Germanys Supreme Tax Court (BHF) recently published two decisions dealing with the income tax treatment of Management Equity Plans (MEP), in which the court confirmed its established case law. Essentially, no employment income should be realized within qualifying MEPs if both the acquisition and the sale of the underlying shares are made at arm's length (market) conditions.

Background

Management Equity Programs (MEPs) are widely used in Privat Equity and Venture Capital deals to align the interest of the investor and the management of the portfolio company and have proven to be an important factor for the success of an investment.

The MEP subject to the court rulings (both decisions dealt with the same MEP) was structured in a fairly common way, containing a preferred instrument and ordinary shares, whereby management had subscribed proportionally more ordinary shares than the investor in relation to the total capital investment (so-called "Sweet Equity"). Although the specific commercial terms are not published, the rulings indicate that the MEP was highly leveraged. Management was pooled through an asset managing German partnership (vermögensverwaltende Personengesellschaft), investing as Limited Partners. The MEP also contained common leaver rules which distinguish between bad- and good leaver events. The participant had acquired his MEP interest below fair market value and the parties agreed out-of-court on the resulting benefit in kind which was then taxed as employment income in the year of acquisition.

Nevertheless, the tax office further intended to treat the exit gains realized by a manager as employment income which should be taxed at ordinary income tax rates of up to 45 % by arguing that the exit proceeds are paid by virtue of the employment relationship of the participant, but not his equity investment.

Decision and Reasons

The court ruled in favor of the manager confirming that the exit gains do not qualify as employment income. Any capital gain realized from the disposal of MEP interest is taxable according to general taxation principles for income from capital assets.

Under current law (2024), such gain would normally be taxable as investment income, generally taxed at a flat income tax rate of 25 % (a slightly higher tax burden may apply to participants with a shareholding of at least 1 % in the underlying company).

In the reasons for the decision, the BFH provides conclusive and valuable guidelines, mainly confirming the previous case law practice:

  • The acquisition of shares in the employer generally establishes a special legal relationship under civil law that can exist alongside the employment relationship and the participation becomes a separate income source. This essentially requires that the participant is the beneficial owner of the MEP interest. Common leaver rules do normally not prevent beneficial ownership.
  • A (potential) discount on the fair market value (FMV) at acquisition does not indicate that any gain made with the sale of the shares at exit proceeds qualifies as employment income. If an MEP interest is acquired at a price below FMV, the undervalue constitutes a taxable benefit in kind at the time of acquisition, i.e. such benefit is taxable as ordinary employment income in the year of the acquisition and does not taint any gains at exit. This is also because acquisition and disposal are two separate and independent events for tax purposes.
  • Should an MEP participant receive a higher consideration for his shares than the current FMV (overpay), i.e. a higher amount per share than the investor or other third-parties receive, taxable employment income would be realized in the amount of the overpay at the time of disposal.

Practical Impact

The court's confirmations are welcomed for the PE/VC industry and provide more certainty on the tax effective structuring of MEPs in Germany. If structured correctly, employment income charges can be avoided and exit gains should generally be taxable as investment income at a flat income tax rate of 25 %. To achieve the favorable taxation, it remains key to consider the overall structure of the MEP to meet the characteristics of an (arms-length) investment, especially with respect to the conditions at acquisition, the exit waterfall (economics), the managers' capital commitment, shareholder rights and disposal restrictions, e.g. vesting and leaver conditions.

The decisions also indicate that the determination of the entrance value of the ordinary shares remains an important point when implementing an MEP and that all relevant characteristics must be taken into account.

Important Note

The court decisions are generally only binding for the underlying cases. It remains to be seen whether the tax authorities will accept the broader applicability of the principles by publication in the Federal Tax Gazette II (Bundessteuerblatt II).

The decisions can be found here:

BFH-Urteil vom 14. Dezember 2023, VI R 1/21

BFH-Urteil vom 14. Dezember 2023, VI R 2/21

Originally published by 04 March, 2024

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.