Many companies offer equity incentives to their employees in Germany and they are becoming increasingly popular as an important source of income for employees. In Germany, such incentives are typically discounted or free stock options or, as the case may be, shares in the employing company or in another group company. The granting of such incentives are not without issue however – in addition to areas such as the tax deductibility of financing the grant of these incentives, as recently decided upon by the German Federal Fiscal Court (Bundesfinanzhof) (see below), specific tax issues in Germany will arise at the level of the employer as well as the employees, which should be borne in mind when planning to provide such incentives for German employees. The following serves as a reminder of some of these particular tax issues, assuming that the beneficiary is an employee resident in Germany.
General income tax principles
All employees resident in Germany must pay tax on their income in accordance with German tax law. An individual's taxable income is taxed progressively depending on their level of income, starting at a 14% tax rate and increasing up to a 42% tax rate, for taxable income above EUR 52,882 (2010) (EUR 105,764 for married couples, having opted for joint returns). A 45% rate then applies for taxable income exceeding EUR 250,731 / EUR 501,462 (single persons/married couples with joint returns). Additionally, a "solidarity surcharge" is payable based on the individual's normal income tax rate (5.5% of the tax rate). The individual's income tax-free amount is EUR 8,004 and twice that amount for married couples. Church tax may apply for church members. Finally it should be noted that German income tax law offers important deductions and benefits sometimes unknown in other countries, e.g. the "double household" benefit.
Generally, an employer in Germany is obliged to withhold monthly income tax pre-payments ("wage tax") and to transfer such prepayments to the German tax authorities. The employer is liable vis-à-vis the tax authorities if he fails to comply with that tax obligation. The employer is also obliged to meet this wage tax obligation where a taxable benefit is granted by a group company of the employer.
These prepayments can be credited by the employee against his/her personal income tax payable at the end of each calendar year in their respective tax return.
The assessment base for income taxation, as well as the employer's wage tax liability, includes not only cash payments, but also contributions in kind, such as shares in the employing company or in a related party of the employing company.
Characteristics of stock options and stock option plans
A discounted (or free) stock option is a right to acquire shares at a price representing a discount to the market value of such shares on the date such right is granted, and such discount may be as much as 100%, so that there is no exercise price to pay at all. However, there would still be an exercise process. Typically, these stock options are not transferable.
A stock option plan may have complete flexibility surrounding exercise and lapsing criteria and vesting or performance conditions in relation to the exercise of discounted stock options. Such vesting and performance conditions may be time based or relate to corporate or individual performance. The option may be granted over unissued shares or issued shares and may be granted by a company in the employing group or a third party (for example, an employee benefit trust).
Additionally, the stock options may be granted to such employees as the employer (or other entity granting the option) may decide in its discretion. It does not have to be offered to all employees, or to all employees of a certain description.
Income taxation of a stock option
Normally, the grant of a stock option should not be a taxable event at the level of the employee in Germany.
However, income and wage tax would arise on the subsequent exercise by an employee of a stock option (whether granted by a German employer company or a related foreign company), calculated on the difference between the fair market value of the shares on the date of exercise and the exercise price (if any). Church tax may apply for members of certain German churches and would have to be withheld at source, according to local legislation.
Once the shares have been acquired on exercise, the general position is that any gain on a future disposal of such shares, which gain would be calculated on the difference between the fair market value of the shares on exercise and their value at the time of sale, would be subject to income tax at a flat tax rate of 25% (plus the solidarity surcharge).
However, this general position is subject to the following: (i) the 25% rate does not apply in certain anti-abuse scenarios; (ii) German residents who are subject to a lower normal income tax rate may file for the application of that tax rate to the gain instead; and (iii) if the employee holds 1% or more of the share capital of the company, 60% of their capital gain will be subject to tax at their normal income tax rate, rather than at the flat rate.
Tax obligations of the employer
The employer would be obliged to withhold the employee's wage taxes on the difference between the fair market value of the shares issued and the exercise price paid by the employee (if any). Furthermore, where the granting company is not the employing company, the employing company would need to ensure it is informed about the issue of shares to German employees in a timely manner in order to be able to meet its German withholding tax obligations.
Tax deductibility issues
The Bundesfinanzhof has recently clarified (FN1) that the capital costs of granting free share options to employees based on a contingent increase of the share capital of a German company do not qualify for a tax deduction at the level of the Germany employing company, which could otherwise apply for alternative ways of financing. The Court held that it is the company's shareholders that incur the capital cost, via a dilution of their existing shareholdings, and that the German company does not actually incur and cannot be deemed to incur such costs.
Footnote (FN) 1: Case reference: Bundesfinanzhof, 25 August 2010, I R 103/09
Tax privileges for employees
There are very limited income tax exemptions in Germany. For example, if an incentive plan is open to all employees and offers additional benefits separate from the employee's salary, an income tax exemption of EUR 360 may be available to the employee. Employees with lower taxable income may claim further, additional tax allowances.
Other incentive plans may offer discounted or free shares to employees, instead of stock options. No restrictions may be imposed on the shares other than any which might be contained in the company's Articles of Association or any existing shareholder agreements. Some plans may provide for non-German instruments, such as Restricted Stock Units, although the German tax authorities do have difficulties in correctly classifying such instruments for German tax purposes.
While there is no taxable event on the grant of a stock option, there would be a taxable event at the time of award of discounted or free shares. The shares would be considered a contribution in kind and treated as deemed salary income at the time of the award, irrespective of a vesting period.
The income tax treatment of such award would then be similar to the tax treatment of the exercise of the discounted or free stock options, i.e. the employee's taxable income would be calculated based on the fair market value of the shares at the date of award less the price (if any) paid by the employee for such award. Any gain on a subsequent disposal of the shares would also similarly be treated for German tax purposes as the sale of shares acquired on the exercise of a stock option, i.e. the general position should apply that the sale would be subject to income tax at the flat rate of 25%, although the gain would be calculated on the difference between the fair market value of the shares at the date of award and their value at the time of sale.
The following is a comparison table of the income tax treatment for an employee of a stock option compared with the award of a free share.
Sample comparison calculation: stock option vs. free share - employee's tax burden
Click here to view the table.
Expatriates: Risk of double taxation
The above table does not take into account the position of employees who work and live in several jurisdictions and are engaged in cross-border activities for their employer. In these cases, an analysis would always be necessary to determine the risk (if any) of more than one country seeking to claim the right of taxation in respect of the employee's equity incentives and whether such risk can be dealt with by an applicable double tax convention with Germany.
The granting of such incentives (at the time of award or exercise) would normally trigger a social security liability of the employer and employee in Germany as well, subject to any social security ceiling. Social security contributions (if any) are split equally in Germany between an employer and employee and the employee's contribution would also be withheld by the employer.
Companies engaged in Germany should consider the structure of any equity incentive plan carefully from a tax perspective, particularly to ensure that potential wage tax liabilities are properly observed.