In its decision of October 4, 2016 (IX R 43/15), the Federal Fiscal Court finally confirmed the taxation of management participations as capital gains. This will put an end to the tax administration practice of qualifying such income as employment income.
Proceeds from Management Participations are not Employment Income
With this ruling, the 9th Senate confirms the judgement of the Tax Court in Cologne dated May 20, 2015 (3 K 3253/11, DStRE (German Tax Law) 2016, 209). In this case, the Tax Court had qualified capital gains from a management participation as non-taxable capital gains (participation below 1%, pursuant to former capital gains taxation). The tax office had taxed these gains as wages.
Facts of the Present Case
According to the given facts of the present case, the taxpayer had in 2003 acquired an equity participation in the holding company of his employer via an asset-managing, and thus tax-transparent BGB Company (a company organized under the German Civil Code). The management participation was sold in 2004 as part of a sale of the entire company group. The purchase and sale had undoubtedly taken place at market value. In particular, in the event of the termination of the employment relationship, the partnership agreement of the BGB Company provided for a purchase right (the so-called Leaver Scheme). Depending on the reason for the termination of the employment relationship, the purchase prices for the exercise of the purchase right were different.
In detail, the Leaver Scheme contained the following provisions:
- Settlement in the amount of the contribution: breach of duty, unreasonableness of remaining in or termination of employment by the employer for cause ("Bad Bad Leaver").
- Settlement in the amount of the contribution plus 5% p.a. since capital contribution: termination of the management participation by the manager, exclusion due to deterioration of assets or termination of the employment relationship by the manager ("Bad Leaver").
- Variable, performance-related settlement, at least in the amount of the contribution plus 5% p.a.: death of the manager, termination of the employment relationship by the employer for any reason ("Good Leaver")
- For the Good Leaver, a so-called vesting applied for over five years, which means the share of the variable settlement increased over time; the share of the contribution repayment decreased correspondingly.
Leaver Scheme and Vesting are Harmless
The Federal Fiscal Court has now explicitly confirmed in the present case the taxation of proceeds as capital gains. In the case of such equity participation, it may be an independent special legal relationship besides the standalone employment relationship. The mere causality of the employment relationship for the purchase of the participation is not detrimental. The profit resulted solely from the equity participation. Even the existing exclusion rights in the event of termination of the employment relationship do not as such justify the assumption that the proceeds from the management participation qualify as employment income. In the present case, the equity participation is also said to have been subject to an effective loss risk.
Relevance of the Market Price and Loss Risk
This decision should now remove the basis of the tax administration's practice that has become common in recent years to qualify gains from management participations as employment income. This applies in any event to the extent that the management participations correspond to or approximate the present case. According to the Federal Fiscal Court, the following criteria are essential:
- Purchase and sale of the management participation at market price
- Participation with effective risk of loss.
This judgment is likely to cover many of the typical management participations. However, if a management participation contains different elements, which may add a further connection to the employment relationship, caution may still be needed. The question of the accrual of wages and capital income is still decided by means of an overall assessment of the facts of the case. This overall assessment may still be different and may still lead to management participations being qualified as employment income.
In the structuring of management participations, a careful design of the contracts continues to be necessary in order to avoid negative tax consequences.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.