French management packages: finally getting out of tax uncertainty?

Contrary to the legislative or regulatory evolutions that have occurred in the last decade, which have stabilized the legal and tax regime especially for employees and funds managers profit-sharing schemes, the subject of the taxation of the management packages of managers in the LBO sector remains orphan and suspect.

Indeed, the legal structuring and tax treatment of capital gain retrocessions remains a political and regulatory taboo that poisons private equity transactions.

Unexpectedly, the economic consequences of the Covid-19 pandemic could create the circumstances for a decisive progress in this field, which investors and company managers should seize at once.

The current state of play: a world of daring and do-it-yourself...

The challenge of structuring management packages consists mainly in securing the alignment of the tax qualification of the amounts (sometimes quite large) that managers may receive when exiting an LBO with the very nature of the gain received.

Thereby, given the investor risk taken by "exiting" managers at the time of the initial investment, the goal will be to ensure that the sums received are qualified for tax purposes as capital gains on the sale of securities, the latter being subject to a net lump-sum tax of approx. 30% (the "flat tax"), which enables this mechanism to remain an incentive for the beneficiary while remaining reasonably contributive from a French social viewpoint.

The slightest misstep in structuring management packages leads, far too often, to a requalification - by the tax and social authorities - of the retrocession of capital gains as salaries and therefore to the levy of both employer and employee social charges and personal income tax at the progressive rate (and generally marginal rate of 45%). In such a case, the part of the management package that evaporates into compulsory levies is such that the financial incentive sought is largely annihilated.

Faced to this threat, M&A practitioners have developed increasingly complex tools, frequently relying on the use of preferred shares or composite securities whose mathematical formulas govern the allocation of the sale proceeds at the exit. The effectiveness of these mechanisms, which are supposed to create a protective smokescreen for managers, is uncertain today and subject to tax and social insecurity that is difficult for managers to accept.

In order to assess the reality of the shareholder risk taken by the managers during the structuring process of the LBO and the subscription to these securities which will entitle them to the package, the managers have independent valuations carried out of these securities intrinsic value with regard to the parameters of the operation. Alas, the gross results of the application of these financial models often results in amounts that are not in adequation with the financial resources available to such managers.

This leads to uncomfortable negotiations with the independent evaluators on the parameters of their study aiming to bring together the very distant shores that separate the mathematical and financial orthodoxy from the reality of the resources of the concerned managers, thereby increasing the risk of requalification in fiscal and social fields.

As the martingale is proved being impossible to find, lots of transactions, particularly in the mid-cap market, finally free themselves from this tedious scaffolding and let themselves be tempted by a logic called the double or leave or the "not seen, not taken" in social and fiscal matters. This jeopardizes both the exit and any subsequent LBOs that may take place on these risky bases.

Until today, the political will or courage necessary to resolve this legal and fiscal no-man's land has been lacking. The prospect for the public authorities to support, by favorable tax and social regimes, the payment of large sums of money to managers, within the framework of speculative financial operations, remains a strong taboo in spite of the (rather marginal) victory obtained at the end of long months of bitter negotiations concerning the favorable tax and social regimes relating to the carried interest. Nevertheless, the carried interest only concerns a limited circle of beneficiaries in an industry that is not very well known of the general public, where the media stake for managers and business leaders is much higher.

The pandemic affecting us may change the rules of the game in this area. Our economy is suffering and will need years and daunting efforts to fully recover from the shock. The number of unemployed in France rose by nearly a million before the end of the 2020 summer and the outlook for the current year is particularly bleak on this front. Our country needs to bounce back quickly, and French companies hold a number of the keys to support and strive against the decline of the labor market that our government desperately needs.

During the last year of Mr. Macron's presidency, negotiations on social issues, under the aegis of the government, are expected to be tense and companies currently under LBO are often in the best position to help with the necessary revitalization of our economy.

They traditionally grow faster and hire more people than those that do not have the support of professional investors in their capital.

This is a unique opportunity for investors and French employers to negotiate, in return for their increased involvement in the collective effort for economic recovery, the creation of a stabilized and balanced regime for management packages, which will put an end to the wanderings we have known for too long.

What balance can be sketched?

For a meeting point to be found, it will be necessary to renounce a few chimeras whose continuation pollutes the constructive discussions on management packages and to find objective criteria for the application of a new regime, which could be imagined as follows :

• Subjection - as a matter of principle - to the capital gains tax regime (flat tax) of all managers' proceeds resulting from the retrocession of marginal capital gains from financial investors, provided that the managers' initial subscription to preference shares or other types of fin "package" securities represented for them a significant risk as a shareholder in the LBO transaction.

• Multi-criteria and alternative definition of significant risk: either as a percentage of the net annual income of the manager concerned, or as a percentage of the total amount of equity invested in the transaction, for example.

• Necessity to run a total and genuine shareholder risk on the sums invested in the package instruments: if the project does not work, the manager's investment may be totally lost, as for the other shareholders.

• Prohibition for the managers to use the "PEA" (share savings plan) to subscribe (through ordinary shares) to the capital, directly or indirectly, of companies under LBO in addition to a management package.

• Discount on the flat tax rate: one could imagine going from 30% to 25%, for example, in LBO operations in which the package is shared with a larger group of managers or rank-2 executives, but then it will be necessary to define sharing thresholds and the categories of employees concerned.

• For the beneficiaries with a moderate personal income tax rate, and to encourage the recruitment of managers in small companies under LBOs, taxation of management package gains at the taxpayer's choice between the marginal effective rate applicable to the capital gains received (as part of his/her personal income tax) and the flat tax rate.

The sketch of a management package regime we have described above is not revolutionary. Numerous circles have worked on this issue, first and foremost within France Invest (French equivalent of EVCA), and have come up with comparable recommendations. What is new in the situation we are living though is the timed but real possibility of a rendezvous with history, without a demagogic or outrageously opportunistic aim, in order to rid the French private equity world of an unwelcome brake to attractiveness and transparency of our national economic space, while assuming for funds and entrepreneurs, on a voluntary basis, an increased contribution to the immense effort that awaits us. Let's not miss this moment!