Employee participation plans under the Future Financing Act (Zukunfts­finanzierungs­gesetz) – Important changes and practical implementation

In mid-2021, the Fund Location Act (Fondsstandortgesetz) added to section 19a of the German Income Tax Act (Income Tax Act) (Einkommensteuergesetz) a tax deferral provision for employee participation plans at small and medium-sized enterprises (“SMEs”) to counteract the “dry income issue” (a situation when shares that employees receive in their company are subject to (income/wage) tax at acquisition even though the employees have not yet received any liquid funds). The initial purpose of the tax deferral, which targets German start-ups in particular, was to strengthen employees’ incentives by using real ownership (employee stock ownership plans – ESOPs), which are more valuable than the plans currently most often used to avoid the dry income issue, virtual stock ownership plans (VSOPs). A mere 2.5 years after its introduction, the provision has now been substantially improved once again. Under the Future Financing Act, its scope of applicability has been expanded and amended to reflect requirements in the venture capital environment. Although some of the amendments do not measure up to the adjustments originally envisaged in the draft Future Financing Act, they will probably give ESOPs a long-awaited boost (see below under Part A).

Because ESOPs can lead to lower taxation of disbursements (dividends or exit proceeds) taxed as capital income (tax rate usually 25% plus solidarity surcharge and church tax where applicable), they offer a clear tax advantage over VSOPs, which are subject to the employee’s regular income tax (tax rate up to 45% plus solidarity surcharge and church tax where applicable) and social security tax up to the income threshold. From a practical viewpoint, the question arises as to how ESOPs can be structured in a more advantageous manner in the future and whether and how existing VSOPs can be transformed into advantageous ESOPs (see Part B below for a summary of the challenges involved in practical implementation).

A. Changes brought about by the Future Financing Act

To make ESOPs more attractive, the Future Financing Act includes the following changes that have been generally applicable since 1 January 2024:

• The (annual) tax-free amount found in section 3, no. 39 of the Income Tax Act has been increased from EUR 1,440.00 to EUR 2,000.00. However, a prerequisite for the tax-free amount is that the ESOP is made available to all employees who have been employed for more than one year. This relegates the tax-free amount to a rather minor role in practice.
• ESOPs can now (also) be offered by the shareholders (or founders/investors), which is a better fit with the structural reality of the PE/VC environment.
• To profit from the tax deferral, an employer company must not exceed certain size thresholds, which have been significantly increased. Now, companies are eligible if they (i) have fewer than 1,000 employees and (ii) do not exceed a balance sheet total of EUR 100 million or turnover of EUR 86 million. It remains advisable to monitor the prerequisites for the time required to establish conformity with the threshold values, but these prerequisites have likewise been made more favourable.
• The maximum age for a qualifying employer company at the time the participation is granted has been increased from 12 to 20 years.
• The maximum duration of the tax deferral has been increased from 12 to 15 years. This gives recipients of ESOPs more time before taxation. However, the tax deferral still always ends prematurely in case of exit (or other liquidation of the participation) or upon termination.
• A theoretical dry income event can still occur if 15 years have expired without an exit or termination; this can now be prevented by an additional tax deferral (“Extended Tax Deferral”) until the actual sale/liquidation. However, this option requires the employer to irrevocably declare that it assumes unconditional liability for the income tax upon subsequent sale/liquidation.
• Another new provision also impacts valuation advantages in “leaver” cases (end of the tax deferral due to termination). As previously, if the tax deferral ends (see above), the maximum taxable amount is capped at the market value when the tax deferral began, i.e. when the ESOP was granted (“entry value cap”), but if the market value is lower at the end of the tax deferral, only the lower value is used for taxation (“lower current value cap”). However, the remuneration actually paid to the “leaver” is now decisive instead of the lower current value cap (with the entry value cap continuing to apply). This provision in particular privileges “bad leavers”, who usually have to assign their shares for an amount equal to the acquisition price or substantially lower than the market value.

B. Challenges in practical implementation

I. Structuring goals under corporate and tax law

Corporate and tax laws pose a few challenges that must be met in order to be eligible for the tax deferral now found in section 19a of the Income Tax Act and ensure that the proceeds from ESOPs are subject to more advantageous taxation as capital income:

• Due to corporate governance considerations and to ensure exit ability, existing shareholders (founders/investors) often do not want a number of micro-shareholdings in the employer company to be established. The options for resolving this situation (vote pooling, trust agreements, sub-participation, pooling vehicles, alternative participation forms) should be considered on a case-by-case basis and vetted and/or structured according to compatibility with the tax deferral provision. This applies in particular to structuring indirect ESOPs via pooling vehicles in the legal form of a limited partnership with a limited liability company as its general partner (GmbH & Co. KG) (possibly taking into account intermediate “warehouse companies”), but also specific structuring of alternative forms of participation such as profit participation rights.
• ESOPs typically involve special reservations of consent, as well as the participants’ rights and obligations under the articles of association or shareholders’ agreements (vesting/bound share disposal/leaver rules; tag-/drag-along rights, etc.). These contractual stipulations are usually included by the German fiscal courts to determine whether a participation offered to employees results in a special legal relationship (if so, preferential taxation of the proceeds in the holding phase or as capital income upon exiting) or (remains) a result of the employment (if so, taxation of the proceeds during the holding phase or upon exiting as employee compensation). Consequently, the entire set of ESOP contracts is to be structured as tax-efficiently as possible, and the desired tax consequences are to be secured, possibly by procuring (payroll) tax rulings from the financial authorities or using tax insurance products (which can already be seen to exist on the market).

II. Applicability to indirect participation structures

Practical challenges are also inherent in indirect participation structures (as typically found in private equity situations). In these situations, foreign or domestic partnerships that hold the shares in the company and do not have any operating assets under tax considerations (e.g. in the form of non-commercial GmbH & Co. KGs, also called “ESOP KGs”) are often interposed. In such structures the employees participate in the ESOP KG as limited partners, and their shares are usually sold by a “warehouse company” or reacquired in the case of a leaver. The warehouse company is usually held by the shareholders of the employing company. As regards taxation, particularly the following challenges result:

• A situation only falls under the scope of section 19a of the Income Tax Act if shares are granted by the company or its shareholders. However, in the structure described above, the limited partners’ shares are transferred by the interposed warehouse company according to civil law. If the structure in regard of taxes is solely asset administering (i.e. if not only the pooling vehicle but also the warehouse company is a non-commercial partnership), it can be argued that the shares in the employer company are to be attributed to the shareholders based on the proportionate attribution found in section 39 of the German Fiscal Code (Abgabenordnung) and that in terms of taxation, it was actually the shareholders that granted the shares. If a structure regarding taxes is not (completely) asset-administering, the indirect shareholding position (possibly in combination with the proportionate attribution) could be invoked. In certain situations, it could be advantageous to use a fiduciary solution in which the warehouse company merely holds its shares in the ESOP KG in trust for the employer company’s shareholders.
• A similar issue arises with the deemed value in cases of leavers, where, during reacquisition of the participation as a result of termination, the reference value for (income) taxation is to be the amount actually paid to the employee by the employer instead of the common value. It is questionable whether remuneration paid via the warehouse company can be classified as “remuneration granted by the employer” within the meaning of the second clause of the fourth sentence of section 19a(4) of the Income Tax Act because in that case there is no reference to the shareholders or group companies. If necessary, trust structures can provide legal certainty in this situation as well.

In any case, it is advisable to ensure the viability of tax structures that arise when a legal entity is interposed (which involve not only the abovementioned issues but also questions in regard to issues such as general share realization concerning joining or leaving employees but also changes in the employer’s shareholders) by means of binding information or income tax information from the financial authorities or by a tax insurance solution.

III. Significance of the employer’s liability declaration for the “Extended Tax Deferral”

A requirement for an Extended Tax Deferral (see Part A above) is that the employer irrevocably assumes liability for the income tax. The (income) tax is not assessed upon termination of the employment or after 15 years have expired, as is the case for an initial tax deferral, but rather not until the actual liquidation of the participation by the employee (usually in the context of a subsequent exit).

An Extended Tax Deferral will probably be particularly relevant when leavers are involved:

• Provisions in ESOPs regarding leavers usually provide for reacquisition of the shares by the employer or the shareholders (call option).
• If the call option is exercised, the remuneration or severance payment paid to the employee is to be subject to (income) tax in consideration of the entry value cap.
• If the call option is not exercised, the employer’s declaration of assumption of liability makes it possible to avoid immediate taxation in a leaver case. It remains to be seen whether this liability declaration will become common practice because it subjects the employer to the risk of being forced to collect the income tax from the employee, which can become impossible, for example, if the employee’s whereabouts are unknown. One possible solution would be to combine the employer’s declaration of liability with an agreement regarding retention and setting off or assignment of some of the exit proceeds from the shares. This would give the employer access to the proceeds to use them to cover the income tax of the (former) employee. However, such proceeds distribution arrangements would only be safe from insolvency and enforcement if they were anchored in the articles of association and/or secured by a lien.
• Additional implications can arise for the tag-/drag along clauses usually contained in partnership agreements. They usually stipulate that employees are obliged to sell their shares at the same conditions as those of the investor. However, if, according to what has been said above, some of the purchase price is paid not to the former employee but to the employer, this might constitute unequal treatment; as a precaution, the clause should permit this as a precaution to ensure that it is enforceable.

IV. Transforming VSOPs into ESOPs

The fact that the tax aspects of ESOPs are more attractive than those of VSOPs could lead especially start-ups and SMEs to consider transforming their existing virtual stock option plans into ESOPs. Such restructuring is basically possible.

If and to the extent that a company intends to transform a VSOP into an ESOP, as far as possible, the transformation should be the same for everyone who participates in the plan to avoid any labour law risks related to the German General Equal Treatment Act (Allgemeines Gleichbehandlungsgesetz). The company should enter into an agreement with each beneficiary that includes the termination of the VSOP and the conditions of the new ESOP. Depending on the structure, each governing body of the company might need to grant its consent to the transformation.

From a tax viewpoint, the structure of the VSOP that is in place is critical. The transformation of a vested claim arising from a VSOP into an ESOP could be considered as advance disposition subject to income tax of a VSOP claim for granting the ESOP. The result would be that this transaction would have to be considered a flow of funds from the VSOP equal to the amount of the ESOP. Such a premature disposal flow would not be privileged under section 19a of the Income Tax Act.

But even for VSOP claims that have not become vested, the question would arise as to whether section 19a of the Income Tax Act is applicable because this assumes that the ESOP shares are granted in addition to the employee compensation that was already owed. If not-yet-vested VSOP claims were classified as “owed employee compensation”, this prerequisite would not be fulfilled. However, in our opinion, the reasons for not classifying these claims as owed employee compensation seem to carry more weight, particularly because they had not yet arisen on the date of transformation and thus were not owed.

Because the boundary between vested and unvested claims is blurry and the evaluation of a transformation under tax law varies from case to case, procuring binding information or income tax information from the financial authorities or using a tax insurance solution should be considered for each individual case.

C. Outlook

Legislators have used the Future Financing Act to expand the scope of applicability of the tax deferral provision in section 19a of the Income Tax Act for ESOPs at companies from start-ups to medium-sized companies and made (direct and indirect) real stock ownership more attractive. The response to the amendments, particularly in the venture capital scene, has been consistently positive, so an increase in the number of ESOPs can be expected. The practical implementation requires attention to some challenges that can arise in individual cases. Feel free to contact us.