Summary
This article provides a practical approach on M&A within family businesses and highlights French tax rules on succession planning and, more importantly, the specific difficulties and tax risks that arise in family-owned businesses, where informal practices and related-party relationships often create exposure.
Introduction
When we know that family-owned businesses make up 70% of all businesses in the world, knowing how to deal with them as a corporate lawyer is inherent to our job. It can be tricky even for a lawyer who has access to all legal information to figure out who is the real decision maker or who is blocking the deal. When it comes to tax, topics can be highly sensitive by essence as it directly involves financials and succession topics. We will explore two main matters that can arise within M&A deals.
1. Succession and inheritance planning
This is crucial as tax reliefs and preferential tax regimes for succession may apply only if they are duly anticipated.
a. Exemption of transfer taxes applying to shares where a special engagement is taken
A partial exemption regime known as the “Dutreil” scheme is applicable to businesses or corporate shares (Articles 787 B and 787 C of the French Tax Code).
The Dutreil Transmission Pact (applicable to lifetime gifts and inheritances) enables taxpayers to benefit from a 75% exemption from transfer duties levied on gratuitous transfers (droits de mutation à titre gratuit), as well as a 50% reduction in gift tax where shares in a company held in full ownership are transferred by way of gift, provided that the donor is under 70 years of age at the time of the transfer.
The mechanism of this regime is primarily based on collective and individual undertakings (on the part of the donee or heir) to retain the shares for a specified period and to refrain from carrying out any transactions in respect thereof.
Also, the performance of a managerial function or the pursuit of the principal professional activity within the company for a specified period following the transfer is required.
In practice, raising the questions of the succession can give rise to tensions and I believe that using the constraints of tax law can be a good excuse to break the ice on this sensitive matter.
b. Capital gain reduction applicable where the seller leaves for retirement
Managers of SMEs subject to corporate income tax who dispose of the shares in their company in connection with their retirement, are entitled by section 150-0 D ter of the French Tax Code to a fixed allowance of Euros 500,000 on the capital gain. Under current law, this regime applies to shares acquired before 1 January 2018.
This allowance is irrespective of the applicable taxation method chosen, flat tax or progressive income tax scale. Indeed French Tax law allows taxpayers to choose between a flat income tax of 12,8% or progressive scale (from 11% to 45%); on top of income tax social charges of 18,6% are applicable. The allowance applies whether the seller chooses the flat tax or the progressive scale.
The benefit of the fixed allowance is subject to the condition that the transferor ceases all functions, whether managerial or salaried, within the company and asserts his or her pension rights within a two-year period.
In practice, it is very common that the founder and CEO does not really want to leave the company. This tax relief can be a motivation for them to duly anticipate their succession as they are the ones who will benefit from the tax regime on the taxation of their capital gain.
2. Specific tax risks in family businesses : compensation and valuation
In the event of a tax audit, family businesses attract more scrutiny from tax authorities as they know that it is likely that some transactions or decisions are made without legal ground, disconnected from economic reality.
a. Compensations, contracts and abnormal act of management
French tax law provides the abnormal act of management concept that consists in any decision that would be contrary to the company interests. When Tax Authorities apply this concept they challenge the deduction of concerned expenses and they may also add back the profit that should have been made by the company into the taxable result.
In practice, when conducting due diligence within M&A, some topics have to be addressed to mitigate those risks :
• Management / leadership compensations : we need to ask questions about how the management compensation was calculated, especially where the beneficiaries are a family member.
• Payments made to a company belonging to a family member : this will trigger Tax Authorities scrutiny so we need to ask the clients if they have contracts, invoices, etc.
• Family members working in the business who do not appear the payroll: this is important to identify this as they might get compensated indirectly through expenses. In practice, what usually happens is that they try to block the M&A deal out of frustration for never having been paid.
b. Valuation of the company upon sale
This is critical as in practice there is often a first phase of “clean up” where initial shareholders (usually related to the CEO) are bought back before a 12-18 months strategy is set up to create value ahead of the exit.
In this case, there is a risk that the price paid to former investors is challenged by Tax authorities. Indeed if the price is too low it will be deemed to be an indirect gift and in French tax law it triggers a 60% tax on the excess price.
In practice, when the investor comes in, the former shareholders (family members) will know about the price offered and challenge the price they were paid, usually significantly lower only a few months apart. This can escalate to a litigation drawing attention to French Tax authorities.
Conclusion
We could have named this article “how to navigate gracefully with the awkwardness inherent to family businesses?” as working with family businesses requires being able to address the elephant in the room and protect the clients’ interest while preserving the relationships with all family members involved.
That is why it is a prerequisite as a lawyer in a family business to be the trusted advisor and build trust from both sides: management and family.
