In a decision dated 25 August 2010 (I R 103/09) concerning the tax treatment of stock options, the Federal Fiscal Court (Bundesfinanzhof, BFH) held that the gracious issue of stock options to employees by a stock corporation in connection with a stock option plan based on a conditional capital increase is to be treated tax neutrally at the time the options are granted.
The decision was based upon a case in which a listed German stock corporation conditionally increased its nominal capital by issuing registered no-par shares (conditional capital increase pursuant to Sec. 192 (2) No. 3 Stock Corporation Act (SCA)). Exclusive beneficiaries were board members, managing directors and other employees of the corporation and other related entities. The issuing of the subscription rights was subject to further conditions such as the development of the stock values. The subscription price at execution was supposed to be 50% of the average market price of the stocks.
The stock corporation issuing the stock options has treated the granting of the subscription rights in its financial statements as personnel expenses by portioning the total value of the granted options evenly throughout the waiting period until the execution of the subscription rights and has booked correspondingly an increase of the capital reserves.
The tax office did not accept such treatment for tax purposes and the BFH followed the opinion of the tax office.
According to the opinion of the BFH, the gracious granting of subscription rights does not qualify as a contribution by the shareholders or the beneficiaries under the option plan because it is not comparable to an agio in the case of the issuance of option loans. The BFH followed a view in tax literature according to which such transactions shall be treated tax neutrally at the level of the stock corporation. The issuance of stock options does, according to the BFH, not result in a financial loss of the corporation itself but only in a financial loss of the existing shareholders in terms of the dilution of the stocks’ value. This financial loss does not impact, according to the BFH, the financial results of the stock corporation issuing the subscription rights and is hence not to be qualified as tax deductible expenses.
The decision of the BFH is contrary to some views in tax literature according to which the granting of subscription rights is to be treated as tax deductible personnel expenses and as an increase of the capital reserves. The BFH held that an increase of the capital reserves pursuant to Sec. 272 (2) No. 2 Code of Commercial Law (CCL) requires that an agio or any other consideration is made to the corporation. The approval of the majority of the shareholders in the shareholders’ meeting to a disadvantageous measure (the dilution of the value of their stocks) may not be considered as a contribution to the corporation. In addition, according to the opinion of the BFH, it is not possible to argue that the existing shareholders receive a compensation for that dilution in form of an obligation of the employees receiving the stock options which, under certain circumstances, may be contributed into the corporation. According to Sec. 27 (2) HS 2 SCA, which is in line with the restrictions pursuant to Sec. 4 (1) s. 1 Income Tax Act (ITA), service obligations may not qualify as contributions. In addition, future services of employees could not be reflected as assets in the financial statements by lack of any claim of the corporation for such services. A waiver of the employees’ remunerations, however, was not given in the case at hand.
The BFH also refused another opinion in German tax literature according to which the issuance of stock options shall be reflected as an accrual for future liabilities. The BFH held that the execution of the subscription rights depends on the future development of the company and a remuneration for services already rendered by the employees which, under certain circumstances, could result in such an accrual, was not given. Even though extraordinary services may have been rendered in the past by the employees, such services would not have resulted in an obligation of the corporation.
The BFH also refused the argument of the complainant that the alleged treatment was in line with IRS and IFRS and held that such standards were not decisive for the determination of taxable income.
The decision of the BFH has provided clarity with respect to the treatment of the gracious granting of stock options to employees for accounting and tax purposes.
Companies considering a participation of their employees in the development of the stock price will increasingly consider not to use typical stock options by creating conditional capital but replacing such options at least partly by a virtual (cash settled) participation of the employees in order to achieve tax deductibility.