Basic principles
With a view to the recent case law it makes sense to recall the basic principles which apply to management participations. It is obvious that the granting of shares or of other (profit participating) instruments results in a taxable benefit whenever the consideration payable by the manager is below the fair market value of the shares or the instrument. In the context of M&A transactions the fair market value of the instrument typically can be derived from the purchase price agreed between the parties of the SPA.
Going forward the income derived by the manager from the shares (held through a limited partnership) or from any other (profit participating instrument) will only be taxed as investment income (flat tax of 25% plus solidarity surcharge and church tax or tax exemption of 40% of the dividend or capital gains income) provided the underlying arrangement can be seen as a legal agreement which is distinguishable from the employment contract.
Distinction of wage income and investment income
The tax courts have confirmed that arrangements under which the shares or other instrument could only be acquired by managers and under which the shares or other instruments are subject to redemption once the employment relationship terminates will not impair the tax treatment of the income except for extraordinary circumstances.
According to the case law the income will only be treated as fully taxable wage income in case it represents a remuneration of the specific services of an individual manager rather than income from capital investment. Hence, the income of the management participation must not be contingent on the performance of the individual manager but should, in principle, represent a pro rata share in any proceeds derived from the underlying investment (dividends / capital gains and potentially income from shareholder loans).
MPP may provide for shares or other forms of profit participation
Since these principles apply to any form of management participation it is not necessary to grant shares in an entity to the managers through a rather complex partnership structure. Also other indirect or derivative structures have been used in the past under which the managers acquire a profit participating bond or an interest in an undisclosed civil law partnership (Unterbeteiligung, a hybrid debt instrument) which tracks the income derived from the investment without conveying any form of shareholder rights or corporate control rights to the managers in the entity which issues the instruments.
The benefit of such "derivative" management participation schemes is that the creation of additional entities or partnerships is not required and that simple written form documentation is sufficient to implement them.
Recent case law
In a recent decision, dated 1 September 2016, the German Federal Fiscal Court has confirmed that the granting of shares in a GmbH to managers of the company may qualify as fringe benefit which is subject to wage tax withholding provided the acquisition price payable by the manager is below the fair market value of the shares and provided further that the benefit is caused by the employment relationship.
However, in its decisions the court made it clear that the mere fact that the benefit was exclusively granted to employees of the company and that the shares were redeemable upon the termination of the employment relationship does not per se justify the conclusion that the benefit is caused by the employment relationship but that these circumstances may in fact indicate that the benefit is attributable for taxation purposes to the employment relationship.
In its decision the court has confirmed that this principle does also apply - without variation - in case the shares were not granted by the employer but by a third party, e.g. a holding company of the actual employer. According to the court a lower than arms' length consideration for the share transfer can only be justified in case the employer has a specific own interest to transfer the shares below fair market value (apart from the intention to grant a benefit or an incentive to the employee).
In 2014 the tax court of Lower Saxony decided that also in case the managers hold shares through a partnership structure the income derived by the managers as limited partners in the partnership can be reclassified in wage income (rather than as investment income) when the income does not result from the shareholding in the underlying entity but is rather calculated on the basis the IRR of the corporate group in which the investment is made and when the individual managers concerned in fact did not make contributions to the partnership's equity (dec. dated 15 January 2014).
Also in 2014 the Federal Fiscal Court decided that the income derived from an MPP in the form of a profit participating instrument (Genussrecht) did not qualify as investment become because the remuneration actually was determined by a committee consisting of representatives of the investors and the management (dec. of 21 October 2014).
It follows from these court decisions that an MPP will only result in investment income provided the investment is made under arm's length conditions and that the remuneration is not left to the discretion of the employer but rather tracks the income and the increase in value of the underlying entities.
