Trust Bulletin: New ruling on Trust Distributions - Income or Capital? 

On 11 October 2024, the Paris Administrative Appeal Court issued a ruling which highlights the challenges when having to evidence the nature of trust distributions for French tax purposes.

Under French Tax Code (“FTC”) Article 120 9º, French tax resident beneficiaries must report the trust “products” they receive for income tax. There is no legal definition of “products”, but practitioners consider this refers to income and gains arising from the trust funds. 

Such distributions are taxed as investment income at a 30% flat rate or, by option, at French income tax scale rates plus 17.2% social surcharges. 

Income and gains accumulate tax-free within a trust until they are distributed. Nevertheless, a trust in a low tax jurisdiction may fall under the scope of anti-tax avoidance FTC Article 123 bis, which provides for look-though taxation. 

By contrast, capital distributions including capitalised “products” may, depending on the circumstances, be treated as taxable gifts or legacies. The liability depends on the relationship between the settlor, (or “deemed settlor” if the original settlor has passed away)  and the beneficiary. 

The “deemed settlors” are treated as the new “owners” of the trust assets, including the capitalised products, valued at the settlor’s death. Provided there is a perfect match of beneficiaries and asset allocation since the settlor’s death, subsequent capital distributions may be exempt from gift tax (i.e. treated as a gift to themselves). 

The case heard in the Appeal Court related to several trust distributions awarded between 2009 and 2011 to the sole beneficiary of a Canadian trust. A first tax audit which led to the application of income tax and penalties, was successfully defeated by the taxpayer. 

Nevertheless, this was subsequently overturned, and the liabilities reinstated, on the grounds that: 

1. The burden of proof on the nature of the distributions fell to the taxpayer;
2. The reply from the Canadian tax authorities was incomplete and unreliable as they had accepted information at face value;
3. The Canadian bank’s documents were inconclusive; 
4. The trust, whilst claiming a deficit, had disguised earnt interest into exempt capital transfers; 
5. The information provided did not corroborate any effective trust activity other than asset-holding. 

On the contrary, in a similar case reviewed in May 2013, the Cergy-Pontoise Administrative Court found the presented evidence adequate to distinguish the capital from the income. This consisted of detailed statements of the trust’s capital movements and a letter from the Canadian tax authorities outlining the settled capital sums since the outset and listing all capital distributions.

The above illustrates the ongoing uncertainties in the absence of any clear legal guidelines or methods to irrefutably confirm the nature of trust distributions. This is crucial, since capitalised income and gains may be included in any taxable gift or legacy.  

Keeping records and accounts is necessary but may not be sufficient without a properly evidenced separation of capital and income. Being able to “follow the money” and retrace the values of settled assets, the income and gains generated thereon, and full distribution history is essential. 

Unfortunately, the trail of evidence may be irretrievably “muddied” when it comes to long-standing trusts. 

These situations would merit an accepted set method such as, for instance, the rules applicable to life assurance withdrawals or a simpler “first in first out” principle, or a trustee arbitration but none of these have any current French legal backup. 

In a context where the French Tax Administration are always on the look-out for extra funds, it is important to review each case to determine the adequacy of past data and identify any areas of risk. 

Contact French.tax@bdo.gg to find out how they can assist with any of the issues described above.