Future Financing Act: Improved Conditions for the Tax Treatment of ESOPs

The German government published a draft referendum for a Future Financing Act (Zukunftsfinanzierungsgesetz - ZuFinG) on April 12, 2023. The Future Financing Act brings together extensive measures and bundles regulations from company law, capital market law and tax law. This is intended to increase the attractiveness of Germany as a financial location, particularly for start-ups, VC and small and medium-sized enterprises (SMEs).

In this Insight, Elnaz Mehrkhah and Bert Kimpel shed light on the tax regulations in connection with employee participation.

Employee participation is an important tool for startups and growth companies, which often rely on attractive but liquidity-preserving compensation models for their key employees. As an incentive, employees should participate in the company's success and development by transferring shares in the employer's company. As a result of the gratuitous or discounted transfer of assets, employees are regularly confronted with the so-called "dry income" problem. At the time of transfer of the GmbH shares or stock, the employee does not receive cash or other liquidity, but a share in the company. The employee has an income without a cash flow (dry). The difference in value between the purchase price and the fair market value is nevertheless taxable as a non-cash benefit and is subject to income tax. The employee would therefore have to use or even procure his own money to pay the income tax incurred. 

To alleviate this "dry income" problem, the legislator introduced a provision (Section 19a of the German Income Tax Act (Einkommensteuergesetz - EStG)) in the summer of 2021 with the Fund Location Act (Fondsstandortgesetz), according to which taxation is deferred under certain conditions and is only to be paid in the future.

The provision in the currently applicable version is to apply only to small and medium-sized enterprises (SMEs) as defined by the European Commission, i.e. only companies that

• employ fewer than 250 people
• do not achieve annual sales of more than 50 million euros or do not exceed the maximum balance sheet total of 43 million euros, and
• are not more than twelve years old at the time of employee participation.
• In addition, these thresholds are deemed to have been met if they were not exceeded in the calendar year of the participation or in the previous calendar year.

Since the introduction of the provision (2021), these requirements have been criticized in some quarters as being too restrictive and are now to be revised in the course of the Future Financing Act to cover all companies that

• employ fewer than 500 employees
• have annual sales of no more than EUR 100 million or do not exceed the maximum balance sheet total of EUR 86 million, and
• are not more than 20 years old at the time of employee participation.
• In addition, the thresholds are deemed to be met if the thresholds were not fallen short of at the time of participation or in one of the six preceding calendar years.

This means that the thresholds have been doubled and extended in terms of time from two to seven years with regard to the relevant observation years and from twelve to 20 years with regard to the relevant establishment period of the company.

Furthermore, the currently applicable version of Sec. 19a EStG provides for the following realization events and thus specifies when (deferred) taxation must occur at the latest:

• upon sale of the share or transfer (contribution) to a business asset,
• after the expiry of 12 years from the transfer of shares, or
• upon termination of the employment relationship.

Thus, according to the current legal situation, taxation of the pecuniary advantage must take place at the latest after twelve years or, what is much more drastic in practice, in the event of a change of employer. These aspects have also been substantially criticized in the past and are now to be revised as follows in the course of the Future Financing Act:

• Taxation only after the expiration of 20 years instead of twelve years after the transfer of shares, and
• The realization events "expiration of 20 years" and "termination of employment" are to have no significance and thus not trigger taxation if the employer irrevocably declares on a voluntary basis that it assumes liability for the wage tax to be withheld and remitted. In these cases, only the subsequent fact of "Exit" should trigger taxation. The otherwise usual, liability-discharging notification is thus not to be possible for the employer.
• Furthermore, the possibility of a flat-rate taxation of 25% is to be created. According to the current legal situation, the taxation to be made up for under Section 19a EStG is to be carried out on the basis of the individual wage tax deduction characteristics (tax class, allowances, etc.). In order to mitigate any high tax burdens that may arise at this point, the option of lump-sum taxation at a flat rate of 25% has been created. The employer is liable for this lump-sum wage tax. It can be passed on to the employee if appropriate contractual agreements have been made.
• Finally, the scope of application of the provision is to be extended to include cases where the shares in the company are transferred to the employee not by the employer itself, but by the (founding) partners. This is intended to cover a situation that is typically encountered in practice.

With the possibility of the employer assuming liability for wage taxes, the realization facts are defused. Furthermore, the provision is made much more attractive by the possibility of lump-sum taxation and the inclusion of other practice-relevant cases.

Furthermore, the tax-free amount for employee shareholdings (Section 3 No. 39 Sentence 1 EStG) is to be increased from the current EUR 1,440 to EUR 5,000. This means that an amount of EUR 5,000 shall always remain exempt for taxation purposes and reduce the tax base. If the monetary benefit granted is higher, the entire income does not have to be taxed, but only the part of the income exceeding the allowance is taxable.

There will be no change with regard to the eligible asset, which are already listed exhaustively in the current version of the provision (Section 19a of the German Income Tax Act in conjunction with Section 2 of the Fifth Capital Formation Act - Fünftes Vermögensbildungsgesetz). The asset must exist in the employer's company. In particular, these are 

• stocks, 
• GmbH shares, 
• convertible bonds and profit participation bonds (Wandelschuld- und Gewinnschuldverschreibungen), 
• profit participation certificates (Genussscheine), 
• profit participation rights (Genussrechte), 
• cooperative shares (Genossenschaftsanteile), 
• dormant holdings (stille Beteiligungen) or 
• a loan claim against the employer company. 

According to the draft bill (Referentenentwurf), however, there is to be a renewal to the effect that asset in other companies belonging to the employer group are also to be considered as eligible assets.

In the future, it will remain the case that the company must grant the participation in addition to the salary that is owed anyway. This means that cases of salary conversion (Gehaltsumwandlung) are not favored under Section 19a EStG. This is intended to avoid undesirable arrangements (salary optimization).

Finally, even after the planned changes, it remains the case that the provision only favors so-called "genuine" participations. This refers to employee participation plans in which "real" shares in the employer's company are transferred to the employees free of charge or at a reduced price. Thus, so-called virtual employee stock ownership plans (VSOPs) are not covered by the regulation.

Overall, the Future Financing Act is intended to significantly expand the scope of application of the tax deferral model of Section 19a EStG and improve its practicality.

In a follow-up newsletter, we will deal with further interesting topics, such as the question of whether it is worth converting a VSOP into an ESOP against the background of the above, or the question of whether shares in a U.S. stock corporation also fall within the scope of Section 19a of the German Income Tax Act (EStG) and qualify as eligible asset.