow the same reasoning and consider that this event is also taxable in France. To our best knowledge, this question has never been tested before the French courts in a similar case.
Legislation and case law suggests the disposal of a French SCI shares by a Luxembourg company should not be taxable in France. Our analysis is based on the fact that no provision of the DTT deals with this type of income and one should therefore rely on article 18 of the DTT for non denominated income according to which it is only taxable where the beneficiary is tax located.
Pursuant to a strict reading of the provision, article 3 of the DTT only refers to real estate asset. In our view, the disposal of the shares in a French SCI cannot be assimilated to the disposal of real estate assets since the shares in a company are qualified as moveable property and not, except very few exceptions, as immovable property.
In addition, article 19-2 should also not apply here since, in our view, the provision should be construed as including the income deriving from the interest in the French SCI (income and capital gains generated by the SCI) but not the capital gain deriving from the disposal of the interest itself.
If possibly, the French courts would share the extensive interpretation of the Luxembourg Supreme Administrative Court on article 19-2 of the DTT, article 244 bis A of the French tax code would allow France to tax also this capital gain. In such a case, the same tax credit as described above should however be applicable to avoid the double taxation. Nevertheless, the French CIT rate is higher than the one applicable in Luxembourg, so the effective taxation of the capital gain should be higher.
The opportunity of investing directly from Luxembourg in French real estate, based on the opposite jurisprudence of the French and Luxembourg Supreme administrative courts on the attribution of the right to tax income from French immovable property held directly by Luxembourg corporate companies, leading to an effective double non taxation, will disappear once the second protocol to the DTT, concluded on November 24 2006, will enter into force, that is on January 1 2008.


In addition to the protocol, the Luxembourg Supreme Administrative Court case law (C-Case and Malux) reduces the interest, from a Luxembourg tax point of view, of implementing investment structures involving Luxembourg corporate companies holding French real estate asset through a French SCI.
Appropriate structuring may however be considered in order to claim the French benefits of holding French real estate assets through a French SCI, with the possible reduction of French deferred tax in case of share deal exit, while managing the taxation of French real estate income in Luxembourg.