Reforming taxation of employee equity participations

Employee equity participations are very popular in M&A practice, especially in private equity and venture capital transactions. The reason for this is the interest of investors in retaining the (top) managers of the target company in the long run to keep relevant know-how within the company and to be able to increase the profitability of the investment.

In order to alleviate the previously existing problem of dry income (or phantom income) and thus to make employee participation programmes more attractive from a tax perspective, the legislator introduced a new Sec. 19a of the German Income Tax Act (ITA) with legal effect as of 1 July 2021. This article provides an overview of the new regulation and its implications for the M&A practice.

Starting point: The dry income problem

Since employees often do not have the financial means to acquire shares in the employer company at market value, shares are often transferred to employees at a discount or free of charge.

In case of an acquisition of shares at a discount or free of charge, the difference between the market value and the purchase price (= non-cash benefit) qualifies as income from employment for tax purposes and is also subject to social security contributions. The applicable tax rate is based on the general progressive income tax rate (max. 47.5%). The tax liability arises at the time of the acquisition, so the employee may be subject to a considerable tax burden without receiving any liquid funds (so-called dry or phantom income problem).

Introduction of Sec. 19a ITA

Due to the introduction of Sec. 19a ITA, taxation and the corresponding dry income problem may be postponed for a maximum period of twelve years if shares in the employer company are transferred at a discount or free of charge. In this case, wage taxes actually due are not initially levied, but only the amount of the non-cash benefit granted is recorded on the employee's payroll account. However, social security contributions are still payable at the time the shares are acquired. As an additional benefit, the tax-exempt amount of the non-cash benefit arising from the transfer of shares has been increased from 360 Euro to 1,440 Euro. The prerequisite for applying the tax exemption is, however, that the acquisition of shares must be open to all employees.

The tax deferral model under Sec. 19a ITA is applicable for all employees who are granted shares in the employer company at a discount or free of charge after 30 June 2021 alongside their normal salary. However, the model only applies to shares held in employer companies that fulfil the criteria specified in the EU’s SME definition (< 250 staff headcount, turnover < 50 million euro or balance sheet total < 43 million euro) at the time of the transfer of the shares or in the previous year and which were founded less than twelve years ago. It also applies to indirect shareholdings where shares are held in the employer company indirectly via an (asset managing) partnership. It does not apply, however, to any form of option rights – apart from the shares transferred upon exercise of a (stock) option previously granted – and virtual shares held in the employer company, as no dry income results from these cases.

The tax deferral granted under Sec. 19a ITA is not applicable in the following three cases:

all or parts of the granted shares were transferred for a consideration or free of charge;
the employment relationship with the employer was terminated; or
twelve years passed since the transfer of the shares.

If one of these criteria is met, tax becomes due, with the amount of the taxable non-cash benefit to be determined on the basis of the fair market value of the shares granted at the time of the transfer, not at the time the respective criterion is met.

Implications for M&A practice and conclusion

The introduction of Sec. 19a ITA has alleviated the dry income problem in case of transfers of shares in the employer company at a discount or free of charge and has made employee equity participations more attractive from a tax perspective. However, Sec. 19a ITA only provides for a tax deferral which automatically ends after twelve years at the latest, social security contributions are still payable at the time of the acquisition and the tax-exempt amount of 1,440 Euro results only in a small tax relief.

In addition, the new regulation provides for a narrow scope and is therefore only relevant in M&A practice if start-ups founded less than twelve years ago and qualifying as SMEs are acquired. Another point of criticism is that no statutory valuation principles have been introduced to determine the fair market value of shares in start-ups for tax purposes, so it is still difficult for employees to reliably assess the amount of the non-cash benefit they will receive from the transfer of shares at a discount.

In summary, although the introduction of Sec. 19a ITA is to be welcomed, the opportunity for a far-reaching reform of the taxation of employee equity participations has unfortunately been missed.