On 27 May 2021, the German Supreme Tax Court published two decisions dated 1 December 2020 regarding the taxation of management participations (Ref. VIII R 21/17 and VIII R 40/18). Both decisions are welcomed from an advisor’s perspective.
Therein, the Supreme Tax Court confirms the preconditions established in its decision dated 4 October 2016 (Ref. IX R 43/15) for the taxation of proceeds from the sale of a management participation as capital gains. Once again, the Supreme Tax Court rejects the tax authorities’ practice of fully taxing gains from the sale of management participations as employment income.
Furthermore, the Supreme Tax Court comments for the first time on the consequences of a disproportionate subscription to financial instruments (so-called “sweet equity”) for the taxation of management participations. However, it does not take a position regarding the valuation of “sweet equity”.
Facts of the Present Cases
According to the given facts of the present cases, the managers acquired an equity participation in a company they were directly or indirectly connected with through an employment or consulting relationship. While the decision VIII R 40/18 concerned an employed manager, the shareholding in the decision VIII R 21/17 was acquired by an independent consultant.
The equity investments in both cases showed typical characteristics of a management participation. These included, inter alia, call options of the lead-investor upon termination of the employment or consultation relationship with different purchase prices depending on the reason for termination, or “drag/tag along rights” (co-selling rights and obligations of the manager/consultant) upon sale of the investment by the lead-investor.
In both cases, the capital of the companies in which the defendants held shares was composed of different financial instruments. In case VIII R 40/18, the share capital of the company was divided into three share classes, of which the manager only acquired shares of the subordinate class C at a very low purchase price due to the low enterprise value at the time of acquisition. In case VIII R 21/17, the advisor only acquired a participation in the share capital and capital reserve I of the company, whereas the financial investors also made payments into the (senior) capital reserves II and III and granted shareholder loans. As a result of such disproportionate subscription to the financial instruments of the company (“sweet equity”), both defendants achieved a significantly higher return (compared to the financial investors) on exit, but were also exposed to a higher risk of loss.
Management Participation as Independent Special Legal Relationship
In both decisions, the Supreme Tax Court addresses the question of whether the proceeds from the sale of the interests are caused by the employment or independent consulting relationship of the manager/consultant, or whether the management participation represents an independent special legal relationship.
The Supreme Tax Court confirms the position taken in its decision of 4 October 2016 (Ref. IX R 43/15). The following facts support the qualification of a management participation as independent special legal relationship: The employment or consulting relationship does not constitute an entitlement to the acquisition of the participation.
- The participation is acquired and sold at market price.
- The shareholder bears the full risk of loss from the participation, regardless of the amount of capital invested.
- There are no special circumstances aris-ing from the professional activity that influ-ence the realizability and value develop-ment of the participation.
In the case of an employee’s participation, the proceeds from the sale are not to be qualified as employment income solely due to the fact that it is (i) held or sold by an employee and (ii) offered only to employees of the company.
According to the Supreme Tax Court, the participation of an independent consultant only causes income from self-employment if the participation is part of the consultant’s special business assets (Sonderbetriebsvermögen). However, pursuant to settled case law, this precondition is only met under the following circumstances:
- The activity of the company complements the consultant’s own professional activity.
- The consultant aspires to establish a business relationship with the company, aiming at the award of contracts.
If, on the other hand, the participation has its own economic relevance as an independent means of income, the investment cannot be associated with the independent consulting relationship. In this respect, the same criteria apply to the distinction between the consultant’s participation and his self-employment income as to the management participation.
“Sweet Equity” does not justify higher Taxation
For the first time, the Supreme Tax Court also commented on the relevance of “sweet equity” for the taxation of management participations. “Sweet equity” refers to the disproportionate subscription to financial instruments by managers and lead-investors, who provide the company with equity and debt capital in different amounts. As a result, the manager’s investment bears a different risk-opportunity profile compared to the investment of the lead-investor: The manager’s participation carries the opportunity of a disproportionately high return, but is also exposed to a higher risk of (total) loss.
According to the Supreme Tax Court, a higher taxation of the sales proceeds is not justified solely because an “increased chance of profit” is associated with the participation. The proceeds are not induced by the manager’s professional activity if the participation is acquired at market price. The Supreme Tax Court takes the position that an “increased chance of profit” is inherent in every equity investment.
In its decision VIII R 21/17, the Supreme Tax Court went even further: As long as the manager acquires the participation at market price, even the chance of a significantly higher return in comparison to the other investors cannot justify qualifying the proceeds as induced by the professional activity of the manager/consultant. He rather receives the pro rata sales proceeds attributable to his participation and thus his regular profit share.
The Supreme Tax Court thus clarified the consequences of “sweet equity” for the taxation of management participations, a question long disputed between German Tax Courts.
No Decision on Valuation
The question of the valuation of “sweet equity” remains unanswered by the Supreme Tax Court. In this respect, the appellant in the case VIII R 21/17 had stated in the oral hearing that the purchase price for the management participation had been too low. However, since this represented new factual evidence that can no longer be considered in appellate proceedings, the Supreme Tax Court was unable to take a position on this. However, the senate did not see any indication that the factual assessment of the Tax Court had been erroneous.