Management participations for top managers have become a standard means of aligning the interests of management and investors. It is especially widespread among private equity funds in the process of acquiring companies, as investors have become very aware of the fact that the attraction and retention of good management is crucial. Consequently, the structuring of management participations has developed into a special product requiring specialized advice with regard to the legal, tax and economic aspects of such participations, not only in Germany but also many other countries.
1) Alternatives to Equity Investments following the Introduction of a Capital Gains Tax in Germany?
Until 2008 a major factor in the 'success' of management equity participations in Germany was the country's favourable capital gains tax regime, which left capital gains tax-free as long as the participation was held for more than 12 months and was equal to less than 1% of a company’s statutory capital. Starting in 2009, Germany established a withholding tax of 25% on any capital income (plus solidarity surcharge and church tax) e.g. on dividends, interest of any kind and on capital gains for shares acquired during or after 2009. These changes did not eliminate the attractiveness of management equity participations from a tax point of view, but reduced it substantially when the income tax rate on employment income of up to 45% plus solidarity surcharge and church tax was taken into account.
Following this development, some investors considered structuring management participations as debt instruments, e.g. sub-participations, warrants, etc., which would allow managers to benefit from the reduced tax rate and enable the paying company to deduct the interest payments as business expenses. However, in practice, the tax authorities accepted payments on debt investments as capital income only in so far as they represented a marketable interest rate for bonds and comparable debt instruments. Any overpayments (and sometimes the total proceeds), e.g. resulting from exit proceeds, were qualified as fully taxable employment income. Equity investments therefore remained the preferred investment form for management participations despite the taxability of capital gains.
2) Stronger Focus on Management Participations by the Tax Administration
In addition, the tax administration has increasingly focused on management participations. It has learned about the specific structures of these participations and developed arguments to challenge them and qualify all or part of the proceeds thereof as employment income:
- Acquisition of beneficial ownership in the shares, e.g. because of restrictions in the disposal, resulting in the qualification of proceeds as employment income instead of capital income.
- Entry valuation of shares compared to acquisition costs paid by management; acquisition at an undervalued price leads to a fully taxable benefit.
- Allocation of management participations to the employment and thereby qualification of proceeds thereof as employment income, irrespective of any capital investment made.
a) Beneficial Ownership in Shares
Beneficial ownership in shares is acknowledged in so far as the shareholders are entitled not only to economic rights from the shares, but also to administration rights, especially voting rights. In fact, management shareholders are minority shareholders and, as such, are bound by tag- and drag-along rights in case of an exit. Furthermore, they usually hold their shares via pooling vehicles, e.g. limited partnerships, and are often subject to call options in case they terminate their employment (leaver scheme). These features are standard features of management participations and, as such, do not result in a denial of beneficial ownership in general. However, since the qualification of beneficial ownership depends on a general qualification of the given facts in total, the tax authorities benefit from the ability to use a certain amount of discretion in their judgment, which makes it difficult to fix a 'borderline'.
b) Acquisition at Fair Market Value
Income tax may occur upon acquisition of a management participation if the shares are acquired at a price below their fair market value. In the determination of the fair market value, the tax administration refers to the general valuation principles for companies, thereby leaving a wide range of probable values. To be on the safe side, management participations should be implemented at the time of or shortly after the investor’s entry into the company.
c) Allocation of the Participation to the Manager’s Employment
The last argument listed above results from a so-called 'obiter dictum' made by the German Supreme Tax Court, in which it came to the conclusion that management participations do not lead to employment income if the following three conditions are met:
- Shares are offered only to certain managers of a company, but not to the public.
- Management shareholders are not allowed to freely dispose of the shares.
- Management shareholders are obliged to sell their shares if they leave the employing company.
This decision set out clear guidelines for the structuring of management participations for the first time and, due to this, was welcomed by tax advisors. In turn, the Supreme Tax Court explained that there may be situations beyond the case decision that would allow a capital investment to overlap with the employment relationship and would thereby qualify capital income as employment income.
Management equity participations still constitute the primary configuration for the alignment of interests between management and private equity investors. However, recent developments in the taxation of management equity participations makes it necessary for all parties involved to structure these shareholdings carefully and involve specialized advisors.