Is the “diluted” partner/shareholder entitled to exemption from income tax?

As part of our advisory practice in Highgate Group We represent not only investors, but also a number of young and innovative companies. We often encounter the various legal, tax and practical nuances of this world. Naturally, it also includes the successful sales of companies by their founders (or “ESOPists”) and the related tax pitfalls. And since I also account for several of these companies e, our relationship with this progressive segment of the Slovak economy is relatively strongly intertwined.

Exemption from income tax on the sale of shares

From 2018 (with application for the first time from 2020) it is possible to sell shares in companies in Slovakia without the proceeds of such sale being taxable income. However, the Income Tax Act makes such a possibility conditional upon meeting a number of conditions. First of all, the exception in question concerns only legal entities, so that under structuring of the business holding companies are the right instrument for such tax optimisation. In addition to this condition, the Income Tax Act requires that the legal entity is not an “empty shell”, has held the business share(s) for more than 2 years and has at least a 10% direct shareholding in the share capital of the company in question.

Dilution (“dilution”) of the founder

Startup founders with investor input typically gradually reduce their level of participation in the company. There can be several reasons for this: (i) sale of part of the company, (ii) entry of an investor, or (iii) some ESOP structure (i.e., employee stock).

The consequence of these movements in the company’s ownership structure is usually the so-called “diluting” of the founder. And if the founder holds his interest in the company in question through his holding company, he may thus benefit from income tax exemption on the sale of individual parts of the company or a complete “exit” (otherwise he would be taxed as in the case of sale of a cryptocurrency).

However, if the founder’s interest in the company falls below 10%, is it still possible to exempt this income from income tax?

Share below 10% and exemption from income tax

In my view, a founder diluted in this way is no longer entitled to exemption from income tax, notwithstanding the fact that his shareholding in the company was originally even dramatically higher than 10%. Such a return would therefore have to be taxed by the founder’s holding company, and in the present case the tax base would be the difference between the sale amount and (by default) the amount of the paid-up contribution.

Such a tax base would be subject to income tax at a tax rate of 15% (if the holding company had total annual taxable income of less than €50,000) or 21% in other cases. However, it is also common for the founder to set up a holding company abroad, where the rules for income tax exemption are more flexible than in this country.

But let us imagine a situation where the founder owns a 19.5% stake in a company and plans to sell it equally in two stages. If he sells 9.75% first and then the remaining 9.75%, he would have taxable income on the second sale. However, if he had structured this sale as a sale of a 9.5% stake in the first round and a 10% stake in the second round, he would have avoided taxation altogether.

Is there any other way to avoid taxation?

In practice, there are a number of creative ways to address this “tax problem” in a way that avoids negative tax consequences. However, it is important to remember that any tax optimization must stand on firm ground.

I have written/discussed many times in various forums as well as on our website about when tax optimization is defensible. I have addressed this topic in more depth, for example, in connection with the KTAG of Andrej Kiska (untenable optimization) or the case of Dominika Cibulka’s move to Dubaia (untenable optimization).

If you are further interested in the topic, you will find many more of my articles, statements or interviews on this topic on the Internet. Alternatively, you can contact me/us.