French Supreme Court confirms "hybrid" trust tax treatment of trust income for non-discretionary revocable trusts with US citizen, French resident beneficiaries

The Supreme Court for Administrative matters in France has recently considered whether Article 4(3) of the US/French double tax treaty (as amended, the "Treaty") should affect the French tax treatment of certain US citizen, French resident beneficiaries of a non-discretionary, revocable trust administered in the United States (case number 406825 of 18 April 2023).

As background, we note that US citizens are subject to US income tax on their worldwide income and gains wherever they happen to live.  The US citizens discussed in the Supreme Court's ruling were also tax resident in France for the relevant taxable period.  As a result, these individuals were also subject to French tax on a worldwide basis.

The Supreme Court indicated that the trust under consideration was fiscally transparent as to its beneficiaries from a US tax perspective.  While the court did cite the technical US basis for that conclusion, it is likely that the trust was either a "grantor trust" or "simple trust" under US federal tax law for the applicable years.  In any case, each of the trust's beneficiaries was apparently treated for US tax purposes as earning their pro rata share of the trust's earnings directly, regardless of if or when that beneficiary received a distribution from the trust. 

However, French tax rules do not recognise such trusts as being fiscally transparent, which means that the trust's beneficiaries are not regarded as earning their rateable share of trust income directly for French tax purposes. 

The French Supreme Court was asked to consider whether Article 4(3) of the Treaty modifies or changes the French tax treatment of offshore trust beneficiaries.  Article 4(3) of the Treaty provides, in relevant part, that if a person who is resident in one of the two treaty countries earns income through an entity which is regarded as fiscally transparent under the internal law of that country, i.e. the individual's country of residence, then that individual may claim to have "derived" the fiscally transparent entity's income directly for purposes of claiming treaty benefits in relation to that item of income.  By way of example, consider a Cayman Islands partnership that has filed a "check the box" election under US tax law to be treated as fiscally opaque from a US tax perspective but which is considered to be fiscally transparent for French tax purposes.   If that Cayman partnership earns US-source dividend income, the principles of Article 4(3) would generally allow a French resident individual to claim a reduced rate of US withholding tax under Article 10 of the Treaty on the Cayman partnership's US-source dividend income, notwithstanding the fact that the US tax system views the income as being earned by a fiscally opaque Cayman entity which is not resident in either of the two countries.  

As explained above, under French tax rules, a US trust's earnings are not viewed as being earned directly by its beneficiaries.  Instead, to the extent the earnings have been distributed to the beneficiary, that income will generally be subject to French tax during the year of the distribution as "property income" arising outside of France, and taxed as such under domestic rules. 

The specific question put to the Supreme Court was whether Article 4(3) should be understood as somehow superseding or otherwise modifying the default treatment of trust beneficiaries under internal French tax law, i.e. that the beneficiaries should not be subject to French tax on the trust's earnings unless and until they have received an actual distribution from the trust.

While the procedural context for the Supreme Court's opinion is not clear, one possibility is that the US citizen, French-resident beneficiaries may have argued to the French tax authorities that Article 4(3) should allow them to treat the trust as if it were fiscally transparent from a French tax perspective and thus match the US and French tax treatment of the trust's earnings.   As a general rule, US citizen taxpayers living abroad in high-tax jurisdictions typically aim to align the timing of tax events in each of the two tax jurisdictions to better position themselves to alleviate double tax through the use of "foreign tax credits," to the extent allowed under US law or the law of the other jurisdiction.  If there a timing mismatch—for example, if US tax purports to tax the individual during the year the trust earns the income in question, while France waits to impose tax until the year of an actual trust distribution — then it is typically more difficult to mitigate double tax leakage in this way.

The Supreme Court ultimately concluded that Article 4(3) of the Treaty should not impact the characterization of the trust as tax-opaque under domestic French tax law.  Among other things, the Court observed that Article 4(3) looks expressly to the taxpayer's country of residence—in this case, France—in determining whether an entity should be regarded as fiscally transparent or opaque for Treaty purposes.  It saw no reason why Article 4(3) should compel the French tax authorities to treat the trust as fiscally transparent given that the trust is clearly opaque under France's internal tax rules. 

The decision reaffirms the basic principle that the earnings of a US trust are not subject to French income tax unless and until they are distributed.  Actual distributions from such a trust to a French resident beneficiary are generally subject to a flat investment income tax rate of 30% in France.  

The Supreme Court did not opine on how a US citizen French resident trust beneficiary might try to remedy this timing mismatch through the use of US or French foreign tax credits.   Although the foreign tax credit system works most efficiently to alleviate double taxation where both of the relevant tax jurisdictions are purporting to tax a particular individual on an item of income in the same year, US citizens residing in France may still in certain instances claim tax paid to the French tax authorities during one year as a US foreign tax credit against tentative US income tax incurred during a different year (or alternatively claim tax paid to the US Internal Revenue Service as a foreign tax credit against French tax).   

In sum, while the Supreme Court's ruling may be disheartening in certain respects for US citizens living in France, there are still a host of cross-border foreign tax credit strategies that they might deploy to fend off double taxation.