Germany’s Federal Fiscal Court confirms that earnings from management participations can be treated as tax-privileged capital gains

The Federal Fiscal Court confirmed with its judgment of 4 October 2016 (case no. IX R 43/15) that earnings from certain management participations can be subject to capital gains tax. The practice of some tax offices of taxing income from management participations as wages was clearly rejected under certain conditions by the Federal Fiscal Court ruling. In the case at hand, the Federal Fiscal Court agreed with the opinion of the trial court (Cologne Fiscal Court) that an investment of employees can establish a privileged relationship in addition to their employment relationship and benefit from tax treatment as capital gains and must not necessarily be taxed as wages. Thus, a more favourable taxation of capital gains can be claimed if the management participation was acquired at fair market value and the manager effectively bears a risk of loss regarding his investment.

The judgment is very important for management participation schemes, as financial investment by managers both in SMEs and in the field of private equity are a common incentive mechanism for aligning interests and granting managers an opportunity to participate in the financial development of a company. The decision of the Federal Fiscal Court is very welcome, as it eliminates existing legal uncertainties for certain management participation schemes and provides criteria for structuring to ensure compliance with capital gains taxation.

Background

In the case at hand, a manager and additional second-line management team members had invested in a German holding company of their employer indirectly via a GbR (i.e., a German private partnership) in 2003. The partnership interests were acquired for the fair market value at the time. The articles of association of the GbR stipulated a so called leaver scheme with good and bad leavers and including also a vesting scheme for a period of five years. The partners in the GbR were obliged to a retransfer of their interests upon termination of their employment. The amount of the compensation for their partnership interests was tied to the good- and bad leaver provisions and aimed to ensure that at least the nominal amount of their investment was paid.

In 2004 the shares of the holding company were sold to a third party for fair market value as part of a sale of the company (i.e., exit). The tax office classified the manager’s capital gain generated as taxable wages, while the manager assumed it was non-taxable (according to the legal situation at the time) earnings from capital assets. The tax office held the view that the capital gain generated would be attributable to the employment as the investment via the GbR was only possible for selected employees, there was a typical call-option in the event of termination of the employment and the loss risk was limited due to additional knowledge gained through the job.

Federal Fiscal Court contradicts tax office

In its decision the Federal Fiscal Court takes the view that management participations can establish a privileged relationship in addition to employment, and the earnings generated from management participations can be classified as capital gains. The financial investment is a standalone income basis, as the employees invest their own capital to generate income.

In this assessment, neither the fact that the management participation scheme was only available to certain managers nor the call-option triggered upon termination of the employment are to be given substantial weight. As in the case at hand both the purchase and sale of the management participation were done at fair market value, the employees were not given a profit opportunity due to their employment or other benefits in kind and the privileged relationship was not superseded by the employment.

The Federal Fiscal Court also confirmed the view of the previous instance that neither a call-option in case of a leaver nor any insider knowledge lead to the absence of a de facto risk of loss. The Cologne Fiscal Court had already argued that the consequences of termination of the employment are to be distinguished from the consequences of any financial difficulties in the holding company. The latter could certainly lead to a (partial) loss of the invested capital.

Positive sign and clear criteria for management participation schemes in Germany

With this ruling, the Federal Fiscal Court confirms the common practice of allowing managers to participate in a company’s success via a management participation and confirms the classification of earnings from management participations as capital gains. One advantage of this classification is the different tax rate. While income from employment can be subject to standard income taxation of up to 45%, capital gains enjoy favourable taxation – normally a flat-rate of 25%.

In its decision, the Federal Fiscal Court formulated clear criteria for classifying earnings from management participations as capital gains. What is decisive is the purchase and sale of the management participation at fair market value and the existence of a risk of loss. The agreement of leaver schemes and vesting rules are not automatically harmful and do not necessarily lead to a re-classification as income from employment.

However, the Federal Fiscal Court also made it clear that the management participation has to be reviewed in its entirety including all of its specific terms on a case-by-case basis to rule out that the participation was granted based on the employment. When structuring future management participations, one must therefore continue to bear in mind that especially ‘sweet equity’ and ‘equity kickers’ can establish a triggering connection with employment and lead to wage taxation. Also, due to the necessity of appraising each specific case, support from professional legal and tax advisors is essential when structuring and drafting management participation schemes.