Carried interest: Belgian Ruling Commission confirms application of Stock Option Law
04 May 2016
The Belgian Stock Option Law sets out the tax treatment of stock options, thereby eliminating the uncertainty as to the taxable value of the stock options. In the past, the Belgian Ruling Commission has been reluctant to confirm that the Stock Option Law also applies to stock options on carried interest shares. In a recent ruling, we obtained confirmation from the Ruling Commission that the Stock Option Law is indeed applicable to stock options on carried interest shares, with a reservation regarding the possible application of the anti-abuse provision.
It is market practise in the investment fund industry that fund managers receive (apart from a management fee which is unrelated to the success of the fund) a share in the profits of the fund in excess of the amount invested in the fund by the fund manager, provided that the return of the fund reaches a certain threshold ("hurdle"). This share in the profits is often referred to as "carry" or "carried interest". Investors expect the fund managers to receive this carried interest, as it aligns the fund managers’ interests with the investors’ interests.
The tax treatment of this carried interest is the subject of debate (and tax litigation) in many jurisdictions that have no specific tax regulations, including in Belgium. In Belgium, under general tax law principles, the acquisition by individual fund managers of carried interest in the form of equity instruments (such as preference shares) should only be taxable as professional income to the extent that the acquisition price is lower than the fair market value at the time of the acquisition; dividends and liquidation bonuses should be taxable as movable income, whereas capital gains should be tax exempt (if realised within normal management).
A popular technique is where the general partner grants stock options to the individual fund managers on carried interest shares that have been subscribed to by the general partner. Under certain conditions, the grant of stock options triggers an upfront tax; the taxable basis is a lump sum value, calculated on the fair market value of the carried interest shares. A gain realised on the exercise of the stock options or on the subsequent sale of the carried interest shares, is not taxable as professional income (which is in line with general tax principles).
Although the upfront valuation of carried interest shares is not easy, it is doable.
In the past, the Belgian Ruling Commission has been reluctant to confirm the application of the Stock Option Law to carried interest shares, despite the absence of valid legal arguments.
In its April 2016 ruling, the Belgian Ruling Commission confirmed the application of the Stock Option Law to carried interest shares issued in the form of preference shares, including the application of the lump sum valuation and the absence of a so-called "guaranteed benefit". It also confirmed that a possible capital gain is not taxable as professional income (which is expressly confirmed by the Stock Option Law) and also not as miscellaneous income.
Regarding fund managers working through personal service companies, the ruling states that the options should be granted to the personal service companies themselves, who can then grant the options to their managers. The personal service companies need to recognise a profit on receipt of the options, but this is compensated by a tax deduction (of the same amount) when the options are granted to the managers. Note that the Central Tax Authorities have taken the view that, under certain conditions, stock options may be granted directly to the permanent representatives of personal service companies.
The ruling makes a reservation regarding the possible application of the general anti-abuse provision, set out in article 344 §1 of the Belgian Income Tax Code (BITC).
Tax abuse is deemed to exist if the taxpayer enters into: (i) a transaction under which the taxpayer remains technically outside the scope of a provision of the BITC or its implementing decrees but in breach of the purpose of that provision; or (ii) a transaction where the main aim is to enable the taxpayer to claim a tax benefit provided for by a provision of the BITC or its implementing decrees, the grant of which would be contrary to the purpose of that provision (this is sometimes referred to as "frustrating the intention of the legislator").
If no grounds other than the intention to avoid income tax can be shown, then the taxable basis and the tax calculation are re-established so that the transaction is subject to a levy which is in line with the purpose of the law, as if the abuse had not taken place.
The ruling states that there may be tax abuse in the present case, as the preference shares have been created to grant carried interest. The carried interest may result in a significant pay-out, compared to the committed capital: the pay-out may be disproportionate to the strike price of the stock options.
This reasoning is in our view unconvincing. The potential pay-out is an item which is taken into account when the fair market value of the carried interest shares is determined, and this is reflected in the lump sum tax value.
In addition, the Ruling Commission does not (try to) rebut any of the arguments we made against the possible application of "tax abuse":
3.1. Stock Option Law grants no tax benefit
Before the enactment of the Stock Option Law, it was commonly accepted that the fair market value of unlisted options could not be determined, making it extremely difficult for the tax authorities to tax a "benefit in kind". The tax authorities could also not tax the capital gain, as the options were part of the beneficiary’s private estate as from the grant, and the capital gain was therefore tax exempt. The Stock Option Law confirmed these general principles, but introduced a lump sum valuation resulting in an effective taxation of the options at the moment of grant.
Given this background, it is hard to see why the application of the Stock Option Law could be viewed as tax abuse. The application of the Stock Option Law results in an upfront tax which would otherwise probably not have been levied, and does not change the tax exemption of the possible capital gain.
The Ruling Commission does not specify on what basis the Stock Option Law could be viewed as potentially resulting in tax abuse. As stated above, the Ruling Commission is concerned that there may be a high pay-out, but this is already reflected in the lump sum valuation. In addition, given the separation of powers, it is up to the legislator (and not to the tax authorities) to determine the lump sum valuation.
3.2 Intention of the legislator is not frustrated
When the Stock Option Law was discussed in Parliament, there was no discussion on its application to carried interest. A couple of years later, when the private investment company was introduced, the Minister of Finance expressly stated that fund managers would be able to apply the Stock Option Law to receive part of their remuneration in the form of carried interest. Although this statement was not made in the preparatory works of the Stock Option Law itself, nothing suggests that it was the intention of the legislator to exclude carried interest from the scope of the Stock Option Law, on the contrary.
3.3 No tax abuse by the beneficiaries themselves
The definition of tax abuse refers to a transaction or series of transactions carried out by the taxpayer. The Minister of Finance reiterated this principle in an answer to a parliamentary question about abusive structures set up by third parties, where he stated that tax abuse required a transaction or series of transactions carried out by the taxpayer themselves. In the present case, the fund managers merely accept the stock options that are offered to them; such acceptance is not an abusive structure.
3.4 Stock Option Law is not in scope of the anti-abuse provision
Article 344 §1 of the BITC is only applicable if the taxpayer claims a tax benefit under a provision of the BITC or one of its implementing decrees, contrary to the purpose of that provision. The Stock Option Law is a separate law and does not form part of the BITC or its implementing decrees. Therefore, Article 344 §1 of the BITC cannot be applied.