Tax considerations
The tax treatment of any sale proceeds (whether received on completion or in the future) and of any holdings in the new structure will directly impact how much value you will end up with as the result of the transaction. You will most likely want to have any transaction to attract the minimum rate of tax available. It is important to note that tax structuring may not be possible shortly before the transaction and generally not be implemented with retroactive effect.
Consideration structures
Your individual tax position will depend on the type of consideration you receive, the method of calculating it and the timing of any payment. You may receive any combination of the following types of consideration: cash, shares, or loan notes, and your tax position may be complicated by any entitlements to receive consideration post-sale, possibly by way of an "earn out".
Where you receive cash for the disposal of shares in the target company your proceeds are, as a general rule, subject to capital gains tax for the fiscal year in which the closing occurs.
Where a founder has held the shares in the target company indirectly through a holding vehicle in the form of a corporate entity as from the incorporation of the target company, any capital gains realized by the holding vehicle are 95% tax exempt under German tax law (effectively resulting in a tax charge of approx. 1.5% of the capital gains). However, any profit distributions made by the holding vehicle to the founder as shareholder (whether or not sourced from the capital gains previously realized) are subject to German flat tax at a rate of 26.375% to be withheld by the holding vehicle. In such a case, the overall tax burden eventually suffered by the founder may even exceed the tax burden imposed on capital gains directly realized by the founder (i.e. without the interposition of a holding vehicle). In the latter case, capital gains are (subject to a 1% participation threshold) subject to the partial income method (Teileinkünfteverfahren) which provides for a 40% tax exemption for capital gains with a full income taxation for the remaining 60% of capital gains (effectively giving rise to a maximum overall tax burden of 28.5% or less depending on the founder’s individual tax position).
Particular care should be taken by individuals in transactions where "rollover" or "earn-out" mechanisms are included in the drafting. Although they are useful commercial tools to incentivise founders and senior management staying on in the business (particularly in a private equity context) and bridge valuation gaps between buyers and sellers, they can result in unexpected tax consequences.
You should seek tax advice as early as possible on the appropriate way to structure such entitlements.
- Earn-outs – An "earn-out" can be structured as a future entitlement to shares or loan notes or as payments of deferred and/or contingent cash consideration. Future entitlement to shares may include allocations of "sweet equity" as discussed in Part 2. Often an earn out is contingent on certain future events or performance metrics. The way an earn out is structured will affect how and when it will be taxed in your hands. Some points to be aware of are set out below.
- Large values of deferred or contingent consideration can trigger significant tax charges on completion of the sale (regardless of when, or if, such amounts are eventually paid). Accordingly, careful consideration should go into the drafting of these provisions and the mechanisms for calculating any future amounts as described in the transaction documents.
- A seller's entitlement to earn out consideration should ideally be linked only to the performance of the company (and not any individual) and should not be conditional on any individual's ongoing employment (among other things) to maximise the likelihood that it is taxed under the preferential capital gains rules. However, in the case of sellers still assuming, after the closing, senior management functions in the target company or any of the buyside companies controlling the target company, face a high risk that the earn-out amount is fully taxed as ordinary income under the wage tax rules rather than the capital gains rules. By contrast, an earn-out should not be an issue for tax purposes if the seller no longer contributes to the performance of the target company after the closing.
- Rollover – As discussed in Part 2, a founder seller may be requested to "rollover" part of their shareholding in the target company to shares and/or loan notes of equivalent value in the new structure.
- Where you receive shares (or certain types of loan notes) in the new structure for the disposal of shares in the target company it may be possible for German tax resident founders/senior managers to "rollover" any existing shares in the target company in a tax neutral manner (for more details, please refer to Part 2, Section 1 Private equity - Rollover and reinvestment).