Taxation on the sale of management shares, wages or capital income?

– BFH confirms positive court ruling from 2016

Management shares, mostly in companies that are part of a group, are a common instrument for incentivising managers.

Not least in the run-up to restructuring and corporate transactions, the aim is also to align the interests of shareholders and management.

Management shares in portfolio companies are thus also common in the private equity fund environment. The question of taxation as wages (fully taxable under the progression system) or (privileged) as capital income subject to withholding tax thus naturally leads to conflicting views between taxpayers and tax authorities.

In a first relevant ruling from 2016 (IX R 43/15), the German Supreme Tax Court (Bundesfinanzhof, BFH) denied the qualification of a manager’s share in their employer as wages. The fact that, in the disputed case, the share was offered exclusively to executives and that rights of exclusion and termination applied in the event the employment was terminated was ultimately irrelevant. At that time, the management share was qualified as a special legal relationship independent of the manager’s employment.

This trend in court rulings, which is advantageous for the application in practice, was confirmed by the BFH in 2 further recent rulings from December 2020, both published on 27/05/2021.

In ruling VIII R 40/18, shares in an affiliated company within the group were offered to a selected group of employees (“managers”) for purchase at USD 0.0625 per share, in this case a total of USD 10. The sales proceeds per share achieved a good 3 years later amounted to approx. USD 1,750 per share.

The BFH ultimately ruled that the share was a separate source of income independent of the employment, if:

  • the employment contract does not provide for any entitlement to acquire the share and a proportionate share of the sales proceeds as consideration for the employment, and
  • the share is acquired and disposed of at the market price (and not at a discount), and
  • the employee bears the full risk of loss, and
  • no special circumstances arising from the employment can be identified that affect the saleability and performance of the share.

The mere fact that the share is held by an employee of the group of companies and was only offered for purchase to a selected group of employees and moreover, as argued by the tax office, the employee did not bear any significant risk of loss, with the simultaneous possibility of achieving an extraordinarily high return, did not result in the qualification of the sales proceeds as income from employment.

In ruling VIII R 21/17, a self-employed management consultant indirectly held a share in a holding company via a GbR [partnership under the German Civil Code]. The tax office qualified the later significant sales proceeds arising from the share as remuneration for the plaintiff’s consulting services. The action and appeal filed against this at the BFH were successful. Here as well, the BFH ruled that an equity investment only counts as business assets in exceptional cases and confirmed that, according to the BFH’s established practice, financial transactions by members of the liberal professions are generally privately initiated and lead to income from capital assets if the equity investment has its own economic weight compared to the freelance activity, e.g. if the taxpayer is primarily concerned with the capital investment and other aspects such as the acquisition of orders as merely a desirable side effect take a back seat. Moreover, it was also decisive in this case that the investment was acquired and sold at the market price and that the shareholder bears the full risk of loss arising from the investment. The increased chance of profit associated with the possibility of investment did not play a part in this respect, since according to the BFH, such a chance is inherent in every equity investment. As a result, there was no evidence that the plaintiff had earned a non-market-based, increased rate of return that could qualify as an additional bonus payment for his consulting work.

Note from practical experience:

Both rulings from 2020 clearly show that, also in view of the amount of the sales proceeds often at issue in relation to the acquisition costs (ex post), which tend to be classified as low, the dispute with the tax office is often predetermined in comparable situations.

It is also significant in this context that in the case of ruling VIII R 40/18, criminal tax investigations had already been initiated against several employees of the company due to the tax treatment of the proceeds achieved from the sale of shares.

In the case of ruling VIII R 21/17, the auditors came to the conclusion during a tax fraud investigation that the payments made due to the sale of shares were to be regarded as remuneration for the plaintiff’s consulting work.

In this context, it is all the more gratifying that the BFH has now worked out clear guidelines for the treatment of sales proceeds from management shares as capital income and the distinction from treatment as wages and salaries. They should provide taxpayers with good arguments in similar cases.

From our point of view, the transparent disclosure of the facts, e.g. in the income tax return of the managers involved, continues to be important in order to eliminate the accusation of “concealment” later on. The issue of the valuation of the shares in the case of purchase and sale remains unresolved; the BFH did not have to comment on it in the cases dealt with. This means that particular attention will continue to be paid to the issue of share valuation at the relevant taxation dates.

Author: Tax Advisor Thomas Jäger

German Supreme Tax Court Decisions:

Download BFH Court Decision dated 4th October 2016, IX R 43/15

Download BFH Court Decision dated 1st December 2020, VIII R 21/17

Download BFH Court Decision dated 1st December 2020, VIII R 40/18

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