Private Equity European Bulletin

Transcription

1 Private Equity European Bulletin December 2006 Management Arrangements

2 UNITED KINGDOM Revised revenue guidance has recently been issued on the new tax regime introduced in the UK in 2003 for the taxation of securities or rights to acquire securities obtained by individuals by reason of employment. This legislation was widely drawn with the aim of bringing into the income tax regime all benefits received by individuals in these circumstances. Tax on ratchets Ratchet mechanisms were caught by the new legislation with management liable to a potential income tax charge on the benefit they received under the ratchet. HM Revenue & Customs ( HMRC ) clarified the position by entering into a Memorandum of Understanding (the MOU ) in July 2003 which provided a safe harbour for ratchets. In recent months HMRC had suggested that a further income tax charge might arise on a ratchet mechanism not covered by the MOU where there was an excess increase in value of the shares, disproportionate to the amount of capital invested by the manager compared with other holders of equity. HMRC also suggested that an income tax charge could arise where a company was thinly capitalised if this gave rise to disproportionate reward in the hands of employee shareholders. HMRC intended to bring test cases to challenge the tax treatment of certain ratchet arrangements. However we understand that they have now been advised by tax counsel that these HMRC arguments were not sustainable (1) either where the benefit arose from rights which were inherent in the share at the time of its acquisition by the employee or (2) in a thin capitalisation situation. Revised Guidance HMRC have now issued revised guidance which makes clear that, where the terms of the MOU are met, individuals will have no income tax liabilities on operation of the ratchet arrangements or on exit. Gains realised on exit will be subject to capital gains tax only. However, where the arrangements are not consistent with the MOU, tax charges remain possible under a number of different provisions of the tax legislation. Now that HMRC have concluded that they cannot attack arrangements of this kind with the existing legislation, it is possible that further legislation will be considered in this area. We would not be surprised to see legislation in the Finance Act 2007, aiming to deal with some of these issues. FRANCE French tax and social security law does not provide for any specifi c regime applicable to profi ts realised by managers pursuant to management arrangements set up in the context of an LBO. Supreme Court ruling Profits derived from equity investments should in principle be eligible to capital gains tax, i.e. a fl at 27% tax rate without any social security charges. This general principle has recently been confi rmed by the French administrative Supreme Court. The Supreme Court held that the fact that a manager plays a signifi cant role in the increase of the company s value is not sufficient, in itself, to cause the recharacterisation of the capital gain made by the manager on exit into employment income. Risk of challenge by the tax authorities However, the French tax authorities have recently launched several investigations into successful exits from LBO companies. They have recharacterised the gains made by the managers upon exit as employment income subject to income tax at the standard progressive rates (up to 40% for income earned in 2006). It was considered, amongst other matters, that the profi ts made by the managers were disproportionate to their respective equity investment when compared to the profi ts made by the private equity sponsors. Consequently the tax authorities took the view that the right to receive these profi ts had been granted to the managers in consideration for their future activity as key employees of the Target. Due to this risk of challenge, management arrangements have now become a key issue in all recent LBO transactions involving a French Target either at inception of the management arrangement or in the context of due diligence of existing arrangements. Even more so since such challenge also creates a related social security charge exposure for the Target, as employer of the relevant managers. Even though the above Supreme Court case is generally regarded as having strengthened the position of managers and target companies, careful attention should be paid when setting up a management arrangement. Key questions will generally relate to (i) the amount of the equity investment made by the managers, (ii) the fi nancial conditions of this investment and its fi nancing by the managers and (iii) good leaver / bad leaver clauses and/or vesting provisions.

3 GERMANY Tax regime In Germany, there is no special tax regime for the taxation of management arrangements and so the general rules apply. Pursuant to these rules, capital gains are tax free for tax residents in Germany, if (i) the individual did not hold 1% or more in the company at any time during the fi ve years preceding the sale and (ii) benefi cial ownership in the shares is held by the individual for at least one year prior to the sale. Whilst these requirements appear to allow an easy route for a manager to escape capital gains tax on disposal of his shares, certain customary features of management arrangements may jeopardise tax neutrality. In particular (i) the sponsor s entitlement to require the manager to transfer his shares upon becoming a leaver; and (ii) the limited down-side risk the manager takes on his investment in the company, may lead the tax authorities to question whether the manager actually holds benefi cial ownership of the shares. In practice, binding rulings obtained from the tax authorities have often given reasonable comfort to managers. This is now changing with tax authorities becoming more familiar with the particularities of management arrangements resulting in tax authorities considering the treatment of gains upon exit as possibly forming employment income which will be taxed at a rate of up to 45% (expected to increase to 47.5% in 2007). Enforceability of call rights In 2005, the Federal Supreme Court adjudicated on whether the sponsor s right to require the manager to transfer his shares upon becoming a leaver could be held unenforceable. The general position is that the unilateral right of a shareholder to force out other shareholders may be unenforceable due to arbitrariness, unless there are plausible reasons for such an arrangement. The Federal Supreme Court stated that the right of the majority shareholder to call for the manager s shares, in the event the manager leaves the company, is generally enforceable since the opportunity to invest in the company had been granted in view of the manager s employment with the company and to motivate the manager to increase shareholder value. Once the manager leaves the company, these reasons no longer exist. While the 2005 ruling gives more legal certainty when managers become leavers, it may be taken by the tax authorities as evidence that gains made by the manager on the sale of his shares are closely related to the manager s employment and should thus be taxable as employment income. ITALY In principle, under Italian tax and social security law any benefi ts obtained by managers by reason of employment constitute employment income subject to tax (at progressive rates) and social security contributions. Stock options As an exception to the above rule, until recently a special favourable regime was provided for stock options. In particular, if certain conditions were met, the gain obtained by the managers was subject to a 12.5% capital gains tax and avoided social security contributions. Recent legislation has severely affected the operation of this favourable regime. A new law, that came into effect as of 3 October 2006, provides for substantial additional requirements that practically render stock options a non tax-effi cient solution for management schemes in a private equity context (e.g. one of the new requirements is that the benefi ciaries, until the fi fth anniversary from the exercise of the options, shall not dispose of a signifi cant portion of the shares so acquired). As a result of these new rules, new management schemes will have to be implemented in order to replace the (until recently) commonly used stock options plans. Management arrangements The new tax effi cient management schemes may provide for a direct or (often preferable) indirect equity investment by the managers. In general, the aim is to obtain capital income or capital gains treatment for profi ts derived by the managers from their equity investment, thus benefi ting from the lower rate of tax (currently 12.5%, but likely to be increased to 20% in the near future) and from the exemption from social security charges. In the absence of specifi c guidance by tax authorities, particular attention will have to be paid to the funding needs of the managers and to the special rights granted to them, such as sweet equity hyper-performing returns on exit not proportional to those obtained by the institutional investors.

4 SPAIN The new law on personal income tax will come into force in Spain on 1 January With this new law, Spain will adopt a dual income tax system in which employment income will be taxed at a sliding scale (from 24% to 43%), whilst income from capital (including dividend, interest income and capital gains) will be taxed at a fi xed 18% rate. However, this new law, as with the current law, does not include any specifi c provision or guidance regarding the tax treatment of income obtained by managers pursuant to management arrangements set up on the context of a private equity transaction which, depending on the case, may be treated as employment income or capital income. Dividends and capital gains on manager investments (including ratchets) Under the new system, dividends and capital gains obtained by managers as a consequence of their equity investments should in principle be taxed at the 18% tax rate. The Spanish tax authorities might however reclassify the income obtained by managers from capital income to employment income where the economic rights granted to managers are disproportionate in relation to the value invested by the manager in comparison to other shareholders. The income obtained by the manager in excess of the private equity sponsors under sweet equity or ratchet schemes might in particular be scrutinised by the tax authorities. This reasoning would be in line with the decision of the General Directorate of Taxes in ruling 1688/2003. Good leaver/bad leaver and other provisions linking the capital income to the employment activity of the managers would also be a factor to support the reclassifi cation to employment income. The good news is that the new law will maintain the favourable tax treatment for long-term employment income. Consequently, even if reclassifi ed as employment income, the income obtained by the manager over more than two years on a nonrecurrent basis would be taxed at a 25.8% reduced tax rate. Interest on debt provided by managers The new law provides that interest income on debt fi nance invested by managers may be taxed at a progressive sliding scale if the manager and the company are related parties. According to a new law, managers will be deemed to be related parties, among others, if they are directors of a group company or they hold a stake of more than 5%. SWEDEN Typically, management make only equity investments in the portfolio company and so benefi t from the leverage on both the external financing as well as loans made by the fund. In order for the gain on the sale of shares by management to be taxed as income from capital rather than employment income, it is critical that those shares are acquired at fair market value, freely transferable and not subject to vesting restrictions. Call options at fair market value With an unlisted company it is possible to have a shareholders agreement pursuant to which the managers must sell their shares at fair market value if they wish to sell them or their employment terminates. This arrangement has been standard practice in the Swedish market and to our knowledge has not been challenged. In a ruling from the Council of Advance Tax Rulings (Sw: Skatterättsnämnden) in 1998 a right of first refusal (triggered if the employee wanted to transfer his/her warrants or upon termination of employment) at the original purchase price plus interest did not change the tax treatment of those securities. The ruling was, however, not appealed to the Supreme Administrative Court and thus the Swedish Tax Agency is not bound by it. Challenges by the Tax Agency More recently the Swedish Tax Agency has in certain situations tried to re-characterise capital gains made on the sale of shares and warrants into employment income. If re-characterised into employment income, the income is taxable at tax rates up to approximately 57% and subject to social security charges payable by the employer at approximately 32%. In contrast, capital gains are only taxed at a flat tax rate of 30% or 25% with no social security charges. The challenges, which are currently pending on appeal, are based on the argument that the managers have not acquired any genuine interest in securities since those securities are subject to heavy transfer and vesting restrictions which give them the character of an exit bonus based on their employment. The Swedish Tax Agency has argued that the managers should at all times be able to realise the fair market value of their securities. We do not believe that the Swedish Tax Agency s opinion will prevail, at least with respect to its characterisation of capital gains on shares as employment income. The risk should be manageable if the shareholders agreement is carefully drafted and complied with, but no outcome can be assured given the lack of directly applicable statutory or case law.

5 This Bulletin is a joint product of the European Private Equity Group of our network of leading independent firms in France, Germany, Italy, Spain, Sweden and the UK. france Bredin Prat Olivier Assant 130 Rue du Faubourg Saint-Honoré, Paris germany Hengeler Mueller Stefan Richter Charlottenstrasse 35/36, Berlin, D italy Bonelli Erede Pappalardo Giorgio Fantacchiotti Via Barozzi, Milano +33 (0) olivierassant@bredinprat.com +49 (0) stefan.richter@hengeler.com +39 (0) giorgio.fantacchiotti@beplex.com spain Uría Menéndez Christian Hoedl c/príncipe de Vergara Madrid +34 (0) che@uria.com sweden Mannheimer Swartling Peter Alhanko Norrmalmstorg 4 Box 1711 SE Stockholm +46 (0) pa@msa.se uk Slaughter and May Mark Horton One Bunhill Row London EC1Y 8YY +44 (0) mark.horton@slaughterandmay.com bau90.indd1206

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