The Importance of Properly Structuring Management Packages: Decision of the Versailles Administrative Court of Appeal dated January 26, 2017 – by Jérôme Commerçon and Raphaël Bagdassarian

On January 26, 2017, the Versailles Administrative Court of Appeal issued an unprecedented ruling regarding management packages[1].

As a reminder, for several years now, the tax authorities have taken a very strict stance on management packages in the context of LBO (leveraged buyout) transactions and frequently issue tax assessments against executives when significant gains are realized, most often attempting to classify the capital gains realized by executives at the end of the LBO transaction as wages.

Tax disputes over management packages stem largely from efforts to align the interests of managers and financial investors in the context of LBOs, which lead to managers investing in the transaction and receiving a share of the financial investors’ capital gains once certain profitability thresholds are met. In this context, the tax authorities typically seek to reclassify as wages the portion of the gain that they consider abnormal or resulting solely from the manager’s involvement in the company’s operations.

In the absence of a clear legal framework, every court decision handed down in this area is closely scrutinized by both executives and legal professionals in order to better understand the body of case law that is gradually taking shape and to ensure, as much as possible, that compensation packages are structured appropriately.

In this particular case, the Court granted the tax authority’s request and ruled against the taxpayers. This is particularly noteworthy given that most recent rulings on this matter have been favorable to the managers, starting with the first-instance judgment handed down by the Administrative Court of Cergy-Pontoise in this very case in 2014.

However, this decision should be viewed in the context of the very specific facts of this case, and in particular: (i) the absence of any financial instruments subscribed to by the executive that could have justified an excess allocation of the capital gain (only a capital gain distribution agreement had been entered into); and (ii) the fact that the executive did not pay a properly valued consideration, accompanied by a risk of capital loss, for the acquisition of the right to reclaim a portion of the capital gain.

In this particular case, in fact, it had simply been agreed—under the terms of an agreement known as a “capital gains sharing agreement” entered into between the financial investors and the executive—that the latter would receive, upon exit, a share of the capital gains realized by the investors, provided that profitability targets were met.

It is this share of the capital gains transferred by the financial investors to the executive that the Administrative Court of Versailles has reclassified here as a salary benefit. The Court emphasizes that the profit-sharing agreement could have resulted in a gain for the executive but that, conversely, there was no risk of loss associated with it, since if the profitability targets had not been met, he would not have had to pay any sums back to the investors. The executive therefore did not bear any investor risk under the terms of this profit-sharing agreement.

This outcome, which is unfavorable to managers, is therefore primarily attributable to the specific nature of the equity incentive plan that had been implemented in this case.

[1] The term “management package” refers to the mechanisms through which managers acquire an equity stake alongside investors as part of an LBO transaction, ensuring that investors can be confident that the managers’ interests are aligned with their own and focused on the transaction’s complete success.