Lucrative Interests: shareholder loans and taxation of management participation plans

On April 14, 2023, the Dutch Supreme Court ruled on the lucrative interest legislation, in particular on the consequences of shareholder loans on the qualification of a management participation. To close the gap created by this judgment, the legislation has been tightened retroactively to June 26, 2023. However, the new legislation leads to overkill.

Background

With management participation plans, managers are given the opportunity to acquire an interest in addition to the existing shareholders or new external investor. A lever is often used in such structures. This allows managers to potentially achieve (very) high returns with a relatively low investment.

In most cases, leverage is achieved by having the investor participate in a mix of preferred and common shares while the managers only participate in common shares. The ratio between the total investment of the existing shareholders or new investor and the investment of the managers in the ordinary shares is called the 'envy ratio'. The higher this ratio, the higher the potential return on the common shares. The management shares do not participate pro rata in the preference capital, which means that management has to pay relatively less for their normal shares. With good results, they enjoy higher dividends and a higher increase in the value of the shares. When the company is sold, the excess profit accrues to the ordinary shares, so that the management shares can generate a lot of money.

The downside, however, is that the risk profile of the management shares is higher as the envy ratio increases: in bad years there is increasing uncertainty as to whether after the (cumulative) preference distributions any income is left for the ordinary shares. It may be the case that the management shares do not yield anything.

In case the management participation plan involves the manager receiving a small percentage of shares in the company, the capital gains and dividends on these shares would typically be taxed as savings and investment income in the Netherlands (box 3) under the Dutch Income Tax Act 2001. In such case an annual deemed income of approximately 6% of the equity value at 1 January is taxed. The actual income is only taxed in case the tax payer demonstrates that the actual income is lower than the deemed income.

To avoid large profits being achieved with very little taxation, lucrative interest legislation was introduced in 2009, which means that for qualifying interests the actual income is taxed as ordinary taxable income (box 1) at progressive rates. Very simply put, an interest qualifies as a lucrative interest if there is a leverage of more than 1 on 10. Although the legislation on lucrative interests is quite complex because there is room for interpretation, in practice there was clarity on how to deal with a number of technical points in practice without ending up in a discussion with the tax authorities. One of these points concerned the consequences of shareholder loans for the presence or absence of a lucrative interest. This changed in 2023.

The old practice

Based on the text of the law (article 3.92b, paragraph 2 of the Income Tax Act 2001), there is a lucrative interest if the shares in which the manager invests are subordinated and represent less than 10% of the total issued share capital. Because the text of the law looks at the ratio of the nominal capital, the use of share premium or a higher nominal value of the normal shares can easily ensure that the normal shares represent more than 10% of the nominal capital. A shareholder loan can also be used instead of preference capital. This way a lucrative interest could be easily avoided.

Article 3.92b paragraph 4 therefore stipulates that property rights that are economically comparable with shares as mentioned in paragraph 2 also fall under the lucrative interest legislation. Based on parliamentary history, and in coordination with the Dutch tax authorities, it was assumed that for paragraph 4 subordinated shares that comprise less than 10% of the total shareholder investment, would qualify as lucrative interests. For this calculation the shareholder investment includes share premium, informal capital and shareholder loans. However, a shareholder loan is excluded in case it can be demonstrated that this loan could be raised from an external party (e.g. a bank or crowdfunding platform) under equal conditions.

The judgment and the new legislation

The Dutch Supreme Court ruled on April 14, 2023 that in order to test whether an interest is economically comparable to shares as referred to in Article 3.29b, paragraph 2, in addition to the issued capital, the share premium and informal capital must be taken into account. Furthermore shareholder loans must be taken into account only if and to the extent that these can be regarded as informal capital for the purposes of tax legislation. Other shareholder loans should be ignored.

This is clearly not in line with the existing practice, which in principle included all shareholder loans, unless it could be demonstrated that a third party would also have been willing to provide this loan.

Therefore a new paragraph 5 of Article 3.92b was added. This paragraph stipulates that:

“For the purposes of this article, the total issued share capital includes a loan that also contributes to a remuneration as referred to in the first paragraph, whereby such a loan for the purposes of the second paragraph is classified as a separate class”.

Impact of the new legislation

While it was supposed to bring legislation back in line with the existing practice, the new paragraph 5 has a far greater reach than that. Firstly, the new paragraph refers to paragraph 2 instead of paragraph 4. As a result, share premium and informal capital are not taken into account. Secondly, the exception for shareholder loans that could be borrowed under equal conditions from a third party is not included in the text of the law. That is why a lucrative interest arises much more quickly under the new legislation than under the old implementation practice.

Example

A company takeover of €10 million is financed, in addition to €4 million bank debt, by a €1 million shareholder loan and by issuing 1,000,000 ordinary shares, each with a nominal value of €0.01 and a share premium of €4.99.

The investor invests €4.95 million in the ordinary shares for a 99% interest and also keeps the shareholder loan of €1 million. The manager obtains a 1% interest in the ordinary shares for his investment of €50,000.

If we include the shareholder loan in the calculation, the envy ratio in this example is only 1.20 ([5.95/99%]/[0.05/1%]).

Under the old legislation and practice this would not be a lucrative interest. As there is only one class of shares there is no lucrative interest under paragraph 2. For paragraph 4 the ordinary shares are subordinated to the shareholder loan, but these shares, including share premium, are 80% of the total shareholder investment (5.0/6.0) so there is no lucrative interest under paragraph 4 either.

Under the new legislation the ordinary shares are subordinated to the shareholder loan for paragraph 2. They have a nominal value of only €10,000, while the entire shareholder loan of €1 million must be considered as issued nominal capital. Thus the ordinary shares represent only 0.99% (10/1,010) which is clearly less than 10% of the nominal capital. The ordinary shares therefore qualify as lucrative interest on the basis of the new legislation.

In existing management participation plans, the interest of managers can become a lucrative interest as of June 23, 2023 due to the new legislation. In that case, a step up to the value at that time applies. Value developments after that date fall into box 1 unless the interest is already structured via box 2. Naturally, it can de difficult to determine the value at June 23, 2023 when no official valuation near this date is available.

Since the test whether an interest qualifies as a lucrative interest is a dynamic one, future changes in the shareholder loans (additional loans or repayment or capitalisation of an existing loan) can cause an interest to be qualified as lucrative or to stop being lucrative. In the latter case, the (unrealised) capital gain on the interest over the period it was a lucrative interest becomes taxable at the time the qualification changes. Since no actual income is realised, even an indirectly held lucrative interest may be taxed in box 1 as paying 95% of the income onwards to the manager (one of the a conditions for the box 2 regime) is not impossible in such a case.  

Avoiding taxation as ordinary income

In case the interest obtained by the manager is not meant as remuneration for the work performed by the manager, it cannot be considered a lucrative interest. However, the tax office will very quickly conclude that there is a sufficient link with the manager’s position to conclude that it is in part meant as a remuneration. The link to the manager’s position is only absent if the manager buys the interest at completely arm’s length conditions in a capacity as investor rather than as manager.

In case a manager obtains a participation in the company as part of a company succession plan whereby the intention is that the manager becomes the new owner or one of the new owners of the company it could also be possible to successfully argue that the income from his participation is related to his new role as shareholder rather than remuneration for his work. However, this greatly depends on the case at hand.

The application of the lucrative interest legislation may also be avoided by eliminating shareholder loans altogether trough repayment and/or refinancing via an external party. This is rarely an option in case of a company takeover or a capital injection by a private equity venture, but may be a viable option in case existing shareholders sell part of their shares to the management.

Another way to avoid taxation as ordinary income is to hold the lucrative interest ‘indirectly’, i.e. through an investment entity, for example a personal holding company owned by the manager. In such case the manager holds a substantial interest in an investment entity, and this entity holds the lucrative interest. Provided that certain conditions are met the income is than taxed under the substantial shareholding regime of box 2 (33% tax [24.5% on the first €67,000]).

International aspects

Based on the Decree of the Dutch State Secretary of Finance from 2021 the allocation of the income from a directly held lucrative interest is deemed to be remuneration for work and, in cross border situations, an allocation of the income should take place on the basis of the tax treaty by applying the employee’s or director’s article. In case of a dividend or capital gain, the other country may not agree to this approach and apply the article for dividends or capital gains. This is a so-called mismatch, which in the worst case may lead to double taxation over the benefit as both countries want to levy tax.

In case of a lucrative investment that is held indirectly, the income is taxed under the substantial interest regime (box 2). In that case the Netherlands agree that the dividend or capital gains article can be invoked under the applicable tax treaty. A mismatch is much less likely in this case.

Conclusion

The new legislation regarding lucrative interests can have a big impact on participants who are Dutch tax residents or who hold or obtain a management participation in relation to a position that is (partially) exercised in the Netherlands.

Please contact us in case you have any questions regarding the recent changes or the lucrative investment regime in general. We are more than happy to assist.