Prepared by Nicola Broggi ed Edgardo Gagliardi
With the ruling 565/2020, the Italian tax authorities express (again) their view on management incentive plans (hereinafter “MIP”) based on the attribution of shares or financial instruments with enhanced economic rights (so-called carried interest instruments).
In particular, the question submitted to the Italian tax authorities is related to the tax characterization of the income deriving from the holding of specific classes of shares (so-called, “Sweet Equity” and “Ordinary” shares – hereinafter both referred as “Shares“) issued by a Luxembourg company (hereinafter also the “Issuer“) and subscribed by an Italian manager of an Italian company belonging to the same group of the Issuer.
The main features of the Shares can be summarized as follows:
- the Shares do not have administrative rights;
- the Shares carry the right to receive ordinary dividends distributions only after the repayment of the financial indebtedness;
- the Shares carry the right to receive a more than proportional return (compared to the shareholding percentage represented in the Issuer’s share capital) only upon the occurrence of certain liquidity events as defined by the MIP (i.e., listing, sale to third parties or liquidation of the Issuer). However, the rights of the Shares to receive the above-mentioned extra return is subject to the circumstance that the holders of the other classes of shares issued by the Issuer (i.e., preference shares and Ordinary) have received the reimbursement of the invested capital and a minimum return (i.e., hurdle rate).
- the Shares “cannot be freely transferred, nor pledged, nor encumbered”. However, immediately before this statement, it is also stated that “the incentive plan does not include the obligation for the participants to hold the shares for a minimum period of five years (the so-called holding period), and, in fact, the plan allows the participants the possibility of “leave” the Group, and therefore the incentive plan, at any time ”. The two statements, if interpreted literally, seem inconsistent each other;
- In the event the manager ceases to be an employee of a company of the group, he will be obliged to transfer the Shares to the persons identified by the Board of Directors (hereinafter also the “BoD“) of the Issuer. The price at which the Shares must be transferred will be determined by the BoD, after consulting the Chief Executive Officer, “reasonably and in good faith”, taking also into consideration the fact that the manager qualifies as a Good Leaver or Bad Leaver. In particular, in case of Good Leaver, the price at which the manager can transfer the Shares is equal to the fair market value; in case of Bad Leaver, the price at which the manager can transfer the Shares is equal to the lower of the acquisition cost and fair market value.
The solution proposed by the taxpayer was to consider the income deriving from the Shares as financial income (taxable at 26%), although some of the conditions set forth by Article 60 of the Legislative Decree 60/2017 (hereinafter also “Carried Interest Legislation”) were not respected. As is well known, the Carried Interest Legislation provides that proceeds deriving from, direct or indirect, participation in companies, entities or collective investment funds, held by employees or directors of such companies, entities or collective investment funds, or by subjects related to them by a direct or indirect relation of management or advisory, if related to shares, quotas or other financial instruments with enhanced economic rights are deemed in any case as financial income if:
- the investment commitment of all employees and directors entails an effective disbursement equal to at least 1 per cent of the total investment made by the collective investment funds or of the net worth in case of companies or entities (hereinafter also “1% Requirement”);
- proceeds deriving from shares, quotas or financial instruments that entail the enhanced economic rights accrue only after all the partners or participants in the collective investment funds have received an amount equal to, at least, the invested capital and a minimum return provided under the statute or in the regulation or, in case a change of control occurs, under the condition that the other partners or participants in the investment have realized, upon the sale of the interest, a sale price at least equal to the invested capital and to the aforementioned minimum return (hereinafter also “Hurdle Rate Requirement”);
- shares, quotas or financial instruments entailing the above-mentioned enhanced economic rights are held by the mentioned employees and directors or, in case of death, by their heirs, for a minimum period of 5 years or, if before the expiration of the 5 year period, until the date of change of control or of substitution of the subject in charge of the management” (hereinafter also “Holding Period Requirement”).
The before-mentioned provisions apply to income deriving from participation in collective investment funds, companies or entities resident or established in Italy or resident or established in States or territories allowing an adequate exchange of information.
The Revenue Agency, disattending the solution proposed by the taxpayer, concludes that the proceeds deriving from the Shares must be subject to employment income taxation. The conclusion of the Italian tax authorities seems based mainly on the following features of the MIP:
- the circumstance that the Shares cannot be maintained by the manager in the event of the termination of its employment relationship considering that he is subject to the obligation to transfer the Shares in case of a leaver events;
- the fact that, in the case of Good Leaver, the fair value is determined on a discretionary basis and not according to objective criteria;
- the circumstance that, in the case of Good Leaver, the manager has the right to receive the payment computed considering the vested portion of the Shares, with the vested portion of the Shares that increases during the vesting period. In particular, “the provision of this growing and progressive mechanism, which guarantees a more favorable return on the investment linked to the length of time, leads us to believe that the remuneration is linked to the working activity performed over time“.
Given the nature of this paper, it is not possible going into much details regarding the various critical issues arising from this ruling (also because a more in-depth analysis deserves a more thoughtful reading of the document analyzed). However, the opinion of the Italian tax authorities provides us the following interesting food of thoughts:
- no issue in relation to the circumstance under point 2 above. A discretionary estimation of the fair market value (hereinafter also “FMV“) of the Shares is not appropriate for the purpose to characterize the income deriving from the Shares as “financial income”. In fact, in similar situations, it is market practice that the MIP documentation provides for the appointment of an expert to determine the FMV;
- the circumstance sub point 3 above must be interpreted in connection with the circumstance sub point 2. In fact, where the quantification of the FMV is discretionary, the line of reasoning of the revenue agency could be shared. If, on the other hand, the determination of the FMV is performed by an expert (and therefore based on objective criteria), the abovementioned “growing and progressive” mechanism should reflect the commercial need to have a vesting period (always present in management incentive plans), in order to achieve the alignment of interests between managers and shareholders (this being, among other things, the purpose of the Carried Interest Legislation);
- regarding the circumstance under point 1 above, the description of the facts reported in the ruling does not give us the possibility to fully understand the legal mechanism adopted in the plan to “oblige” the manager to sell the Shares in connection with a leavership event. It seems that the position expressed by the Italian tax authorities depends on the fact that from the beginning the manager has an obligation to transfer the Shares. However, our view is that alternative legal mechanisms that do not impose, from the beginning, an obligation on the manager, such as, for example, call (and sometimes put) options mechanisms, may not create issues.
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