Facts and Circumstances
In August 2006, a private equity fund (“Fund”) acquired – through a holding company – all shares in a target company for a (rounded) consideration of EUR 24,500,000, of which EUR 13,200,000 was financed with a bank loan. The equity of the holding company of EUR 11,300,000 consisted of 10,000 ordinary shares of EUR 10 per share and 112,210 (8%) preference shares of EUR 100 per share. Hence, the preferred share capital amounted to EUR 11,221,000 and the ordinary share capital amounted to EUR 100,000 (ratio 1:112).
The management of the target company was given the opportunity to participate in this investment. On 14 November 2006, it was agreed that one of the managers (“Manager”) would acquire 450 depositary receipts (“DRs”) of the ordinary shares for a consideration of EUR 10 each, as well as 1,210 DRs of preference shares for a consideration of EUR 100 each. This investment implied a significant envy for the Manager compared to the investment by the Fund.
At July 6th, 2007, one of the other members of the management team of the target company sold DRs of the ordinary shares for an amount of EUR 2,277 each. In 2010, the shares in the target company were sold to an American PE fund for a total consideration of EUR 520,000,000.
The tax inspector argues that upon acquisition, the value of the DRs of the ordinary shares was substantially higher than the price that was paid. Subsequently, the DRs of the preference shares should have been valued at a lower price (discount), since these shares were entitled to a coupon of only 8%, whereas the preference shares represented the vast majority of the equity that was at risk.
The disproportionate amount of DRs of ordinary shares held by the Manager – reflected in the envy factor – created a leverage that enabled the Manager to realize a very substantial share of the profits that were expected. The tax inspector uses several documents, among others the Investment Recommendation of the Fund, to demonstrate that the expected IRR for the total investment amounted to 45%, whereas the expected IRR for the Manager was 4,152%. This higher value is, in view of the tax inspector, substantiated by the fact that in July 2007, the value was already EUR 2,277 per DR of each ordinary share.
According to the tax inspector, the difference between the price paid for the DRs of the ordinary shares and its fair market value should be considered taxable wage.
Conversely, the Manager argues that since the fund acquired the shares from a third party, the acquisition price of the shares in Target was at arm’s length. Additionally, the EUR 10 paid per DR of each ordinary share is an arm’s length price, since the Fund paid the same price.
Court of Appeal judgement
The Court of Appeal agrees with the tax inspector that the value of the DR’s on 14 November 2016 was higher than the par value of EUR 10. The Court of Appeal states that it is commonly known that an equity stake for management is very profitable. Not without reason, the terms sweet equity and envy are used. Due to the mechanism of the participation, leverage is created that may lead to a disproportionate value increase of the ordinary shares. With regard to the valuation of the ordinary shares, the expected value of the shares, with due observance of potential future developments (e.g. increased EBITDA, sale and leaseback, improvement strategies), should be taken into account. On the other hand, the Court of Appeal states that the principle of prudence should be taken into consideration, since it is highly uncertain whether the assumptions made in advance will turn out to be correct. Based on the above, the Court of Appeal has decided that the value of the DR of each ordinary share should be set at EUR 260, which is significantly lower than the value that was calculated by the tax inspector.
After full repayment on the 8% preference shares, the Manager’s entitlement to the excess profit can be considered disproportionate compared to the Fund’s entitlement, given the investment of both parties. In such cases, the Dutch Tax Authorities take the position that the envy represents a certain value, which is taxed as an employee benefit (i.e. max 51.95% wage tax). The Court of Appeal now confirms that point the view. It is interesting that the valuation of the shares by the Court of Appeal is relatively moderate, based on the principle of prudence. We expect that, since this principle is explicitly mentioned in the verdict, this will have an impact on future valuations of leveraged shares. Although not likely, we are closely monitoring whether appeal in cassation is filed by either party.
Should you have any questions about this verdict or about management incentive plans in general, please contact your designated contact person at Atlas.
 Envy ratio = Investment by investors / % Equity
Investment by manager / % Equity
 Initially the risk is borne by the entity that employs the beneficiary of the envy factor. In practice however, the risk will be borne by the manager on the basis of the contractual arrangements.