I. Differentiation difficulties in the qualification of income

On the part of the parties involved, as the manager and the employer, in which (directly or indirectly) a participation is granted, the question arises as to which type of income the subsequently generated income is to be allocated. The employer is exposed to risks with regard to the obligation to withhold and pay wage tax when granting and selling the participation, but has the possibility to secure himself by means of a so-called Lohnsteueranrufungsauskunft. In contrast, the managers often remain in the dark with regard to the actual tax burden until the final sale of shares or the exit-event. Unfortunately, the results may even differ depending on the region of the competent tax office.
The BFH has dealt with the taxation of management participation programs several times in recent years and established important principles for practice. The two most recent BFH decisions (case no.: VIII R 40/18 and VIII R 21/17, both dated 1 December 2020) also provide new insights and ensure greater legal certainty. In one ruling, the BFH has for the first time commented on so-called sweet equity structures, which will be discussed in more detail below.

II. Jurisdictional principles of the BFH

As already explained in the honert+partner newsletter article of 28 March 2018, the BFH has in the past taken a different view than the tax authorities and has developed its own principles or differentiation criteria for the taxation of management participation programs. According to the BFH, in order to differentiate between the types of income in question (income from (non-)self-employment versus capital income), the causal connection and the economic ownership of the participation must be taken into account in particular.

1. Causal connection and risk of loss

In the opinion of the BFH (continuing the previous case law: ruling of 4 October 2016 – IX R 43/15, BStBl. II 2017, 790), there is no remuneration for work if the income from the participation program to be assessed was granted due to other legal relationships or due to other relationships between the employee and the employer that are not based on the employment relationship. If such special legal relationships exist, there is no causal connection between the capital investment and the employment relationship.
In this context, it must first be examined whether the capital investment arose with regard to the respective employment relationship and whether any benefits were granted in the broadest sense as consideration for the provision of the individual’s labor. If this can be affirmed, the income is to be qualified as income from employment. In contrast, there is no wage or salary if the employee uses his capital as an source of income independent of the employment relationship.
In the opinion of the BFH, the agreements typical for management participation programs, such as the so-called call/put options and good/bad leaver regulations, are not in themselves sufficient evidence for the assumption of an inducement connection between the capital participation and the employment relationship. The BFH justifies this with the fact that every form of employee participation is by nature related to the employees (cf. BFH ruling of 17 June 2009 – VI R 69/06, BStBl. II 2010, 69).
According to BFH case law, a risk of loss associated with the capital investment is also considered a further differentiation criterion for qualifying the income, whereby the exact amount and probability of the risk of loss is not decisive. It is solely a matter of the fact that own funds can be used and also lost as a result of the existing legal relationship.

2. Economic ownership

In addition to the aforementioned causal connection, the qualification of the income is also based on the allocation of the economic ownership of the shares. According to BFH case law (cf. inter alia BFH of 11 July 2006 – VIII R 32/04, DStR 2006, 2163; of 4 July 2007 – VIII R 68/05, DStRE 2008, 69; of 9 October 2008 – IX R 73/06, DStRE 2009, 313), the allocation of economic ownership within the meaning of sec. 39 para. 2 no. 1 German Fiscal Code (Abgabenordnung – AO) is based in particular on the corporate rights conveyed by the participation and on the opportunities for increases in value and risks of loss associated with the participation. If the rights, opportunities and risks conveyed by the participation are comparable to a “normal” equity investment and if this comparability, i.e. arm’s length, also applies with regard to the acquisition, a link between the legal relationship “capital investment” and the employment relationship cannot be considered according to case law.

3. Purchase price

Furthermore, it is of essential importance in this context whether the participation from which the relevant income results was acquired at market value or at a discount. The acquisition of a capital interest at a discount is a strong indication that it qualifies as wages and salaries. Conversely, this also means that if the purchase price is in line with the market value, there is no economic or financially measurable advantage that could be attributed solely to the employment relationship.

III. New findings from the current BFH decisions

The two most recent decisions of 1 December 2020 concerned managers with capital participations in a company with which they had entered into an employment or consulting relationship. The agreed management participation programs contained the typical provisions regarding purchase rights upon termination of the employment relationship and co-sale rights and obligations upon sale of the participation by the main investor.
In these cases, the tax authorities assumed that the revenue from the sale of shares was to be recognized as wages or as income from self-employment. The BFH, however, ruled in favor of the taxpayers and considered the proceeds to be income from capital assets. In its decision, the BFH referred back to the principles described above and confirmed and supplemented its previous legal opinion:
The BFH has for the first time commented on so-called sweet equity structures. This is understood as a disproportionate subscription of capital participation on the part of the participating managers. At the level of the financial investors, one usually finds a combination of fixed-interest capital instruments in the form of shareholder loans and/or preference shares as well as ordinary shares. The participation of the management, on the other hand, consists mainly of ordinary shares. This exposes the participating manager to a higher (total) risk of loss. At the same time, however, he has the opportunity to achieve a higher share of the income compared to the financial investors (so-called leverage effect), provided that a predefined minimum return (preference shares) is exceeded.
In one of the two cases to be assessed by the BFH (VIII R 21/17), such a structure was chosen. Unlike the financial investors, the manager did not make any payments into the capital reserve II and also did not provide any shareholder loans. As previously explained, in return he had the opportunity to achieve a significantly higher return compared to the financial investors. Contrary to the opinion of the tax authorities and some tax courts (cf. inter alia Münster Fiscal Court, 15 July 2015 – 11 K 4149/12 E, DStRE 2016, 1489), however, according to the BFH such a shareholding structure cannot be regarded as evidence of an causal connection between the disposal proceeds achieved and the consulting activities. The participation was sold at market value. Even beyond this, there were no indications that the manager in the case of the judgment had achieved a non-market, increased return which could have qualified as an additional bonus payment for his consulting activities. Instead, the entire proceeds from the sale were initially to be used to repay existing liabilities and other costs, and only the remaining net assets were to be distributed among the shareholders in accordance with their respective profit entitlement quotas. The manager had therefore only received the “exit” proceeds attributable to his share.

IV. Consequences for the practice

As a result, two important statements and findings can be derived from the two most recent decisions on the taxation of management participation programs: Firstly, from an advisor’s perspective, it is to be welcomed that the BFH has once again confirmed its previous legal opinion. The qualification of income must continue to be based on the causal relationship and it must be examined whether the capital gain represents consideration for the individual work performed or whether it is attributable to an independent special legal relationship that is independent of the employment relationship. On the other hand, the BFH decision VIII R 21/17 in particular is of high practical relevance, as there is now supreme court case law on management participation programs with a sweet equity structure. If a manager invests exclusively in equity and not (or only to a disproportionately low extent) in fixed-interest capital instruments (e.g. shareholder loans, preferred shares), this does not in itself necessarily constitute remuneration for work. The restrictive view of the tax authorities as well as parts of the tax courts has been countered by the BFH in favor of the taxpayer.
However, it is still not possible to speak of unrestricted legal certainty, as the BFH did not have to make any comments on the valuation of sweet equity, for example. As explained, the decisive factor is that the manager acquires the participation at market value, which may be doubtful in the case of extremely leveraged equity structures due to the option character involved.