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The French “Conseil d'Etat” clarifies the tax treatment of management packages

In three important decisions of 13 July 2021

29/07/2021

In three important decisions of 13 July 2021, the “Conseil d'Etat” (French Highest Administrative Court) ruled on the tax treatment of gains realised in the context of management packages put in place for the benefit of certain directors and managers in the form of share subscription warrants and share purchase options.

As regard the characterization of gains made by executives and managers in the context of LBO transactions in particular, the characterization of capital gains is frequently challenged by the French tax authorities, which consider that these gains are in fact salaries and wages, which are subject to heavier taxation.

The method adopted by the Conseil d'Etat consists in dissociating the gains related to the successive phases of the life of the management package in order to apply a distinct characterization to them. The Conseil d'Etat thus makes a distinction between the benefit derived from the actual delivery of warrants or purchase options at a preferential price and the gains subsequently withdrawn by the taxpayer when the warrants or the options are exercised, or when the warrants are sold.

While the adoption of this method clarifies case law, it leaves some legal and practical questions unanswered.

1. A first advantage materialised at the time of delivery of the warrants or options

The principle stated by the Conseil d'Etat is that the acquisition or subscription of options or warrants at a preferential price compared to their real value at the date of acquisition or subscription is likely to reveal the existence of an advantage up to the difference between the price thus paid and this value.

If this benefit is "essentially" derived from the exercise of the person's duties as a manager or employee, it has the character of a benefit granted in addition to the salary, taxable in the year of acquisition or subscription of the options or warrants in the category of salaries and wages.

In practice, this means that the administration's limitation period for the taxation of this first gain runs from the granting of the warrant or the option.

2. A second advantage materialised at the exercise of the warrants or options, or the sale of the warrants

The gain realised on the unwinding of a management package must be clearly distinguished from the gain realised on the initial grant of the warrant or call option. Thus, the preferential nature of the price paid on entry is deemed to have no impact on the nature of the gains made subsequently by the taxpayer.

Having made this distinction, the Conseil d'Etat distinguishes between several types of gains.

Firstly, the taxpayer may realise an exercise gain when he exercises a call option or a warrant. This gain is in principle equal to the difference between the real value of the shares at the date of exercise of the option or warrant and the purchase price. It is taxable in the year in which the exercise takes place and also constitutes a salary for tax purposes if it is essentially derived from the performance of a management or employee function. If the sale of the share takes place shortly after its acquisition, so that the share has not increased in value between its acquisition and its sale, the gain on exit from the management package is then taxed in full in the category of salaries and wages.

Secondly, the taxpayer may sell a warrant without exercising it. The gain realised on this occasion is then taxable in principle as a capital gain on the sale of securities. This tax classification applies even if the warrants were acquired or subscribed for from a company of which the taxpayer was a director or employee or from a company in the same group. Nor is it affected by the low risk initially taken by the taxpayer, as this risk only affects the value of the warrant on entry.

However, the Conseil d'Etat rules that the capital gains regime does not apply when, having regard to the conditions of realisation of the gain on disposal, this gain must be considered as acquired, not because of the transferor's capacity as an investor, but in consideration for his functions as a manager or employee. Thus, for example, when a mechanism for guaranteeing the transfer price or sharing the capital gain is put in place because of the functions performed by the person concerned, the capital gain is subject to tax recharacterization.

3. Numerous open questions

Although the method of characterizing the gains made by executives or managers in the context of management packages is to some extent clarified by the decisions of 13 July 2021, the decisions are not free of ambiguity. Thus, for example, the Conseil d'Etat specifies that in order to avoid double taxation of the gain on entry, the gain on exit must be calculated taking into account "the advantage that may have been taxed" on entry. The practical application of this mechanism raises questions in the event that the limitation period relating to the taxation of an undeclared salary gain on entry has expired.

Beyond the technical questions raised by the decisions discussed above, it is now necessary to consider the impact of the new case law on management packages structured differently from those in the particular case. Somewhat surprisingly, the Conseil d'Etat now considers that an investment mechanism generating a real risk of financial loss for the parties concerned may nevertheless have the nature of a salary if it turns out favourably. This position should lead practitioners to consider how best to structure management packages.