date | theme

30. November 2020 | Taxation of phantom shares when selling a company

December 1, 2020 | Vesting at Phantom Shares: how to regulate the early exit

28. January 2021 | Phantom Shares: how to indirectly involve employees in the company

29. January 2021 | Phantom Shares in the balance sheet: how to balance virtual investments?

25. May 2022 | C-Shares for managers: advantages of an interim holding in Luxembourg (this article)

C-shares are discretionary investments in corporations. If investors set up a company in Germany for which they want to involve managers in success, this is possible via an intermediate holding in Luxembourg. In Luxembourg, C-shares are established as an independent share class. C-shares come to the fore in certain events, such as the company sale, and lead to compensation for the performance contributed by managers to success. Since C-shares are genuine equity investments, C-shares are taxed by managers as capital gains on the sale of capital assets rather than as income from self-employment. Thus, the taxation takes place either by capital gains tax or via the likewise advantageous part income method. The tax advantage here is that the applicable tax rate is only about 25% instead of up to 45%.

The participation of particularly important employees in the company’s success is particularly widespread among startups, but by no means limited to it. At the same time, however, entrepreneurs also attach great importance to the fact that such employee shares by no means affect their own shareholder rights. Therefore, in Germany, various constructs are being used to establish the differences between these participation variants. This can be done both through company law and through employment contract provisions.

In Luxembourg, however, one follows a different regulatory philosophy. This is because there are various investment classes defined by law, of which the A-shares correspond to those of a regular German GmbH shareholder or common shares. C-shares, on the other hand, are disquotal investments that only have an effect at certain events.

In this article, we would now like to show how an investor generates tax advantages for himself via a Luxembourg corporate structure and also for managers of a company based in Germany via C-Shares. The main focus should be on the C-shares for managers, more precisely the associated tax advantages.

As we have just stated, C-Shares are to be regarded as real equity investments. The legal basis for this can be found in § 17 EStG. In this regard, the first sentence of paragraph 1 states that ‘income from commercial operations shall include the profit from the sale of shares in a limited liability company if the seller has directly or indirectly held at least 1 % of the company’s capital within the preceding five years’. Thus, we first of all look at the event that occurs, which leads to the sale of shares in a corporation or of transactions treated as such. At the same time, we must note that the conditions are only met if the participation rate is at least 1%. In this context, the time aspect is also important. Because the participation must have existed for at least five years in order to meet all requirements. In this case, the partial income procedure offers itself as a taxation method.

However, if the shareholding is less than 1 %, the taxation of the profit from the sale of C-Shares could also be regulated by § 20 EStG. In this case, one speaks of the capital gains tax, which has a valid effect because it takes place alongside the regular income taxation.

We explain why taxation according to § 17 EStG or § 20 EStG is important for our considerations in the course of our article. At this point, however, it should already be noted that the only other relevant alternative to this is the taxation of income from self-employment within the framework of the regular assessment for income tax.

Let us now assume that you, dear reader, would like to invest in a German company. They have the necessary financial freedom to do so, but you want particularly capable managers to take over the management of the company. In order to motivate the management accordingly, you provide for a participation in the expected company success. For this purpose, you first set up a holding company in Luxembourg with your capital. We want to call this holding LuxCo. LuxOpCo is now establishing a Luxembourg company called LuxOpCo. As you can easily see, LuxInterHolding also acts as a holding company. However, since it is a subsidiary of LuxOpCo, we want to describe it as an intermediate holding company.

As a holding company, LuxInterHolding now holds the entire shares in a company in Germany. This company is now actually an operating company. Here, newly hired managers should now ensure a successful economic development. And it is precisely these managers who will now receive C-Shares at LuxInterHolding as a special incentive. Whether you assign all managers hired for this purpose more or less than 1% of the shares in the intermediate holding should remain open at this point. We then examine both cases separately. Overall, however, it can be noted that the disquotal division of C-shares for managers can in reality be in the order of 20%.

Let us now assume that with your LuxInterHolding you have invested your capital in a promising company. This can be an existing company, a startup or a joint venture. Let us continue to assume that the company value, also thanks to successful management, increases considerably over time. This also increases the value of the intermediate holding (LuxInterHolding).

Finally, you realize that selling your business, for whatever reason, is beneficial to you. You will therefore also quickly find a buyer who is willing to pay a good price for your shares via a share deal. Of course you agree. Because even if you are only entitled to 80% of the sales proceeds – the remaining 20% are reserved for the C-Shares – this is still a good deal for you. But how is the taxation of the profit shares, especially those that your managers receive via their C-shares?

First of all, let’s take a brief look at how you have to tax the profit from the sale of the shares in LuxInterHolding. As the sole shareholder of LuxOpCo is located in Luxembourg, as is the subsidiary sold, the taxation is carried out in accordance with the applicable tax laws. Thus, you avoid taxation in Germany at this level. If you are subject to unlimited taxation in Germany, then taxation is only considered for you if you receive profit distributions from your LuxCo. But you can decide for yourself.

Let us now turn our attention to the taxation of managers, which is in the foreground here. In doing so, we now distinguish between a level of participation of less than 1% and one that meets or exceeds this quota.

4.2.1. C-Shares with a share below 1 %: Capital gains tax

In the case of a shareholding of less than 1% or in the absence of the other conditions specified in § 17 EStG (five-year holding period), your managers tax their profits by way of capital gains tax according to § 20 EStG. This has the tax advantage for their managers that the flat-rate corporate tax rate of 25 % applies. For the sake of simplicity, we completely disregard additional taxes such as solidarity surcharge and church tax in this blog post.

If instead the profit share from the sale of the company had been regulated by agreements in the employment contract, the taxation would be carried out under the wage tax procedure. And that would in turn mean that the personal tax rate applies to this, which, as you know, is 42% at the top tax rate and can even rise to 45% if income is particularly high. In addition, your managers would probably also have to pay social benefits to a considerable extent from their profits. These too should generally be left out here.

4.2.2. C-Shares with a participation of at least 1 %: Partial income procedures

In the opposite case, i.e. with a minimum participation of your managers of 1%, the part income procedure applies. Here, the income tax is usually also well below the personal tax rate. Finally, only 60 % of the profits generated by the sale of the C-shares qualify as a taxable share in the partial income procedure. It is true that only 60% of the advertising costs can be deducted in the partial income procedure. However, this is hardly relevant in connection with the C-Shares, because hardly any advertising costs arise here anyway.

If we now assume that the taxable share of the profit from the sale of the C-shares is subject to the highest possible personal tax rate of 45%, this means a tax of a maximum of 27% (60% x 45% = 27%). With a slightly more realistic tax rate of 42 % (top tax rate), the tax actually incurred would only be 25,2 %. Thus, we are also quite close to the capital gains tax that would otherwise be paid. In any case, this is a clear improvement over taxation at the personal tax rate.

The sale of the Luxembourg-based intermediate holding company for the purpose of transferring the operating subsidiary thus offers several advantages. On the one hand, as an investor, you can shift the taxation of the associated profit to the often more tax-advantageous abroad. On the other hand, it can also provide a tax advantage for the managers involved via the C-Shares. In any case, this is also a good argument when it comes to winning the managers for your own company. After all, this design model means that managers only have to pay about half of the taxes from the profits from the sale of their C-shares. Or even more positively: they get paid out about 75% of the profit!

Employee participation via this design model also works without C-shares. It can therefore also be transferred to an intermediate holding company based in Germany with adjustments. However, the necessary adjustments must then be written down in the social contract. This in turn requires a revision of the social contract in the event of subsequent changes, such as the hiring of further privileged employees. So you have to hire a lawyer and a notary to regulate the participations accordingly. But because in Luxembourg the division of share classes that we use in our design model is already regulated by law, it is much easier to implement the model in our neighbouring country.