Taxation of carried interest and management incentive plans part of proposed Belgian tax reform
As part of the governmental discussions on the 2023-2024 federal budget, the Minister of Finance has been instructed to prepare “the first phase of an ambitious tax reform”, in view of reaching an agreement at government level before year-end. Reportedly, changes to the tax treatment of share-based compensation structures could be part of this first phase. Pending publication of the detailed proposals, the vision paper on a tax reform (NL/FR) and recent press reports suggest a significant impact on carried interest structures and management incentive plans. It should be noted that currently no political agreement has been reached on these proposals, however, there seems to be a real chance that these proposals will be agreed at government level and become law in the coming months.
Excess return linked to a professional activity: taxable professional income
The first and most important change would relate to financial instruments held by individuals in connection with their professional activity and which generate a disproportionate return compared to what a passive investor would obtain. This measure mainly targets carried interest structures of managers of private equity funds and “sweet equity” held by senior management of groups in which such PE funds invest (see also the vision paper on a tax reform, (NL/FR) p. 80). It is considered that such disproportionate return compensates professional activity and should therefore be taxed as a bonus and not as eg a capital gain on shares (a capital gain would under current law either remain tax-free or, if the gain is realised “outside the normal management of a private estate”, be taxed at 33% plus local surcharges) or a dividend (taxed at 30%).
It remains to be seen how this proposal will be reflected in legal texts, but it is expected that they will be broadly drafted to avoid that the tax can be easily circumvented.
The proposal immediately raises a number of basic questions.
What is “excess return”?
The vision paper suggests that the “excess financial return” on financial instruments would be determined by reference to the return realised by non-professional or “passive” holders in the same company or group. Basically, it would have to be determined how much more euro’s the professionally active individual would derive from each invested euro, compared to a non-professional investor.
In determining the excess return, the question arises as to whether it would be relevant that the price which the individual paid for the financial instrument (or on which the individual was taxed in the case of an allocation free of charge) reflected the potential for a disproportionate return (eg based on a probability analysis of the underlying group’s business plan); or whether the professional investor holds a package with a different risk profile (typically, the professional will hold a package of financial instruments with a higher upside potential but also a higher risk of not getting any return). If these elements cannot be taken into account, it could lead to an overstatement of the real “excess return linked to a professional activity”.
These considerations also cause us to question the fact that the entire additional return of the manager (compared to that of a “passive” investor) would no longer be treated as a capital gain on shares. At least part of that excess financial return may have a closer link to the manager’s long-term share investment than to his/her personal performance as manager. From this perspective, it could have made more economic sense to treat the excess financial return only as professional income above a certain ratio.
Another question is how the required link with the professional activity would be determined. Will it be sufficient that the individual can acquire the instruments because it is an employee or director of (a related company of) the company that issued the financial instruments? Or is it also required that the investment documents specifically link the investment to the individual’s employment (eg through leaver provisions, non-compete clauses, etc).
Finally, the return on financial instruments may also be difficult to compare if the professionally active and the passive investors invest at different times or if the passive investor is a long-term investor.
In any case, it seems to be intended that the new rule would apply irrespective of the underlying legal arrangement that creates the leverage effect (eg preferred shares) and irrespective of how the financial instrument was acquired (for free, against payment of the market value, by exercising a stock option, etc). In order for the excess financial return on shares acquired upon exercise of stock options (falling within the scope of the Law of 26 March 1999) to be qualified as professional income, that Law would have to be amended.
How will the excess return be taxed?
The excess return would seemingly be taxable as professional income. Since the measure intends to tax the real return, the taxable moment would presumably be at the time the return is effectively realised.
The “normal” return on the underlying instrument would continue to follow its normal tax regime, eg a capital gain on shares (or a dividend).
A key question is at which rate the excess return would be taxed: at the normal personal income tax rates (of up to 50%, to be increased with local surcharges) or at a separate tax rate (of eg 15% or 30%). Considering that the excess return is by nature a capital gain on shares and that it concerns a gain generated over a longer period, it would not seem appropriate to apply the normal personal income tax rates especially if the proposed measure would qualify the entire “excess return” as professional income (see above). It is also important to note that in many countries the gains from such schemes are subject to capital gains tax treatment if the instruments were acquired at market value.
It is unclear whether under the current proposals losses on a financial instrument held by an individual in connection with its professional activity would be tax-deductible.
A qualification as professional income would seem to imply that either the Belgian company granting the benefit or (in case of a foreign grantor) the Belgian company that employs the manager, or in which a director’s mandate is exercised, would have to calculate, report, withhold and pay professional withholding tax over the excess financial return. This liability will be an attention point in case of a sale of the group to another investor.
As regards employees, the question further arises whether it is intended to introduce a similar excess return concept for social security purposes. We understand that this is not the case at present. To the extent that the excess return is not borne by the employer it should in any case not come within the scope of the Belgian social security regime.
Impact on pending schemes?
It is unclear when and under which transitory rules the new measure would enter into effect.
In line with the principle that accrued rights should be respected, the new measure should not apply on the excess return relating to instruments acquired before its entry into effect (or its announcement) or to instruments acquired upon exercise of stock options granted before that date.
If the measure would instead apply to any excess return realised after its entry into effect it would have an unprecedented retrospective effect, considering that many of the targeted schemes are usually mid or long term in nature.
It should be repeated that no political agreement is reached around the discussed measure and that it remains uncertain whether and when it would be adopted. It is, however, already clear that, if and when adopted, it would have a significant impact and give rise to questions of interpretation. Taxpayers would however be able to obtain certainty on the application of these rules via a tax ruling.
In the meantime, relevant funds, groups and managers will need to assess the potential impact of such measure on their specific situation and start considering adjustments or alternative structures (eg holding instruments via a company).
Belgian stock option law: more limited scope
Under the Belgian stock option regime set out in the Law of 26 March 1999, stock options granted for free are in principle taxed at the time of grant on a lump sum value (eg 18% of the value of the underlying share in case of a 5- year option or even half of that value if several conditions are fulfilled). The taxable benefit is in principle exempt from social security contributions.
The regime is generally considered favourable given the potential for a low effective tax rate if the share price increases by the time the option can be exercised, but also bears the risk of financial loss since the upfront tax cannot be recuperated if the option expires out-of-the-money.
As has been anticipated for some time, we understand that the government is now considering the following changes to bring the regime in line with the initial intention of the legislator:
- Only options on shares issued by the company with which a professional activity exists (or a parent company)
The stock option regime would be limited to options on shares issued by the company with which a professional relationship exists or a group company. This change mainly seeks to put an end to the practice of granting bonuses in the form of “warrants” on shares issued by regulated investment companies, but the impact may be broader. It is also not yet clear whether shares issued by a related company of the employer that it not a parent company would still qualify for the regime. This would in our view make sense bearing in mind the objective of the change.
- Compensation for upfront taxes abolished
Under the Law of 26 March 1999, if the stock option provides clauses that grant a “certain benefit” to the option holder, such benefit is separately taxable if it exceeds the benefit in kind on which the upfront tax was calculated. This provision has sometimes been interpreted in such way that “certain benefits” can be granted tax-free so long as they do not exceed that benefit in kind. A well-known example approved by the Belgian ruling commission is a clause under which the upfront taxes are repaid to the option holder if the option expires out-of-the-money. The government now considers a change to the Law of 26 March 1999 to put an end to such use of the “certain benefit” concept.
- Only non-transferable and non-redeemable options
Under the current regime, options can be transferrable but, in that case, the lower valuation (9% of the value of the underlying share, in the example mentioned above) cannot be applied. It is now considered to limit the stock option regime to non-transferable options. We also understand that the change would seek to prohibit a cash cancellation of stock options. In other words, under the proposals, options can either be exercised or they expire without a financial gain.
The change may also impact the way options are treated in the context of corporate restructurings or a change of control over the employing company and option plans may need to be revised from this perspective. The change may also have an impact on the application of the stock option regime to persons working through management companies.
New share plan regime
The government also considers introducing a new manner of taxing employee share plans. Reportedly, shares acquired for free or below fair value would not be taxable at the time of acquisition, but at the time they are sold.
It remains to be seen whether the entire capital gain would be taxable as professional income or only the benefit in kind on acquisition (with the remaining gain then being treated as a capital gain).
This new regime could be an interesting addition to the range of possible share scheme structures as it would allow the employee to become a shareholder and benefit from dividends without any initial investment, whilst paying taxes only if and when a capital gain is realised.
Even though the changes discussed in this briefing remain subject to political agreement and the legislative process, it may be a good time for concerned funds, groups and managers to consider the potential impact of such measures on their specific situation. If you would like to discuss these topics with us, please contact our Tax team or your usual Freshfields contact.