On 28 May 2021, the German Bundesrat approved the so-called Fondsstandortgesetz (FoStoG), which implements a directive of the European Parliament and the Council of 20 June 2019 into German law, and was adopted by the German Bundestag on 22 April 2021. The Act aims to strengthen Germany as a location for funds, in particular for venture capital funds. Germany is to become more attractive for start-up companies which are an important factor for the innovation and growth potential of the German economy. In future, start-ups will be able to grant their employees equity awards more easily in turn enabling them to attract (and retain) talent. In an international comparison, the tax framework applicable so far in Germany with respect to equity awards has been very unattractive.
Current tax regime
Under the current system, the transfer of shares in a corporation to an employee at a price below the fair market value results in income taxation of the employee, although the employee does not receive any cash (the so-called dry income). The employee must therefore pay the income tax due from other sources of income. As the general tax allowance for equity awards was previously only EUR 360 per year, whilst remaining subject to further requirements, actual equity participations of the employees have (so far) not proven attractive in Germany. For this reason, phantom stock awards were regularly granted as the preferred option.
New tax regime
The new Section 19a EStG provides for a temporary tax exemption of income from employment resulting from the transfer of shares to the employee at a price below the fair market value and
applies to all transfers after 30 June 2021. To benefit from the tax exemption, the equity award must be granted in addition to the regular salary.
Eligible companies are such founded no more than twelve years ago and qualifying as small or medium-sized enterprises at the time of the transfer or in the preceding calendar year. To qualify as a small or medium-sized enterprise, the following thresholds must not be exceeded:
- fewer than 250 employees,
- no more than EUR 50 million in annual sales, and no more than 43 million euros in annual balance sheet total.
Under the Section 19a EStG, the taxation occurs twelve years upon the transfer of the shares to the employee or - if earlier - at the time of the transfer of the shares by the employee (either against payment or not) or at the time of the termination of the employment relationship.
In general, the value of the shares at the time of their transfer to the employee is decisive to determine the taxable amount. If, however, the fair market value of the shares has decreased by the time of the taxable event, this lower fair market value (less any payments made by the employee) will be taxed as income from employment. This does not apply so far the decrease in value has not been caused by operations or is due to the corporate law measures, in particular the payment of dividends or repayment of capital. The increase in value and dividend distributions are, on the contrary, generally subject to the 25% flat income tax rate or, if certain requirements are met, subject to the so-called partial income procedure, according to which 40% of the realized income is tax-free.
In case the employment relationship is terminated, the law provides for further relief stating that in any such case the wage tax assumed by the employer does not have to be treated as taxable salary.
The new Act also provides that the responsible tax office must issue a binding wage tax ruling confirming the taxable benefit in kind not taxed by the employer. This is to avoid any future arguments with the tax authorities about the value of the shares at the time of their transfer.
The new provision also applies if the shares are held indirectly by the employee via a partnership. Such indirect ownership structure is often implemented in practice to avoid notarization of the transfer of shares in corporations in case of changing employees.
Applicable tax regime
If the taxable event occurs three years or later after the transfer of the shares to the employee, the taxable benefit in kind can be made subject to the so-called one-fifth-rule which might result in a lower income tax burden for the employee.
The temporary non-taxation by the employer in the wage tax procedure at the time of the transfer of shares to the employee is subject to the employee’s approval. It is not possible for the employee to opt for the taxation when filing the income tax return.
Social security treatment
The temporary exemption does not apply to social security contributions. Therefore, social security contributions are due at the time of the transfer of the shares to the employee provided the applicable social security contribution ceilings have not yet been exceeded. It remains to be seen whether the German legislator will align the social security treatment with the tax treatment as urged by the Bundesrat.
Tax allowance for equity awards
From 1 July 2021, the annually available tax allowance for equity awards in the amount of currently EUR 360 in accordance with Section 3 No. 39 EStG will increase to EUR 1,440 and will thus already apply for the current fiscal year 2021. This shall incentivize all employers (not only start-ups) to grant equity awards to employees. However, the tax allowance only applies if all employees employed by the company for one year or more are eligible to participate in the plan. In addition, only real equity participations (in contrast to phantom stock) qualify for the tax allowance. Therefore, the tax allowance is not available if only selected employees are eligible to participate in the plan or phantom stock is granted.
Moreover, despite its increase, the amount of the tax allowance is still modest compared to other European jurisdictions. The Bundesrat had campaigned for an additional allowance of EUR 3,000, however, with no success.
As of 1 July 2021, start-up companies will be able to grant shares to employees in a tax efficient way: The taxable event will be postponed while the increase in value in the shares as well as the dividends will be taxed as income from capital investment either at the flat income tax rate or by applying the so-called partial income procedure. This is the greatest advantage when comparing "real" equity participation to phantom stock. For this reason, it is worth reconsidering the currently applicable phantom stock plans and possibly replacing them by real equity participation or to prefer real equity over phantom stock in the future.
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