The Falcons Ruling and the Participation Exemption: Why This Principle Is Still Relevant for Startups

What the Falcons ruling fundamentally changed

The Falcons ruling marks a pivotal moment in the tax treatment of stock options within corporate income tax. The underlying principle is fundamentally simple: if the economic interest in a share is split, the tax treatment should not artificially detach from that share. In other words, the option right is not always treated as a completely independent instrument that stands alone for tax purposes.

As a result, the ruling made the participation exemption more broadly applicable than was often assumed previously. It's not just direct share ownership that counts, but also whether a party, through an option or a related obligation, has an economic interest in shares that belong or would come to belong to a qualifying participation.

That sounds technical, but its practical impact is significant. After all, many transactions involve not only the shares themselves, but also call options, put options, purchase rights, sale rights, and other contractual mechanisms by which parties distribute value, risk, and control over time.

The Core Tax Principle: The Interest Follows the Share

The most important lesson from Falcons is that the participation exemption can extend to benefits and disadvantages arising from a stock option, as long as that option right is sufficiently connected to shares that belong to a participation or would form such a participation upon exercise.

This works both ways.

For the holder of a participation who grants a call option on their shares, the premium received may fall under the participation exemption. Even upon exercise, the tax treatment remains linked to the shares. The same applies in reverse for a put option: there too, not only the contract is considered, but also the underlying position in the shares.

Furthermore, the scope extends beyond situations where an option is actually exercised. Even when an option is ultimately not exercised, or when an option right is alienated or an option obligation is transferred, the participation exemption can still apply. The decisive factor then is whether a qualifying participation would have been acquired upon exercise.

That is precisely why the Falcons ruling has remained so influential. The ruling does not treat options merely as separate derivative products, but rather considers the economic link to the underlying share interest.

Its Broad Application to Date

The influence of Falcons has not been limited to the original type of publicly traded call option on existing shares. In the years since, its scope has been broadened, but also refined.

1. Not just existing shares, but also new shares

An important development is that the principle from Falcons was later extended to rights on newly issued shares. This is relevant because, strictly speaking, in such situations, an existing share is not first 'split'. Nevertheless, the tax approach has further evolved to include such rights, under certain circumstances, within the scope of the participation exemption.

For practical purposes, this is an important signal. Thus, the tax assessment does not automatically cease simply because the shares do not yet exist at the time the right is granted. The structure of the right and its connection to a future participation remain decisive.

2. The application is not unlimited

Precisely because Falcons was broadly formulated, it was later more clearly delineated when this broad approach does and does not apply.

An important refinement is that not every agreement with an economic dimension automatically leads to a 'split interest' in the sense of Falcons. For this to apply, it is crucial that parties genuinely intended such a split AND that the agreement actually created rights to the relevant share. This is a fundamental point. Therefore, anyone who includes only economically similar incentives in contracts, without a true legal link to the shares, may fall outside the scope of Falcons.

Furthermore, recent case law and policy have emphasized that there must be a real connection to the underlying shares. For a call option, it is therefore not enough for a structure to merely resemble shares economically. The presence of the underlying shares with the option writer plays a significant role. This means the Falcons principle has not been reversed, but it has certainly become less unlimited than some interpretations suggested in the first years after the ruling.

3. Not every benefit related to shares is covered by Falcons

Another important lesson from later developments is that the benefit must genuinely be linked to the share or participation itself. If the result essentially stems from a separate business model, and not from the value development or profit of the underlying company, the participation exemption will not automatically hold.

This distinction is crucial in practice. Falcons is therefore not a general exemption label for every cleverly structured benefit involving shares or options. The origin of the benefit remains decisive.

4. Timing and exercisability also matter

Further clarification also shows that timing counts. For options with gradual exercisability, it is important from which point a position can contractually arise that qualifies as a participation. The tax treatment can therefore shift over time. For deals with phased entry or the build-up of participations, this is not a detail, but a structuring point.

Why this is so relevant in the startup world

In the startup world, equity interests are rarely arranged in one simple step. Many growth companies work with phased investments, buy and sell rights between shareholders, exit agreements, entry mechanisms for investors or management, and structures where economic value is already distributed before the definitive transfer of shares takes place.

Precisely in such structures, the concept of Falcons is relevant. Not because every option right is automatically correct, but because the tax outcome heavily depends on the precise link between the contract and the share.

For startups and scale-ups, this is particularly relevant in three situations.

Shareholder agreements with call and put mechanisms

Shareholder agreements often include buy and sell rights for specific scenarios, such as bad leaver, deadlock, breach, exit, or phased collaboration. It is then tempting to look at the deal purely from a commercial perspective. From a tax perspective, that's too simplistic. The constant question is whether an interest in shares is genuinely created or split, and whether that interest is sufficiently closely linked to a qualifying participation.

Phased investments and later equity entry

In scale-ups, it often happens that an investor does not immediately take the full equity, but first obtains a contractual right to acquire shares later. In such structures, the precise design is decisive. Not only the economic intent, but also the legal implementation determines whether the tax treatment can remain within the scope of the participation exemption.

Holding structures of founders and investors

Falcons is particularly relevant at the level of companies that participate via a holding company. That's where the participation exemption applies. This also immediately means that the ruling is not simply the right framework for every option in a startup, and certainly not automatically for ordinary employee options. As soon as there is no qualifying participation in sight, the significance of Falcons quickly fades into the background.

What founders, investors, and legal teams should take away from this

The practical lesson is simple: when dealing with share options, don't just look at the term sheet or the commercial outcome, but at the tax architecture of the right.

A few questions should always be on the table:

Does the option right genuinely relate to shares, or is it primarily an economically derived right without sufficient linkage to those shares?

Does it concern existing shares or newly issued shares, and what does that mean for the structure?

Would exercising it create a qualifying participation?

Are the underlying shares actually present where it is tax-relevant?

Does the benefit truly stem from the shareholding, or primarily from a separate business model or a technical mismatch?

For legal and finance within startups, this is a typical topic that is addressed too late. In practice, valuation, governance, and exit mechanisms are often negotiated first, and only then is the tax treatment considered. By then, the scope for smart structuring is usually smaller than desired.

The true lesson of Falcons for startup practice

The Falcons ruling is still relevant, but not as a carte blanche. Its lasting significance lies elsewhere: in the recognition that economic interests in shares should not always be viewed separately from those shares for tax purposes.

For startup practice, this is a valuable insight. Modern growth companies often work with hybrid agreements, tiered participations, and contractual equity mechanisms. Precisely then, Falcons helps to maintain focus on where the value lies, who truly holds the equity interest, and whether the tax outcome still aligns with the economic reality of the deal.

Those who design this well prevent a seemingly straightforward share agreement from later turning out differently than intended for tax purposes. And precisely therein lies the broad, still relevant significance of the Falcons ruling today.

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