A thorough review of the rules governing the taxation of management packages
28 July 2021
In three decisions handed down in plenary session on 13 July 2021 (LBO France case n°428506; G7 case n°437498; Financière Derby case n°435452), the French Administrative Supreme Court (Conseil d'Etat) clarified the taxation terms and conditions that must be applied to incentive schemes granted to managers and employees who are involved in the creation of value of their company.
These so-called "management package" schemes are most often set up in the context of LBO transactions alongside institutional investors. The ways in which managers acquire equity can take various forms depending on the type of transaction in which they are involved and market practice which is constantly adapting to the tools available and to legal reforms.
In the three cases brought before the Conseil d'Etat, instruments used were the issuance of warrants with cross-purchase and cross-sale promises or options to purchase ordinary shares granted in return for a lock-in payment.
The extensive case law of recent years in tax matters seemed to have developed a framework with criteria that made it possible to distinguish between whether the scheme involved a sufficient capital risk of real loss of the manager's stake and uncertainty as to the exit gain, or whether the preferential conditions of acquisition or resale of the instruments characterised the existence of a link with the functions of employees or managers within the group. If the capital risk was proven, the gain was linked to an investor's profit and benefited from the capital gains regime. Otherwise, the gains from these schemes could be reclassified and taxed as salaries and wages. The French Tax Authorities generally prorated the gain, which was adjusted in proportion to the reduction in the subscription price on entry, with the residual gain remaining taxed as a capital gain.
After the thunder of the Barrière judgement regarding social matters ...
The French Civil Supreme Court (Cour de cassation) made a first stop in the Barrière judgment of 4 April 2019 (n°17-24.470) by not using this analysis grid in social matters. The Cour de cassation ruled that the existence of a link between the granting of the instrument giving access to capital and the existence of a contract of employment (or a corporate mandate) was sufficient to reinstate the gains in the basis of social security contributions for the period during which the manager had free disposal of the instrument, without it being necessary to look for preferential conditions other than having been able to participate in the management package.
... the Conseil d'Etat also considers that the existence of a direct link with the employment contract or the corporate mandate is decisive and sufficient ...
From now on, the Conseil d'Etat drops the previous reading grid and adopts the more systematic position of the Cour de cassation by also seeking, for the tax analysis, to determine whether the implementation of the scheme "essentially stems from the exercise by the person concerned of the functions of a manager or employee". The criteria for linking the functions of employee or manager to the access to capital scheme are multiple: they may result from the non-transferability of the shares outside certain restrictively listed exit cases, an obligation of loyalty, exclusivity, or a non-competition undertaking to which the management package is conditional. Mechanisms that guarantee a transfer price from the outset, or at a later date, in exchange for the retention of functions within the group are also considered to have a direct link with the employment contract. More generally, the existence of contractual agreements organising the retrocession of part of the capital gain to the managers according to the internal rate of return (IRR) or the resale multiple of the institutional co-investor is also identified as likely to characterise this direct link.
It is up to the French Tax Authorities that intend to reclassify the gain as salary and wages to demonstrate the existence of this direct link, as shown by the decision in the G7 case.
... and no longer focuses on whether an advantage has been granted to managers ....
On the other hand, the Conseil d'Etat now considers that the amount of the initial investment and the existence or not of a risk of loss have no bearing on the way the gain is taxed. If the gain on disposal is acquired by the manager in his capacity as an employee or director, it may be fully requalified and taxed as salary and wages. The gain however retains its natural character as a capital gain if it can be shown that the manager was acting as a pure investor. In practice, this may be difficult to demonstrate for managers who co-invest in transactions where their functions within the group are required to be maintained until exit. The pragmatic approach of adjusting only a share of the gain now seems to have been dropped.
... to adjust the entire profit in wages and salaries
The Conseil d'Etat specifies that the taxable gain consists of the difference between (i) the resale price of the instruments and (ii) their purchase price plus, where applicable, the amount paid to acquire the warrant or right as well as any advantage that may have been taxed at the time of grant.
The issue of the financial advantage granted at the time of the grant of the instrument is also addressed. If it exists, the Conseil d'Etat considers that this benefit is taxable as a salary for the year of acquisition or subscription of the instrument at a reduced price. Thus, in practice, the administration will generally be precluded from acting to tax a benefit granted at the time of entry into the plan. But it will be taxed de facto at the exit if it was not taxed at the entry, taking into account the above-mentioned methods of determining the gain.
The Conseil d'Etat also clarifies the issue of exercisable warrants or options and rules that the gain from the exercise of the option (which is not governed by any text, unlike capital gains) is taxable as a salary if the instrument was subscribed in respect of the functions of an employee or manager.
These combined decisions on social and fiscal matters will make the market practice evolve on management packages. The use of legal schemes such as allocation of free shares (AGAs) or warrants to subscribe to business creators' shares (BSPCEs) seems to be the preferred solution in a more restrictive legal framework that will have to be complied with.
Author: Emmanuelle Pontnau-Faure, Partner.
