ESOP – A model for profit sharing in a startup

a) Founder

As shareholders, the founders are most interested in the increase in value of their shares. You run the risk that the subscription to the ESOP will be attributed to you personally as a hidden profit distribution (vGA). According to case law, this includes all transfers of assets that are caused by the partnership relationship if a prudent and conscientious manager would not have granted the advantage to a person who is not a partner. A vGA does not necessarily mean that the shareholder receives money. In vGA cases, however, the GmbH must pay capital gains tax of 25% + SolZ to the tax office. The expenses or However, the addition to the ESOP provision is not counted as a gross dividend but as a net dividend. The effective tax borne personally by the shareholders is almost 36% of the ESOP value. This can and should be avoided through proper design.

To the extent that the shareholder incurs the expenses in order to increase the (taxable) proceeds from the sale of his shares, the expenses represent business-related costs in the income from capital assets. However, business-related costs may not be deducted if the tax on the capital gains is to be settled with the withholding tax. But that is the rule. The income-related expense deduction would therefore be lost.

However, if the partner holds at least 25% of the capital company, or at least 1% if the partner works professionally for the corporation, he or she can submit an application to be admitted to the partial income procedure instead of the withholding tax. The taxable profit must then be determined from the difference between the proceeds and the acquisition costs of the shares. The advertising costs and thus also the shareholder's performance must be credited to the ESOP. The remaining amount is subject to individual income tax at 60% of its value for shareholders resident in Germany. The application is then valid for this and the following four assessment periods. The application requirements only need to be proven in the first year. The application can be revoked within the 5-year period, but no new application is possible after the revocation.

The bottom line, however, is that the withholding tax, which is more favorable when the income is accumulated in the year of sale, does not apply and you only have 60% of your expenses on the ESOP tax deductible anyway. You will also be personally excluded from the application of the withholding tax in the following four years. This is an additional disadvantage when the proceeds from the sale are reinvested.

If the ESOP is agreed when the company already represents a certain value, then the pro rata value is taxed as a transfer of assets or as current income at the time of subscription.

But the choice between plague and cholera cannot be the goal. Therefore, it should be avoided as much as possible that the shareholders end up in the situation of having to service the ESOP from their sales proceeds.

If the founders are not a natural person or partnership (e.g. OHG or GmbH & Co KG), but are themselves a capital company, then their dividends and the capital gains they receive are largely tax-exempt according to Section 8b KStG.

Shareholders resident abroad, whether natural persons or companies, must determine and tax taxable income in accordance with the national law applicable there.

Due to the different legal consequences for the shareholders and co-obligors of an ESOP, no blanket recommendation can be made as to what is best practice, i.e. what is most advantageous for everyone involved. After examining the factual and legal situation, a balanced solution may have to be found for everyone, which may not reflect every individual interest in the best possible way.

b) Society

The purpose of an ESOP is to provide a benefit to the employee. If the virtual share in the company already has a certain value at the time of subscription and is also marketable, the employee must tax this value as wages. The wage tax has to be paid by the company, which puts a strain on liquidity. This can quickly run into the hundreds of thousands. It is therefore important to ensure that the tax-triggering moments are taken into account and immediate taxation is avoided.

The claim of those entitled to an ESOP is directed against the company, hereinafter referred to as GmbH. The GmbH must disclose this obligation in its annual financial statements. The initial creation, as well as the subsequent additions or reductions to the provision, must also be recorded in profit or loss with tax effect. If the start-up is already in the profit phase, the contributions can become tax-effective, meaning the taxable income will be lower. However, within the framework of Section 248 Paragraph 2 of the German Commercial Code (HGB), it is also possible not to book the additions at the expense of the commercial and tax results, but rather to book the expenses as production costs of an intangible asset (IP = intellectual property) and then this value depreciated for tax purposes from the time the IP is used. With this right to choose, German commercial law comes closer to international standards. According to IFRS, the capitalization of research and development services on IPs is mandatory. If a self-created intangible asset is capitalized based on the option in Section 248 of the German Commercial Code (HGB), the development costs must also be included, while research costs must always be treated as expenses.

If the activity of the ESOP beneficiary is aimed directly at the development of a product (“hardware”), there is no right to choose. Then his salary and thus also the addition to “his” pro rata provision must be capitalized.

If the GmbH does not have the means to fulfill the ESOP itself and it receives the funds, for example as part of the sale of shares from the shareholders (from their taxed income), the infusion of funds are, depending on the payer, either loans and therefore liabilities or deposits, to book equity capital. If the money comes from non-shareholders, such as obliged related companies or pure investors, you will have to check whether loans were granted (tax-neutral) or whether there was a gift. Then gift tax could apply. If customers, which can also include related companies, co-finance the ESOP out of their own sales interests, then the infusion of funds could also be assigned to the exchange of services and thus become relevant for VAT and income tax purposes.

c) Employees in Germany

In the case of pure stock options, the tax authorities and jurisprudence have so far assumed that taxation only takes place at the time the options are exercised at the then valid value. It is therefore largely agreed that stock options are taxable as income from employment and that the increase in value from the time of commitment is not taxed as a sale of shares - which would often be cheaper. Consequently, final taxation, ie taxation when the options are actually exercised, is practiced.

According to the BFH, however, an inflow can already exist when the options are granted, provided that the option right itself is marketable, i.e. the employees can also sell the rights. This is because an inflow takes place within the scope of the excess income of the EStG through obtaining economic control. Income is deemed to have been received at the point in time at which the recipient has or can dispose of it economically. The existence of the possibility of sale is sufficient for the inflow of the monetary benefit from real or fake “stock options”.

From the time of the tax inflow, at the latest from the exercise of the option right, the increase in value is no longer taxed as employment income, but rather as capital income upon sale.

From the time of the tax inflow, at the latest from the exercise of the option right, the increase in value is no longer taxed as employment income, but rather as capital income upon sale. This was recently confirmed by the BFH in its judgment of October 4.10.2016, 43 - IX R15/25.1.2017, published on January XNUMX, XNUMX

d) Employees with international assignments

ESOPs are often offered to employees who contribute to success through a stay abroad, for example by being posted to a foreign affiliated company. If the activity associated with the ESOP is physically carried out in other countries, it must be checked according to the criteria of the respective double taxation agreement which country has the right to tax which partial amount. According to most agreements, Germany must then exempt the part taxed abroad.

The BMF letter of November 12.11.2014, XNUMX on the taxation of wages according to the double taxation agreements represents the view of the German tax administration, which is not entirely the correct one and is also not internationally coordinated with the contracting countries.

The domestic exemption is only granted to people who are subject to unlimited tax liability in Germany at the time of exercise (usually upon exit) if they can prove that they have been taxed abroad or can prove that they have disclosed the income to the responsible tax authorities, but the latter can see it Eyes have waived taxation. This results from Section 52d Paragraph 9 EStG. Beneficiaries who are no longer living in Germany at the time of exercise are not subject to unlimited tax liability, but may only be subject to limited tax liability. You can be taxed on the proceeds from the ESOP in accordance with Section 49 Paragraph 1 No. 4 EStG in Germany (proportionally if necessary, see above) if and to the extent that the proceeds are attributable to the physical exercise of work.

If the source of income is not in Germany at the time of exercise, for example because the company has a different tax residence in the meantime, the limited tax liability in Germany is excluded. The obligation to provide proof of taxation abroad does not apply to those subject to limited tax liability.

e) Employees in Switzerland

The taxation of employee shareholdings in Switzerland is regulated in the circular dated July 22, 2013. This is about real employee participation, which ultimately gives employees a share in the employer's equity. So not like in the typical ESOP, according to which the employee participates in the proceeds from the sale of shareholders and/or in the proceeds from the sale of the employer's shares in its subsidiary. Employee shares within the meaning of this circular are shares of the employer or related companies, which are generally transferred to the employee by his employer on preferential terms due to his employment relationship.

ESOPs are equity or share price-related incentive systems, which ultimately do not offer the employee a participation in the employer's equity, but usually only a cash benefit, which is definitely treated differently depending on the performance of the underlying security. Because these instruments do not generally grant employees any further rights such as voting and dividend rights, the fake employee shareholdings are considered mere entitlements for tax purposes until they are realized. This means that in Switzerland too, taxation only occurs when the option right is exercised or when the value is received.

f) Design variant: exercise & sell

The taxation only at the time of exercising the right can also be changed in such a way that, for example, the marketability of the ESOP is intentionally established at the time of subscription (exercise & sell) and thus immediate taxation occurs. If the values ​​are low, that's manageable. According to these principles, exercise can also take place at any later point in time. Exercising the option is taxable as wages. However, wages are to be treated as remuneration for an activity lasting several years if the activity extends over at least two assessment periods and covers a period of more than twelve months. According to Section 34 EStG, such income is to be taxed preferentially using the so-called fifth rule (BFH 19.12.06/136/01, VI R 18.12.07/62). This gentle taxation can also be claimed multiple times and in stages if the employee has been repeatedly granted stock option rights and has not exercised the respective option to the full extent. BFH (December 05, XNUMX, VI R XNUMX/XNUMX).

The other tax consequences are then the same as with an equity program, in which those entitled are usually allowed to purchase shares immediately or later at reduced prices. If appropriately structured, the further increase in value is no longer subject to taxation as wages. Instead, when the right is exercised, i.e. at the exit, the increase in value is taxed as part of capital income. The country of residence is responsible for this. If the beneficiary lives in Germany at the time of exercise, this will usually be settled with the withholding tax. If he lives in another country, the laws there apply.

However, those entitled must be careful when moving from Germany to another country. The so-called exit taxation of Section 6 AStG taxes the increase in value resulting from the change of residence to another country as a fictitious sale. Further performance is subject to the tax law of the new country of residence.