In good company

Executive-level salaries, severance pay and pension benefits are being targeted by the Dutch tax authorities – but forming a special type of limited company can halve the size of the eventual bill.

In good companyThe rich might not keep on ­getting richer in the Netherlands. Senior management salaries came under scrutiny this May after the government sent a bill to the Dutch parliament to take a stand against the ever-rising pay packets of the top bosses.

The bill comprises three measures. The first is the introduction of an extra levy of 30 per cent on severance payments made to people with a yearly salary of more than e500,000 (£404,400), when the payment exceeds one year’s salary. The second is an additional tax on pension payments that are seen as excessive and the third deals with carried interest schemes.

The last of these measures is perhaps the most contentious and will be hotly debated in parliament. This bill is due to come into force on 1 January 2009.
Boris Emmerig, tax partner at DLA Piper in Amsterdam, says: “In view of the state of the debate, it has become clear that a large majority in the Dutch parliament will be in favour of the bill.”

Under current Dutch tax law it is not clear whether taxation should take place at the moment of entering into a carried ­interest scheme or when that actual income is realised out of the carried interest scheme. The actual income received out of the scheme is of no importance.

“The uncertainty is due to the question that lies behind carried interest schemes – to what extent can these schemes be seen as a wage?” says Emmerig.

If the scheme were considered a wage, the actual income would be taxed at a rate of 52 per cent. If not, only a rate of 1.2 per cent of income tax would be levied over the ­economic value of the interest in the carried interest scheme. Private equity managers would naturally prefer the latter option. To manage the uncertainty, advance tax ­rulings were sought from the tax authorities on a large scale.

The proposed bill retains the possibility of levying income tax at the moment of entering into the carried interest scheme. The taxable income consists of the difference between the economic value of the interest acquired on the one hand and the amount that has to be paid for acquisition by the holder of the interest on the other.

In case this carried interest scheme leads to actual income in the future, this income will also be taxed with income tax at a rate of 52 per cent. Any costs to finance the acquisition price of the carried interest scheme are tax deductible. Existing carried interest schemes will have to be assessed to see whether they fall under the new law.

“Looking in more detail at the new legislation, the first condition for the new tax treatment is that the tax inspector has to establish that the carried interest is also meant to be a wage,” explains Emmerig. “Assuming that the tax inspector can establish this, the second question is whether the carried interest falls within the scope of the new legislation. This isn’t always the case.”

The first type of carried interest scheme that falls within the new legislation’s scope involves shares in a company that has more than one kind of share. The shares must be subordinated to the shares of other investors with respect to the entitlement of profits. According to the current regulations, the total share capital of this particular kind must amount to less than 10 per cent of the total outstanding share capital.

The second type involves receivables. Not every receivable qualifies as a carried interest – only those receivables where the realisation of management or shareholders’ targets influence the interest to be paid, such as profit, turnover or cost reduction, qualify. The third type involves assets that are economically similar to the shares or receivables but are ­different in name and regulatory regime.

Lawyers who have nervous but rich clients with a substantial holding in shares will be able to reduce their tax from 52 per cent to 25 per cent by setting up a type of Dutch limited company called a ‘carried interest scheme BV’. The holders of the ­carried interest scheme become shareholders and so do not have to pay the top level of income tax.

Emmerig says: “In that case it will be the BV that will receive the income out of the carried interest and, assuming that the ­participation exemption is applicable to this income, it will not be taxed at the level of the interposed BV.”

When the BV subsequently makes a ­dividend distribution to the shareholders, this dividend will only be taxed at 25 per cent. But time is of the essence. For this scheme to work, lawyers will have to set up the BV before the end of 2008. Lawyers could save their clients money, and get ahead of the new Dutch laws, by acting fast and ­getting on board with limited companies.