In two decisions dated 14 December 2023 (Ref: VI R 1/21 and VI R 2/21), the Federal Fiscal Court (BFH) confirmed that the profit from an employee’s equity participation in their employer’s company is not taxable as employment income, even if the participation was previously acquired at a price below market value. If the participation was acquired after 31 December 2008, the profits from it are therefore only subject to capital gains tax, provided that the profit does not contain a disproportionate share of the proceeds attributable to the employment relationship. The 6th (wage tax) Senate of the BFH thus confirms and defines the decisions of the 8th Senate (Ref. VIII R 40/18, VIII R 21/17) and the 9th Senate (Ref. IX R 43/15) on the taxation of employee equity participations.
Summary
In both proceedings, the claimants each held a participation typical of private equity investments in a corporation via an asset-managing limited partnership, in which the managers had subscribed proportionally more ordinary shares than preference shares in relation to the majority shareholder (so-called sweet equity).
It remained open whether this participation had actually been acquired below market value in 2006. The managers had sold the participation in 2007 as part of an IPO at a high profit. The tax authorities argued that the sales proceeds were taxable wages. As in the preceding decisions of the lower tax court, they were unable to prevail with their view in the appeal before the BFH.
Acquisition below market value has no influence on sale proceeds
The BFH expressly clarifies that the purchase of a management participation at a price below market value does not lead to a reclassification of the sale proceeds as employment income. Acquisition of the investment below market value only leads to a taxable benefit in kind at the time of acquisition, which has no effect on the qualification of the type of income of subsequent sale proceeds. The acquisition and sale of the investment are two different, separate issues.
Individual valuation of capital instruments required
The question of whether a benefit in kind exists upon acquisition depends solely on whether the purchase price paid by the manager for the individual capital instrument corresponds to the market value, i.e., the price that a third party pays or would pay for the same capital instrument. In contrast, the ratio of the acquired capital instruments to each other, i.e., the sweet equity, does not constitute a relevant factor for the valuation of the investment. Therefore, the principle of individual valuation of the capital instruments also applies here.
Sale proceeds as capital gain if equity investment is effective under civil law
Accordingly, the sale proceeds must be assessed independently to determine whether they are attributable to the employment relationship or to the equity investment. It does not constitute employment income if a benefit is granted due to other legal relationships or other relationships between the employee and the employer that are not based on the employment relationship. In principle, an equity participation by an employee is to be recognized as an independent special legal relationship alongside the employment relationship, if it is structured in accordance with civil law, the manager has acquired economic ownership of the participation and the participation has actually been implemented. The leaver clauses usually stipulated (repurchase right of the investor upon termination of the employment relationship) do not prevent the equity investment from being independent of the employment relationship.
Disproportionate sale proceeds indicate a taxable benefit in kind
However, taxation as employment income occurs if the manager realizes a price above market value upon sale. In this case, however, only the proceeds from the sale in excess of the market value can be attributed to the employment relationship as a taxable benefit in kind. The fact that the managers in the aforementioned rulings realized higher proceeds on the capital invested in relation to the majority shareholder is not to be qualified as an excess price, as this resulted from the manager’s proportionally higher portion of the share capital.
Conclusion
The decision of the 6th Senate answers some unresolved questions regarding the taxation of management participations:
- The acquisition of the equity participation below market value does not have a negative effect on the subsequent taxation of the proceeds from the sale.
- An equity participation that is to be recognized for tax purposes regularly leads to income from capital gains, even if it is a management participation.
- The sale proceeds can be divided for tax purposes if they contain a disproportionately high portion above market value that is attributable to the employment relationship.