Employee stock ownership plans are also growing in popularity in Germany. However, their tax treatment is highly complex. Legislators and the courts are now strengthening their tax status and practicality.
Types of Employee Stock Participation Plans
The term “employee stock ownership plan” encompasses a wide variety of models of differing legal nature. Therefore, these plans always require a prior definition of their terms and tax classification. For example, employees may acquire direct ownership interests in their employer’s legal entity and thus become shareholders; alternatively, employers may grant, in a more limited form, so-called options for the future acquisition or allocation of ownership interests or shares (“Restricted Stock Units” or “Restricted Stock Options”) at a predefined preferential price. The greatest flexibility is offered by so-called virtual employee equity plans (“Virtual Shares”), which constitute a purely contractual relationship under the law of obligations between the employee and the employer and allow the employee to participate financially in the sale of the company upon the occurrence of a certain event (“trigger event”), such as the sale of the employer’s company to a new investor (“exit event”).
Upstream Tax Disadvantages Due to “Dry Income”
The acquisition or grant of employee stock options (shares, options, VSOP) at a preferential price or entirely without consideration are to be treated for tax purposes as a regular component of salary and are therefore subject, like cash wages, in full and at the progressively increasing income tax rate (in the worst case, 45% plus solidarity surcharge and church tax), to immediate withholding tax and thus to income tax and social security contributions. It is not uncommon for this withholding tax (payroll tax deduction) on such non-cash benefits—treated as taxable salary (“dry income”)—to lead to significant liquidity problems for employees and tax risks for employers, since the current net salary is insufficient to cover the payroll tax and social security contributions due on allocated shares, shares, or tradable option rights. In practice, the so-called “sell-to-cover” model has therefore emerged as a common solution for employers; that is, employees immediately sell a certain portion of their employee stock options at preferential prices at the time of acquisition or allocation to ensure sufficient liquidity for a full withholding of income tax and social security contributions. In this way, employers can avoid being held liable to the tax authorities for insufficient withholding of income tax.
The recently enacted Future Financing Act of December 11, 2023 (Federal Law Gazette 2023 I No. 354) aims to strengthen Germany’s position in the area of employee stock ownership plans and to increase their attractiveness in an international comparison. Essentially, the law is intended to counteract the negative effects of “dry income” and, in particular, to reduce the extent to which employees are required to sell shares to cover tax liabilities (“sell-to-cover” measures). To this end, the German Income Tax Act provides for both an annual tax-exempt allowance and a tax deferral provision (Section 3 No. 39 EStG and Section 19a EStG, respectively). Since the Future Financing Act took effect, the annual tax-free allowance has been €2,000 (previously €1,440 per year). Given the modest amount, its financial significance is likely to be minor; in Spain, a similar tax provision grants an annual tax-free allowance of €50,000.
The scope of application of the tax deferral provision for “dry income”—introduced in 2021 by the Fund Location Act—could prove far more relevant in practice. Under this provision, employees of certain companies (so-called growth companies that are no more than 20 years old, have no more than 1,000 employees, and have annual revenue of €100 million or total assets of €86 million) to defer the income tax (payroll tax) due upon the acquisition or allocation of employee stock options at preferential prices for a maximum period of 15 years (12 years until 2023). If the so-called “trigger event” occurs by that time—for example, if an “exit” takes place in the form of the sale of the respective employer to a new majority shareholder, or if the participating employee leaves the company as a result of the termination of their employment (“leaver event”)—the deferred taxes are owed by the employer or employee only at the time of the exit and can be paid out of the proceeds from the sale and the resulting liquidity (“cash proceeds”). This tax deferral is intended to eliminate the disadvantages of the actual taxation practice involving “dry income” and render “sell-to-cover” models unnecessary, at least with regard to payroll tax.
Social security contributions are not covered by this deferral provision. As a rule, the current salaries of managers, executives, and other eligible employees already reach the maximum contribution limits, so that these individuals do not, in fact or economically, incur any additional burden from social security contributions.
As a result, this tax deferral provision enables a legally certain taxation model for granting employee stock options on preferential terms, provided that the underlying company qualifies as an SME under the provisions of the law. However, with regard to the taxation of gains from the sale of employee stock options, there is far greater legal uncertainty in tax practice.
Legal uncertainties regarding the applicable type of income
In general, capital gains realized on investments, such as business shares, stocks, or similar rights, constitute taxable income from capital assets (Section 20 of the German Income Tax Act (EStG)), which is subject to a separate income tax rate of 25% plus the solidarity surcharge and, if applicable, church tax (Section 32d EStG). This special, linear income tax rate is generally significantly lower than the top tax rate applicable to participating employees, which is 42% or 45% plus the solidarity surcharge and, if applicable, church tax.
For this reason, tax authorities and tax auditors very often attempt to reclassify the taxation of exit proceeds from the sale of business shares or stocks as salary income—and thus subject to the top tax rate—due to the close connection to the existing employment relationship. The argument put forward is that employees who hold shares are actually supposed to receive additional compensation through employee stock ownership plans for their commitment and the entrepreneurial value they create; however, this arrangement was structured—solely for tax reasons—under the legal framework of a lower-taxed shareholder or stockholder status.
In consistent case law, the Federal Fiscal Court—much to the delight of human resources professionals—has ruled in favor of participating employees on the merits and classified capital gains from employee stock ownership plans as capital income subject to the special income tax rate (judgments of October 4, 2016 — IX R 43/15 — and December 1, 2020 — VIII R 21/17 and VIII R 40/18). Accordingly, the following aspects should be incorporated into the contractual structure of employee stock ownership plans in order to reflect them as independent legal relationships under corporate law between the company/employer and the shareholder/employee:
- Employee stock ownership plans with ordinary shareholder rights, such as voting rights or dividend rights
- No implementation based solely on tax considerations (so-called “abuse of tax planning” under § 42 AO)
- The same rights to proceeds from employee shares as other shareholders in the event of a sale of the company (this is particularly important to note in the case of Sweet Equity)
- Acquisition of employee stock options at their quoted or market value (“fair market value”)
The necessary corporate rights are generally granted to employees through the structure of an asset-managing GmbH & Co. KG acting as an intermediate company, in which the general partner—often a financial investor—serves as the general partner, and a so-called “warehouse company” assumes the role of the limited partner with management authority.
Employees’ claims to proceeds must correspond to those of other shareholders and may therefore not include any additional proceeds that could be linked, legally or economically, to the employment relationship. However, issuing and subscribing to different classes of shares (in terms of the number of shares) is permissible and generally does not constitute tax avoidance. The acquisition of employee equity interests at “fair market value” has historically been an indicator that such gains would be taxed as capital gains; however, according to a recent report in a trade journal, this factor may no longer be relevant for tax purposes in the future, allowing for the employee-friendly classification of such gains as capital gains (see: Der Betrieb, Steuerboard, January 17, 2024). However, with regard to so-called “leaver” clauses, tax caution should be exercised in the contractual drafting to ensure that proceeds from the sale of shares are taxed at a preferential rate when a participating employee leaves the company (Federal Fiscal Court [BFH], ruling of November 5, 2013 – VIII R 20/11, BStBl. II 2014, 275).
Conclusion
In conclusion, the policy measures involving tax exemptions and tax deferrals are to be welcomed, and their scope of application could be expanded even further to enhance Germany’s attractiveness as a business location. This is especially true given that, from a tax perspective, the practical application of these measures can be made more legally certain through the taxation principles that the Federal Fiscal Court is continually defining in greater detail.
