Management participation programs − current case law and legislation

published on 28 January 2025 | reading time approx. 4 minutes

Management participations play an important role − particularly in the context of venture capital and private equity transactions − in order to promote the alignment of interests between investors and management. Managers participate directly in the success of the company and at the same time are tied to the company and encouraged to act entrepreneurially. From a tax perspective, however, there are a number of pitfalls to consider when structuring management participations. Two selected problem areas are presented below against the background of the current case law of the German Federal Fiscal Court (Bundesfinanzhof – BFH) and the legislative changes resulting from the German Annual Tax Act 2024 (Jahress-teuergesetz 2024).

Problem area of tax income qualification - wages vs. capital income

In principle, income from a shareholding in a corporation is subject to preferential taxation as capital income in accordance with the flat-rate withholding tax of 25% plus solidarity surcharge (effectively a total of 26.38%) or - in the case of a so-called substantial share-holding of at least 1% - as income from business operations under the partial income method, i.e. 60% is taxed at the personal tax rate of 45% plus solidarity surcharge (effectively a maximum total of 28.49%). In the context of management shareholdings, however, the question arises as to whether income associated with the shareholding is not a component of the remuneration for the employment and therefore leads to income from employment, which is taxed at the personal tax rate of 45% plus solidarity surcharge (effectively a maximum total of 47.48%). This is generally the case if the shareholding is provided free of charge or at a reduced price and this is due to the employment relationship. In this case, the difference between the market price and the purchase price is deemed to be a non-cash benefit within the meaning of Section 19 para. 1 sent. 1 of the German Income Tax Act (Einkommen-steuergesetz – EstG). It was previously disputed whether, in such cases, a gain from the sale of a management shareholding (at market value) at arm's length also constitutes a non-cash benefit. The German Federal Fiscal Court (BFH) commented on this on December 14, 2023 (see BFH, decisions of 14.12.2023 - VI R 1/21 and VI R 2/21).

Recent decisions of the BFH on the capital gain from an arm's length sale

The case (case no. VI R 1/21 and parallel decision case no. VI R 2/21) concerned an employee resident in Germany who worked as an executive (hereinafter: manager) at a German limited liability company (Gesellschaft mit beschränkter Haftung – GmbH) (employer company). The GmbH was acquired in 2005 by a group of investors indirectly via several domestic and foreign Luxembourg subsidiaries. In 2006, the manager was offered a stake in the parent Luxembourg S.à r. l. by the investor group. This stake was held via an investment vehicle in the form of an asset-managing German limited partnership (GmbH & Co. KG) (Management-KG), in which the manager participated as a limited partner. In 2007, the subsidiary of S.à r. l., which held the shares in the German employer company, was converted into an AG and its shares were listed on the stock exchange. As part of this process GmbH & Co. KG transferred its shares held in the parent S.à r. l. in exchange for shares in the transformed Ger-man stock corporation (Aktiengesellschaft – AG) in accordance with the agreed conditions. These shares were transferred to sub-custody accounts in accordance with the respective managers' shareholdings in GmbH & Co. KG, which were held in the names of the individual managers. In accordance with the tax regime applicable at the time in 2007, i.e. before the introduction of the flat-rate capital gains tax, the manager treated the capital gain arising from this as non-taxable. However, the tax office assessed the capital gain taxable third-party wages during a subsequent external tax audit of the manager.

The legal dispute deals with the question of whether the profitable sale/cessation of a management shareholding is to be regarded as remuneration for the manager's activities and therefore as wage. The Baden-Württemberg tax court upheld the manager's appeal against this in the first instance.

The BFH has rejected the tax authorities’ appeal against the ruling of the Baden-Württemberg tax court as unfounded. It stated that the profit from the sale of an employee shareholding at normal market conditions is not a non-cash benefit even if the employee has previously acquired the shareholding from his employer at a reduced price. A connection between the acquisition of the shareholding and the employee's salary does not continue in the subsequent sale. The sale is independent and must therefore be assessed separately from the acquisition for tax purposes. Consequently, the capital gain from the sale at arm's length does not constitute wages. The fact that the manager held proportionately more shares/equity via the management participation vehicle than the investor (so-called sweet equity) did not change this in the opinion of the BFH, nor did the leaver clauses, which linked the manager's retention in the management partnership to the continuation of his employment relationship. According to the BFH, the qualification as wages can only be assumed if the manager achieves an excess price that is not in line with the market as a result of the employment relationship from the sale of the shareholding.

Problem area taxation without liquidity inflow (so-called dry income)

If shareholdings are transferred to employees free of charge or at a reduced price, this may result in a non-cash benefit subject to income tax. As the benefit is not in cash, taxation often results in a liquidity problem (especially if the amount of salary paid out is significantly reduced as a result or even a tax claim may arise for the employee). In order to avoid this so-called dry income problem, the German Fund Location Act (Fondsstandortgesetz – FoStoG) in 2021 (re)introduced the provision of Section 19a of the German Income Tax Act, which makes it possible to defer this taxation under certain conditions. Subsequent taxation only takes place if (i) the participation is transferred in whole or in part, (ii) 15 years have passed since the transfer of the participation or (iii) the employment relationship is terminated. However, it should be noted that the provision is subject to strict conditions, particularly with regard to the employer's company (in terms of annual turnover, balance sheet total and number of employees) and the type of shareholding. Until now, the participation also had to be granted directly in the employer's company. In the opinion of the tax authorities, participations in companies of the same group within the meaning of Section 18 of the German Stock Corporation Act (Aktiengesetz – AktG) (e.g., in a foreign parent company of the employer company) were not covered by the deferred taxation of Section 19a of the German Income Tax Act. This was amended with the German Annual Tax Act 2024.

Extension of the scope of application of Section 19a EStG to group shareholdings

With the German Annual Tax Act 2024, the scope of application of Section 19a of the German Income Tax Act was extended to the transfer of shareholdings in group companies (companies within the meaning of Section 18 of the German Stock Corporation Act). However, the extension, which will apply from the 2024 tax assessment period, does not apply without restriction. In the case of a participation in a group company, the size- and age-dependent requirements of Section 19a of the German Income Tax Act must be observed with regard to the group or the companies belonging to the group. According to the new regulation, an investment in a group company is only included in the scope of application of Section 19a of the German Income Tax Act if the size-related thresholds are not exceeded in relation to all group companies and no group company was founded more than 20 years ago. Irrespective of this, the extension is to be viewed positively, as employee and management participation programs with an international connection (e.g. transfer of shares to foreign parent companies) can now also be tax-privileged (in the sense of deferred taxation) under the aforementioned conditions.