German Federal Fiscal Court allows employee to steer timing of taxation to reduce tax burden on stock option gains
A recent German Federal Fiscal Court decision has opened the door to optimizing the tax treatment of stock options for employees. Applying the principles of the court decision, employees may steer the timing of taxation to significantly reduce any tax burden arising in respect of stock option gains.
Generally, German employees are deemed to receive employment income upon the exercise or similar disposal of a stock option. Income tax at personal tax rates between 14 percent and 45 percent (plus solidarity surcharge and, if applicable, church tax) is payable on the difference between (i) the amount paid by the employee to exercise the option and (ii) the fair market value (FMV) of the underlying shares, calculated at the date the shares are booked into the account of the employee (the option gain). In addition, the employer and the employee must pay social security contributions on the option gain, up to certain ceilings specified by German social security laws. Therefore, as an example, the total income tax and social security burden of employment income in the amount of €40,000 is approximately 40 percent.
Facts of the Case
In the underlying case, the employee was granted 15,000 stock options in 2002. Shortly after the grant of the stock options, the employee sold the options to a German limited liability company (the Company) which he fully owned. The options were sold at a price well below the then current FMV. The Company was not incorporated in connection with the stock option grant and did not have as its sole purpose the holding of stock options. The Company exercised the options in 2004; at this time, the FMV of the options had increased by a factor of nine. The German tax authorities and the local tax court took the view that the employee was subject to wage tax and social security contributions in 2004 on the nine-fold increase in value.
The German Federal Fiscal Court rejected the view of the German tax authorities and the local tax court, deciding that the “disposal” which crystalized the employment income tax charge occurred at the time of the employee’s transfer of the stock options to the Company in 2002. At that time, the FMV of the shares had only increased by a factor of two, which led to a significantly lower taxable amount.
The Company’s exercise of the stock option did not lead to further employment income, nor did it constitute any other type of taxable event for the employee. In particular, the German Federal Fiscal Court declared that the sale of the options to the Company did not constitute an abuse of rights, as the Company was not incorporated in connection with the stock option grant and did not have as its sole purpose the holding of the stock options.
The judgment and reasoning by the German Federal Fiscal Court was consistent with the court’s principles that a transfer of stock options is viewed as a disposal and therefore leads to employment income at the time of the transfer. Interestingly (and logically), even a transfer of options at well below the shares’ FMV to a company fully owned by the employee (i.e., a hidden contribution to the company) is regarded as a disposal and does not constitute an abuse of rights. The main practical implications are twofold:
- Timing: The German Federal Fiscal Court’s decision grants flexibility to the employees with respect to the timing of the taxation of employment income. Through the sale of the stock options to a fully owned company, the employee may trigger wage tax at an early stage when the shares’ FMV is low and therefore the “tax base” (i.e., the margin between the share price upon exercise and the exercise price) is lower. A subsequent increase in value will not be subject to wage tax. Consequently, the greater the increase in the shares’ value after the transfer of the options to the company, the higher the tax saving.
- Overall tax rate: In addition, by transferring the options to a fully owned company, employees may benefit from lower tax rates. Where an employee holds stock options, the option gain is taxed at the personal tax rate of the employee (i.e., often 40 percent or more) and the subsequent sale of the shares is subject to a flat tax rate of 25 percent (plus solidarity surcharge and, if applicable, church tax). In contrast, holding the options via a corporation leads to a tax burden of only 30–35 percent, as (i) the capital gain resulting from a sale of the shares is subject to a 95 percent tax exemption for corporate income tax purposes and (ii) the employee benefits from the partial income taxation regime for dividends distributed by the corporation (i.e., only 60 percent of the dividend is subject to tax). This case therefore opens up opportunities for tax structuring of employee options that could give rise to significant tax savings and make the participation in stock option programs even more attractive to employees.