Germanys Supreme Tax Court Confirms Tax Treatment For Management Equity Plans

• Published date: 12 March 2024
• Subject Matter: Corporate/Commercial Law, Tax, M&A/Private Equity, Venture Capital, Corporate and Company Law, Income Tax, Tax Authorities
• Law Firm: Alvarez & Marsal
• Author: Christian R'pke and Simon-Alexander Kiene

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 (verm'gensverwaltende 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...