The Federal Court restricts the tax-free capital gain

In a new ruling, the Federal Court has relativized the principle of tax-free capital gains, raising many questions. When an entrepreneur sells his shares in a company at a profit, this is fundamentally tax-free. However, in the Federal Court’s decision, the profit was reinterpreted as taxable income.

The principle of tax-free capital gains is anchored in Art. 16 para. 3 DBG. In the ruling of April 3, 2015 (BGer 2C_618/2014 and 2C_619/2014), the Federal Court decided that the entire capital gain from the sale of a company should be qualified as taxable income. The court's justification raises many questions and also significantly restricts young entrepreneurs.

Capital gain qualified as income

In the facts of the case, one partner of a financial company spun off part of his financial business into a new company. He funded the new shares with his private assets and sold them a month later to a bank. The purchase price of the shares was paid in four installments. The agreement stipulated that the first installment was due at the conclusion of the contract and the remaining three installments were to be paid in the following years. However, the last three installments were always paid by the bank under the condition that the divesting partner continues to work at the sold company. The tax office qualified the profit made in this transaction as taxable income from non-independent employment. The partner initially disputed this with the tax office and then before the administrative court, maintaining that it was a tax-free capital gain since the shares originated from his private assets.

The decision was appealed by the partner all the way to the Federal Court. The judges confirmed the tax office's assessment that the gain should be taxed as income. The decision was justified by the fact that the purchase price for the shares actually represents remuneration for work to be performed in the future by the partner. There was, in fact, no purchase agreement for the transfer of ownership of the shares because the payment of the purchase price was made dependent on the continuation of the employment relationship with the company.

The court criticized that the goodwill, which the bank paid, was only created because the skilled partner continued to work in the company and generate profits. From an economic perspective, this is therefore a combination of a signing bonus (first installment) and loyalty premiums (second to fourth installment) that clearly constitute components of salary.

Risk for young entrepreneurs

The court, by its qualification, significantly restricts the principle of tax-free capital gains. Shareholders are thereby exposed to the risk that any sale of the company, in which the seller commits to continue being employed by the company, involves a reinterpretation of the gain as taxable income. Especially in startups, the continuation of the employment contract in the company is often desired, as the founders are the driving and innovative forces. The sale is often a means to an end to open up further growth opportunities for the company through the freshly incoming risk capital.

Young entrepreneurs should therefore clearly differentiate between the amount for the value of the company and the amount for the continuation of the employment contract in future sales of their company shares.

This article is based on the case review by Andrea Opel and Barbara Stillhart-Zimmermann in the NZZ of June 25, 2015.