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From ESOP to EIP: Navigating Germany's Changing Tax Landscape for Employee Benefits

Legal Know-How
January 23, 2024

Introduction

 

Are you baffled by the barrage of acronyms like ESOP, VSOP, EIP, and the latest changes in Germany's employee benefit taxation laws? Feeling lost in the labyrinth of legal lingo? You're not alone! Our comprehensive guide is here to shine a light through the maze and clarify how these changes can benefit both you and your employees. Stay tuned as we unravel the complexities of employee incentive schemes and guide you towards leveraging these new opportunities.

 

Content:

 

1.     What is the status quo with respect to ESOPs and VSOPs

2.     What changes now

3.     What do you have to do to benefit from the changes?

 

 

1.     What is the status quo with respect to ESOPs and VSOPs

Till now there was one big problem in Germany when it came to employee participation. It even has its own name amongst lawyers: the “Dry-income”-Problem. To understand, why we issue ESOPs or VSOPs in Germany you only need to understand this. We try to keep it as simple as possible:

 To understand the rationale behind issuing ESOPs (Employee Stock Ownership Plans) or VSOPs (Virtual Stock Option Plans) in Germany, it's crucial to grasp the differences between income tax and capital gains tax. Income tax rates can soar up to 50%, whereas capital gains are taxed at a more manageable 25% for natural persons. The implication? A staggering 50% tax saving could be achieved by employees holding real shares in the company.

 Under previous laws, when employees received actual shares, the current value was immediately taxable as income – despite no actual cash flow. This led to a 'dry taxable income' situation, nudging companies towards alternative participation methods like real or virtual option programs. These programs offered future share acquisition options or bonus entitlements, delaying tax liability until actual monetary gain. However, this also meant facing higher income tax rates upon exit, rather than the more favorable capital gains tax rates. This situation was a complex puzzle for employees, but recent legislative changes have transformed the landscape.

 This is a problem that was previously impossible for employees to solve.This has now been changed by the Future Financing Act.

 

2.     What changes now

 The Future Financing Act (Zukunftsfinanzierungsgesetz) represents a significant shift in the taxation of employee shares in Germany. Thislegislative change was largely driven by the lobbying efforts of startup founders, investors, and the prestigious German startup association. Their goal? To make the taxation system fairer and allow employees to enjoy the benefits of capital gains taxation and by this to increase the chances ofGerman companies to win employees in the global war for talent.

 The Future Financing Act fundamentally changes the taxation landscape for employee shares. For companies falling under the requirements of this new legislation, the income tax on shares issued to employees is deferred until the actual sale of these shares. This means employees can now receive real shares without the immediate burden of income taxation. This change aligns the tax event with the actual receipt of cash, enabling companies to finally issue real shares to employees and by this enabling them to benefit from capital gains taxation.

 

3.     What do you have to do to benefit from the changes

 

But you must be careful. It is a common misunderstanding in German startups that all ESOPs or even VSOPs benefit from the new taxation. This is not the case! To fall under the benefits of the new legislation, companies need to transition to a new form of employee incentivation: the Employee IncentiveProgram (EIP). EIPs differ fundamentally from ESOPs and VSOPs as they involve issuing real shares to employees. This shift necessitates a reevaluation and restructuring of existing incentive schemes.

This leads to one concern often voiced by companies, the potential complication of their capitalization table (cap table) with numerous employees as shareholders. However, this can be elegantly addressed within the framework of a well-structured EIP.

 By pooling employees in a separate entity, companies can avoid direct entries on their cap table, maintaining a clean and straightforward shareholder structure. This approach not only complies with the new legislation but also preserves the organizational integrity of the company and avoids voting rights of employees.

 

Adopting an EIP requires careful planning and execution. It involves understanding the legal nuances, aligning with tax regulations, and communicating effectively with employees to ensure they are aware of and understand the benefits and implications of the new scheme. It's a transformative process, but one that can yield substantial rewards in terms of employee motivation, retention, and alignment with company goals.

 

If you are interested to learn more about the new EIP you can explore our dedicated EIP page.  

 

In our upcoming series of articles, we will explore in detail the process of setting up an EIP.

Janina Möllmann

CEO @ GAIA

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