Tax reform proposals for carried interest will increase taxes for managers

A significant element of the “broad tax reform” originally proposed in October 2022 and included in the amended proposal for the first phase of the reform released by the Belgian minister of finance on 2 March 2023, is the intention to introduce a clear framework for the tax treatment of carried interest and management incentive plans. The proposals as currently drafted not only change the taxation regime of investment vehicles, but also increase the taxes for management.

The proposed draft provisions introduce:

1.  A capital gain tax of 15% for shares granted for free or at a discount to employees and directors (in addition to the taxation of the discount as professional income at 53.5% at the moment of realisation);
2. A stricter scope for the regime of options taxable on grant, excluding directors of management companies;
3. Legislative provisions for the taxation of options on exercise that do not fall within the tax regime for options taxable on grant; and
4. A 35% tax for excess returns on shares, that would be qualified as taxable professional income in the hands of the person who is directly or indirectly professionally active in the entity to which the scheme applies.

This alert focuses on proposal 4. above, since contrary to the current tax regime for stock options and co-investments, the tax treatment of so-called “sweet equity” offered to management by investors lacks a specific tax framework under existing legislation and is therefore subject to the most controversy. If enacted, the expectation is that the proposed new tax regime would enter into force for equity instruments granted on or after 1 January 2024. However, some uncertainty exists since the memorandum of understanding seems to refer to excess returns realized after the entry into force.

Excess returns

The proposed provision aims to tax as professional income the “excess” returns realised directly or indirectly by managers to the extent the return exceeds the return a passive investor would realise. 

Typically, the investors (venture capital (VC) or private equity (PE) funds) require an investment from management and/or grant the right to participate in a “waterfall” structure with different classes of share whereby managers are granted carried interest shares (for key managers often combined with preference shares as the investors). These shares normally receive a return once a predetermined “hurdle rate” is reached, and in that case, this return is a “catch-up” (typically 20% of the preferred return). 

An excess return can also result from the coexistence of preferred shares (with a fixed preference return) and ordinary shares, where the return on the ordinary shares can be disproportionately higher once the preferred return of the preference shares is reached.

It is envisaged that the proposed rules would apply to "management incentive" plans that aim to motivate executives of portfolio companies in the event of a sale of the company, as well as "carried interest" arrangements intended to incentivise managers of VC or PE funds. The wording of the draft reform proposal is broad and covers any situation in which an individual acquires financial instruments in connection with their professional activity with an excess return or that offer the opportunity to deliver an excess return.

Furthermore, a management company may, if applicable, be part of the arrangement, so that any corresponding dividend distributions from this company or capital gains realised on the shares of this company would also qualify as an excess return for the manager. The fact that the manager pays the market price for the shares or that the financial mechanism for the investment by the different shareholders, including management, is at arm’s length, is not taken into account.

Determination of excess return

The excess return is determined as follows:

1. Calculate the percentage return that the external investor has realised on its investment in financial instruments of the same nature as those held by managers professionally connected with the enterprise or group (“percentage return for external investor”).
2. Determine the return of the managers as if they had obtained the same percentage return as the external investor (“hypothetical return”).
3. Compare the actual return in absolute terms by the management with the hypothetical return calculated based on the percentage return of the external investor (“actual realised return”).
4. The taxable excess return is the positive difference between the actual realised return and the hypothetical return.

Applicable rates

The tax rate is set at 35%, plus communal taxes, resulting in a tax rate of approximately 37.5%. It is currently not clear whether the social contribution would additionally be charged. If considered as professional income, for employees, social contributions generally would be payable at approximately 28% for employer contributions and 13.07% for employee contributions. It may be hoped that an explicit exemption would apply (as is the case for stock options taxable at grant) otherwise the tax burden for employees would be approximately 46% including social contributions, and for employers approximately 28%. 

For self-employed directors, the social security impact should be none or limited as social contributions are capped at approximately EUR 20,000 per year.

The potential corporate income tax implications should not be overlooked. Additional corporate income may be payable where the dividends received deduction (DRD) would no longer apply given the proposed more stringent DRD rules.

Application and taxable moment

The above definition of the excess return is difficult to apply if instruments are exclusively acquired by management, e.g. where management acquires a specific class of share with particular rights.

Moreover, there may also be an undesirable outcome for founders who have typically invested at a different time and at a much lower price than a later investor. This could potentially lead to founders being reluctant to allow new investors because of adverse personal tax consequences.

Finally, in cross-border situations—which in these times of remote working are becoming increasingly common—the classification in Belgium of capital gains on financial instruments as professional income would generally be expected to lead to a difference in classification compared to the treaty partner state. On the basis that most tax treaties grant taxation rights on capital gains to the state of residence, whereas professional income is generally taxable in the state in which the employment is exercised, this “mismatch” has the potential to lead to discussions on the applicable tax treaty provisions and consequently possible double taxation.

Capital gains, interest, or dividend income that are not qualified as an excess return, continue to fall under the existing individual taxation regime applicable to such income.

The taxable moment would be the time of actual receipt of the excess return, by distribution or realisation.