Last Friday, 17 November 2023, the German Bundestag passed the so-called Future Financing Act (Zukunftsfinanzierungsgesetz,"ZuFinG"). The law significantly strengthens the opportunities for employee equity participation and simplifies access to capital markets. What is going to change, what might remain - our VC, employment law and tax experts provide initial answers to the most pressing questions, in particular with respect to Section 19a EStG which stipulates a tax deferral for employee participations.
Does section 19a EStG, renewed by the ZuFinG, also apply to our company?
The scope of Section 19a EStG, which was only introduced in 2021, will be significantly increased by the ZuFinG.
In future, Section 19a EStG will still be applicable even if the European SME thresholds are exceeded materially.
- As of today, only companies (i) with less than 250 employees and (ii) an annual turnover of less than EUR 50 million or an annual balance sheet total of less than EUR 43 million have been able to benefit from the tax deferral under Section 19a EStG.
- In future, the provision will apply to companies that (i) employ less than 1,000 employees and (ii) have an annual turnover of less than EUR 100 million or an annual balance sheet total of less than EUR 86 million.
Due to the extended temporary scope, a large number of additional companies will be covered.
- In future, companies that have not exceeded the new, higher thresholds in the year of the transfer of the employee participation or at least once in the previous six calendar years will be able to make use of the tax deferral, ie within seven years.
- Companies which have been founded up to 20 years ago at the time of the transfer of the employee participation, can benefit from the tax deferral.
If shares with share transfers restrictions are granted, which is usually the case, such shares will in also be deemed to have been accrued to the beneficiary for tax purposes without limitation.
Which major advantages does Section 19a EStG stipulate for employee participations?
The major advantage of the renewed provision is the prevention of so-called dry income taxation. In General, the granting of the employee participation is taxable as a non-cash benefit (geldwerter Vorteil). In order to prevent the employee from being subject to taxation before any cash is received (dry income taxation), the ZuFinG maintains the current concept of a tax deferral, which is, however, granted for a period for up to 15 years instead of the previous 12 years. Dry-income taxation is now also excluded if a leaver event occurs and the employing company exercises the right to buy back the shares (vesting). Taxation is then not based on the market value of the shares at the time of transfer, but only on the actual payment received by the leaving employee, which in many cases will be EUR 1 per share. The generally employee advantageous rule that the market value of the shares at the time of transfer to the employee remains relevant for income tax purposes under Section 19a EStG, even if taxation is deferred for up to now 15 years, continues to apply.
However, it is important to note that the law provides for mandatory subsequent taxation at the earlier of (i) 15 years (see above) or (ii) upon termination of the employment relationship. In particular the latter is likely to have deterred many from seriously considering deferred taxation to date. According to the ZuFinG the employer can generally exclude out the threat of subsequent taxation in both cases of mandatory subsequent taxation. This comes at a price - the employer must assume the liability for the subsequent income tax in the event of an exit (more precisely: on every transfer pursuant to Section 19a para. 4 sentence 1 no. 1 EStG) and make a binding declaration of such assumption of liability. Put simply, the employer must bear the risk that the relevant amounts are not paid by the employee or are not reimbursed.
Potential assumption of liability for future income tax by the employer
Section 19a EStG relieves the beneficiary employee of the potentially considerable tax burden after the 15 years have expired or upon termination of the employment relationship if the employer irrevocably declares that it is liable for the income tax due in the event of a transfer of the shares held by the employee. Such declaration by the employer leads to an unlimited tax deferral until the exit by the beneficiary. While this solves one problem in the short term (employees do not have to worry about triggering taxes when changing employer), a new one arises: the employer who has assumed the liability must bear its economic burden and, if necessary, also recognise it as a liability in its balance sheet or seek indemnity by investors similar to exiting virtual share programs.
Will (share based) ESOP programs now becoming the new standard?
In contrast to virtual employee participations (VSOP), ESOPs grant the employee the option to purchase a predetermined number of shares in the company after a vesting period. Section 19a EStG only comes into effect when the option is exercised and the shares are issued. Only upon issuance of shares and the beneficiary becoming a shareholder, the described mechanisms of tax deferral and any declared assumption of liability will come into effect. While it is possible to structure an ESOP in a way that options can be exercised prior to an exit, it would require an additional payment by the beneficiary without having received additional financial means. If the options are (only) exercisable upon occurrence of an exit event, then the beneficiary will have to means to do so or a cashless exercise (shareholder for a legal second) will be necessary, but then the shares are only transferred at the time and at the valuation of the exit event transaction, with a respective impact on the income tax for the issuance of the shares. Taxation would depend on the fair market value of the transferred shares at the time of the exit, which will usually equal the purchase price of the exit transaction. In simplified terms, the exit proceeds would then be subject to full individual income tax; it would not be possible to defer taxation in this case.
Anticipating that future ESOPs will therefore rather provide for exercise windows prior to exit events at terms (i.p. strike prices) that will allow respective subscriptions by and issuances to beneficiaries, companies and their advisors will have to find practical solutions how to handle a potentially large number of employees becoming shareholders with generally participation, voting and information rights. Warehouse entities in which employees will have to be pooled will be one of the likely reactions, other alternatives may include specifically designed share classes with potentially restricted shareholder rights.
”Conversion” of an existing VSOP into an ESOP?
If a VSOP has already been established in a company, it can be converted into an ESOP. However, the change of the legal framework of the employee participation only makes sense if the options will exercisable by the beneficiary generally irrespective of the occurrence of an exit event. If shares are issued under a “converted” ESOP, the relevant point in time for the income tax of the issued shares, will be the time of the share issuance, but not the issuance of a (virtual) option or shares under the (previous) ESOP. Another question is whether a VSOP can be “converted” into real shares. In principle, this is possible. The value of the shares at the time of the issuance would again be taxed as income, which may be deferred until the earlier if (i) the lapse of 15 years or (ii) an exit. The future increase in value could be realised at the lower capital gains tax rate. The prerequisite is that the “conversion” to an ESOP programme is not seen as a realisation of the VSOP; this may need to be clarified with the tax authorities. It should also be noted that the utilisation of an individual holding company to hold the employee participation is not yet possible. The law does not provide for such optimisations.