Employee participation proceeds may be considered as income from employment, income from business operations or as capital income. Given that the virtual participation is made available to the employee for his or her labour as a wage or wage surrogate , these are regularly classified as income from employment. From a tax point of view, therefore, participation programmes should be designed in such a way that no income tax is payable on the granting or successive vesting of the virtual stock options. An ordinary employee would not be able to bear the tax burden due to a lack of cash available.
On the other hand, a genuine participation in a German law limited liability company GmbH transferred to an employee free of charge or at a reduced price would lead to an increase in assets and trigger taxes at the time of the share transfer.
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The virtual investment should therefore not be too closely based on a genuine GmbH investment. Otherwise, depending on the contractual structure, the virtual employee may be liable for income tax at the time it is granted, i. The tax situation should in any case be assessed carefully for each virtual participation programme.
It is important to prevent the ESOP from significantly increasing the current social security obligation and resulting in the contributions from the employer and employee not being paid correctly. The risks from the tax and social insurance area do not only affect the employee involved increased, possibly unnoticed burdens , but can also affect the employee's social security contributions and may cause significant penalty payments for the company and the employee and even cause criminal prosecution if left unchecked.
In most German law employee participation agreements, employees are not granted the full amount of the promised participation immediately upon conclusion of the agreement. They earn the participation in a staggered manner "vesting" - after a so-called waiting period "cliff" - within a savings period of regularly up to five years "vesting period".
The vested shares generally will expire if the employment or management service relationship between the employee and the company is terminated due to circumstances for which the employee is "responsible", i. Should an expiration clause be applicable, a premium payment is excluded, i. In Germany, too narrow and one-sided clauses catering mostly to the interest of the company may be open to challenge under labour law or general GTC law.
In most cases, the virtual participant of a young company is denied protection against dilution anti-dilution in certain capital measures, so that investors can be taken up in later financing rounds without obstacles, e. Besides the risk of dilution posed by capital measure, it is also in the best interest of the employee to consider carefully to what extent investors have been granted protection from down-rounds in the event of a decline in company value and at what fixed price they may be entitled to take over participations in future financing rounds at a discount, e.
If an exit event occurs, under German law the employee receives a payment claim under the law of obligations against the company. The amount of the premium payment due is determined by a formula defined in the contract and usually will be linked to the total amount of consideration received in the course of the exit. In practice, it is common that the so-called liquidation proceeds of one or more shareholders and financial investors are first deducted from the exit proceeds e.
Special regulations are often found for partial company sales. Some German law participation programmes give the company the opportunity to buy back vested virtual shares if an exit event occurs. A company can then buy the invested virtual shares from an employee before the exit actually happens utilizing a one-sided re-purchase right i. Virtual participation agreements are a useful instrument for young companies and qualified employees alike, if the necessary transparency and balance of interests between all participants is ensured.
Generally, financial investors tend to be keen to secure their own interests as thoroughly as possible. This may, however, easily lead to imbalances in the design of employee programmes and may in the end pose the risk that a German court may hold parts of the agreement to violate the law due to the imbalance created. It should be taken into account that under German law, an employee participation scheme will usually be considered general terms and conditions and thus be subject to the rather rigorous fairness and balancing tests applied in this regard.
It has already been pointed out that virtual participation programmes are not the same as a real equity participation. The protection of minorities, which is a key factor in German corporate law, especially regarding the German limited liability company GmbH , therefore does not apply to virtual participation agreements. Thus, a certain level of protection must be established in the programs in the interest of the employees on a contractual level.
One important aspect in this regard is to include a minimum level of control and, especially so, information rights in order to create a level of transparency in line with German law. The purpose of the participation agreement is to ensure that the employee is incentivized as an entrepreneur would be incentivized. The employee also assumes corresponding risks with his or her commitment. The requirement of fairness stipulated by German law means that the virtual participant is provided with all required information regarding opportunities and risks involved.
In particular, non-transparent revenue and liquidation preferences in favour of investors and former shareholders must not place employees at too great a financial disadvantage. In contrast to shareholder agreements and participation agreements in connection with the accession of VC financial investors, many virtual share option plans VSOP, also called employee share option plan, ESOP only provide for abstract preferential rights of investors and shareholders which are not comprehensible to the employee and which may reduce the potential amounts payable to the employee in case of an exit event considerably.
Transparency has to be ensured in a German law participation agreement in regards to what amount of transaction costs, fees, taxes and other items may reduce the employee's total consideration in the event of an exit. It must also be clear to the virtual participant whether a liquidation preference may lead to an additional financial penalty.
It should be noted that participation agreements in Germany may, on the basis of labour law and general terms and conditions law, be prone to legal challenge if they are overly favourable for equity investors as compared to virtual participants or lack a certain amount of transparency required under German law. Balanced contract structures that take into account the interests of all parties involved prevent expensive disputes and court proceedings. For a non-binding enquiry, please contact one of our senior attorneys directly via phone or e-mail or the contact form at the bottom of this page.
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We will get back to you shortly. I consent to the processing of my data pursuant to the data protection statement para. My data will be required for processing my query and will not be forwarded to third parties. Areas of Application of Virtual Participation Programs Virtual participation programs are particularly common in the startup ecosystem. What is the basic structure of virtual investments? Tax treatment of virtual participations Since virtual participations are a form of employee remuneration, questions may arise in connection with the correct tax classification.
Typical contractual mechanisms: Key points to be taken into account In most German law employee participation agreements, employees are not granted the full amount of the promised participation immediately upon conclusion of the agreement. This relief is granted for shares of the employing company and of the parent company controlling and consolidating its subsidiary.
A favourable tax rate may apply if the period between grant and exercise exceeds 12 months and if the employee is employed with the granting company at least for the first 12 months of this period. Tax on net income from professional activities or from carrying on a trade or business is collected by assessment.
Quarterly instalments might be assessed on an estimated basis and credited against the final income tax burden. Capital gains from financial investments e. Capital gains qualify for the 'investor's allowance' of EUR per taxpayer and year for the total of all financial investment income, but related expenses cannot be deducted. This amount is doubled in the case of married taxpayers filing jointly. Other capital gains are taxable in Germany at individual progressive rates only if the sale is within one year for movable assets or ten years for real property after the purchase date.
These capital gains are only taxable if the profit exceeds EUR per year in total.
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Further tax relief may be applicable under specific conditions if the property was used for private purposes. Dividend income qualifies for the annual investor's allowance of EUR per taxpayer for the total of all financial investment income, whereas related expenses cannot be deducted. Interest income qualifies for the annual investor's allowance of EUR per tax payer for the total of all financial investment income , whereas related expenses cannot be deducted.
Note that the investor's allowance is only provided one time for the total of interest and dividend income and capital gains.
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Rents received less allowable expenses form part of taxable income. Under treaty provisions rental income from sources abroad is mostly exempt. Employment income connected to special construction, engineering, or consulting work outside Germany, lasting at least three months, might be exempt if:. Your message has been sent. Your message was not sent. Please try again.
Taxation of Stock Option Plans in Germany
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