The classic A/B model has become a popular generational transition modelfor many family-owned businesses, but it has been challenged by changes in the rules from the Danish Parliament and the Danish Tax Agency. The A/B model, which previously made it easier for the next generation to take over the business, must now be adjusted in relation to new tax conditions and the valuation of B shares.
In this article, we review the most important changes and consequences for your business.
The A/B model as a generational change model – How does it work?
Today, A/B models are typically used in connection with generational change to make it easier for the next generation to acquire part of the company. In short, a classic A/B model involves dividing the company's capital into A and B shares, so that the A shares are entitled to a specific amount as an advance dividend. This means that the B shares are only entitled to dividends once the A shares have received the amount in dividends covered by the preferential dividend right and – between related parties – assigned a return (revaluation). According to current practice, the return must be market-based.
This division of the company's capital has so far had the effect on valuation that B shares have a lower value than A shares, as the value is, so to speak, shifted from B shares to A shares. Generally, B shares have thus been able to be transferred to the next generation at a low price, as the value is mainly in the A shares. At the same time, the next generation gains access to a proportional share of the added value that will be created in the future.
The model is well known and frequently used in generational transfers, and it has so far been fully accepted by the Danish Tax Agency. However, the model has gradually come under pressure from several quarters.
Tax Council rulings and "profit opportunities" with B shares
In two rulings dated December 18, 2018, and June 25, 2019, respectively, the Danish Tax Council has, for the first time, introduced an "option approach" using A/B models in connection with generational change.
The Tax Council has determined that B shares without preferential dividend rights have a "profit opportunity" in certain cases. Where this is the case, a separate value must be calculated for the profit opportunity, which must be included in the valuation of the B shares in future. The aforementioned gain potential must be understood as the potential "upside" that B shareholders can receive if the company proves to be profitable and capable of generating additional returns beyond the preferential dividend plus market interest rates.
The Tax Council's argument for introducing valuation of this profit opportunity is that the holder of the B shares gains access to a potentially large profit for a relatively low investment. According to the Tax Council, this creates an asymmetric opportunity for profit and loss, similar to that seen in financial options. This is because the value of the B shares will increase if earnings and future expectations rise, while conversely, there will only be a loss of a relatively modest investment if earnings and future expectations deteriorate.
Had the transaction been a purchase and sale on the open market, the Tax Council's argument is that an independent buyer of the B shares would have to compensate the seller for the added value represented by the potential gain.
The inclusion of the value of a potential gain opportunity upon transfer to the next generation reflects a tightening of the practice regarding the well-known and otherwise proven A/B model. The change in practice will therefore only take effect six months after the Danish Tax Agency has issued a guidance note on the matter. Such a guidance signal has now been published.
We often hear these questions:
The A/B model divides the company's capital into two types of shares: A shares and B shares. In this model, A shares typically have a preferential dividend right, which means that A shareholders receive dividends up to a certain amount before B shareholders can receive their dividends. B shares only receive dividends once A shares have received their preferential dividends.
This structure enables the next generation (who often acquire B shares) to purchase these shares at a lower price, as B shares do not have the same value as A shares, which are associated with the preferential dividend right. This difference in share rights makes it possible to transfer part of the company to the next generation at a lower price, which can be advantageous in the event of a generational change.
The Tax Council has determined that B shares may have a 'profit potential', which means that the value of B shares must in future include a potentially large profit if the company is profitable. This may increase the value of B shares upon transfer.
This means that B shares must in future be valued taking into account a potential gain that may arise if the company is profitable. This potential gain may cause the value of B shares to increase upon transfer.
In this context, the Tax Council has applied an "option approach," whereby B shares could potentially generate a gain if the company performs well. This could result in B shares having a higher value than previously, when they were considered less valuable due to the preferential dividend rights attached to A shares.
The new practice may lead to an increase in the value of B shares, while the value of A shares declines.
The so-called "gain potential" of the B shares refers to the potential value that B shareholders can achieve if the company is profitable and generates additional returns. When this profit opportunity is included in the valuation, the value distribution between the A and B shares changes, meaning that the B shares are given a higher value and the A shares a lower value, as the B shares have a greater future profit opportunity.
This creates an asymmetrical distribution of value in the company, which can change the financial conditions for a generational change and thus make the A/B model less attractive as a generational change model.
This may change the economic conditions for generational change and make the A/B model less attractive as a generational change model in the future.
The value of the potential gain is determined based on option theory, and the Danish Tax Agency has recommended using the Black-Scholes model or the binomial model, even though these models require a comprehensive data basis.
Consequences of the Danish Tax Agency's guidance and changes in practice
Following the Tax Council's decisions, the Tax Agency has finally issued a policy statement that describes in detail their view of future practice in this area.
Firstly, the control signal attempts to determine when there is a profit opportunity for the B shares, which must be calculated at a separate value. According to the Danish Tax Agency, this is the case in the following two situations:
- where the pre-tax dividend represents the entire market value of equity, or
- where the pre-tax dividend yield largely corresponds to the market value of equity.
According to the Danish Tax Agency, the asymmetry between potential gains and losses will be greatest where virtually the entire market value of the equity – and thus also the greatest risk of loss – is held by the owners of the A shares and the prepaid dividend.
It is obvious when the prepaid dividend right represents the same value as the market value of the equity. On the contrary, it is less clear when the prepaid dividend right predominantly corresponds to the market value of the equity. The Danish Tax Agency states that it depends on a specific assessment in each individual case whether the potential gain has a value that is significantly different from DKK 0. However, according to the Danish Tax Agency, this will typically not be the case if the advance dividend represents less than 70-75% of the market value of the equity.
As a consequence, there is still considerable uncertainty as to whether a potential gain should be included in the valuation of B shares in cases where the pre-tax dividend does not represent the entire market value of the equity.
However, as a starting point, it must be expected that it is possible to omit a potential gain when valuing the B shares if the size of the advance dividend right remains below 70% of the market value of the equity. If this solution is chosen, however, it requires that the remaining value of the market value of equity that is not transferred to the A shares must be financed in another way upon the transfer of the B shares. If the financing is provided, for example, by taking out a loan, in practice the B shares will need to receive a share of the company's dividends from year one in order to pay the interest on the loan. This will have the knock-on effect that it will take longer before the preferential dividend entitlement in favor of the A shares is exhausted. This will increase the significance of the level of the preferential dividend entitlement.
Secondly, the control signal relates to how the value of a potential gain should be determined.
On this point, however, the Tax Agency merely repeats what the Tax Council has already stated in its 2019 decision, namely that the valuation should be based on option theory. This can be done using either the Black Scholes calculation model or the Binomial model. However, the Danish Tax Agency has added the caveat that the models are indicative. This implies that other models may be considered if, according to the tax authorities, the models mentioned do not provide a fair value.
The control signal therefore does not provide much clarity on this point, as it is unclear when a valuation based on the aforementioned calculation models from option theory will be disregarded.
The Danish Tax Agency does not elaborate on how these models can be transformed into calculating an option value in connection with the use of an A/B model.
Firstly, by definition, this does not involve the valuation of an option for tax purposes. In tax law, an option relating to shares is defined as a right to buy or sell that gives the acquirer a right, but not an obligation, to buy or sell a specific number of shares at a specific time at an agreed price. The potential opportunity for B shares to participate in the company's future "added value" in an A/B model cannot therefore be equated with an option in the sense of tax legislation. The steering signal therefore fails to make the entirely relevant and necessary link between the option theory calculation models and the "profit potential" for B shares in an A/B model.
Secondly, both of the aforementioned calculation models are complex and require a comprehensive data basis, which is typically not available for unlisted shares that are subject to generational change. If the value of a potential gain on unlisted B shares is to be calculated according to standard option theory, it will therefore probably be necessary in practice to fall back on the "Ligningsrådet formula" for valuing options. The formula is schematic and practical for options in the classical sense, as it only takes into account the trading price of the shares, the exercise price (settlement price), the term of the option, and the option holder's alternative financing interest rate after tax. However, time will tell whether the formula is equally applicable to the potential gains of B shareholders in an A/B model.
Legal basis lacking
As mentioned above, the introduced "profit opportunity" is far from the tax law definition of an option. The taxation of the profit opportunity is therefore not supported by practice or legislation in the area of stock options. In addition, the clear starting point in Danish tax law is the realization principle, according to which a gain is only taxed when it is actually realized. Taxation of unrealized gains is therefore not supported by current practice and legislation. If a potential gain is included in the valuation at the time of transfer, this leaves uncertainty as to how any gain will be taxed when/if it is realized.
If, instead, the "potential gain" is considered to be a price advantage for the holder of the B shares as a result of the more favorable financing, this does not improve the legal basis. Within the scope of gift tax, there is no legal basis for either interest rate fixing or capitalization of interest rate advantages.
This therefore suggests that the tax authorities are in the process of pushing the boundaries of previous practice and developing a new concept that lies outside the framework of the law, even though this should be the task of the legislator.
It is also worth noting that the "option approach" in connection with A/B models has not yet been tested by higher courts than the Tax Council. It is therefore uncertain whether the announced change in practice will be overturned in the future if, for example, the National Tax Tribunal has the opportunity to consider the new concept.
How do the changes affect your choice of generational change model?
It is CLEMENS' opinion that any future gain potential of the B shares does not affect the total value of the company at the time of transfer of the B shares. The company will have the same market value regardless of whether or not a gain potential is recognized. The difference lies in how the difference between the value of the A and B shares is distributed. According to the previous view, the difference has been linear, meaning that the entire value of the advance dividend has been added to the value of the A shares. Going forward, this will continue to be the case where no potential gain is to be included. However, if a potential gain is to be included, the above will only apply up to a certain limit. CLEMENS therefore expects that the portion of the company's total market value that constitutes the potential gain for the B shares will not be added to the value of the A shares, but will instead be allocated to the B shares without taking into account the size of the advance dividend. This shifts the value of the "potential gain" from the A shares to the B shares, while the market value of the entire company remains unchanged.
Although the value of the B shares will thus increase and the value of the A shares will decrease in relation to the current practice, the B shares will continue to be subordinate to the A shares when dividends are distributed – exactly as before. At first glance, this does not seem particularly attractive to B shareholders.
In light of the above, CLEMENS Law Firm believes that the change in practice will have a significant impact on the choice of generational change model going forward.
The A/B model has so far been used as an alternative to loan financing from third parties. One of the advantages of the model is that the liquidity requirement for the next generation when acquiring B shares is significantly lower when all or most of the already earned value in the company is placed on the A shares. This means that it is possible to avoid taking out loans from third parties to a large extent in connection with the transfer of B shares. However, this advantage will no longer be available in the same way as before if a potential gain is to be included in the valuation of the B shares, because the increased value resulting from the potential gain must be financed.
Furthermore, there is no guarantee that the shares in the company will generate a return that exceeds the dividend plus a market rate of return. In other words, there is a risk that the gain will remain merely a possibility and never become a reality.
When the choice going forward is between ordinary loan financing and use of the A/B model, the above factors are additional elements that may argue against use of the A/B model in connection with generational change.
In addition, the range of uncertainties associated with the use of the A/B model will increase once the change in practice takes effect – despite the published guidance. In addition to the already well-known uncertainties associated with the model, there will be particular doubts going forward about:
1) whether a potential gain should be specifically included in the valuation
2) how the value of the potential gain should be calculated in such cases.
Depending on the specific requirements for the generational change model, it may be relevant to identify any uncertainties in advance by obtaining a binding response from the tax authorities. Alternatively, the risk can be covered by a well-considered tax reservation.
Looking at the A/B model in general in light of the change in practice mentioned in the steering signal, the A/B model will in most cases be a less attractive generational change model compared to other models. If the A/B model is nevertheless to be used going forward, greater demands should be made on the advisory assistance in relation to rethinking the various elements of the model, including the size of the advance dividend, the value difference between the A and B capital classes, and any financing of the value of the profit opportunity.
The change in practice will take effect on February 28, 2021. It is therefore still possible to use the A/B model in accordance with current practice for a little while longer.
Want to know more?
CLEMENS has extensive experience with generational change and the application of the A/B model and other well-known models.
If you are facing a generational change or would like more information about the new rules, CLEMENS offers professional advice. Contact our experts for a no-obligation consultation.
