When a financial investor purchases a shareholding, they must convince the management at the company being taken over of their goals. That is why private equity companies generally offer managing directors and selected executives shares in the company to enable them to participate in the company’s success.
High profits but risk of total loss
Unlike success-based remuneration defined in employment contracts, managers first invest their own money in order to purchase the shares. The employees and the investor pay into a holding company. In the event of the sale of the company, the employees, as co-owners, receive a disproportionate share of the profits in comparison to the holding company. The motivation for the managers lies the very high chance of profits via corporate re-investment, known as ‘sweet equity’. On the other hand, they also face the risk of a total financial loss (skin in the game).
With its ruling, the German Federal Fiscal Court approves this common incentive practice for employees of the target company for the first time. The judges in Munich ruled that the profits do not have to be taxed as income from employment as per Section 19 EStG. Instead, the regulations of the more favorable tax rates for income from capital assets as per Section 20 EStG shall apply.
Shareholdings as an independent means of income
What are the requirements? A clear boundary between the employment relationship and the corporate shareholding is definitive. According to the German Federal Fiscal Court, the reinvestment to the employer should be regarded as an independent means of generating income. The court specifies four characteristics:
- The employment contract does not stipulate any entitlement to the purchase of the shareholding and possible proceeds from the sale.
- The shareholding is acquired and sold at the market price and not at a reduced price.
- The employee bears the full risk of loss.
- The employment relationship does not show any particular circumstances that could influence the ability to sell the shareholding or its value development.
The tax office’s argumentation failed to convince the judges in Munich. The tax office argued as follows: The profit from the sale of capital shareholdings must be classified as taxable income from employment because an employee of the company held and sold the shares. According to the German Federal Fiscal Court, it is immaterial that only specific employees are offered shares and that these employees do not possess full shareholding rights. The dependence of profit from sales on achieving specific turnover and profit figures does not contradict the more favorable taxation as income from capital assets, provided that the shareholder receives these regardless of whether they remain employed by the company or not.
With its decision, the German Federal Fiscal Court provides legal security regarding tax issues concerning management programs. Up until now, the fiscal courts had disputed how sweet equity affects the taxation of management shareholdings.