Share Grants to Employees under the Draft Future Financing Act (Zukunftsfinanzierungsgesetz)

Tax Improvements and Remaining Obstacles

In mid-April, the Federal Ministry of Finance (Bundesfinanzministerium) and the Federal Ministry of Justice (Bundesjustizministerium) presented the draft bill for a so-called Future Financing Act (Zukunftsfinanzierungsgesetz – "ZuFinG"), which is intended, among other things, to improve the tax framework for ESOPs of startups.

This is the German government's response to ongoing criticism of the current Section 19a of the German Income Tax Act (Einkommensteuergesetz – EStG), which particularly affects ESOPs of startups. The main points of criticism are the narrow scope of application and the deferred taxation regime – ultimately, the problem of dry-income taxation is not sufficiently solved.

The draft bill takes up these points and, in particular, provides for the following improvements:

• Expansion of the scope of application of Section 19a EStG;
• Improvements to the deferred taxation rules, particularly in the event of a change of employer;
• 25% lump sum (flat) taxation (Pauschalbesteuerung) of the benefit in-kind.

However, no amendments of the company law have been proposed. The existing limitations (specifically: the restriction of shareholders' rights) therefore remain and are likely to continue making broad adaptation of the new rules difficult.

The proposed new tax regulations should be welcomed in every respect. They will lead to an internationally competitive taxation framework. However, in order to achieve the hoped-for breakthrough for internationally competitive ESOPs – especially for early-stage startups – company law would have to catch up. Naturally, it remains to be seen how the draft bill will "develop" in the legislative process.

The draft bill contains, in particular, amendments to Section 19a EStG, each of which is to come into force on January 1, 2024, and which we explain in more detail below:

1. Extended Scope of Application for the Grant of Shares to Employees

1.1 Rules Apply to Larger and Older Companies

Section 19a EStG requires that the employer's company does not exceed certain (SME) thresholds at the time of transfer of the shares. These parameters are to be doubled so that larger companies can also be covered by Section 19a EStG:

• Up to 500 employees (previously: 250 employees),
• annual turnover of EUR 100 million (previously: EUR 50 million) and
• annual balance sheet total of EUR 86 million (previously: EUR 43 million).

The temporal frame of reference is also to be extended:

• It is sufficient if the three above-mentioned thresholds were met at the time of the transfer of the shares or in one of the six preceding calendar years (previously: at the time of the transfer or in the preceding calendar year).
• The date of formation of the company may be up to 20 years in the past at the time of the transfer of the shares (previously: twelve years).

1.2 More Constellations are covered, e.g., Company Groups

In the future, additional case constellations are also to be covered by Section 19a EStG that were previously not or not explicitly covered by the regulation, namely cases,

• in which the shares are not transferred by the employer itself but by a shareholder of the employer, e.g., a founding shareholder, and
• in which shares in parent companies, subsidiaries and sister companies are granted, i.e., shares in affiliated (group) companies within the meaning of Section 18 of the German Stock Corporation Act (Aktiengesetz – AktG).

The background is, on the one hand, that shares in the employer's company that are to be transferred to employees are often held by shareholders that already hold equity, e.g., the founders. On the other hand, company group constellations are also to be covered, which are typical especially for startups operating internationally and certain regulated companies.

2. Improvement of Deferred Taxation Rules

The dry income problem in Section 19a EStG, i.e., the risk of (wage) taxation on the basis of share values (benefit in-kind) without a corresponding inflow of liquidity for the employee, is to be mitigated in three respects:

2.1 Longer Maximum Period of Deferral of Taxation

Firstly, the so-called long stop taxation is to occur only after 20 years (previously: twelve years). Long stop means that the (wage) taxation of the benefit in-kind from the shares granted takes place at the latest through the passage of time if no other taxation event has been triggered by then.
According to the draft, this postponement of the final taxation date will also apply to shares that were granted under the current law.

2.2 Further Deferral of Taxation in Case of Voluntary Assumption of Liability by the Employer

Secondly, the draft bill provides that taxation which, according to the current law, is triggered by termination of the employment relationship or by the long stop (see above) and thus leads to taxation of dry income, is omitted under certain conditions and is deferred further into the future, i.e., regularly until the point in time at which the employee disposes of the shares, i.e., sells it, e.g., as part of an exit.

The prerequisite for this further deferral of taxation is that the employer irrevocably declares, at the latest in the context of the wage tax filing following the expiry of the 20 years or the termination of the employment relationship, that it is liable for the wage tax that arises (likely in the future). A liability-discharging declaration by the employer, as otherwise provided for in the wage tax law, is then no longer possible. On the basis of the employer's declaration, the tax office is supposed to be able to examine the facts (e.g., as part of an external wage tax audit) and, if a taxation event occurs, to assert tax claims against the employer without further discretionary examination.

This is intended to provide a course of action to avoid taxation of dry income. A typical example is the employee leaving the company (termination of the employment relationship) but being allowed to keep the shares (at least in part). If, in this situation, the employer assumes liability for the tax (which will only arise in the future), no taxation event is triggered at the time of leaving, but only when the (former) employee actually sells or transfers the shares. The employer's liability secures the tax authorities' tax claim, especially in cases where the employee has moved abroad at the time of disposal.

2.3 Leaver Cases: Taxation on the Basis of the Remuneration for the Shares

Thirdly, in so-called leaver cases, it is to be ensured that only the remuneration actually paid to the employee is relevant as the basis for taxation. This refers to leaver cases in which the employee leaves the company, and the company reacquires the shares – either because the shares have not yet vested under the relevant vesting rules or because the shareholders’ agreement grants the company a call option at a certain price for such cases. For taxation purposes, only the remuneration actually paid to the employee is to be taken into account. This is intended to provide greater certainty in practice.

3. Lump Sum (Flat) Taxation

Finally, the draft bill provides for the possibility of applying a lump sum taxation at a (flat) rate of 25% for all deferred taxation events under Section 19a EStG (sale or transfer, expiry of 20 years, termination of the employment relationship).

According to current law, taxation must always be based on the personal tax rate and on the individual wage tax deduction characteristics (wage tax class, allowances, etc.).

If lump sum taxation is chosen in accordance with the draft bill, the employer generally must pay the lump sum wage tax amount but can pass the tax burden on to the employee. The amount of wages subject to lump sum taxation and the lump sum wage tax amount are then not taken into account in the employee’s income tax assessment. This means that the final tax rate – similar to the flat tax on capital income (Abgeltungsteuer für Kapitaleinkünfte) – is 25%, with no option for a test if the general rules are more favorable (Günstigerprüfung) in the event that the individual tax rate is lower. The so-called 1/5  rule (Fünftel-Regelung) to alleviate the progression effects in the case of extraordinary income then consequently does not apply.

Even if the employer has declared the assumption of liability at an earlier point in time and taxation has therefore been further deferred (i.e., upon termination of the employment relationship or upon the occurrence of long stop taxation), the lump sum taxation at 25% remains applicable.

As a result, taxation of the benefit in-kind from the share grant is put on equal footing with capital gains taxation, also with regard to the tax rate. Systematically, this can also be justified by the fact that the issue of shares at the level of the startup should not allow for a deduction of business expenses and thus not reduce its taxable income, as would otherwise be the case with the payment of wages.