Real estate structures and tax treaty issues: questioning current thinking
Real Estate Investment Trusts (“REITs”) give all investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate in the same way they typically invest in other asset classes – through the purchase and sale of liquid securities. Qualifying REITs are also tax transparent in that they can declare and distribute income to investors on a gross basis.
However, as the REITs industry has grown, the tax exemption status of these structures has led to questions with regard to the application of tax treaties. For example, distributions by French REITs may be subject to withholding tax when beneficiaries are domiciled outside of France.
In an OECD public discussion draft published on October 30, 2007 entitled “tax treaty issues related to REITs”, from which recommendations have already been included in OECD guidelines (comments on article 10), the OECD indicated that: “It seems, however, that in most cases, the REIT would meet the condition of being liable to tax for purposes of the treaty definition of “resident of a Contracting State”, subject to particular problems arising from the application of tax treaties to trusts. There are a few countries, however, where this may not be the case and this is a question that would need to be clarified on a country-by-country basis during treaty negotiations”.
As regards the relevant tax payer for tax treaty purposes, the OECD said: “It seems clear that absent specific provisions, the determination of whether the tax treaty provisions should be applied at the level of the REIT or at that of its investors will not be uniform between countries”.
As a consequence, a number of different situations have to be determined with regard to international tax treaty provisions and the treatment of REITs.
First, the tax treaty can expressly mention the REITs as beneficiaries of the provisions of the tax treaty. For example, the France – UK tax treaty allows REITs to benefit from its provisions, even if they are expressly excluded under withholding tax rules. In such cases, the company is considered as resident under provisions of the tax treaty. If the tax treaty does not contain any specific provision concerning its applicability to REIT structures, the OECD public discussion draft indicates that the applicability of tax treaties at the level of the REITs or the investor needs to be analysed on a case-by-case basis.
In this respect, the French Administrative Guidelines provides that French REITs (SIIC) are subject to withholding tax on distributions realised abroad, depending on double tax treaty provisions. As a consequence, it seems that, in principle, the French tax authorities consider that REITs may benefit from tax treaty provisions, notably when the tax treaty does not contain any specific provision as regards to real estate structures.
Nevertheless, this approach could fundamentally change since the residency notion has been subject to precision by the French Administrative Supreme Court (or “Supreme Court”) in 2015 and 2016. Indeed, the Supreme Court has denied tax treaty benefits to companies exempt from corporate income tax (“CIT”). As a consequence, these decisions could question the application of tax treaties to real estate structures, in particular REITs which are partially or totally exempt from CIT.
The residency notion depends on the definition of liability to tax …
As a rule, in order to benefit from tax treaties, a company must be considered a resident of both signatory States. In this respect, most of the tax agreements signed by France are drafted in accordance with a model provided by the OECD which defines the term resident as “any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any criterion of a similar nature”.
Nevertheless, neither the tax treaties nor the OECD guidelines provide an accurate definition of the liability to tax. As a consequence, the Supreme Court, as would have any other local Court questioned about the applicability of the tax treaties, had to clarify this notion in order to determine whether the claimants could benefit from the favorable provisions of the tax treaty or not.
While the expression “liability to tax” is not defined by the French tax law, the ordinary meaning of “to be liable”, notably with regard to VAT, refers to being in the scope of the tax, regardless of any tax exemption applicable. Whereas “to be subject” to tax refers to being in the scope of the tax and effectively paying it.
However, this ordinary meaning of liability to tax under French tax law was not retained by the Supreme Court, which considered that a company cannot be defined as a resident and benefit from tax treaty provisions if it does not effectively pay its cross-border tax obligations. This view was developed through three decisions.
… whose meaning has been specified by the French Administrative Supreme Court …
In two decisions dated 9 November 2015, pension funds based in Germany and Spain had received dividends from a French company. Withholding tax on cross-border distributions of dividends was applied under provisions of the French Tax Code (art. 119 bis and 187-1). In accordance with tax agreements – reached by France and Germany in the first case and France and Spain in the second case – entities had claimed a partial refund of withholding tax. Indeed, both tax agreements allow the State, where the beneficiary of the distribution is established, to tax the income and the State of the paying entity to apply withholding tax which is limited or suppressed by the tax agreement. Nevertheless, the French Tax Administration, followed by the Supreme Court, has rejected the claims of the pension funds to benefit from the provisions of the tax treaties, arguing the funds are not residents of any Contracting State because they are not taxed by them.
As a consequence, in these two decisions, the Supreme Court has chosen a restrictive approach of the term “resident” corresponding to the common use of the expression “subject to tax”, instead of considering each person liable to tax (even in the situation of a specific tax exemption) as a resident. Not only has the Supreme Court considered that a person shall be subject to tax, but also that it must be subject to tax in the recipient State (or in the State benefitting from the exclusive right to taxation) on the cross-border income to benefit from the “resident” status.
This additional requirement was ruled in a third decision dated 20 May 2016 involving a Lebanese offshore company providing informatics services in France. This entity had paid salaries from France to a Lebanese company for its own activity purposes, triggering the application of withholding tax on salaries (art. 182 B of French Tax Code). The offshore company had claimed the benefit of the tax agreement between Lebanon and France to obtain a refund of withholding tax on payrolls. French Tax Administration, followed by the Court of Appeal, rejected the claim arguing that the offshore Lebanese company was subject to a specific tax, different from CIT covered by the tax agreement since it was not based on turnover. The Supreme Court overturned the decision of the Court of Appeal since it did not take into account whether the tax applicable in Lebanon on the offshore company was to be qualified as corporation tax for purposes of the tax agreement or not.
In any case, the Supreme Court ruled in this decision that cross-border income must be subject to tax in the recipient State (or in the State benefitting from the exclusive right to taxation) in order to make a company eligible for “resident” status and apply the provisions of the tax agreement.
…but further clarification is necessary
First, these decisions can be criticised with regards to the method used by the Supreme Court for the determination of the notion of “resident”. Indeed, in the case at hand, the interpretation method was applied considering their context and in the light of their object and purpose, which means the term “resident” was interpreted according to the ordinary sense given to the tax agreement terms. The Supreme Court considered that the aim of the tax agreement was to avoid double taxation and, as a consequence, that being “effectively subject” to a tax is a requirement in order to benefit from “resident” status.
Nevertheless, this method corresponds to an application of the Vienna convention of 1969 whereas the OECD model provides with its own interpretation method: when terms of a tax agreement is not defined or is unclear, it shall be interpreted by the meaning given in the national law. In the case at hand, the tax agreement terms between France and Germany are the same as the OECD model. In any case, the Supreme Court has decided to use the Vienna Convention interpretation method instead of the one provided by the OECD model.
In addition, the interpretation of resident retained by the Supreme Court is also subject to criticism. In the first two decisions, it has been considered that companies exempt from tax when applying local law and those subject to a nil tax rate are excluded from the qualification of “resident”. In this respect, the public attorney (“rapporteur public”) has indicated that the question is not to know whether the company has effectively paid tax or not, but if the legislator wanted to exclude this entity from the scope of the taxation laid down in the tax agreement (due to its specific status or activity). In such cases, the company cannot be considered as resident under the terms of the tax agreement.
Moreover, the ruling dated 20 May 2016 does not indicate precisely how corporation tax is determined. Indeed, the Lebanese offshore company had effectively paid a specific tax only due by offshore companies which is not based on the turnover of the company, is very modest and is calculated from a flat rate. As a consequence, according to the French Tax Authorities, these circumstances were not sufficient to qualify as CIT covered by the tax agreement and the company was excluded from tax treaty benefits. Even if the Supreme Court has not ruled on this question (since the Court of Appeal did not analyse the nature of the aforementioned Lebanese tax), the public attorney seems to follow the analysis of the French Tax Authorities. Shall the Supreme Court rule this way in a future decision, it would have to specify with more accuracy the conditions a tax has to comply with to be considered as a tax in the scope of the tax agreement.
Furthermore, the interpretation of the Supreme Court can be questioned since it implies that a company can be considered as both resident and non-resident for the application of the tax agreement, depending on the nature of the revenue and its effective submission to tax in different countries.
Indeed, would a company receiving two cross border incomes be considered as resident in a country for both revenues purposes when only one is effectively taxed, or would it be considered as a resident and benefit from the tax agreement provisions for the taxed income treatment only?
Finally, the consequences of these decisions on real estate structures and the REITs regime is now highly uncertain, particularly as these regimes exempt real estate structures from tax. In France, for example, the SIIC regime provides that these structures are within the scope of CIT, but exempt from tax on real estate revenues, including dividends received from similar structures.
In this respect, both French Tax Authorities and OECD guidelines tend to be in accordance on the tax treaty benefits to real estate structures where no provision expressly excludes such benefits.
Nevertheless, on the basis of the decisions described above, could the Supreme Court consider that REITs cannot benefit from international tax treaties, regardless of the provisions set out by the French administrative doctrine and the fact that these structures effectively pay corporation tax on the non-real estate revenues?
Article written by Elena Aubrée (Tax Partner) & Denis Moati-Marcozzi (Tax Associate)