Global Private Equity Newsletter - Summer 2016 Edition: LBO & Management Packages In France: Are Recent Developments In The Practice Driven By Tax Considerations?

by Dechert LLP

The management packages offered to managers in LBOs can sometimes be differentiating factors for financial sponsors enabling them to win a competitive process for the acquisition of a target company.

However, although the financial profitability of the management packages is an attractive element, for several years tax considerations have become paramount in structuring management packages. Indeed, gone are the days when a manager could simply invest a few tens of thousands of euros in order to receive a capital gain of several million euros, fully exempted from income tax, if the investment was undertaken through a share savings plan (PEA)!

Despite the decision of the Council of State1 on this topic, should we conclude that the capital gains allocation mechanisms (ratchet) is no longer viable? Or should we believe that since the Macron law, free shares now constitute the new El Dorado of management packages2?

Nothing is less certain. Management packages should not be driven solely by the search for a balance between tax optimisation and risk; above all, management packages should aim to enable managers to participate in the entrepreneurial and capitalistic adventure of the LBO and ensure an alignment of interests between managers and investors.

The Main Objective: To Align The Interests of Managers and Investors

In LBO deals, the profitability of investment funds depends on an increase of the equity value of the portfolio company. For investment funds, aligning their interests with those of the managers consists in ensuring that it will be in the best interest of the managers to increase the value of the company’s business by offering them equity in the company.

Given that the financial resources of the managers are often limited, the financial sponsors often propose investment structures that enable the managers to receive a higher portion of the equity value on exit relative to the amount of their investment in the company (the "ratchet" or “promote”). 

The Manager: An Investor Like No Other

For managers, due to their operational functions as employees in the group, access to the equity may be granted in two ways: 

  • Either through an investment, which requires managers to bear a financial risk and acquire securities at their fair market value. The acquisition price of a ratchet instrument can be expensive as it enables the manager to receive a significant amount of the gain realized by the financial sponsor when selling the portfolio company (through a liquidation preference mechanism).

  • Or through an incentive mechanism, which offers managers privileged or free equity based on their position as employees or directors. 

Investment and incentive follow two different paths: to benefit from a financial investment opportunity vs. to benefit from additional remuneration for incentive.

However, their methods of implementation, which each imply equity access, are close. This has led French taxing authorities to question the favourable tax rules applicable to capital gains made by the managers in the case of packages structured as an investment.

The tax treatment of capital gains--- where the use of a liquidation preference benefits to non- employee third parties such as venture capital investors--- has never been questioned by the taxing authorities. However the controversy with liquidation preferences in the management incentive situation arises because the beneficiary of the preference plays the role of both an investor and an employee. 

Tax Uncertainty: A Ticking Time Bomb

Issues related to the taxation of management packages are not new and can be compared with those which were debated on carried interest, which aims to align the interests of the investors (LPs) and the managers (GPs) of investment funds. Unlike taxation of carried interest, there is no clear legal tax regime in France for LBO management packages.

The lack of clear tax law on the subject has enabled the French tax authorities to tax the profits made by managers as employees (maximum rate of 62%) and, consequently, refuse to apply capital gains taxation, which is traditionally more favourable (depending on the duration of ownership prior to the disposal and the size of the company, the rate can be limited to 23.75%). 

The main argument of the French tax authorities is that the sums received pursuant to ratchet mechanisms remunerate the work of the manager (like a bonus) and not a financial risk borne by the manager as investor (like a capital gain). 

To support this argument, the tax authorities refer, in particular, to the leaver clauses usually include in the shareholders agreement signed by the managers with the financial sponsor. These leaver clauses require a manager who resigns before his shares vest, or who breaches the terms of the shareholders agreement, to sell back his shares to the financial sponsor for par value (meaning the face value of the shares). Thus the tax authorities assert that the employee’s status as an equity holder is tied to his status as an employee and therefore the tax authorities refuse to grant a manager the status of an investor.

Unfortunately, to date, the only decision rendered by the Council of State with regard to management packages supported the position of the tax administration (Gaillochet case law of 26 September 2014). The decision was surprising insofar as it was inconsistent with the opinions issued by the Committee regarding abuse of tax law available on this topic.

To mitigate the risk relating to this unfavourable case law and to be able to benefit from capital gains taxation, it is now commonly accepted that managers must make a significant investment as part of a management package (depending not only on their position within the group but also the size of their personal assets) and pay for their securities at the fair market value (according to a valuation determined by an independent third party expert). 

The Ratchet: From Warrants to Preferred Shares

If the tax authorities refuse to grant managers the status of investors, the very principle of ratchet could be in question, regardless of the instrument subscribed by managers. Does the position of the tax authorities now call into question the use of warrants, which enabled managers to increase their interest in the capital under certain conditions immediately before a liquidity event, to preferred shares, which affects the waterfall relating to the allocation of the liquidation surplus or the sale price? In other words, why did the practice move from warrants to preferred shares? 

Once again, the change in the taxation explains a lot! Indeed, until recently, warrants were eligible for share savings plans (PEA) and, if it was not subscribed through a share savings plan, any capital gain was taxable at a fixed rate of 19% (i.e. a rate of 34.5% with the social contributions). The rate was even 16% until 2009 (i.e. a rate of 31.1% with the social contributions).

Since 2013, capital gains on securities are taxed at the progressive income tax rate through, with regard to shares exclusively, allowances based on the duration of ownership (reduction of 50% after 2 years of ownership, and 65% for over 8 years3). It is therefore more favourable for the shareholders to hold preferred shares than warrants, which do not benefit from these allowances.

In addition, preferred shares may, in certain cases, enable managers to benefit from a lower level of risk, in the absence of a successful LBO, by providing managers with the ability to convert them into ordinary shares.

Macron Law (6 August 2015): A Move Towards Incentive?

Certain experts believed, wrongly in our opinion, that the reduction of the tax rates applicable to free shares and their resulting attractiveness, should resolve the uncertainty with regard to the tax treatment of management packages. 

Indeed, the tax regime for free shares (AGA) is secure and attractive for its beneficiaries (i.e. application of the capital gains regime with allowance based on period of ownership). In addition, the Macron Law shortened the required allocation and lock up periods (minimum of 2 years instead of 4 years) to make them more compatible with the investment horizons of the funds at the time of their investment. 

However, AGAs still have a significant cost for companies, the extent of which is not necessarily measurable at the time of grant. Previously, the employer's share (deducted at a rate of 30%) was payable at the time of grant, when it was not certain that the shares would vest (the contribution was therefore possibly paid at a loss). The employer's share (reduced at the rate of 20% since the Macron Law) is now due at the time the shares vest. However, it is calculated based on the value of the shares on the date they vest and depends on the value created during the vesting period. 

In addition, the AGA only partially address the issue of aligning the interests of investors and managers since they are, by nature, free. Therefore, the manager could receive a significant return on their shares allocated for free upon a liquidity event, even though the financial sponsors have not received their desired return (IRT). 

Thus, the position of the French tax authorities results in a certain paradox, since managers who have invested a significant amount in a management package could be prevented from applying the capital gains regime (in the absence of a legal regime) while managers benefiting from shares allocated for free would have access to the advantageous tax regime. 

We hope that this situation does not become widespread and that the legislator finally addresses the question of management packages to implement a secure legal regime, as it did in 2009 for the carried interest.


1) Council of State, 26 September 2014, no. 365573, M. Gaillochet

2) Law no. 2015-990 of 6 August 2015 on economic growth, activity and equal opportunities

3) Additional reductions are applicable under certain conditions relating to the subscription date of the securities and the size of the company.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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