In the latest Financing for the Future Act (Zukunftsfinanzierungsgesetz) draft, the German government made significant adjustments to the intended tax relief for employee share ownership plans (employee shares).
In this article, we explore the main differences between the original draft bill and the current government draft and provide a summary of the proposed improvements to the tax framework for employee shares.
Under the government draft, improvements to the tax framework for employee shares are intended to make asset formation more attractive to employees. In addition to increasing the tax allowance, the adjustments aim to alleviate the problem of so-called “dry” income taxation in connection with employee shares.
THE GOVERNMENT DRAFT VS. THE ORIGINAL DRAFT
In Section 3 no. 39 EStG, there are plans to raise the tax allowance for employee shares from €1,440 to €5,000. In a departure from the original draft bill, the government draft includes a tax benefit of up to €2,000 that may be granted by means of deferred compensation. A tax benefit exceeding this amount would still have to be granted in addition to the salary owed.
Under Section 19a EStG, the company-related employee threshold for claiming tax deferral will increase to 1,000 employees, which is four times the current threshold for small- to medium-sized enterprises (SMEs). For the annual turnover and balance sheet total, the government draft retains the original draft bill’s increase of two times the SME threshold.
The government draft eliminates the option to tax the tax benefit from the discounted transfer of employee shares at a flat wage rate of 25% in cases covered by Section 19a EStG.
The government draft allows for the tax-neutral repurchase of granted employee shares (e.g., in a leaver case) provided for in Section 19a (4) sentence 4 EStG—not only by the employer or an affiliated company of the employer but also in the case of an acquisition by a shareholder of the employer.
OVERVIEW OF THE LEGISLATIVE PROPOSAL Tax Allowance Increase for Employee Shares
As previously mentioned, the tax exemption (Section 3 no. 39 sentence 1 EStG) for employee shares will increase to €5,000 annually per employee.
To limit windfall gains from targeted deferred compensation and to promote long-term participation in the employer company, the government draft includes the following supplementary provisions:
If the tax benefit exceeds €2,000 per calendar year, the benefit must be in addition to the salary already owed (i.e., limit the ability to defer compensation).
In the event of a sale or transfer of the employee shares, the non-cash benefit, which is tax-exempt under Section 3 no. 39 EStG, is to be considered as acquisition costs only after a period of three years.
If the employee shares are sold before the minimum holding period of three years, there would be no subsequent wage taxation. However, the original tax-exempt amount would be indirectly subject to the final withholding tax (25% plus solidarity surcharge and, if applicable, withholding tax) due to the higher capital gain.
The increase in the tax-free amount would make the granting of employee shares notably more attractive for both employers and employees. The requirement for a partial sale of shares to cover the payroll tax (so-called “sell-to-cover”) would only be necessary for individual grants of more than €5,000. This would benefit companies for which a sell-to-cover has previously only been possible with considerable effort due to the low trading volume of their shares.
The possibility of a limited deferred compensation of up to €2,000 per year would also allow so-called “matching models”—in which parts of the cash income are converted into company shares—to benefit from the tax exemption.
Tax Deferral Relief When Granting Employee Shares
The government draft is also intended to facilitate the possibility of tax deferral when granting employee shares under Section 19a EStG. This section, introduced in 2021, is intended to make it possible for employees of startups and growth companies to receive employee shares through tax deferral without dry income taxation. From the perspective of the employer company, this will also have a liquidity-saving effect.
The government draft would also significantly expand the scope of Section 19a EStG:
In addition to shares granted by the employer, the government draft addresses shares in the employer company granted by a shareholder of the employer. This takes into account the fact that employee shares are often not granted by the employer company itself but by the founding shareholders.
The government draft extends the deferral option to include the granting of shares in affiliated companies of the employer as defined in Section 18 AktG. The granting of shares to employees in multilevel group structures would also be included.
The government draft raises the thresholds for classification as a beneficiary employer as defined in Section 19a (3) EStG:
The employer company may not exceed twice the value of the SME threshold in terms of annual sales and annual balance sheet total (maximum €100 million and €86 million, respectively). As for the number of employees, the fourfold increase of the SME threshold to a maximum of 1,000) would replace the existing SME threshold.
The observation period for exceeding the threshold will increase from two to seven years.
The company may not have been founded more than 20 years ago (previously 12 years).
The maximum deferral period will be extended from the current 12 years to 20 years from the transfer of the asset interest (Section 19a (4) sentence 1 no. 2 EStG-E). This also applies to shares that were or will be transferred before 2024. However, taxation will continue to apply automatically if the employment relationship with the previous employer is terminated (especially in leaver scenarios).
If employee shares are repurchased by the employer, an affiliated company of the employer or a shareholder of the employer, the remuneration granted by the employer (not the fair market value of the shares) will be used to determine the tax basis (Section 19a (4) sentence 4 second half EStG). Here as well, the common practice is taken into account according to which leaver regulations regularly provide a repurchase value that deviates from the fair market value.
Following the issuance of the government draft, the parliamentary legislative process can now begin. We expect the Financing for the Future Act to become law before the end of this year.