Tax incentives included in the Federal Ministry of Finance’s draft bill dated April 12, 2023, are intended to promote and expand employee ownership in companies.
As currently drafted in the Federal Ministry of Finance’s published draft bill dated April 12, 2023, the Future Financing Act (ZuFinG) contains significant changes to corporate and tax law relating to the German capital market, with the aim of increasing its attractiveness for capital-market-oriented companies and private investors. In particular, the retention and financing instrument known as management or employee stock ownership programs—which is popular in the startup and venture capital segments—is affected by the upcoming tax law changes.
Both real and virtual employee stock plans—often referred to in technical jargon as ESOPS, virtual shares, etc., depending on their structure—have long been very popular in the startup and capital markets scenes. However, due to the changing interest rate landscape, company valuations—which serve as benchmarks for employee stock plans—are currently suffering from a commercial perspective; this makes the proposed improvement to the tax framework in this area all the more welcome.
German tax law currently provides for two specific measures designed to increase the appeal of employee stock ownership plans:
- First, this is a tax exemption under Section 3, No. 39 of the German Income Tax Act (EStG) in the amount of €1,440 per year for the transfer of actual company shares to employees at a reduced price or free of charge. In order for this exemption to be granted, the equity participation program must be offered to all employees who have been employed by the company for one year or longer.
- Section 19a of the Income Tax Act (EStG) also applies to the transfer of shares in the employer’s company at a reduced price or free of charge. However, this constitutes deferred taxation, which is intended to prevent so-called “dry income” taxation for employees (taxation even though no cash has yet been received). Accordingly, taxation of the discounted shares received generally does not occur until 12 years after the transfer or upon termination of the employment relationship.
However, the scope of application of Section 19a of the Income Tax Act (EStG) is limited in that only companies classified as small or medium-sized enterprises (SMEs) may avail themselves of it. Even in the case of corporate groups, its application is limited to the specific company that is the employer; holdings in other group companies are excluded.
The Future Financing Act is intended to address these obstacles in particular, strengthen these two incentive mechanisms, and make them accessible to a larger number of companies. Specifically, the following changes are proposed:
- First, the tax-exempt allowance under Section 3(39) of the Income Tax Act (EStG) is to be raised from €1,440 to €5,000 per year—in other words, nearly tripled. However, financing equity participations through deferred compensation will no longer be permitted. From now on, employee stock options may be granted for this purpose only in addition to the wages already owed. In addition, a minimum holding period of three years for the transferred company shares is to be introduced in a new Section 20(4b) of the German Income Tax Act (EStG). If the shares are sold within this period (lock-up period), a 25% withholding tax will be levied on the tax-exempt amount by including it in the capital gain. As a result, the tax exemption is effectively eliminated.
- The provision in Section 19a of the Income Tax Act (EStG) is also to be made more user-friendly. For example, shares may now be issued not only by the employer itself but also by the (founding) shareholder. This should be particularly helpful for startups. In addition, shares in other group companies may now qualify for the tax benefit, and the size category will in the future be determined based on double the SME threshold. Eligible companies may then employ more than 500 employees and report either a maximum annual revenue of €100 million or total assets of €86 million (these thresholds are assessed as of the date of the asset transfer or over the past six calendar years). The period of tax exemption, as well as the maximum time that may have elapsed since the company’s founding, are also to be extended from 12 to 20 years.
- In the event that an employee leaves the company and the company repurchases the shares, only the compensation actually paid shall be taken into account for tax purposes (so-called “good or bad leaver” events). In addition, a flat-rate tax (a flat-rate payroll tax borne by the employer) of 25% is to become the standard under the law, although this may be passed on to the employee through appropriate contractual agreements.
However, aside from employee stock ownership plans, the draft bill lacks two specific tax incentives for all private investors that had previously been promised and included in the policy paper on which the draft bill is based:
- The introduction of a separate tax exemption for gains from the sale of stocks held as part of personal assets
- The Elimination of the Separate Loss Offset Process for Losses on the Sale of Stock
All in all, the proposed amendments to the Future Financing Act aimed at promoting employee stock ownership programs through tax incentives are welcome and demonstrate that the federal government intends to address this issue as part of a comprehensive package of measures. In particular, however, the tax-exempt amounts for discounted or free employee stock options could have been significantly higher in order to provide a tangible incentive for executives in emerging industries.
