Ruling Signals Change in French Tax Treatment of LLP Distributions

Earlier this year, the French authorities signaled that a welcome change may be afoot in the tax treatment of distributions from UK LLPs under French law. (Most U.S. firms operate in France through the UK, unless they are grandfathered and in practice in France since the early 1990s.) This article discusses the scope of the ruling and its ramifications for UK firms considering a LLP conversion or those already in or contemplating alliances with French firms.

Background

Until very recently, there was no equivalent entity to a limited liability partnership under the French tax system, and this has created uncertainty about the appropriate tax treatment of partner distributions under French tax law. Under French law, the key issue is whether income flowing to a partner should be treated as flow-through income or whether it should be deemed a dividend and taxed at the entity level. In the UK and the United States, such distributions are considered flow-through income, which is reported by and taxable to the partner directly. This treatment avoids double taxation and is seen as a key benefit of the LLP structure.

The growth in the number of international mergers in the law firm market has increased the presence of UK firms in the French market in recent years. As of 2007, nearly all the leading French firms have formed alliances with international firms, with UK firms claiming the lion's share. A recent change in the UK tax law has made the LLP structure more beneficial to international firms, and accordingly clarification on the taxation of distributions has become more pressing. If the French law were to consider such distributions a dividend, this would have negative tax ramifications on all partners in the firm by subjecting them to double taxation on the French source income. This could put a strain on existing mergers and has left some firms pondering if the tax disadvantage is worth accepting in return for having a presence in one of the world's largest economies.

If the French authorities did not recognize the flow-through nature of the LLP structure, one way to limit the negative impact on the French partners was to have their status changed from partner to either independent contractor or employee. Because the French partners would lose their voting rights, this was often deemed to be an unacceptable solution.

Recent Changes

On May 15, 2007, the French authorities issued a decree allowing for French lawyers to create 'legal associations with individual limited liability,' the first step toward the French equivalent of an LLP.

In addition, in April, the French authorities issued a favorable ruling that French partners in a UK LLP should not be subject to double taxation. The ruling came about partly as a result of the lobbying efforts of UK firms Linklaters, Lovells, Freshfields, and Ashurst to gain clarification on the matter. While this ruling is a positive step, it is important to note that the ruling issued bears a resemblance to a U.S. Private Letter Ruling: It is client specific and cannot be relied upon as precedent.

At this stage, the publishing of a broader ruling is not thought to be imminent, and firms with similar fact patterns may wish to seek similar private rulings on their situation. UK firms with a classic LLP arrangement should be able to obtain the same ruling. In terms of timing, a private ruling should take four to six months depending on the time of year that the ruling is submitted. It is also advised that the firm's representative stay in close contact with the French authorities while the ruling is in progress to keep the process moving. The original ruling took two and a half years, but such a delay is unlikely for subsequent rulings.

Furthermore, once in possession of a favorable ruling, firms may consider claiming a refund at the entity level for the distributions previously taxed as dividends. The original ruling suggests that no philosophical objection remains to the principle of flow-through treatment and should bring some relief to the entities already established in the French market.

Looking Ahead

The election of Nicolas Sarkozy as French president in May is expected to bring greater liberalization of the French market, and this should spill over into the legal field. Nonetheless, we still expect significant delays before the new UK-France Tax Treaty signed in 2004 is ratified. This treaty, unlike the old treaty, addresses the issue of partnerships and LLPs and should help to entrench the concept of limited liability as applied to foreign partnerships into French law.

Law firms with an interest in France or planning to enter the French market should consider the implications of this ruling. It provides encouragement for those firms considering conversion to a UK LLP, and also provides planning opportunities for firms that have implemented arrangements to navigate the previous double taxation issue.

Stanley Kolodziejczak is a partner in PricewaterhouseCoopers' National Law Firm Tax Services, where he has served since 2006 as the lead national tax resource for PwC's Law Firm Tax Services Sector. Michael Jaffe is a partner and leads the Law Firm Tax Services Sector in France. Rachel Bentley is a member of PricewaterhouseCoopers' Law Firm Services Sector and practices in New York. Reach Kolodziejczak at 646-471-3160 or [email protected]; Jaffe at 33-1-56574042 or [email protected]; and Bentley at 646-471-7824 or [email protected]. Copyright 2007, PricewaterhouseCoopers, LLP. This article was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties.

Earlier this year, the French authorities signaled that a welcome change may be afoot in the tax treatment of distributions from UK LLPs under French law. (Most U.S. firms operate in France through the UK, unless they are grandfathered and in practice in France since the early 1990s.) This article discusses the scope of the ruling and its ramifications for UK firms considering a LLP conversion or those already in or contemplating alliances with French firms.

Background

Until very recently, there was no equivalent entity to a limited liability partnership under the French tax system, and this has created uncertainty about the appropriate tax treatment of partner distributions under French tax law. Under French law, the key issue is whether income flowing to a partner should be treated as flow-through income or whether it should be deemed a dividend and taxed at the entity level. In the UK and the United States, such distributions are considered flow-through income, which is reported by and taxable to the partner directly. This treatment avoids double taxation and is seen as a key benefit of the LLP structure.

The growth in the number of international mergers in the law firm market has increased the presence of UK firms in the French market in recent years. As of 2007, nearly all the leading French firms have formed alliances with international firms, with UK firms claiming the lion's share. A recent change in the UK tax law has made the LLP structure more beneficial to international firms, and accordingly clarification on the taxation of distributions has become more pressing. If the French law were to consider such distributions a dividend, this would have negative tax ramifications on all partners in the firm by subjecting them to double taxation on the French source income. This could put a strain on existing mergers and has left some firms pondering if the tax disadvantage is worth accepting in return for having a presence in one of the world's largest economies.

If the French authorities did not recognize the flow-through nature of the LLP structure, one way to limit the negative impact on the French partners was to have their status changed from partner to either independent contractor or employee. Because the French partners would lose their voting rights, this was often deemed to be an unacceptable solution.

Recent Changes

On May 15, 2007, the French authorities issued a decree allowing for French lawyers to create 'legal associations with individual limited liability,' the first step toward the French equivalent of an LLP.

In addition, in April, the French authorities issued a favorable ruling that French partners in a UK LLP should not be subject to double taxation. The ruling came about partly as a result of the lobbying efforts of UK firms Linklaters, Lovells, Freshfields, and Ashurst to gain clarification on the matter. While this ruling is a positive step, it is important to note that the ruling issued bears a resemblance to a U.S. Private Letter Ruling: It is client specific and cannot be relied upon as precedent.

At this stage, the publishing of a broader ruling is not thought to be imminent, and firms with similar fact patterns may wish to seek similar private rulings on their situation. UK firms with a classic LLP arrangement should be able to obtain the same ruling. In terms of timing, a private ruling should take four to six months depending on the time of year that the ruling is submitted. It is also advised that the firm's representative stay in close contact with the French authorities while the ruling is in progress to keep the process moving. The original ruling took two and a half years, but such a delay is unlikely for subsequent rulings.

Furthermore, once in possession of a favorable ruling, firms may consider claiming a refund at the entity level for the distributions previously taxed as dividends. The original ruling suggests that no philosophical objection remains to the principle of flow-through treatment and should bring some relief to the entities already established in the French market.

Looking Ahead

The election of Nicolas Sarkozy as French president in May is expected to bring greater liberalization of the French market, and this should spill over into the legal field. Nonetheless, we still expect significant delays before the new UK-France Tax Treaty signed in 2004 is ratified. This treaty, unlike the old treaty, addresses the issue of partnerships and LLPs and should help to entrench the concept of limited liability as applied to foreign partnerships into French law.

Law firms with an interest in France or planning to enter the French market should consider the implications of this ruling. It provides encouragement for those firms considering conversion to a UK LLP, and also provides planning opportunities for firms that have implemented arrangements to navigate the previous double taxation issue.

Stanley Kolodziejczak is a partner in PricewaterhouseCoopers' National Law Firm Tax Services, where he has served since 2006 as the lead national tax resource for PwC's Law Firm Tax Services Sector. Michael Jaffe is a partner and leads the Law Firm Tax Services Sector in France. Rachel Bentley is a member of PricewaterhouseCoopers' Law Firm Services Sector and practices in New York. Reach Kolodziejczak at 646-471-3160 or [email protected]; Jaffe at 33-1-56574042 or [email protected]; and Bentley at 646-471-7824 or [email protected]. Copyright 2007, PricewaterhouseCoopers, LLP. This article was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties.