France has long been one of the few countries without a withholding tax for payment of income taxes. Instead, taxes are paid in the year following the year in which the income is earned through a declaration of income. The French tax administration then calculates the tax on the reported income and sends a final tax bill in September of the following year. Thus, for someone arriving in France in January 2017, his tax bill payment deadline is generally September 2018.
After President Hollande's stalled efforts to modernize this complex, archaic system, President Macron's administration has finally begun the process to revise the system in 2018. The changes will apply to salaries, retirement payments, and lifetime annual annuities with certain transition relief measures in place to prevent tax abuse and double taxation. The impact of these transitional measures will create significant issues for US taxpayers residing in France and immediate action may be necessary.
In devising a new system, the French government needed to maintain annual tax revenue while preventing double taxation and incentives for tax abuse given with the quandary of the "année blanche" or "blank year". If the government forgave income tax obligations in 2018, taxpayers might inflate income in 2018 to benefit from this tax holiday. Yet asking taxpayers to pay both 2018 and 2019 taxes in 2019 would cause an undue and politically unpopular cash burden.
The administration's compromise divided the withholding tax system in two: pay-as-you-earn (PAYE) for employees and retirees (withheld by the payor of income) and account payments (paid by the taxpayer). For those subject to PAYE, double taxation is eliminated by the Crédit d'Impôt pour la Modernisation Recouvrement (CIMR), or the tax credit for the modernization of tax collection, which is equal to the amount of tax calculated on 2018 income (other than "exceptional" income), thereby eliminating tax on 2018 income.
From a cash flow perspective, the government would be whole: instead of collecting 2018 taxes in 2019, they would collect 2019 taxes on 2019 income. Similarly, for salaried or retired taxpayers, they would continue to pay tax each year, though during the course of a lifetime, one year of tax, 2018, would be eliminated.
The CIMR and Non-Exceptional income
As 2018 is the non-taxed année blanche, the taxpayer dream is to make 2018 a big salary year giving rise to PAYE subject to the restriction that exceptional income does not qualify for the CIMR. The formula for calculating the CIMR is:
To be eligible for the CIMR, the income must be subject to PAYE, which covers certain salaries, retirement pensions, and certain lifetime annuities. Other types of income are not subject to PAYE but are subject to account payments: industrial and commercial profits, non-commercial profits, agricultural profits, real estate income, family support payments, and certain lifetime annuities. Also, dividends and interest, capital gains on sales of securities, and capital gains on sales of real estate are all not subject to PAYE. Accordingly, common sources of non-salary revenue for high net worth individuals and families will be excluded from the CIMR calculations for obvious abuse reasons.
While wages and salaries are subject to PAYE, certain employment income is excluded, including:
- Income from qualified equity plans (stock options, free shares, carried interest shares and BSPCE (options to increase the capital for certain creators of enterprises));
- Salaries of nonresidents of France; and
- Income from foreign sources giving rise to a tax credit equal to the French tax thereon.
Knowing that taxpayers would be inclined to take a liberal view in construing non-exceptional income to maximize CIMR, the administration broadly defined four categories of exceptional income:
- Income linked to exceptional circumstances occurring in 2018 (e.g., cessation of employment or directorship, assuming a directorship, transfers of professional athletes, retirement including capitalized retirement plans, monetization of time savings accounts beyond 10 days);
- Income not paid when due (anti-abuse) (payments which normally would have corresponded to a payment prior to or subsequent to 2018, e.g., a payment normally made in March 2019 accelerated to December 2018);
- Non-contractual "supererogatory" income ("gratifications surérogatoires"), which includes bonuses that are not linked to an employment contract or a directorship or going beyond that which is otherwise contractually provided (historical discretionary bonuses?); and
- Income which, by its nature, is not annual (retention bonuses?).
Where the classification of income as "exceptional" is not clear, the taxpayer can request that the administration formally state its position on the classification within three months of a good faith request from the payor. No response from the administration within three months is treated as an acceptance of the request.
The transition impact on US taxpayers residing in France
The transition to a withholding system creates a significant tax issue for US taxpayers subject to French resident individual income tax, in particular those taxpayers with significant non-exceptional income.
The problem arises because most US taxpayers elected the "accruals" basis for foreign tax credit purposes on IRS Form 1116 (Foreign Tax Credit) of their US income tax return. Under the default rule, US taxpayers may take foreign tax credits in the year in which the taxes are paid to the foreign jurisdiction. Section 905 of the US Internal Revenue Code permits a US taxpayer to alternatively elect to take foreign tax credits in the year in which the taxes are accrued.
This strategy made perfect sense for an American entering the French tax system (whether physically moving to France or returning to US tax compliance after a period of non-compliance). For example, imagine an American arriving in France on January 2, 2016, earning $150,000 in 2016. Her tax on the $150,000 would not be due until issuance of the bill by the French tax administration around September 2017. However, on her 2016 US tax return, she would probably owe tax on the $150,000 earnings in the absence of claiming a foreign tax credit for French taxes. Since no French tax was paid in 2016, the US taxpayer would typically elect on Form 1116 to take the French tax credits as they accrued in 2016 (though not payable in France until 2017). This would lower or eliminate the 2016 US tax otherwise payable. However, the election for the accruals method for foreign tax credit purposes is irrevocable.1
As we look to the 2018 "année blanche", if the accruals election has been made for foreign tax credit purposes, there will be no 2018 French tax to accrue to credit against the 2018 US tax liability in the case of non-exceptional income. As a result, many US taxpayers residing in France are discovering that significant balances will be due for 2018 US taxes. For US taxpayers resident in France with exceptional income earned in 2018, French taxes will accrue in 2018 and can be used against 2018 US taxes. Exceptional income that can be accelerated in 2018 may mitigate the negative effects of the transition year for some US taxpayers.
For US tax purposes, adjustments for withholdings or estimated tax payments can still be made for 2018 but there may nevertheless be a very significant surprise tax impact if all or a significant portion of the taxpayer's income is non-exceptional income. A thorough review of foreign tax credit carryovers to 2018 should also be made, which may help offset some of the 2018 US tax liability. One should note that the IRS currently denies the creditability of the hefty Contribution Sociale Généralisée (CSG) and Contribution au Remboursement de la Dette Sociale (CRDS) taxes (8% of income until 2017).2
As an aside, even if the taxpayer is on the "paid" basis for foreign tax credit purposes, there will also be no credits for 2018 non-exceptional French income. However, since 2017 French taxes are paid in 2018 and 2019 taxes will be paid in 2019, there is no gap in claiming the foreign tax credit when compared to the accrual basis taxpayer.
In conclusion, the advent of withholding taxes on salary and current year taxation is a major shift in the French tax system. For French taxpayers, the transition addresses the potential double taxation on employees through the CIMR on non-exceptional income in order to reduce or eliminate 2018 French tax. However, this may create a foreign tax credit gap for US taxpayers who no longer have 2018 French income tax to accrue as a credit against US taxes. The sooner that US taxpayers can assess their potential US liability, the sooner they can consider the acceleration of exceptional income, take other action to potentially limit penalties and interest, and, especially, set aside the necessary funds for the potentially larger underlying liability. Even with what planning may be available, as US taxpayers resident in France are paying French tax in 2018 on their 2017 income, the cash flow impact of making higher estimated payments of 2018 US tax may be catastrophic.
1 IRC § 905(a); Treas. Reg. § 1.905-1(a).
2 This position was challenged in Eshel v. Comm. 118 AFTR 2d 2016-5375 (831 F.3d 512) where the Court of Appeals reversed the Tax Court and remanded to give additional consideration to the US-France totalization agreement and the contracting parties' official views. If the challenge is successful, including CSG/CRDS as foreign taxes would increase the foreign tax credit carryover potential.