Management incentives are a key element of leveraged buyout acquisition structures. Structuring of management incentives in Germany is, to a considerable extent, tax-driven: stock option schemes are taxed as bonus schemes, that is, the gain realized by management at exit is fully taxable as employment income. In contrast, management equity programmes (MEPs) can be structured to generate capital gains for managers. Capital gains are tax-free in Germany after a minimum holding period of 12 months if the manager holds less than 1% of the nominal capital; otherwise, exit gains are taxed at 50%, subject to the manager's individual tax rate. If family partnerships are used, the 1% threshold applies separately for each family member holding an interest in the family partnership.

So German MEPs are designed to achieve capital gains treatment.

Beneficial ownership

Beneficial ownership of the management's shareholding is essential to achieve capital gains treatment. If management's shareholding is too strictly tied up, German tax authorities might treat it as phantom stocks. This would result in fully taxable ordinary income rather than tax-free or tax-privileged capital gains treatment. Tax authorities will only accept beneficial ownership if the manager bears both the risk and the chance that the shareholding increases or decreases in value and if the manager can exercise the administrative rights deriving from their shareholding, especially voting and pre-emption rights. Negative criteria might be a vesting schedule restricting the benefits of the management beyond what is acceptable, irrevocable voting powers to the majority shareholder, or unlimited transfer restrictions. Ratchet schemes, which provide for a reallocation of exit proceeds in favour of management depending on performance or on the internal rate of return (IRR) achieved by the financial sponsor, are increasingly being scrutinized after a recent tax court decision held that an option to increase management's shareholding depending on exit performance might constitute employment income. Negative ratchets (that is, structures according to which management receives a higher shareholding from the outset but a reduced share in proceeds if certain IRR targets of the investor are not met) are less risky. However, all parties involved should be aware that there are no specific stipulations or official tax decrees dealing particularly with MEPs. Increasingly, individual advance rulings for wage withholding tax purposes are being sought.

Leverage and tax impact

The manager must receive the share at the same equity valuation as the investor. As management typically has limited funds available, this usually requires elements of leverage. In principle, personal loans by the financial investor to managers can be used. To mitigate management's downside risk, this might, however, need to include certain non-recourse elements. At least in extreme situations where management bears no downside risk, tax authorities might challenge non-recourse structures. Typically, the required leverage is achieved by granting disproportionate shareholder loans (that is, only a limited portion of the shareholder funds for the acquisition structure are granted as proportionate equity contributions by all shareholders, whereas the remainder is provided only by the financial investor).

Tax-wise, shareholder loans are limited by thin-capitalization rules (which were tightened in 2004). To the extent shareholder loans exceed 150% of the investor's pro rata share in the company's net equity, interest is non-deductible for corporate income and municipal trade tax purposes. As this excessive portion of interest payments is recharacterized as constructive dividends, withholding tax issues might arise with regard to foreign investors. To deal with the tightened restrictions, it has become common practice to achieve the leverage element of MEPs by way of preferred shares or preferred capital reserves: the financial investor and management invest proportionately in common equity and the investor subscribes for an additional, disproportionate amount of preferred equity; the preferred shares or preferred reserves have similar features to a shareholder loan (cumulative preferred dividends, preferred allocation of liquidation and exit sale proceeds but no conversion right, that is, the increment over the fixed return only goes to common shareholders).

Anticipated changes of tax laws

Preliminary proposals by Germany's new government indicate that a general capital gains tax regime (possibly with a 20% flat rate irrespective of the percentage shareholding) might be implemented as of 2007.

New case law on vesting schedules

In 2004, two court decisions of higher regional courts created uncertainty with regard to the enforceability of leaver schemes in MEPs. The subject of both decisions was the validity of an MEP for managing directors of local branches of a trade chain, under which a managing director was obliged to retransfer their shares in the company upon dismissal as managing director. The Higher Regional Court of Frankfurt held that the clause was invalid because the termination of the position as managing director was at the sole discretion of the majority shareholder, who was therefore able to repurchase the shareholding without cause. In contrast, the Higher Regional Court of Düsseldorf affirmed that the managers' shareholdings are dependent on their position as managing directors in the company, as otherwise the company could not establish the MEP for a longer period and for further forthcoming managing directors. Accordingly, the court ruled that the MEP is valid. The Federal Supreme Court has now clarified the matter in favour of the view taken by the Düsseldorf Court.

Disclosure of directors' remuneration

A new law on the disclosure of directors' individual remuneration passed the German legislation. Listed stock corporations will be obliged to disclose a statement of the company's remuneration policy, which will be included in the notes to the annual accounts of the company. The remuneration statement has to show the total remuneration and other benefits granted to the individual directors over the financial year. The statement should differentiate between variable and non-variable directors' remunerations and provide information on supplementary pension or retirement schemes. Furthermore, the statements should also disclose whether these payments are made by the company or a third party. By way of a shareholders' resolution in the shareholders' meeting, the shareholders might opt not to disclose this information, provided however that the resolution needs a majority of at least 75 % and will be valid for a maximum of five years. The law will apply for annual reports and accounts for business years starting after December 31 2005.

The new legislation will have an impact on private equity transactions, especially in private investment in public equity (PIPE) transactions, as share-based incentive schemes and any other benefits paid to or receivable by an executive director have to be disclosed. Additionally, the reasoning of the new law expressly states that compensation paid to former executives for services rendered during takeover negotiations have to be disclosed. Germany has seen several takeovers of publicly listed companies by private equity funds in the past, and these payments have to be disclosed soon as well, which will certainly lead to further public debate.

Outlook

Anticipated changes in German tax laws as of 2007 might include the introduction of a general capital gains tax scheme. This would adversely affect MEPs in which managers (or their family members) hold less than 1% of the nominal capital of the relevant company and therefore would realize a tax-free exit gain under the current regime. Nonetheless, MEPs will remain an important element of German LBO structures. Tax authorities are becoming increasingly experienced on the taxation of MEPs. This could expose ratchet schemes and non-recourse financing of managers' shares by investors to closer scrutiny. On the corporate law side, a Federal Supreme Court decision has eliminated uncertainty with regard to the enforceability of leaver schemes.

Author biographies

Philipp von Braunschweig P+P Pöllath & Partners Philipp von Braunschweig specializes in transactional M&A/private equity work (legal and tax structuring of acquisitions, purchase documentation, management participation schemes, and leveraged financing transactions). He has been admitted to the Bar in Germany (1992) and New York (1993) and holds an LLM degree from Fordham University (New York, 1992). Philipp von Braunschweig is a lecturer in the mergers and acquisitions graduate programme at the University of Muenster (Germany) and is listed as a frequently recommended lawyer for M&A and private equity work in JUVE Handbuch 2005. Benedikt Hohaus P+P Pöllath & Partners Benedikt Hohaus specializes in legal and tax advice on private equity structuring and transactions as well as the structuring of management participations. He graduated from Münster University in 1995 and a PhD in 1998, and is the author of numerous articles and a frequent lecturer on tax and corporate law issues, especially on management participations.