I. Purpose and structuring of management participation programs

MManagement participation programs are a popular financial incentive element to boost the commitment of employees from the upper and partly also from the middle level management and to achieve a stronger identification of such managers with the company. These programs are being regularly applied during, but not only, acquisition projects of financial investors (private equity). The management is supposed to stay permanently within the company and to contribute its knowhow until a later exit, i. e. until a resale or an IPO.
It is a common feature of management participation programs that managers (generally indirectly) acquire “real” company shares. However, this acquisition does usually not take place by means of a direct acquisition of shares by an individual manager, but by pooling the entire management’s equity participation in an investment entity (e.g. asset managing GmbH & Co. KG [limited partnership with a limited liability company as general partner] or GbR [company constituted under civil law]).
As management participation programs are set up with the aim to create financial incentives to increase in the company’s value and to involve the management in an economic success or failure of a later transaction, shareholders’ agreements usually contain provisions, which are applicable in case of a termination of the manager’s employment before the scheduled exit. The financial investor typically gets the right to acquire the respective manager’s shares (call option). In this case, the purchase price under the call option depends on the reason of the exit of the manager, distinguishing between “good leavers” and “bad leavers”.
Good leavers are managers who leave the company without their fault, e.g. because of an ordinary termination of employment by the company, an occupational incapacity, retirement or death. Basically, they receive a regular payment of the market value of their shares, sometimes at least the invested capital plus a customary market interest rate. Bad leavers, on the other hand, are managers who leave the company due to their own conduct, e.g. if the employment is terminated by the manger himself or by the company for good cause. Bad leavers usually receive only the lower value of their initial cost and market value of their participation.

II. Tax issues regarding management participation programs

If a management participation program is to be implemented, the question arises whether the manager’s income resulting from this program is to be classified as wage or as income from capital investment. This question is of particular importance, because the classification of income as wage may entail a taxation with the personal tax rate of the respective manager which may amount up to 47.5 %, while income from capital investment is taxed tariff-favored, i. e. by applying a flat tax of around 26.4 % or, within the framework of a partial-income method, at a tax rate of 28.5 %. In addition, the manager’s employer is obliged to withhold and pay a wage tax if classified as wage, even if the remuneration is not paid by the employer, but a third party. An incorrect classification of income from a management participation program may therefore involve substantial tax risks not only for the manager, but also for the company.

III. Position of the tax authorities on management participation programs until now

Management participation programs have been frequently addressed by the tax authorities in the past to classify the corresponding income as wage. The tax authorities in particular were of the opinion that the contractual structure of such participation programs, especially due to leaver provisions, lead to a close connection between the respective manager’s employment and his investment, resulting in an overlaying effect of the actually provided capital by the employment.

IV. Recent case law on management participation programs

1. BFH judgment dated 4 October 2016, file no. IX R 43/15

The BFH does not follow the illustrated tax authorities’ practice. It points out that capital gains from capital participation do not lead to income from employment as wage simply because the participation is being held and sold by an employee of the company.
The Court correctly states that wages should be presumed to be paid when benefits accrue to the employee based on and for the provision of his or her individual work force. On the other hand, there is no wage if the income is granted due to a legal relationship or other relationships between the employee and the employer which are not based on the employment relationship. Such special legal relationships may exist in addition to the employment relationship and may be an independent means of income. So, if proceeds from a management participation program are generated by the employee, it must be examined whether the proceeds are induced due to the employment relationship or by the provision of capital.
The examination requires an overall assessment of all circumstances. The mere fact that management participation programs are only offered to management level employees does not itself lead to a causal connection with the employment relationship. According to the Court’s consideration, existing option rights and rights of exclusion in the form of leaver provisions themselves do not justify the conclusion that the manager concerned is given a wage by granting him a participation in the company either.

2. Baden-Wuerttemberg Finance Court’s decision dated 9 May 2017, file no. 5 K 3828/14

The decision of the BFH has already been adopted by the finance courts and implemented in equivalent judgments. The Baden Wuerttemberg Finance Court’s decision is interesting in this context, as it comments on two further contentious points. For instance, managers are typically granted tag-along rights and are, at the same time, subject to drag-along obligations in order to grant the financial investor a smooth exit. In addition, the free transfer of shares is regularly being limited by restricted transferability of such shares.
However, the Finance Court does consequently not classify these circumstances as further indications for an instigation within the employment relationship. It clarifies that drag-along obligations can usually be found in companies with majority shareholders and that interests of minority shareholders are being taken into account by corresponding tag-along rights. Also, the restricted transferability is not owed to the legal relationship of employment, but rather the corresponding desire of all shareholders to co-determine who is supposed to become co-shareholder.

3. Consequences for practice

The current jurisdiction leads to an increased legal certainty in the consulting practice, as unlike the tax authorities have probably assumed so far, leaver provisions do not per se “trigger“ the assumption of wage. However, this does not imply a “carte blanche” for all management participation programs. An overall assessment of all circumstances within an individual case is still required to determine the tax classification of a management participation program. Only if this leads to the conclusion that the proceeds are incurred from a management participation program on the basis of a special legal relationship, i.e. owing to the provision of capital, it is a tariff-favored income from capital investment.
Therefore, it is particularly necessary to further ensure as part of the implementation process of management participation programs that the shares in the company are (indirectly) assigned to the participating manager for tax purposes, that the shares are not acquired under its market value and that the participating manager is not only granted the chance of an increase in value, but has to assume an effective risk of loss as well. Extreme value appreciation possibilities through leverage effects which are only granted to the manager are to be critically evaluated, too.