PRIVATE EQUITY 01 - OCTOBER 2008 PRIVATE EQUITY 01 - OCTOBER 2008Lefèvre Pelletier & associés is one of France’s leading law firm, with more than 150 lawyers.

One of the main characteristics of capital investment activities is that people working for private equity funds(1) are in charge of investing money belonging to third parties (investors) in the best interest of the latter. The issue is therefore, how to ensure that those employees will always act in the best interest of the investors and therefore will make the best investments possible in a view of maximizing the return on investments for investors.

The solution usually put in place consists in allowing key employees and managers of private equity funds to subscribe stakes in the funds under their management (“carried interest” shares).

By making the investment team members of private equity funds, invest in the fund along with the ordinary investors, this system purport to put in line the financial interests of both the investors and investment team members, in allowing the latter to realize capital gains based on the proceeds derived from the investments they made.

This mechanism acts like a strong incentive for investment team members to maximize the performance of the invest-ment fund(2).

(1) Private equity funds in France are mainly organized under the legal form of either venture capital funds (fonds communs de placement à risques - FCPR) or venture capital companies (sociétés de capital-risque - SCR) managed by the investment team of managing companies (société de gestion).(2) In private equity funds, usually, in order to receive carried interest, the manager must first return all capital contributed by the investors and in certain cases

the fund must also return a previously agreed upon rate of return (the hurdle rate) to investors.

The tax treatment of gains derived from the sale of these shares hadn’t been clearly regulated in France until 2002. Therefore, until this date, there were real doubts as to how these proceeds should be taxed.

Indeed, in France, when an individual receives proceeds which are, to some extent, linked to its professional regular activity, the French tax authorities are used to qualifying such sums as income (wages, non-commercial profits or divi-dends) then subject to progressive income tax (impôt sur le revenu), whatever the origin or the nature of such sums.

Pursuant to the provisions of a tax statement of practice dated 1995, the French tax authorities reserved their right to subject to progressive income tax the profits drawn from shares subscribed under preferential conditions or linked to the holders’ professional activity within the managing company of the funds.The consequences were that such sums were subject to progressive income tax, which highest marginal rate is 40%, instead of being subject to capital gains tax which amounted previously to 16% and has been increased this year to 18%. Income tax and capital gains tax are increased by social contributions which overall rate is 8% for wages and non-commercial profits and 11% for capital gains and dividends.

PRIVATE EQUITY AND FRENCH TAX REGULATIONS ON CARRIED INTERESTS

Why carried interests exists in private equity funds?

Before 2002 : Debate over the tax treatment of the proceeds received

PRIVATE EQUITY 01 - OCTOBER 2008Lefèvre Pelletier & associés is one of France’s leading law firm, with more than 150 lawyers.

PRIVATE EQUITY 01 - OCTOBER 2008Lefèvre Pelletier & associés is one of France’s leading law firm, with more than 150 lawyers.

Taking into account the distinctive nature of the capital investment activities and therefore the specific constraints to be taken into account, the 2002 Finance Law and a tax statement of practice dated March 28, 2002 put an end to all doubts concerning the way profits resulting from carried interest mechanism must be taxed. This tax statement of practice provides that, in most circumstances, gains on carried interest are not liable for income tax but for capital gains tax.

The main characteristics of the above-mentioned regulation are the following:

Beneficiaries

The above mentioned tax treatment concerns only carried interest mechanism put in place for:

•employees of the managing company of the fund, employees of the venture capital company or employees of a company having entered into an agreement with one of the first two companies pursuant to which it provides management services;•managers of the managing company of the fund, managers of the venture capital company or managers of a company having entered into an agreement with one of the first two companies pursuant to which it provides managing services and whose compensation is taxed as wages.

Any other beneficiaries of carried interest (sponsors, qualified persons…) are liable for progressive income tax instead of capital gains tax.

Subscription conditions of carried interest shares

For this tax treatment to apply, the following conditions must be simultaneously met:

•carried interest shares must be acquired or subscribed in return for a capital investment of the beneficiaries. The necessary amount of capital investment and the subscription terms and conditions can be contractually provided at the funds creation or upon issuance of the venture capital company’s shares;•carried interest shares must form a sole share category subscribed at a sole subscription price and give the same rights in the fund’s investment gains to their respective holders. Nevertheless, the number of shares acquired or subscribed by the different members of the management team can vary;•the holders of carried interest shares shall not hold any other categories of fund shares unless such shares do benefit from the preferential tax treatment applicable to ordinary investors.•the holders of carried interest shares must receive in addition an ordinary compensation under their employ-ment contract, manager position or services agreement.

PRIVATE EQUITY AND FRENCH TAX REGULATIONS ON CARRIED INTERESTS

In 2002 : Clarification of the tax treatment of carried interest

PRIVATE EQUITY 01 - OCTOBER 2008Lefèvre Pelletier & associés is one of France’s leading law firm, with more than 150 lawyers.

PRIVATE EQUITY 01 - OCTOBER 2008 PRIVATE EQUITY 01 - OCTOBER 2008Lefèvre Pelletier & associés is one of France’s leading law firm, with more than 150 lawyers.

Exclusion of preferential tax treatments set up in favor of individuals

Although mainly positive as for the certainty of the carried interest tax treatment, these 2002 clarifications came also with some bad news for the managers of private equity funds. It is thus provided that:

•the beneficiaries of the carried interest tax treatment can not also benefit from the preferential tax treatment set up by the law in favor of individuals holding venture capital funds’ shares;•nor can they register their carried interest shares in the Shares Saving Plan (Plan d’Epargne en Actions – PEA), which would have allowed them to benefit from another preferential tax treatment.

The issue of ensuring the “alignment of interest” between investors and managers (or key employees) is almost the same in LBO transactions than at private equity funds’ level.

Indeed, in this kind of transaction, the way the managers are encouraged to work hard, in order to maximize the capital gains that the investors may derive from the sale of the holding company (set-up to acquire a target company), is cru-cial.

If a clear safe incentive mechanism now exists in favor of the investment team members of private equity funds, para-doxically, nothing really exists for management packages in LBO transactions in France.

Indeed, there is no official position of the French tax authorities, which establishes precise criteria allowing profession-als to keep for certain that the package they have implemented in favor of the managers will not be challenged by the French tax authorities and therefore the capital gains be, at the end of the day, subject to the progressive income tax.

Based on the judicial precedents on the matter, it could be deduced that it is mainly the absence of a real financial risk for the manager or the recurrent character of the operation that increases chances that the tax authorities consider any proceed deriving from management packages as income.

On this basis, and since the stock options and free shares mechanisms are not really adapted to LBO transactions’ constraints, the private equity practice has tried to set-up appropriate performance-based equity incentive packages for the managers, granting them “sweet equity” in the form of: options, preference shares or securities giving access to the company’s capital as equity warrants (bons de souscription d’action - BSA) or business creator equity warrants (bons de souscription de parts de créateur d’entreprise - BSPCE).

Uncertainty unfortunately persists (except for BSPCE, which cannot be issued in most of LBO transactions) as to how proceeds deriving from management packages will be taxed should the tax authorities challenge the mechanism put in place. It would therefore be desirable that French law change on this matter in order to support the private equity activ-ity in France and give the certainty that economy needs.

PRIVATE EQUITY AND FRENCH TAX REGULATIONS ON CARRIED INTERESTS

Carried interest in private equity funds compared to management packages in LBO transactions

PRIVATE EQUITY 01 - OCTOBER 2008Lefèvre Pelletier & associés is one of France’s leading law firm, with more than 150 lawyers.

Lefèvre Pelletier & associés is one of France’s leading law firm.With more than 150 lawyers, the firm has expertise in all areas of business law.www.lpalaw.com

PRIVATE EQUITY AND FRENCH TAX REGULATIONS ON CARRIED INTERESTS

Pierre AppremontPartner, Taxpappremont@lpalaw.comTel: +33 (0)1 53 93 30 12

Dimitri PubellierCounsel, Private Equity / LBOdpubellier@lpalaw.comTel: +33 (0)1 53 93 39 78

Matthieu FinazAssociatemfinaz@lpalaw.comTel: +33 (0)1 53 93 30 12

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