December 03, 2020 Briefing

SMP Briefing
New rules for German ESOP taxation: The Federal Ministry of Finance publishes draft of new rules on taxation of employee stock ownership plans – a real opportunity for startups?

The German Federal Ministry of Finance has presented a draft bill aiming to improve the tax framework for employee stock ownership plans (ESOPs) for startups in response to growing criticism of the current rules expressed by the startup industry in an area considered fundamental for the success and global competitiveness of German startups.

This SMP Briefing summarizes the current legal situation and presents the general concept and the main requirements of the draft bill. Based on this, we then explore whether the proposed bill would indeed improve the attractiveness of employee participation schemes for startups and their employees and examine what conditions would have to be met in order to benefit from the new rules.


A. SummaryI. Content of the new rules

  • The draft bill only applies to discounted acquisitions of shares by employees (e.g. when options are exercised).
  • No changes are planned for so-called virtual plans (VSOPs).
  • Pursuant to the proposed new rules, the tax imposed when shares are acquired at a discount (an option is exercised) may generally be deferred until the employee sells his/her shares. However, mandatory taxation occurs after ten years or when the employment is terminated.
  • The tax base as well as the tax rate will not be changed.

II. Assessment

  • We welcome legislative efforts addressing the topic of employee stock ownership in startups.
  • The tax position of employees will particularly improve with respect to option programs that allow an acquisition of shares irrespective of an exit or an IPO. However, this is an extremely rare case in German startups.
  • From the point of view of founders and investors of startups that are set-up as German limited liability companies (Gesellschaft mit beschränkter Haftung, GmbH), equity participation plans that allow employees to acquire shares in the startup generally are not advisable because German corporate law does not provide sufficient legal protection against excessive influence of the employees acting as shareholders on the business of the startup. The ministry has not made any suggestions for revisions in that respect (e.g. by creating a new share class with limited minority protection). It is generally possible to address this issue by interposing a limited partnership (Kommanditgesellschaft, KG) as a pooling vehicle for employee participations. However, this increases the structural complexity and gives rise to certain legal and tax risks.
  • From the employees' point of view, the mandatory taxation after ten years and upon termination of the employment creates a significant tax risk. In addition, the high level of uncertainty with regards to the valuation of shares in startups (and the resulting consequences for taxation) is not addressed in the draft at all, creating a high level of uncertainty for employees. In this context, a participation plan aiming to benefit from the draft bill currently appears very unattractive for employees.
  • In light of the shortcomings of the draft bill, we cannot currently recommend offering new employee stock ownership plans or converting existing programs accordingly. Market standard exit or IPO-related option programs or virtual programs remain the more favorable option for the time being. We remain hopeful that the draft bill will be revised during the legislative procedure, taking these aspects into account. 

B. Current legal situation and its weaknesses

I. Current situation

Pursuant to the law currently in force, the discounted acquisition of shares by an employee is considered employment income (monetary benefit) and is thus subject to income tax. Taxation is triggered once the employee acquires the shares, i.e. in the case of option programs, once the option is exercised.

A tax is imposed on the difference between the fair market value of the shares at the time of acquisition (or exercise of the option) and the price paid for the shares (in the case of options: the strike price).

The tax rate is based on the general progressive income tax rate and may therefore amount to up to 47.5% (including solidarity surcharge, excluding church tax).

The employer is obligated to withhold and pay salary tax in the corresponding amount from the employee's current salary.

If the employee sells the shares later on, a withholding tax rate of approximately 26.4% is imposed on the amount of the difference between the value of the shares when acquired (i.e. when the option was exercised) and the sales price (including solidarity surcharge, excluding church tax).

This means that the discounted acquisition of the shares (exercise of options) gives rise to a considerable tax burden even though the employee does not receive any liquidity (dry income). Bearing in mind that the sale of shares of startups may be difficult – due to certain sale restrictions or a lacking market – the employee must pay these taxes with other means.

Additionally, the imposed tax depends on the value of the shares at the time of acquisition or exercise of the option. The determination of this value is, however, prone to immense uncertainties. Furthermore, German tax authorities often refuse to issue private letter rulings relating to the value of shares. Without such binding rulings it is impossible to reliably assess the impending tax payments and make correct tax filings.

II. Practical experience and problems

Due to the previously mentioned difficulties, employee stock ownership plans in German startups are practically only offered in the form of options that may only be exercised when the startup is sold to a third party (exit) or in the case of an initial public offering (IPO). Under these plans, the employee has the option (or even obligation) to immediately resell his received shares either completely or partly, which enables him/her to use the proceeds to pay the imposed taxes. Alternatively, many startups offer virtual shareholdings, granting the employee purely contractual claims on a certain amount of the profit from the sale of shares in the event of an exit or IPO. Taxes are then only imposed at the time of the payment, which may be used to pay the imposed tax.

From a startup's point of view, allowing employees to participate in the company as shareholders may generally be desirable. Accordingly, the Federal Association of German Startups (Bundesverband Deutscher Startups) has requested that such equity participations should be made possible without tax risks for startups and their employees in its study "ESOPasap". Such participation could create an even closer bond between employees and the company and further the alignment of their interests. In addition, employees could benefit from the preferential taxation of capital income in the event of future increases in value of the company, like financial investors, after the shares have been acquired (the option exercised).

Currently, a tax exemption of 360 euros is the only preferential treatment for employee stock ownership plans provided for under German tax law. However, this exemption requires the scheme to be open to every employee having been employed in the business for at least one year. As employee stock ownership plans in startups are often only granted to particularly talented and qualified employees, this tax-free allowance is therefore practically irrelevant for startups.

The "ESOPasap" study by the Federal Association of German Startups claims that the current law puts the competitiveness of Germany as a business location for the tech-industry at risk.

C. Content of the draft billAccording to the federal ministry of finance's draft bill, the planned provision intends to double the tax exemption pursuant to Section 3 No. 39 of the German Income Tax Act (Einkommensteuergesetz, EStG) to 720 euros. Due to the fact that the conditions of granting the exemption remain unchanged, this revision will most likely not be relevant for startups but rather only benefit large, listed companies that allow all of their employees to acquire discounted shares.

Conversely, the proposed addition of Section 19a to the German Income Tax Act (Einkommensteuergesetz, EStG) specifically targets startups. It allows for a tax deferral, meaning that taxes will not be imposed when discounted shares are purchased or an option is exercised. Taxes will, however, be imposed mandatorily at a later point in time:

1. Once the employee transfers his/her shares, whether in exchange for a payment or free of charge.
2. Once ten years have passed since the acquisition of the shares.
3. Once the employment is terminated.

The tax deferral is subject to the condition that the company qualifies as a small or medium enterprise (SME) as defined by the European Commission when the shares are acquired or in the previous year and no more than ten years have passed since the company was founded. This means that the startup must have fewer than 250 employees and an annual turnover below 50 million euros.

The new regulation does not provide for any changes regarding the tax base and the tax rate. Accordingly, the regular income tax rate will continue to be imposed on the difference between the fair market value of the shares when acquired (or an option is exercised) and the price paid (strike price). However, if the value of the shares has decreased by the time of the actual taxation, the new regulation provides that taxation is to be based on the lower value.

The tax deferral may only be applied in the wage tax withholding procedure if the employee consents and certain documentation requirements are met. It cannot be claimed in later tax filings by the employee.

According to the draft, the new regulations will affect acquisitions of shares as of July 1, 2021.

D. Legal and practical assessment of the draft regulation If existing employee stock ownership plans meet the requirements outlined above, they should fall within the scope of the new regulations. Due to the fact that the applicability of the new regulations is determined by the time at which shares have been acquired, the new rules will only concern existing option programs if and insofar as options are exercised after June 31, 2021.The draft regulation is irrelevant for so-called virtual, purely contractual programs.

The objective of the draft regulation is to avoid taxation at the time of the discounted transfer of the shares and impose taxes only when these shares are sold. This should serve to avoid dry income taxation situations, which is a major disadvantage of the current system. To support this objective, decreases in the value of the shares until the actual taxation reduce the tax base resulting in limited or no taxation at all if the value of the shares is completely lost. This is a welcome and systematically reasonable development. Further, the reference to the definition of SMEs pursuant to EU law is a workable solution and ddoes not give rise to similar legal and practical concerns as the requirement to qualify for certain German public funding programs which had been suggested in an earlier draft of the bill.

1. Problem: Taxation after ten years
However, this objective will no longer be achieved if taxation is definitively triggered after ten years. Even if startups often aim for an exit or an IPO within a time period of ten years and, in many cases, an assessment, whether the company has developed a viable business model, can be made within such time period, this is not always the case. With certain business models it may take more than ten years to develop a compelling product and a company that may be ready for an exit or IPO.

2. Problem: Taxation upon termination of employment
The mandatory taxation incurred when the employment is terminated is extremely problematic. If this remains a part of the final draft, German startups are unlikely to set up employee stock ownership plans in which shares can be acquired by employees that could qualify for the deferred taxation.

Acquiring shares (exercising options) would create an unacceptable risk for employees, as any termination of the employment would potentially result in a significant tax burden without receipt of any liquidity. This is particularly relevant for the startup industry, in which changing employers happens relatively frequently and flexibility is of great importance for employees. A termination would not only result in a job loss for the employee but may also create a considerable tax burden. Taking into account the immense bargaining power this would give to employers and the principle of free choice of occupation in German law, this strongly conflicts with the general intention of the draft bill.

Under these conditions, it is unlikely that an employee would be willing to acquire shares in the employer's company. The rules would fail to meet the general intent of the draft.

3. Problem: Share valuation
Furthermore, the new rules do not address the problem of share valuation at all. Against the backdrop of the immense legal uncertainties surrounding the valuation of startups for German tax purposes, tackling this issue would be a fundamental prerequisite for a practicable and marketable employee stock ownership plan in which employees are to be given shares of an unlisted startup company (at least for as long as taxation is based on the fair market value upon acquisition).

While the reduction of the tax base in case of a subsequent decrease in value ensures that the taxes that become due never exceed the sales proceeds, the problem of valuation is not at all solved by this provision. Employees will still be burdened with incalculable tax risks, especially when a mandatory taxation is incurred after ten years or upon termination of the employment.

Only if tax law provides for fixed standards to determine the relevant value and requires tax authorities to issue rulings that are binding for the employer and the employee in this respect, a level of legal certainty could be achieved that would allow startups to set-up attractive employee stock ownership plans. If we look beyond our own national borders, there are numerous examples for such schemes (see also the study "ESOPasap").

4. Problem: No separate share class
Regardless of the previously mentioned problems, a tax regime allowing for the deferral of taxation until the receipt of liquidity will only be attractive for German startups, if it is accompanied by regulations under company law. Founders and investors of startups will only be open to grant employees full equity participations if company law ensures that the employees will not, by their position as shareholders, be able to impair the company's ability to function or exit, and if issues of confidentiality are considered. In particular, there is a necessity to preclude the risk of an abuse of information rights, the potential blocking of waivers regarding any time and form requirements for the announcements, the preparation and implementation of shareholder resolutions, the challenge of any shareholder resolution as well as the blocking of an exit.

One way to achieve this would be to introduce a separate share class for employee shares. This has also been proposed by the Federal Association of German Startups in its "ESOPasap" study. Alternatively, employees could hold their participation through an employee-pooling limited partnership (Kommanditgesellschaft, KG). As this may give rise to certain legal and tax risks, drafting a model contract for such an employee-pooling limited partnership that is recognized by the legislator with regards to its legal and tax consequences might be worth considering.

E. ConclusionThe draft is the first attempt to improve the tax framework for employee stock ownership plans for startups in Germany and a welcome step in the right direction.

However, on the basis of the current draft, considerable tax risks for employees remain, particularly in view of mandatory taxation in case of a termination of the employment and the lack of clear guidelines on share valuation. A participation scheme based on the draft bill would therefore hardly be an attractive offer for employees.

From the founder's and investor's viewpoint, the draft lacks accompanying company law regulations precluding the possibility for employees to impair the company's ability to function and to carry out an exit transaction through their position as shareholders. Without such accompanying regulations it will be practically impossible for German startups to grant their employees full equity participations.

Unless the draft is further revised and improved, we cannot currently recommend that startups offer new employee stock ownership plans under the new regulation or to convert existing programs accordingly. In the meantime, exit- or IPO related option programs and virtual programs still remain the preferred option. With the current draft, the well-intentioned initiative risks failing to have the desired effect – to promote both, employee participation schemes as well as Germany as a business location.