On October 4, 2016 the German Federal Fiscal Court (Bundesfinanzhof) delivered its decision in respect of matter number IX R 43/15. The decision was not published until January 25, 2017 but was eagerly awaited by, in particular, managers, private equity houses and fund sponsors because of the implications for the tax treatment of management participations in private equity style investments.

In the case before the Court, a member of the management team (indirectly through a holding vehicle (HoldCo)) acquired shares in his employer's holding company (InvestCo) at market value. HoldCo's articles of association provided for the compulsory transfer of a manager's interests in certain circumstances (for example, the termination of his employment) which would subsequently result in that manager losing his/her participation in InvestCo. On such a transfer, the manager would be entitled to cash compensation, the amount of which was dependent on the grounds for his departure.

The shares in InvestCo were later sold at market value to a third party by way of an exit. The tax authority determined that the manager's gains should be treated for tax purposes as employment income. The tax authority argued that the offer to the manager to acquire shares in HoldCo was an opportunity for the manager to profit from that investment that was tied to his employment. This was supported, in the tax authority's opinion, by the fact that this opportunity was exclusively offered to carefully selected employees, who could – as mentioned before – be excluded from HoldCo for reasons, including amongst others, the termination of their employment.

The manager successfully challenged the income tax treatment in relation to the gain on exit.

The Federal Fiscal Court confirmed the Tax Court's (court of first instance) decision and held that the gain on exit did not constitute employment income for tax purposes but was, in fact, a – tax-privileged – capital gain. In the Court's opinion, the profit arising from the manager's investment had a legal basis separate from and independent of his employment.

The Court was clear in its ruling that:

• a return on the sale of shares does not automatically qualify as employment income simply because the participation is held, and later disposed of, by an employee, or because the option to acquire the shares is offered only to employees or to certain employees;
• in the case before the court, the shares were acquired at market value and therefore it could not be said that the offer to buy shares constituted a chance to make a profit that had been extended to the employee solely because of his employment;
• the fact that a manager can, in accordance with the articles of association of the company, be required to transfer his shares upon termination of his employment, of itself should not lead to gains from that investment being treated as employment income for tax purposes - to the contrary - this was considered by the court to be the very nature of management participation programs and a consequence of such a scheme and therefore, was not sufficient to establish a nexus between the opportunity to invest and the services rendered; and
• the fact that the manager had been exposed to an actual risk of making a loss on his investment in HoldCo was a strong argument in favour of the gain on exit qualifying as a capital gain and not employment income.

For management taxpayers, the Federal Fiscal Court's decision marks a highly positive development as the tax authorities have in the recent past increasingly been trying to levy taxes with respect to management participations, on – as the court confirmed in this case – a doubtful legal basis.

Following the Federal Fiscal Court's decision, it will be far more difficult for the tax authorities to carry on with this practice. Although the treatment of management participation gains for tax purposes will continue to be a matter of fact in each individual case, taking into account all facts and circumstances, i.e. all legal relationships (and also the interaction of the various legal relationships constituted by the articles of association, partnership agreement, employment agreement etc.), the court's decision clarifies the relevance and irrelevance of certain factors typical in management participation programs.