Management exit considerations: capital gains tax treatment

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1 Key topics in M&A Management exit considerations: capital gains tax treatment Highlights When managers invest in shares of the private equity-backed company they work for, exit profits aren t necessarily treated as taxable income. Should managers invest directly or via a Personal Holding Company? Is it worth having the tax treatment of a share investment confirmed by the Tax Ruling Service? Uncertainties and optimisation in the current tax environment: How are profits taxed at exit? Executive summary To meet performance objectives, private equity firms rely on talented and highly motivated managers within their portfolio companies. Aligning the financial interests of portfolio company managers with those of investors, has, to date, proven to be the most motivational tool to drive them. Portfolio company managers are asked to jump into the transaction equity package and can expect to obtain (significant) gains when performance objectives are met. But how are these gains taxed? How the investment arrangement for management is structured can make a huge difference from a tax perspective. There are two possibilities for managers to consider: investing directly or investing via a Personal Holding Company (PHC). Normally, investing via a PHC means the capital gain realised by the PHC upon exit is tax exempt, provided the shares have been held for at least one year. When exit profits are distributed in the form of dividends, these most likely suffer corporate tax at 34%, which isn t really favourable. A manager could decide to keep the proceeds in the PHC or distribute them as dividend income (taxed at 25%) or liquidation proceeds. Provided that the PHC qualifies as a small company, the 25% tax rate may be reduced to 15% if distribution is deferred by five years or to 10% in case of liquidation. Investing via a PHC may not always seem to be the best way to invest. Would a manager be better off investing directly in the structure? When exit profits take the form of dividend distribution, the aggregate Belgian income tax will likely reach 25%, much better than the corporate tax cost of 34% for the PHC. But when exit profits take the form of a capital gain, how is it taxed?

2 (1) If the exit proceeds are distributed as a dividend (i.e. the sale occurs below NewCo 1), the dividend will be taxed at 33.99% in the PHC (no DRD available). If the PHC sells its NewCo 1 shares, the capital gain realised will be taxed at either 25.75% in case it concerns a short-term capital gain, or 0% in case it is a long-term capital gain for SME s and 0,412% for large corporations. (2) In case the PHC distributes the proceeds as a mere dividend, the individual will be taxed at 25%. One could opt for creating a liquidation reserve (subject to immediate taxation at 10% and possibly a second taxation, upon a future distribution, at 5% or 15%, depending on the circumstances). (3) If the exit proceeds are distributed as a mere dividend (i.e. the sale occurs below NewCo 1), the dividend will be taxed at 25%. If the manager sells his NewCo 1 shares, the capital gain realised will either not be taxable or be taxed at 33% (+ local taxes). Key topics in M&A - 2 -

3 1. Belgium doesn t tax capital gains from private share investments, myth or reality? There are no clear guidelines regarding the absence of tax on capital gains realised upon the sale of shares. Taxation of capital gains from private investments The Belgian Income Tax Code states that capital gains on shares realised beyond the scope of the individual s professional activity are taxable (@ 33% + local taxes) as miscellaneous income, unless the investment in shares falls within the scope of the normal management of the individual s private estate. As such, the statement that capital gains from private investment in shares are not taxable in Belgium is, at a first glance, a myth. But this myth becomes reality when the share investment may be regarded as normal. But what is the normal management of a private estate? The Belgian Income Tax Code doesn t foresee any specific definition of what is meant by normal management of a private estate. In other words, it s subject to interpretation, there s no consensus about what normal management of a private estate is. The Belgian Tax Authorities, the court, tax payers and tax practitioners all have their own interpretation of what it might mean. As a result, the Tax Ruling Service has been required on several occasions to confirm the tax treatment of capital gains realised from private investments in shares and has issued some guidelines which may help taxpayers identify the need to apply for a ruling decision. In most cases, capital gains on the shares put under the spotlight actually arose in the context of internal reorganisation of the shareholder structure of a private company ( internal capital gains ). There have been few rulings on the tax treatment of capital gains arising from a mere share investment. Key topics in M&A - 3 -

4 The Tax Ruling Service steps in As mentioned above, the courts and tax authorities hold significantly different views on what should be understood by normal management. Conflicting statements were also made by Ministers, State Secretaries and others leading to further legal uncertainty for taxpayers. To offer clarity, the Tax Ruling Service published a number of the criteria used to determine whether transactions could be considered as normal management of an individual s private estate based on jurisdiction. These criteria are merely guidelines which the Tax Ruling Service applies to confirm the (ab)normal character of a specific transaction (or combination of transactions). While these guidelines are helpful, they don t offer taxpayers certainty as to whether a specific transaction is considered normal or not. To get that certainty, they can request a ruling. Key topics in M&A - 4 -

5 Legal certainty A ruling is a decision by the Belgian tax authorities on how the tax legislation applies to a specific situation or transaction. This decision provides legal certainty to the requestor as it s binding for all Belgian tax authority services. Two interesting rulings have been made about the tax treatment of capital gains from a share investment by the management of a private equity-backed company. Published rulings First Ruling In the first situation, executives and managers were invited to invest, alongside the main investors, in shares of the company for which they were working. They acquired the shares at fair market value and their professional activity was not to invest in shares. The Tax Ruling Service confirmed that the capital gain realised upon the sale of the shares was not considered taxable remuneration. This confirmation was (in our view) unnecessary as the definition of employment income and director fees (remunerations) doesn t include capital gains realised upon the sale of assets by the individual, even if those assets were to be used for professional purposes. Only if the sale price would ve been higher than the fair market price could the excess have been taxed as remuneration. To be taxable professional income (other than remuneration), a share investment needs to be treated as a standalone professional activity, separate from the manager s employment/directorship. But this will rarely be the case. The Tax Ruling Service confirmed that the investment could be considered as normal management of the individual s private estate for the following reasons: It s common practice in the private equity industry to invite managers and executives to invest in the company so this investment wasn t really an initiative of the managers. The amount invested was low in view of the managers and executives total estate, so the risk was considered to be limited. The holding period of the investment was between three to seven years. Second Ruling In the second situation, the tax ruling also confirmed that exit profits weren t taxable as miscellaneous income as the investment was held for several years and there was no external funding needed at the time the managers originally invested. Key topics in M&A - 5 -

6 Conclusion The two aforementioned decisions are encouraging as the tax ruling service doesn t consider that share investment in the company in which the investor works is necessarily speculative or beyond what could be considered normal. That the investment doesn t put the estate at risk and that the holding period of the investment is not short term are still key in determining whether the capital gain from a share investment is taxable at 33% (+ local taxes) or not. Encouraging decisions however don t mean binding decisions for other taxpayers. You may request a ruling expecting the outcome to be favourable, but find that local tax inspectors aren t as familiar with the concept of normal management as in the above. Key topics in M&A - 6 -

7 2. Alternative: investment structured in the form of stock options Under current Belgian legislation, granting stock options to managers may also be considered a solid alternative. Source: Driving portfolio company performance in a changing private equity environment, 2013, PwC While share investment is common practice, resorting to stock options may be considered a solid alternative to help incentivise managers. Our Driving portfolio company performance in a changing private equity environment survey found that over 90% of incentive plans in US private equity-backed companies are options or profit interests. Favourable tax regime in Belgium There s specific legislation in Belgium to tax stock options at grant on a lump sum basis provided the stock options are accepted in writing within 60 days of the offer. The 60th day is the taxable moment. The lump sum valuation is calculated as follows: Taxable time value: 18% of the stock s fair market value at the time of the offer for options that have a maximum life of five years. For options that have a life of more than five years, the value will be increased by 1% for each year or part thereof in addition to the five years. Provided certain conditions are met, the 18% and 1% figures may be reduced by half to 9% and 0.5%. Taxable intrinsic value: the positive difference between the fair market value of the stock at offer date and the exercise price (the discount). Upon exercise of the option, in principle, no further income tax is due. Upon sale of the shares, no capital gains tax is due if the sale is made within the normal management of the individual s private assets. Key topics in M&A - 7 -

8 Pros and cons Structuring an investment via options may provide additional flexibility as options can include performance conditions and vesting conditions without altering their tax treatment. And no upfront investment, except the tax, is required by managers. However on the downside, if the options aren t exercised, the income taxes paid at grant cannot be recuperated. Key topics in M&A - 8 -

9 We re here to listen This contribution was written by Luc Legon, Bart Van den Bussche, Dominique Vanhove and Hugues Lamon. Please feel free to contact us. Luc Legon Director Tel: luc.legon@be.pwc.com Bart Van den Bussche Senior Manager Tel: bart.van.den.bussche@be.pwc.com Dominique Vanhove Senior Consultant Tel: dominique.vanhove@be.pwc.com Hugues Lamon Partner Tel: hugues.lamon@be.pwc.com Do you want to stay up to date with the latest developments in M&A? Visit our website To subscribe to our next publications, visit our newshub page About PwC PwC helps organisations and individuals create the value they re looking for. We re a network of firms in 157 countries with more than 195,000 people who are committed to delivering quality in assurance, tax and advisory services. Find out more and tell us what matters to you by visiting us at PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see for further details PwC. All rights reserved.