German Fund Location Act: Employee Share Ownership Taxation

Owning shares by employees in the company they work for by acquiring them free of charge or at a discounted price is a popular way, especially among start-ups, to create employee loyalty and add value on top of the employees’ often low fixed pay.

According to a draft of the German Fund Location Act, an act on strengthening Germany as an investment fund location (German: Fondsstandortgesetz or FoG-E), passed by the Federal Cabinet on 20 January 2021, employees of start-up companies should now feel more encouraged to own shares in the companies they work for. The draft law envisages greater tax incentives for this type of employee share ownership.

Taxation according to current legislation

According to current legislation, the granting of company shares to an employee free of charge or at a discounted price constitutes a pecuniary benefit which is normally treated as taxable income. The pecuniary benefit is the difference between the market value of the share and the purchase price paid by the employee. As a rule, the pecuniary benefit accrues to the employee on the date on which he or she acquired the power of disposition over the share in the company. In the case of shares in a limited liability company (German: GmbH), this is usually the moment of concluding an effective agreement on the assignment or the takeover of shares (in the case of capital increases).

Even if the employee does not physically receive liquid funds, he or she still earns income in the form of "dry income", which is subject to income tax plus solidarity surcharge and, if applicable, church tax (maximally 47.48 per cent excl. church tax).

If the company share is later sold, any capital gain (gain from the sale > acquisition cost) is taxed as income derived from capital assets subject to final withholding tax (share ownership < 1 percent, effective tax burden of approx. 26.38 per cent incl. solidarity surcharge, excl. church tax) or according to the "partial income method" (German: Teileinkünfteverfahren) (share ownership ≥ 1 percent, 40 per cent tax-free, effective tax burden maximally approx. 28.49 per cent excl. church tax).

Taxation according to the draft law

By adding Article 19a to the Personal Income Tax Act (EStG-E), the draft law introduces a taxation deferral model. According to this new rule, if a company share is transferred to the employee free of charge or at a discounted price, taxation may be deferred subject to consent of the employee. This means that the pecuniary benefit is not immediately subject to income tax, and thus "dry income" can be taxed later. Only social security contributions are due.

The tax on the pecuniary benefit only becomes due when

the company share is sold;
ten years have passed since the company share was granted; or
the employment relationship ends.

The subsequent taxation is generally based on the market value of the shareholding at the time of granting. However, if the value of the shareholding decreased after the date of granting, these losses in value are fully taken into account for tax purposes by basing the subsequent taxa¬tion on the market value of the shareholding when realised. This means that losses in value are fully taken into account for income tax purposes, whereas increases in value are not. Increases in value are taken into account as income from capital assets when realised in the form of capital gains.

The planned taxation deferral model only applies to companies that meet the EU-defined criteria of a SME (small and medium-sized enterprise) at the time of the granting of shares and have not operated for longer than ten years. Start-up companies normally meet the following thresholds:

SME: < 250 employees, an annual turnover not exceeding EUR 50 million or an annual balance sheet total not exceeding EUR 43 million.
Small company: < 50 employees, an annual turnover and an annual balance sheet total not exceeding EUR 10 million.
Micro company: < 10 employees, an annual turnover and an annual balance sheet total not exceeding EUR 2 million.

The planned taxation deferral model should apply to company shares granted after 30 June 2021.

Conclusion

In contrast to the status quo, the presented draft law along with its tax incentives for employee share ownership is a ray of hope for start-up companies and their employees. It would be an important contribution to strengthening Germany as an innovation hub. We will keep you posted on the legislative process.