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Taxation in the Benelux countries

Fund managers in France and Germany are looking desperately for an escape from full progressive taxation on distributions on their carried interest. In the neighbouring Benelux countries, the skies are far from clear, although careful tax structuring may lead to a more than acceptable after-tax return. Marco de Lignie and Frederic Feyten of Loyens & Loeff look at the options available.

The tax position of fund managers, in particular the taxation of the carried interest, is a hot item at any time and in any place.

In the countries surrounding the Benelux, such as Germany and France, fund managers are looking desperately for an escape from full progressive taxation on distributions on their carried interest. In the Benelux, the skies are far from clear, although careful tax structuring may lead to a more than acceptable after-tax return. Tax authorities, however, seek arguments to tax the carried interest.

Perhaps the tax authorities may become less greedy than in the last few years now the climate has changed (a substantial number of funds may never be able to make a distribution on the carried interest shares due to bad results), but nevertheless tax planning remains important.

In the analysis below, we will compare the very basics with respect to the tax position of the fund manager who lives in one of the Benelux countries, and we will summarise for each country the alternatives for the tax structuring of the carried interest for a fund manager residing in the respective jurisdiction.

The Netherlands

As from January 1, 2001, a new income tax system has been introduced in the Netherlands. For many individuals resident in the Netherlands, the introduction of this system resulted into a fundamental change in the tax treatment of their income, most strikingly regarding the income derived from savings and investments.

Generally, under Netherlands tax law, an individual resident in the Netherlands is subject to income tax in respect of his world-wide income. Most categories of taxable income (the so-called ‘Box I income'), such as income derived from an enterprise and income derived from employment, are subject to the (high) progressive personal income tax rate of up to 52 per cent (for income exceeding E46,309).

There are two main exceptions to the general rule. First, all benefits, dividends and capital gains, realised by a Dutch resident from a ‘substantial interest' in a Dutch or foreign company, are subject to a rate of 25 per cent (the so-called ‘Box II income'). A ‘substantial interest' is an equity interest in a company representing five per cent of issued share capital or five per cent of a special class of stock.

Second, income and gain from investments of any kind (not representing Box I or Box II investments) is deemed to generate a four per cent return on an amount equal to the balance of taxpayer92s assets and liabilities (the so-called ‘Box Ill income').

There is no possibility for evidence to the contrary in case the actual return is less than four per cent. The deemed annual income is subject to a flat tax rate of 30 per cent.

In other words, the taxpayer is subject to income tax that is effectively computed as a flat 1.2 per cent of total net value of savings and investments, irrespective of the actual return realised on these investments.

Structuring of carried interest: investment income or employment income?

A fund manager investing in a fund, may be taxed for the return on his investment in either Box I, Box II or Box Ill.

As a general rule, the manager will be taxed in Box I for his annual salary (earned in the capacity of employee of the management organisation; the latter will generally fund the salaries and other operational expenses from a management fee charged to the fund). In case the manager is allowed to (co-)invest in the fund alongside the investors (the carried interest), the manager will generally be taxed in either Box II or Box Ill for any benefits derived from such investment, as explained below.

It should be noted that if the manager participates in the fund equity for a price that is not at arm92s length, the difference between the price paid and the at-arm92s-length price that should have been paid, may be taxed as employment income, and accordingly be taxed as Box I income in the year concerned.

Any subsequent benefits derived from the carried interest should be taxed in either Box II or Box Ill, as the case may be. In order to determine whether the manager paid a market price for his part of the carried interest, two criteria seem to be important in particular.

First, the actual value of the carried interest shares should not exceed the price paid by the manager for his portion of these shares. The actual value of the shares depends on the value of the underlying investments of the fund. If the fund is brand new, the actual value of the fund is generally based on cost price of investments.

In such a case, and assuming fund investors receive an at-arm92s-length hurdle rate on capital invested in the fund, it seems virtually impossible to recognise an excess value for the carried interest shares taken by managers (such an excess value, if any, would be equal to the so-called ‘expectation value').

Moreover, if the manager receives at-arm92s-length compensation (salary, etc.) for his activities as fund manager, it seems difficult to argue that the carried interest forms part of the employment remuneration package. Second, the relative and absolute amount invested by the manager should not be a de minimis amount, and this amount should be fully at risk.

As set forth previously, the character of the income determines the applicable tax rate. Assuming the income derived from the carried interest qualifies as investment income (see above), the question is how to structure the carried interest for the individual manager/investor.

Carried interest held directly

Generally, in the event the taxpayer holds a less than five per cent stake in the fund, the taxpayer should decide to hold his carried interest in the fund directly to seek Box Ill treatment. This proves to be tax efficient, as the income will generally be characterised as Box Ill income, subject to an annual 1.2 per cent effective tax rate on the value of the carried interest shares (30 per cent rate times four per cent deemed return).

This means that tax must be paid, even if the fund has not made a distribution yet. As a general rule, however, it can be said that Box Ill taxation is very attractive.

It is important to note that benefits derived from carried interest shares will not be taxed in Box Ill if they are deemed to form a substantial interest92, the income from which is taxed in Box II. As mentioned above, a five per cent or more stake in any class of stock constitutes a substantial interest, It is therefore attractive to structure the carried interest in such a way that a special class of shares for solely the carried interest holders is avoided, in order to arrive in Box Ill.

Carried interest held indirectly

Usually, if Box Ill treatment cannot be achieved, the manager will own the carried interest shares through a personal holding company.

The goal is to achieve deferral of Box II taxation. Any profits distributed by the fund to the holding company should qualify for a full exemption from corporate income tax under the rules of the ‘participation exemption'.The holding company can decide to reinvest the proceeds, to achieve the tax deferral. Only when BV distributes the proceeds to the manager/shareholder, the income will be taxed at the level of the shareholder in Box II.

Belgium

An individual resident in Belgium is subject to income tax on his world-wide income. Professional income, that is, income derived from an enterprise or employment, is subject to high progressive personal income tax rates of up to 55 per cent, to be increased further with certain surcharges.
Certain types of income derived by an individual on assets belonging to the private estate (ie, not belonging or attributable to the professional assets) are taxed at lower flat rates or even exempt: Interest, dividends, etc are generally subject to a flat personal income tax rate, being 25 per cent for dividends (a reduced 15 per cent rate applies for certain type of shares issued by Belgian companies in exchange for cash contributions) and 15 per cent for interest income.

Capital gains derived on shares are exempt. An exception applies in case (i) such capital gains are realised with a speculative intent (33 per cent tax rate) or (ii) such capital gains are realised on a transfer for consideration to a non resident company whereby the shares belong to a so-called ‘substantial participation' in a Belgian company (16.5 per cent tax rate). A substantial interest exists if more than 25 per cent is held solely or together with certain close relatives at any time during the five years preceding the alienation in a Belgian company.

Distributions made by a Belgian resident or non-resident company in the form of liquidation or redemption proceeds are explicitly exempt from personal income tax. It is noted that the Belgian government has announced plans to introduce a 10 per cent withholding tax on liquidation and redemption distributions.

The above-mentioned categories of income (dividends, interest, capital gains) derived from financial assets are subject to the attractive low rates only if these assets cannot be characterised as professional assets. Whether or not such assets should be attributed to the professional assets is normally a question of explicit allocation by the taxpayer.

Structuring carried interest:investment income or professional income?

In general, the tax treatment of investment income received by a fund manager will largely depend from the fact whether aside from a co-investment in the fund, the fund manager also receives a salary as an employee or a fee as self-employed consultant to the fund at market conditions.

In the latter case the professional remuneration will be taxed at the above-mentioned progressive tax rates, whereas the investment income should be subject to the above-mentioned flat rate income tax or full exemption depending on the type of income. Because of the low flat rates applicable to investment income it would be interesting for a fund manager to seek remuneration in the form of investment income. The question is whether the Belgian Revenue could successfully re-characterise the lowly taxed investment income into more highly taxed professional income.

Under Belgian tax law such re-characterisation can be done on the basis of the ‘sham transaction' doctrine or on the basis of the general anti-abuse provision.although no specific authoritative case law exists with respect to the treatment of remuneration received by fund managers, the successful re-characterisation of investment income to professional income on the basis of the ‘sham transaction' doctrine could not be excluded in situations were a major disproportion would exist between the activities carried out by the fund manager for the fund and the compensation received for those activities in the form of salary or consulting fee.

This is based on existing case-law in relation to so-called earn-out payments in connection to the sale of a business. The proportion of the investment income to the investment itself compared to the return realised by the investors will also be particularly relevant in this respect, as well as whether, with respect to his investment, a manager is at the same risk as the other investors.

Carried interest held directly

In the case where the carried interest is held directly, one should tend to achieve an acceptable allocation between professional income for activities performed for the fund and the private (risk bearing) co-investment alongside the investors.The manager may benefit from the flat 25 per cent or 15 per cent rate, as the case may be, for the return paid on the carried
interest shares if the shares are allocated to the private assets.

Carried interest held indirectly

In the case where the carried interest in the fund would constitute a ‘substantial participation' or would give rise to periodical distributions, which it normally does, it may be considered to hold the interest via a holding company (either a personal holding company or a jointly-owned holding company together with other managers).

In this way, taxation can be deferred substantially. Assuming the fund would be a capital company subject to normal corporate income tax, dividends are generally exempt for 95 per cent in the hands of the personal holding company. The latter may decide to reinvest, achieving a tax deferral. The personal holding company may be liquidated at a later stage, exempt from tax.

Luxembourg

Individuals resident in Luxembourg are taxed on world-wide income. In Luxembourg, professional income such as business income and employment income, is subject to personal income tax at progressive tax rates up to 38 per cent, to be increased with certain surcharges and municipality taxes.

Income from movable property such as dividends, interest derived on financial assets is in general taxed as separate type of income, but subject to the same progressive tax rates.

However, dividends as well as profit sharing interest distributed by Luxembourg resident companies, qualifying EU companies and tax treaty companies are taxed at half the progressive tax rate.

Structuring of carried interest: investment income or professional income?

With respect to the treatment of income derived by the fund managers as either investment income or professional income, Luxembourg tax law will normally follow a ‘form over substance' approach. Luxembourg tax law does not have specific provisions in its tax law which would re-characterise investment income into professional income. However, on the basis of general anti-abuse provisions and transfer pricing rules it would be recommended to apply an acceptable
allocation between professional income and investment income taking into account the activities of the manager for the fund and, on the other hand, the investment at risk.

Carried interest held directly

Generally, dividends paid on the carried interest shares are taxed beneficially (compared with professional income), that is, at half the progressive rates, provided the fund is a Luxembourg company, a qualifying EU company or a qualifying tax treaty company.

Carried interest held indirectly

In the case where a co-investment by the fund manager would constitute a substantial' participation it could make sense to hold such investment via a personal Luxembourg holding company.

If, for instance, the fund would have the form of a Luxembourg company (but also a qualifying EU company or foreign company), a personal holding company holding more than 10 per cent in such company would be exempt on dividends and capital gains realised under the Luxembourg participation exemption provided that holding period (12 months) would be ultimately met.

In the case of liquidation of the personal holding company after 6 months the proceeds could be distributed to the manager free of any income tax.

The same solutions could be envisaged in case the fund would make periodical distributions in the form of dividends even if the participation in the fund is not at least 10 per cent, provided that it has an acquisition value of at least E1 200,000 (alternative threshold criterion for the participation exemption). To the extent the participation of the manager would not attain this level, he could envisage to pool his investment with other manager in joint holding company.

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