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Article by Maxime Budzin, Tax Counsel at Clifford Chance Luxembourg and Mélissa Kdyem, Corporate Senior Associate at Clifford Chance Luxembourg as published in Insight/Out magazine #31
Management incentive plans (“MIPs”) are a confidential (and crucial) component of Private Equity deals, and one which LPEA community members should be familiar with, whether as participants or architects. Structuring a MIP can be a complex journey towards a tailor-made structure reflecting commercial terms agreed among sponsors and management (“Management”).
In this article we will try to unveil certain key tax and corporate aspects of Luxembourg MIPs.
Key tax considerations
Taxation is a key aspect in the structuration of a MIP as the beneficiaries are generally keen to have their tax burden mitigated. That being said, putting in place an efficient tax structure can be rather tricky as multiple factors come into play: the nature of the expected return (e.g. capital gain, dividend, employment income) and the type of vehicle used (opaque vs. transparent), but also the tax residency of the beneficiaries, who are often domiciled in various jurisdictions.
While there is no one-size-fits-all approach, a “capital gain” qualification (as opposed, for instance, to employment income) is usually the preferred route to achieve an efficient tax treatment in the hands of the beneficiaries, even if many jurisdictions tend to requalify certain schemes into ordinary income taxable at higher rates or try to close the tax loophole of the carried interest treatment as capital gains. For instance, the UK’s carried interest reform recently proposed by the Labour party could result in carry receipts being taxed at more than 45% as opposed to 28% under the current UK regime, while certain jurisdictions have already introduced special carried interest regimes with clear requirements to be met to avoid the requalification of the income/gains received as employment income (e.g. France).
Regarding non-Luxembourg resident managers, capital gains derived from the sale of a substantial shareholding (i.e. more than 10%) in a Luxembourg company are not taxable in Luxembourg if the period between the acquisition and the disposal exceeds six months (or if a double tax treaty grants the exclusive taxation right to the country of the non-resident manager). Dividends are, in principle, subject to 15% Luxembourg withholding tax, while there would be no withholding tax on arm’s-length interest.
As for Luxembourg, there is currently no specific carried interest taxation regime in place. Typically, Luxembourg resident managers investing in the most common forms of Luxembourg carry vehicles (i.e. tax transparent vehicles with several investors) as limited partners would, depending on the nature of the underlying assets, be subject to the following tax treatment:
- While short-term capital gains, i.e. when the disposal takes place within six months of the acquisition, are subject to Luxembourg progressive income tax rates (0% to 45.78%), any capital gain realised on the disposal of underlying shares after a six-month period are not taxable, unless the beneficiary has a substantial participation of more than 10%, which would trigger a taxation as extraordinary income at half the average combined tax rate, i.e. a maximum rate of 22.89% (proper structuring would allow to avoid such tax leakage).
- Dividends and income from employment (including all benefits in cash and in kind received) are also subject to progressive income tax rates (0 to 45.78%). Under certain conditions, half of the dividend income received may be tax exempt and part of the employee income can be structured as a profit-sharing scheme (prime participative), 50% of which is exempt from tax. Interest income will generally be subject to a 20% tax in full discharge of personal income tax.
Like many jurisdictions, capital gains realised by Luxembourg resident managers would typically enjoy a better tax treatment than any other type of income, which is the reason why the grant of share like instruments is the most common route in terms of incentives. However, specific attention will be needed to avoid a potential requalification as deemed employment income or director remuneration due to the nature of the legal arrangement and/or the quality of the beneficiaries (e.g. employee). It should also be kept in mind that the set-up of a MIP is not only tax-driven but requires a holistic approach to take into consideration the commercial terms and align the interests of the managers and other shareholders.
Corporate and economic interaction
Retention of employees in line with the business strategy: vesting and leaver concepts
Contractual arrangements are an important part of the MIP as they lay out the agreed economic terms, which are designed to give employees “skin in the game” and thereby foster talent retention and motivation.
The vesting period delineates the time frame over which Management earns its full incentives and its timing shall be aligned with the business owners’ strategy. Vesting can either be graded over years or cliff-style, where all incentives vest after a set period.
Leaver provisions set out the terms of an employee’s exit, impacting the financial terms of such departure. The major metric is the price at which the leavers’ instrument will be sold. Leavers are generally qualified as good (commonly relating to retirement or health disability) or bad (resignation/fraud or negligence). However, we have also seen the emergence of the intermediate leaver concept, introducing a nuance to a standard distinction of good/bad leavers. As such concepts are not regulated by law, the trigger event for the relevant leaver qualification is fully dependent on the commercial discussions.
Non-compete undertakings are another tool to prevent Management from leaving the group. Their terms shall also be carefully reviewed from a labour law perspective, especially (but not only) the location and the duration of such non-compete undertakings.
Acquisition costs of management instruments: with or without financial assistance to Management?
Business owners may provide financial assistance to Management through the granting of loans to partially finance the acquisition costs of their equity instruments. A thorough analysis must be made to determine the lending entity within the group, especially in light of potential tax consequences.
The terms and conditions of such loan must be carefully determined, with a specific focus on the arm’s length interest rate as well as the terms of the reimbursement. The loan agreement may be silent with regards to the possibility of an early reimbursement, in which case the full reimbursement will be made at the time of the sponsors’ exit. Alternatively, the loan agreement may provide for a mandatory annual reimbursement via the allocation of a certain percentage of the variable part of the remuneration package.
To secure Management’s obligations under the loan, a Luxembourg law pledge agreement is an efficient and commonly used collateral, by which a pledge is taken over the instruments held by Management. In this perspective, there is great contractual freedom to build a robust and safe framework for the provision of such financial assistance to Management. Out of the various substantial clauses of the pledge agreement, the situations triggering an event of default (thus a potential enforcement of the pledge) shall be carefully negotiated.
Conclusion
While this paper highlights certain key tax and corporate aspects of Luxembourg MIPs, it is not intended to constitute an exhaustive list. In addition to the alignment of economic interests of business owners and Management, MIPs are also the crystallisation point of usually long and complex negotiations reflecting the commercial position acceptable for all other stakeholders. While a good MIP helps to build a fruitful environment for collaboration between Management and business owners, its efficiency will be measured through employee stability as well as the return on investment on exit.
