Pending landmark reform of the German ESOP taxation

Corporate 19.04.2023

It is finally published: the draft bill of the Future Financing Act (in short “ZuFinG”). The act is probably the most important legislative initiative for the startup ecosystem in Germany in this legislative period – and maybe even beyond. 

Blog Visual 3000 3000 px 3
PXR team portrait overview peter close
Managing Director, Corporate/M&A Lawyer and Tax Consultant

The draft bill of the ZuFinG (hereinafter referred to as "Ref-E"), which was jointly submitted by the German Federal Ministry of Finance and the German Federal Ministry of Justice, contains a large number of new regulations: encompassing the areas of financial market law, corporate law and tax law.

The framework conditions for Germany as a financial centre generally, and for start-ups and growth companies in particular, are to be substantially improved by the Ref-E.

The most important change for the startup ecosystem is certainly the revision of Sec. 19a German Income Tax Act (Einkommensteuergesetz - EStG) and thus the change in taxation of employee share ownership.

In short: if the revision of § 19a EStG is implemented as envisaged in the Ref-E, it would be a quantum leap – both for employees in startup companies and for Germany as a location for tech companies. Germany would thus become competitive for the first time in the area of employee share ownership.

The weaknesses of the current § 19a EStG

The Fund Location Act (Fondsstandortgesetz) of 3 June 2021 introduced Sec. 19a EStG and thus fundamentally redesigned the taxation of employee share ownership in Germany. However, Sec. 19a EStG in its current version has a number of weaknesses that have led to Sec. 19a EStG remaining largely useless in practice.

The main points of criticism relate on the one hand to the scope of application of Sec. 19a EStG (i.e., narrow SME criteria, which in particular exclude growth companies from the scope of Sec. 19a EStG, issue of shares in affiliated companies). On the other hand, the criticism focused on the so-called "dry income" problem.

The law currently stipulates that the non-cash benefit from the discounted provision of an employee share ownership will not be levied on right away. However, it will be levied after twelve years at the latest (so-called long-stop taxation) or in the event of a change of employer.

According to the current legal situation, an employee therefore may have to pay wage tax on a non-cash benefit without receiving any cash proceeds at the time of taxation ("dry income").

This phenomenon has proven to be downright prohibitive in startup practice with regard to the design of Sec. 19a EStG.

The Ref-E is now intended to remedy the situation on various levels – and would be quite effective in doing so. The amendments to Sec. 19a EStG proposed in the Ref-E would address the objections raised by practitioners and thus render the taxation of employee share ownership in Germany internationally competitive for the first time.

The Ref-E addresses this in three instances: increasing the tax allowance for the acquisition of employee share ownership, expanding the scope of application of Sec. 19a EStG, and solving the "dry income" problem within the framework of Sec. 19a EStG.

Finally, the Ref-E provides for the possibility of a uniform lump-sum taxation at a rate of 25% in Sec. 19a EStG – however, it remains uncertain whether this lump-sum taxation will in fact find its way into the final bill.

Increase of the tax allowance

The tax allowance for the (discounted) acquisition of employee share ownership is to be increased from a current level of 1,440 euros to 5,000 euros per annum.

This significantly expands the possibility of employee share ownership even outside the startup ecosystem. Of course, the allowance is particularly relevant with regard to participation programs of "mature" companies, such as employee stock programs, etc.

Extension of the scope of application of Sec. 19a EStG

The Ref-E provides for the scope of application of Sec. 19a EStG to be extended in several respects. So far, the special regulation for employee share ownership only applies if the so-called SME thresholds (250 employees, € 50 million turnover, € 43 million balance sheet total) are met at the time of the share allocation or were not exceeded in the previous year.

In addition, according to the current legal situation, companies fall outside the scope of Sec. 19a EStG if more than 12 years have passed since their foundation.

According to the Ref-E, the scope of application will be extended on the one hand by doubling the SME thresholds (500 employees instead of the previous 250, € 100 million turnover threshold instead of € 50 million, € 86 million annual balance sheet total instead of € 43 million).

Furthermore, according to the Ref-E, the doubled thresholds can be exceeded for six years (previously: one) without a company falling out of the scope of Sec. 19a EStG. Combined, both measures (doubling of the SME thresholds and grace period of 6 years) already represent an expansion that is as significant as it is meaningful. In an international talent market, late-stage growth companies in particular are dependent on being able to offer attractive equity packages, as common in other tech locations and frequently demanded by employees. In this respect, from the point of view of Germany as a tech location, it is right and important to extend the tight corset of SME thresholds.

It is also to be welcomed that the Ref-E stipulates that companies are no longer covered by Sec. 19a EStG until 20 years after their foundation (instead of the previous 12). Startup companies have to be granted a development time of far more than 12 years. It is unrealistic for tech companies to be "mature" after 12 years and no longer dependent on attracting and retaining employees through an attractive equity participation.

Finally, according to the Ref-E, the scope of application of Sec. 19a EStG is extended by the fact that employee share ownership can also be issued to affiliated companies of the employer company. In the previous version of the law, these cases are not covered, at least in the opinion of the tax authorities. For example, an employee who is employed in a subsidiary of a start-up cannot receive a tax-privileged employee share ownership in the start-up company – i.e. an affiliated company – under the current Sec. 19a EStG.

It is not clear why such employee should be excluded from Sec. 19a EStG just because they is employed by a subsidiary of the startup. It is now expressly clarified that groups of companies (which, of course, must comply with the doubled SME thresholds in summary) are also covered by Sec. 19a EStG.

Solution of the "Dry Income" problem within the framework of Sec. 19a EStG.

The so-called long-stop taxation pursuant to Sec. 19a (4) sentence 1 no. 2 EStG, which occurs after 12 years under the current legal framework, is extended to 20 years by the Ref-E. This means that an employee must "pay retrospective tax" on a discounted employee share ownership after 20 years at the latest. Even in the event of a change of employer, it remains the case that this generally leads to "subsequent taxation" (Sec. 19a (4) sentence 1 no. 3 EStG).

However, according to the Ref-E, the two subsequent taxation events (long stop and change of employer) will be harmless in the future – and then only the actual sale of the employee share ownership will matter (Sec. 19a (4) sentence 1 no. 1 EStG) – if the employer irrevocably declares "at the latest" in the wage tax return following the subsequent taxation event that he is liable for the wage tax then incurred in the event of the actual sale of the share (subsequent taxation pursuant to Sec. 19a (4) sentence 1 no. 1 EStG).

This is regulated in a newly inserted Sec. 19a (4b) EStG. The assumption of liability by the employer is not only irrevocable.

It also applies regardless of any discretionary examination that would otherwise take place (whether it is feasible to make a claim against the startup company as a secondary debtor) and without the employer having the opportunity to escape the claim by notifying the company tax office accordingly.

In short, it can be said that according to the Ref-E, a startup company assumes responsibility for ensuring that wage taxation takes place properly after the long-stop period has expired (according to Ref-E: 20 years) or after an employee has left the company if the employee's stake is actually sold.

Since the possibility of discounted employee share ownership according to Sec. 19a EStG represents a significant economic advantage for startup companies in talent competition, it appears to be appropriate that startup companies and their managing directors or board members are obliged to ensure the proper implementation of corresponding employee participation programs.

In addition, it will be possible to get a grip on employer liability and thus also the personal responsibility of the management through the appropriate design of employee participation programs.

Hence the proposal that is now on the table solves the problem of dry income taxation in a way that is as effective as it is appropriate. In practice, the assumption of liability by the employer will become the rule (presumably even a contractual commitment by the employer company to the participants in a Sec. 19a-compliant program).

In this respect, the task for the consulting practice will be to design ESOP programs in such a way that the management is able to effectively meet its tax obligations.

Possibility of lump-sum taxation

According to the Ref-E, it is envisaged that the "initial taxation" – i.e. the initially deferred wage taxation of the non-cash benefit from the discounted transfer of shares – can be carried out at a flat tax rate of 25% (plus solidarity surcharge, if applicable). This would mean that both the transfer of an employee share ownership and its subsequent sale (insofar as the participation amounts to < 1%) would be subject to the so-called "withholding tax rate".

This lump sum not only means a considerable tax advantage for the employees involved in the startup company (as long as their average income tax rate is above 25%). It also has a practical advantage: the possibility of flat-rate taxation would make the question of "initial valuation" less relevant (although not meaningless, because it arises, for example, for the immediately due social security contributions).

More on this topic: The Future Financing Act bill also includes the possibility of multiple voting shares. Read more in our blog post "The multiple voting share - a new edition of an old acquaintance".